The monetary approach to BOP and exchange rate determination Concept and exemplification

The monetary approach Changes in BOP and exchange rates are monetary in essence These changes have little to do with exports, imports, real income, etc.

The money supply The money supply is a function of a nation’s monetary base: M = m(MB) = m(DC + FXR)

The money demand The money demand is a function of how much of the national income is held in cash. M d = k(P)(y)

Equilibrium The demand for money equals the supply of money k(P)(y) = m(DC + FXR)

Purchasing Power Parity Absolute PPP says that a Big Mac should cost the same C$amount, regardless of the country: P = s(P*) s = spot exchange rate P* = foreign price of goods and services

Equilibrium k(s)(P*)(y) = m(DC + FXR)

What happens under a fixed exchange rate arrangement? If DC is increased, the money supply outgrows demand: k(s)(P*)(y) < m(DC + FXR) Households and businesses would increase their purchase of goods and services from other countries. A current account deficit might result.

More... If DC is decreased, the money demand outgrows supply: k(s)(P*)(y) > m(DC + FXR) Households and businesses would decrease their purchase of goods and services from other countries. A current account surplus might result.

More…(fixed exchange rate arrangement) If the price of foreign goods, and/or real income increase, the money demand outgrows the supply k(s)(P*)(y) > m(DC + FXR) Households and businesses would decrease their purchase of goods and services from other countries. A current account surplus might result.

What happens under a floating exchange rate arrangement? If DC is increased, the money supply outgrows the demand Households and businesses would increase their purchase of goods and services from other countries. The domestic currency might depreciate. If DC is decreased, the money demand outgrows the supply Households and businesses would decrease their purchase of goods and services from other countries. The domestic currency might appreciate

More…(floating rate) If the price of foreign goods, and/or real income increase, the money demand outgrows the supply Households and businesses would decrease their purchase of goods and services, from other countries. The domestic currency might appreciate. If the price of foreign goods, and/or real income decrease, the money supply outgrows the demand. Households and businesses would increase their purchase of goods and services, some of them from other countries. The domestic currency might depreciate

A two-country example New Zealand M d NZ = k NZ (P NZ )(y NZ ) Australia M d A = k A (P A )(y A ) and P A = (s) P NZ

A two-country example It can be shown that: s = (M A /M NZ )(k NZ y NZ /k A y A )

A two-country example: Numbers Monetary base Australia: A$37,780 m New Zealand: NZ$10,091 m Money multiplier Australia: 2.22 New Zealand: 3.37 Money supply Australia: A$83,847 m New Zealand: NZ$34,050 m Nominal GDP Australia: A$473,390 m New Zealand: NZ$91,045 m Real GDP Australia: A$432,960 m New Zealand: NZ$79,269 m

A two-country example: Numbers s = (A$83,847/ NZ$34,050) [(0.374)(NZ$79,269)/(0.177)(A$432,960)] s = A$0.9526/NZ$

A two-country example: Numbers Assume the Australian money supply increases by 5%, to A$88,039 m The new spot rate, s = A$1.00/NZ$

The monetary approach: Summary relative increase depreciate A relative increase in a nation’s money supply causes its currency to depreciate relative decrease appreciate A relative decrease in a nation’s money supply causes its currency to appreciate

The monetary approach: Policy implications Sterilized foreign exchange interventions are totally ineffective because they leave the money supply unchanged

The monetary approach: Criticism Assumes absolute PPP holds. It is difficult to translate into a multi-country setting