Transcript The monetary approach to BOP and exchange rate determination

The monetary approach to BOP and
exchange rate determination
Concept and exemplification
The 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 supply
The money supply is a function of a nation’s monetary
base:
M = m(MB) = m(DC + FXR)
The money demand
The money demand is a function of how much of the
national income is held in cash.
Md = k(P)(y)
Equilibrium
The demand for money equals the supply of money
k(P)(y) = m(DC + FXR)
Purchasing Power Parity
Absolute PPP says that a Big Mac should cost the same
C$amount, regardless of the country:
P = s(P*)
s = spot exchange rate
P* = foreign price of goods and services
Equilibrium
k(s)(P*)(y) = m(DC + FXR)
What happens under a fixed exchange rate
arrangement?
If DC is increased, the money supply outgrows demand:
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...
If DC is decreased, the money demand outgrows
supply:
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)
If the price of foreign goods, and/or real income
increase, the money demand outgrows the supply
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
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)
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 example
New Zealand
MdNZ = kNZ(PNZ)(yNZ)
Australia
MdA = kA(PA)(yA)
and
PA = (s) PNZ
A two-country example
It can be shown that:
s = (MA/MNZ)(kNZyNZ/kAyA)
A 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: 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: 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: Summary
A relative increase in a nation’s money supply causes
its currency to depreciate
A relative decrease in a nation’s money supply causes
its currency to appreciate
The monetary approach: Policy implications
Sterilized foreign exchange interventions are totally
ineffective because they leave the money supply
unchanged
The monetary approach: Criticism
Assumes absolute PPP holds.
It is difficult to translate into a multi-country setting