1. LECTURE 9: The Monetary Approach to the Balance of Payments
Sterilization definitions
Price-specie flow mechanism
Income-money flow mechanism
Brief history of the Gold Standard
Appendix: China sterilizes inflows,
ITF Prof.J.Frankel

2. The Monetary Approach to the Balance of Payments (MABP)
Defining assumption: Reserve flows are not sterilized.
Another assumption sometimes associated with MABP: Goods prices are flexible => PPP holds.
ITF Prof.J.Frankel

3. Definitions:
Monetary Base: Liabilities of CB  assets held by CB MB  Res + NDA where Res ≡ International Reserves & NDA ≡ Net Domestic Assets
Broad Money Supply (M1): Liabilities of entire banking system
M1 = a multiple of MB <= fractional reserve banking
Sterilization:
Changes in reserves (i.e., BP) offset by NDA , D NDA = - DR, so MB unchanged.
Non-sterilization: D MB = DR.
ITF Prof.J.Frankel

4. David Hume’s Price Specie-Flow Mechanism
Initially, Spain piles up gold, from the New World (mercantilism).
But if England has a more productive economy (Industrial Revolution),
its demand for money will be higher, in proportion to its higher GDP.
If the economies are closed off, the disproportionately
high money supply in Spain will drive up its price level.
ITF Prof.J.Frankel

5. Hume’s Price Specie-Flow Mechanism
continued
If trade is open, then money flows to England
(Spain runs a balance of payments deficit),
until prices are equalized internationally.
ITF Prof.J.Frankel

6. Mundell’s Income-Flow Mechanism
MB↑ => M1 ↑ => (via i ↓ => I ↑) => A ↑ => Y ↑
But A ↑ => TB<0
=> Res then falling gradually over time
+ nonsterilization
MB falling over time
A falling over time.
In the long run, TB=0 and everything is back to where it was.
ITF Prof.J.Frankel

7. Mundell’s Income-Flow Mechanism, continued A Monetary Expansion, and Its AftermathLM IS
NS-I´
LM´ TB Y + -
NS-I
As long as BP<0, reserves continue to flow out, i rises, and spending falls.
In the long run BP=0; we are back where we were before the monetary expansion.
ITF Prof.J.Frankel

8. Example: response to the 1994 tequila crisis
LM´ IS M A
Example: response to the 1994 tequila crisis
Mexico sterilized reserve outflows in 1994.
Stayed at point M, but ran out of reserves in December. . Y
Argentina was on a currency board => no sterilization.
In 1995 allowed reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A.
ITF Prof.J.Frankel

9. The Gold Standard
Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other).
Pros and Cons Pro: prevents excess money creation and inflation.
Cons:
prevents response to cyclical fluctuations
long-term drag on world economy, e.g., , no gold discoveries => prices fell 53% in US, 45% in UK.
ITF Prof.J.Frankel

10. Capsule History of the Gold Standard
1844 – Britain adopts full gold standard US restores gold convertibility.
From , the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices.
ill-fated UK return to gold <= misplaced faith in flexible prices.
Bretton Woods system, based on gold as the reserve asset de facto: based on $.
Start of US BoP deficits. <= European growth > US growth
Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $ . Solutions: raise price of gold, or create SDRs.
Nixon suspends convertibility & devalues.
ITF Prof.J.Frankel

11. Appendix -- Example of sterilizing money inflows: China, 2004-08 & 2010
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12. The Balance of Payments
≡ rate of change of foreign exchange reserves (largely $),
rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows
Reserves
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 12
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13. FX reserves of the PBoC climbed higher than any central bank in history
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14. Sterilization of foreign reserves: People’s Bank of China sold sterilization bills, thereby taking RMB out of circulation.
Data: CEIC Source: Zhang, 2011, Fig.4, p.45.
ITF Prof.J.Frankel

15. In 2003-04, forex inflows accelerated rapidly
In , forex inflows accelerated rapidly Initially, the PBoC had no trouble sterilizing the inflows.
=> The MB growth rate was kept down to the growth rate of the real economy (≈ 10%/year), so there was little inflationary pressure.
ITF Prof.J.Frankel

16. In 2007-08 China had more trouble sterilizing the reserve inflow
PBoC began to have to pay higher domestic interest rates
and to receive lower interest rate on US T bills
=> “quasi-fiscal deficit” or “negative carry.”
Inflation became a serious problem in
Also a “bubble” in the Shanghai stock market.
ITF Prof.J.Frankel

17. Money growth accelerated sharply, 2007-08
Sterilization faltered in 2007 & Growth of China’s monetary base & its components:
Money growth accelerated sharply,
Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008
ITF Prof.J.Frankel

18. China’s CPI accelerated in 2007-08
Inflation 1999 to 2008
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
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19. Sterilization of foreign reserves: Decreases in PBoC’s domestic assets offset increases in foreign assets
Source: Zhang, 2011, Fig.7, p.47.
ITF Prof.J.Frankel

20. China’s inflation broke sharply in 2009, (<= big one-year loss of China’s exports due to global recession),
But took off again in
Inflation 2001 to 2011
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21. Real Beijing land prices
After the interruption of mid-2008 to mid overheating resumed: rapid rise of land prices in 2010
Real Beijing land prices
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22. When house prices rise relative even to rents, that suggests a bubble or easy money
Scott Reeve blog
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23. China in 2010 resumed attempts to sterilize money inflows by raising banks’ reserve requirements -- to slow M1 growth even while MB is growing rapidly.
ITF Prof.J.Frankel