The monetary approach to BOP and The monetary approach to BOP and

exchange rate determinationexchange rate determination

Concept and exemplificationConcept and exemplification

The monetary approachThe 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 supplyThe money supply

The money supply is a function of a nation’s monetary base:

M = m(MB) = m(DC + FXR)

The money demandThe money demand

The money demand is a function of how much of the national income is held in cash.

MMdd = k(P)(y) = k(P)(y)

EquilibriumEquilibrium

The demand for money equals the supply of money

k(P)(y) = m(DC + FXR)k(P)(y) = m(DC + FXR)

Purchasing Power ParityPurchasing Power Parity

Absolute PPP says that a Big Mac should cost the same C$amount, regardless of the country:

P = s(P*)P = s(P*)

s = spot exchange rate

P* = foreign price of goods and services

EquilibriumEquilibrium

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

What happens under a fixed exchange rate What happens under a fixed exchange rate arrangement?arrangement?

If DC is increased, the money supply outgrows demand:

k(s)(P*)(y) < m(DC + FXR)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...More...

If DC is decreased, the money demand outgrows supply:

k(s)(P*)(y) > m(DC + FXR)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)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)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 What happens under a floating exchange rate arrangement?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)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 exampleA two-country example

New Zealand

MdNZ = kNZ(PNZ)(yNZ)

Australia

MdA = kA(PA)(yA)

and

PA = (s) PNZ

A two-country exampleA two-country example

It can be shown that:

s = (Ms = (MAA/M/MNZNZ)(k)(kNZNZyyNZNZ/k/kAAyyAA))

A two-country example: NumbersA 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: NumbersA 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: NumbersA 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: SummaryThe monetary approach: Summary

A relative increaserelative increase in a nation’s money supply causes its currency to depreciatedepreciate

A relative decreaserelative decrease in a nation’s money supply causes its currency to appreciateappreciate

The monetary approach: Policy implicationsThe monetary approach: Policy implications

Sterilized foreign exchange interventions are totally ineffective because they leave the money supply unchanged

The monetary approach: CriticismThe monetary approach: Criticism

Assumes absolute PPP holds.

It is difficult to translate into a multi-country setting