Department of Economics

Chapter 1 Introduction

“Balance of payment” is the record of economic transaction of a country with the rest of the world during a year. It mainly consists of three accounts; current account, capital account and reserve account. Balance of payment keeps the complete record of a country trade, net foreign asset, imports and exports of goods, financial transfer and financial capital. Simply it summarizes international transaction for specific period, mainly a year. The method of analyzing the balance of payments is called the monetary approach to the balance of payment. The monetary approach to balance of payment regards money as a stock, and argues that money stock can be changed through international reserve flows. It states that a fixed exchange rate system could work without having to resort to devaluation, provided a country has a sound monetary policy; thus, devaluation will only occur as a result of a failure of monetary policy (Umer, 2010). This argument stems from the fact that disequilibrium in the balance of payments is a temporary situation that will be corrected if the “money market is in equilibrium” ( Plessis, 1998). The monetary approach may be claimed to be compatible with absorption approach on the proviso that the former stresses the need for equality in the demand for and supply of money, while the latter stresses the need for equilibrium in the market for domestic output, they differ however, on grounds that the monetary approach is a more general theory, since it explains the overall balance of payments (including the capital account), whereas the absorption approach is concerned mainly with explaining the current account (Akpansung, 1998).


Department of Economics

Although the monetary approach has been commended for explaining the balance of payments well, it has prompted criticism from other scholars as an approach that ignores other parts of international trade in determining the balance of payments. The MABP has been blamed for disregarding the fiscal and real factors that influence changes in the balance of payments, whilst concentrating only on monetary factors (Umer., 2010) Contrary to these views, it can be stated that the monetary approach does not ignore these factors. Valinezhad (1992) contends that “the MABP only asserts that the effect on the balance of payments of a higher rate of economic growth should be analyzed with the tools of monetary theory”. An enormous number of studies have emerged throughout the years testing the validity of the MABP empirically. There is credible evidence that the MABP in fact applies to small open economies with fixed exchange rates. Most parts of the empirical literature were based on the „reserveflow equation‟, where a country‟s international reserves, or the rates of change in reserves, are regarded as the dependent variable. On the other hand, the independent variables vary in the different studies. They can include domestic income, prices, the interest rate, government expenditure, money multiplier, money stock, the exchange rate, and demand for nominal and real money balances (Ume, 2010). The monetary approach to balance of payment provoked sever criticism from some economist that it only consider monetary phenomenon, ignoring other important factors of international trade in formatting balance of payment. Though, the MABP approach has been much-admired for the implications of balance of payment. It is also criticized for neglecting errors transpire in balance of payment as well as responsible for disregarding to fiscal and real that manipulate changes in the balance of payments. Others are of the view that it does not ignore other factors but mainly concentrate that balance of payment should be analyzed and observed from monetary theory. (Valinezhad, 1992) The main aim of this paper is to examine the monetary approach to the balance of payments (MABP), which argues that the balance of payments is a “monetary phenomenon”. Whereas the absorption and elasticity‟s approaches concentrate on the


Department of Economics

Current account balance, the MABP emphasizes the overall balance of payments – including the capital account (Coppin, 1994). By employing the MABP, the paper also intends to offer a basis for understanding the relationship between monetary policy and balance of payments problems in Pakistan. The research could also serve as a recommendation to monetary authorities in handling disequilibrium in the balance of payments.

Objective of the Study
The main objectives of the study are:  What are the factors and causes that bring disequilibrium in the balance of payment of Pakistan?  The monetary variables are responsible for creating disturbance of the balance of payment.  Whether excess of money supply has played a significant role in the disequilibrium of balance of payments.

Organization of study
This paper is divided into five sections, one consist of the introduction while section two the literature review. The methodology is in section three. The conclusion was taken care of in section four and finally the recommendations are in section 5.


Department of Economics

Chapter 2 Literature Review
The review of literature plays a significant role in identifying the backdrop of the study being conducted. It also gives direction about the problem and eradicates the possibility of needless repetition of the efforts. In addition, precious information on research skill is obtained from the previous research description. The main purpose of this section is to assess the related literature review. Literature on the fundamental basis of the MABP in a country has been generated by scholars such as Dornbusch, 1971, Frenkel, 1971, Johnson, 1972, Laffer, 1969, and Mundell, 1968 & 1971). Chacholidas, 1990 studied the relationship between country‟s balance of payment and money supply as a “monetary phenomenon” through MABP approach. Further Stated that disequilibrium in the money market is due to the deficit in the balance of payment. If money supply exceeds money demand, then there will be deficit in the balance of payment, if money demand exceeds money supply than surplus in the balance of payment. Howard and Mamingi, 2002 emphasized that deficit in the balance of payment due to fluctuation in general price level, as the real value of nominal assets. Further, they argued that MABP specifies money supply identity, money demand identity and an equilibrium condition. They showed positive relationship of money demand with prices and income, while negative relationship of money demand and interest rate. Dhliwayo, 1996 concluded that increase in the domestic credit will have an equal and opposite change in the international reserve the co-efficient of change in domestic credit has known as offset co-efficient, because it has inverse effect on international reserve. Further, added that basic equation of MABP, the deficit in balance of payment mainly comes due to the divergence of growth of domestic credit and money demand.

