The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination

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.

Daniels and VanHoose

Monetary Approach

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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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.

Daniels and VanHoose

Monetary Approach

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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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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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 sell FER until M = Md.
m(DC + FER = KP*Sy )
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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.

Daniels and VanHoose

Monetary Approach

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.

Daniels and VanHoose

Monetary Approach

Small Country Model

Consider the impact of an increase in DC. Again money supply will exceed money demand m(DC + FER) > kP*Sy. Now the domestic currency must depreciate to balance money supply and money demand m(DC + FER) = kP*Sy.
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Small Country Model

The monetary approach postulates that changes in a nations balance of payments or exchange rate are a monetary phenomenon. The small country illustrates the impact of changes in domestic credit, foreign price shocks, and changes in domestic real income.
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The Portfolio Approach to Exchange-Rate Determination

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 domestic and foreign financial securities demanded and the quantities supplied.
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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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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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The Portfolio Approach

The portfolio approach postulates that the value of a nations currency is determined by quantities of these assets supplied and the quantities demanded. In contrast to the monetary approach, other financial assets are as important as domestic money.
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An Example
Suppose the domestic monetary authorities increase the monetary base through an open market purchase of domestic securities. As the domestic money supply increases, the domestic 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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Example - Continued
Households shift out of domestic bonds. They substitute into domestic money and foreign bonds. Because of the increase in demand for foreign bonds, the demand for foreign currency rises. All other things constant, the increased demand for foreign currency causes the domestic currency to depreciate.

Daniels and VanHoose

Monetary Approach

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Spot Exchange Rate

Domestic currency units/foreign currency units

SFC S2 S1 DFC

DFC Q1 Q2
Daniels and VanHoose

Monetary Approach

Quantity of foreign currency.

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