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The Monetary Approach toThe Monetary Approach to
Balance-of-Payments andBalance-of-Payments and
Exchange-RateExchange-RateDeterminationDetermination
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Daniels and VanHoose Monetary Approach 2
Introduction
The Monetary Approach focuses on the
supply and demand of money and the
money supply process.
The monetary approach hypothesizes that
BOP and exchange-rate movements result
from changes in money supply and demand.
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Daniels and VanHoose Monetary Approach 3
Small Country Example
A small country is modeled as:
(1) Md = kPy
(2) M = m(DC + FER)
(3) P = SP*
and, in equilibrium,(4) Md = M.
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Daniels and VanHoose Monetary Approach 4
Small Country Model
The balance of payments is defined as:
(5) CA + KA = FER.
For example, if FER< 0, then CA + KA < 0,
and the nation is running a balance of
payments deficit.
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Daniels and VanHoose Monetary Approach 5
Small Country Model
(4) and (3) into (1) yields,
M = kP*Sy.
Sub in (2),(6) m(DC + FER) = kP*Sy.
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Daniels and VanHoose Monetary Approach 6
Small Country Model
Fixed Exchange Rate Regime
Under fixed exchange rates, the spot rate, S,
is not allowed to vary.
FER must vary to maintain the parity value
of the spot rate.
Hence, the BOP must adjust to any
monetary disequilibrium.
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Daniels and VanHoose Monetary Approach 7
Small Country Model
Consider what happens if the central bank
raises DC. Money supply exceeds money
demand.
m(DC+ FER) > kP*Sy
There is pressure for the domestic currency
to depreciate. The central bank must sellFER until M = Md.
m(DC+ FER) = KP*Sy
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Daniels and VanHoose Monetary Approach 8
Small Country Model
There has been no net impact on the
monetary base and money supply as the
change in FER offset the change in DC.
There results, however, a balance of
payments deficit as FER < 0.
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Daniels and VanHoose Monetary Approach 9
Small Country Example
Flexible exchange rate regime:
Under a flexible exchange rate regime, the
FER component of the monetary base does
not change.
The spot exchange rate, S, will adjust to
eliminate any monetary disequilibrium.
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Daniels and VanHoose Monetary Approach 10
Small Country Model
Consider the impact of an increase in DC.
Again money supply will exceed money
demandm(DC+ FER) > kP*Sy.
Now the domestic currency must depreciate
to balance money supply and moneydemand
m(DC+ FER) = kP*Sy.
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Daniels and VanHoose Monetary Approach 11
Small Country Model
The monetary approach postulates that
changes in a nations balance of payments
or exchange rate are a monetaryphenomenon.
The small country illustrates the impact of
changes in domestic credit, foreign priceshocks, and changes in domestic real
income.
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The Portfolio Approach toThe Portfolio Approach to
Exchange-RateExchange-Rate
DeterminationDetermination
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Daniels and VanHoose Monetary Approach 13
The Portfolio Approach
The portfolio approach expands the
monetary approach by including other
financial assets. The portfolio approach postulates that the
exchange value is determined by the
quantities of domestic money and domesticand foreign financial securities demanded
and the quantities supplied.
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Daniels and VanHoose Monetary Approach 14
The Portfolio Approach
Assumes that individuals earn interest on
the securities they hold, but not on money.
Assumes that households have no incentive
to hold the foreign currency.
Hence, wealth (W), is distributed across
money (M) holdings, domestic bonds (B),and foreign bonds (B*).
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Daniels and VanHoose Monetary Approach 15
The Portfolio Approach
A domestic households stock of wealth is
valued in the domestic currency.
Given a spot exchange rate, S, expressed as
domestic currency units relative to foreign
currency units, a wealth identity can be
expressed as:W M + B + SB*.
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Daniels and VanHoose Monetary Approach 16
The Portfolio Approach
The portfolio approach postulates that the
value of a nations currency is determined
by quantities of these assets supplied andthe quantities demanded.
In contrast to the monetary approach, other
financial assets are as important as domesticmoney.
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Daniels and VanHoose Monetary Approach 17
An Example
Suppose the domestic monetary authorities increasethe monetary base through an open market
purchase of domestic securities.
As the domestic money supply increases, thedomestic interest rate falls.
With a lower interest, households are no longer
satisfied with their portfolio allocation. The demand for domestic bonds falls relative to
other financial assets.
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Daniels and VanHoose Monetary Approach 18
Example - Continued
Households shift out of domestic bonds.
They substitute into domestic money and foreign
bonds. Because of the increase in demand for foreignbonds, the demand for foreign currency rises.
All other things constant, the increased demand for
foreign currency causes the domestic currency todepreciate.
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Daniels and VanHoose Monetary Approach 19
Spot Exchange RateDomestic currency units/foreign currency units
Quantity of
foreign currency.
SFC
DFC
DFC
S1
S2
Q1 Q2