International Economics II Lecture Notes 5

International Economics II
Lecture Notes 5
Alper Duman
July 16, 2009
Alper Duman
International Economics II Lecture Notes 5
The Monetary and Portfolio Approaches to External
Balance
I
The monetary approach to the balance of payments means
that the balance of payments should be analyzed in terms of a
country’s supply of and demand for money.
I
If a country has a BOP deficit (an official reserve transaction
deficit) then there is an outflow of international reserve assets.
An outflow implies that country’s supply of money exceeds its
demand for money.
Alper Duman
International Economics II Lecture Notes 5
Ms = a(BR + C ) = a(DR + IR)
where:
Ms is money supply
BR is reserves of commercial banks
C is currency held by the nonbank public
a is the money multiplier
DR is the domestic reserves
IR is the international reserves
Alper Duman
International Economics II Lecture Notes 5
(1)
I
The money multiplier reflects the process of multiple
expansion of bank deposits, (1/r) where r is the reserve
requirment ratio
I
Monetary base is (BR + C). This is the liability side of the
central bank.
I
On the asset side there are (1) loans and security holdings
-domestic assets and (2) international reserves -FX and gold
Alper Duman
International Economics II Lecture Notes 5
The demand for money (L) can be specified as :
L = f (Y , P, i, W , E (p), O)
where:
Y is the level real income in the economy
P is the price level
i is the interest rate
W is the real wealth
E (p) is the expected percentage change in the price level
O specifies all other variables
Alper Duman
International Economics II Lecture Notes 5
(2)
I
Equation 2 can be written as
L = kPY
(3)
where k is a constant embodying all other variables
I
The equilibrium implies
Ms = L
(4)
or
Ms = a(BR + C ) = a(DR + IR) = L = f (Y , P, i, W , E (p), O)
(5)
Alper Duman
International Economics II Lecture Notes 5
The effects of excess money supply (excess cash balances) will be
I
A rise in P, Y and W will worsen current account.
I
Purchase of domestic bonds will dampen the interest rate and
due to portfolio diversification there will be acquisition of
foreign financial assets. Both will lead to a capital outflow
and a tendency for a deficit to occur in the private account.
I
The country will face BOP deficit (official reserve transaction
balance deficit). That requires a decrease in IR (credit).
I
The decrease in IR will decrease Money Supply
I
Thus the conclusion of the monetary approach is is that
markets are self-adjusting
Alper Duman
International Economics II Lecture Notes 5
Define exchange rate e as
e = PA /PB
(6)
Remember equation MsA = kA PA YA and use the similar equation
for country B to obtain
e=
kB YB MsA
kA YA MsB
Alper Duman
International Economics II Lecture Notes 5
(7)