Answer to Question #292833 in Macroeconomics for Douglas

Question

Discuss the monetary approach to the balance of payment. Use graphs also to demonstrate your discussion.25 marks

Answer 1

Monetary Approach to the Balance of Payment
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Monetary Approach to Balance of Payment

Approaching the idea from the background of a closed economy, we establish the unique concept on the monetarist as compared to the Keynesian as; the monetarists put significant stress on money supply changes effect to economic activity. Here, monetary base is viewed as a monetary policy instrument. Results from changes in this instrument are monitored by interests, with the scope of application being in internal prices, the output, and the rates of interest. It is believed that, with fixed output, only rates of interest and prices naturally fluctuate. For the case of an open economy with fixed rates of interest, money supply seizes to be an exogenic instrument of policy formulation as it gets altered by the balance of payment surplus or deficit. Therefore, money supply is viewed from the perspective of association between the domestic monetary base, rates of interest, prices and output with which monetary approach concerns itself with. Generally, excesses in the demand for financial assets and goods bring about disequilibrium to Forex markets and B.O.P. Resultant excesses of money supply affect domestic prices, interest rates and general output. (Johnson, 2018)

According to a study by Bhatia (2020), surpluses in the balance of payment can be escorted by excesses in money supply. A deficit on the other hand, will be escorted by excesses in the demand for money. According to the BOP Equilibrium Graph below, the line LM represents the demand for money, and the BOP is at equilibrium, where LM cuts IS curve that shows the money supply in the economy. To the left of LM and above it, the supply for money exceeds its demand. To the right and below the LM curve, money demand exceeds it supply. At the equilibrium point, we have the interest rates as applying in the domestic market represented by $i_1$ . The LM curve is upward slopping, as an indication that recorded increase in the monetary base is a result of increase in non-traded goods so as to maintain real balances at equilibrium. The IS curve on the other hand resolves to the price levels that arise from the BOP equilibrium. Along this line traded balance is zero. A deficit in the BOP is indicated by the point above and to the right of the IS. A surplus on the other hand is recorded by the point below and to the left of IS. IS has a negative slope as its increase results to deficits in the BOP

The version perceived in the study for monetary approach, assumes a small country with fixed rates of exchange, alongside a perfect mobility of goods and assets internationally. In this case, a notable disequilibrium in the goods and financial assets market is wholly replicated to the BOP. It is to be noted however, there exists two versions of the monetary approach to Balance of Payment. The first is the Evolutionary Approach, and the other the Johnson’s approach. Developed by Khan-Keynes 1931, the distinctive feature in the Evolutionary approach is that is developed from a multiplier model, by a monetization process. That is achieved under three steps, which include, (a)the multiplicand. The multiplier concept responds to an earlier stimulus triggered by government expenditure. (b) Marginal Propensity to Spend. According to Khan, this step relies on two coefficients, which include the weighted marginal propensity to consume, and the marginal propensity to invest. (c) Multiplier process over time. At this step, early stages are ignored, with emphasis put on the final equilibrium position. (Bijan & Mohsin, 2018)

In the second version of Johnson’s, contrary to the Evolutionary approach, the approach is presented as a revolution. In this approach, Johnson and his followers disregard attributes of the Keynesian, as such presuming mass unemployment and elasticities approach. In this approach, it is notable that, money is not featured as a contributing aspect to the equilibrium of the BOP.

From the BP Curve Graph, curve BP represents certain price level and exchange rate in the domestic market. For equilibrium to be obtained in the market, surplus in the current account has to equate to the deficit in the capital account. From the lower panel, CS curve represents surplus of the current account, while curve CD show the capital account deficit. The capital account, is however presumed a function of interest rate. Initially, the economy is at equilibrium at point A.

Reference.

Bhatia, A. (2020). Block-4 Balance of Payments and Exchange Rate.

BIJAN, B. A., & MOHSIN, S. K. 11. (2018) The Monetary Approach to Balance of Payments Determination: An Empirical Test. In The Monetary Approach to the Balance of Payments. International Monetary Fund. <span style="font-size: 10.5pt; line-height: 107%; font-family: &quot;Open Sans&quot;, sans-serif; color: rgb(2, 109, 168);">https://doi.org/10.5089/9781557752772.071</span>

Johnson, H. G. (2018). The monetary approach to balance-of-payments theory. In International trade and money (pp. 206-224). Routledge. https://www.taylorfrancis.com/chapters/edit/10.4324/9781351043915-11/monetary-approach-balance-payments-theory-harry-johnson