Department of Economics

However, Watson, 1990 investigated the model of Trinidad and Tobago‟s balance of payments for the period 1965–1985 and examined that all other variables show reliable results except dependent variable „the change in international reserves‟ that is against MABP. The monetary approach to the balance of payments IMF 1977, Johnson 1972 & Polak, 1957, which is a modern approach, considers the balance of payments from a broad perspectives rather than taking it as the current account balance. According to Salvatore, 1998 & Fleermuys, 2005, the monetary approach to the balance of payments balance of payments is a “monetary phenomenon”. They further argued that the monetary approach focuses on how the demand and supply of money affect the balance of payments and the exchange rate. Their argument is based on the view that since the exchange rate is the price of currency, movement in this rate is basically a monetary phenomenon, and can be explained by concentrating on the market for money. On how the demand and supply of money affect the balance of payments and the exchange rate. Their argument is based on the view that since the exchange rate is the price of currency, movement in this rate is basically a monetary phenomenon, and can be explained by concentrating on the market for money. Umer, 2010, in their paper which examines the money μ tarry approach to Pakistan‟s balance of payments for the period 1980-2008. Through the reserve flow equation, it tests whether excess money supply played a significant role as a disturbance by using Cointegration test and error correction modeling. The conclusions showed that monetary variable does not play an overwhelming role in determining Pakistan‟s balance of payments. The results evidently showed that, although some variables suggested by the monetary approach play significant roles, the balance of payments is not a purely monetary phenomenon. Balance of payments disequilibrium can, therefore, not be corrected only through monetary actions by the authorities.


Department of Economics

Chapter 3 Methodology
Model Specification
According to Koutsoyiannis, 1977 the first and most important step the econometrician has to take in attempting the study of any relationship between variables is to express this relationship in mathematical form that is to specify the model with which the economic phenomenon will be explored empirically. The model aims to illustrate whether monetary variables are fundamental in determining the balance of payments of Pakistan. In order to test this role, the study employs the standard model of the MABP. The equation and expected signs of the coefficients are as follows: L NFA t = β0 + β1 L GDP t-1 + β2 INF L t-1 - β3 INT t-1 - β4 LC t-1 + μ t Where: LNFA = log of Net foreign asset LGDP = log of GDP INF = rate of inflation INT = interest rate LDC = log of domestic credit μ t = stochastic or error term

Estimation procedure
The ordinary least squares single equation technique is the estimation procedure chosen for this study. It will be used for estimating the equations already specified. As a


Department of Economics

Justification for this method, Maddala, 1977 identified that ordinary lest squares is more robust against specification errors that many of simultaneous equation methods and also that predictions from equation estimated by ordinary least squares often compare favorably with those obtained from equations estimated by the simultaneous equation method. Among other reasons is the simplicity of its computational procedure in conjunction with optimal properties of the estimates obtained and these properties are linearity, unbiased and minimum variance among a class of unbiased estimators. For the results and estimation procedure, advanced statistical software E-Views are used. The null hypothesis states that monetary variables put significant effect on the balance of payment of Pakistan. The significance of results obtained from regression analysis is checked from t-statistics at 5% confidence level. If t-ratios are equal to or greater than two(2) in absolute than the estimator will be significant, if it is less than two (2) in absolute than estimator will be in significant and null hypothesis will be rejected.

Sources of data
This study used Secondary data. The macroeconomic variables of interest (inflation and interest rate, GDP Growth) were obtained from the World Bank development indicator, and Bank of Ghana database.

Data Analysis Technique
Annual time-series data on the variables under study covering thirty year period (19802010) are used in this study for estimation of functions. The study employs ordinary least squares in the estimation of the coefficients of the parameters. The strength of the coefficients derived from ordinary least squares model was used to establish the relationships between the dependent variable and the independent variables. Various tools such as Durbin Watson were used to test for autocorrelations. Data obtained was analyzed using statistical and econometric software such as E-views and Excel application software.


Department of Economics

Chapter 4 Conclusion

This study is conducted to examine the balance of payment of Pakistan through monetary approach and tested whether this approach applies to Pakistan‟s balance of payment situation. The main objective is to find out that excess money supply can play an important role in the disturbance of the balance of payments in Pakistan. The study also identifies the role of excess money supply and its role on balance of payment interruption. Moreover, the study also helped to analyze the relationship of monetary variables and balance of payment. One of the main finding of this study is that Central bank requires policies for sustainable balance of payments with stable exchange rate. The study finds that monetary variables are not the only cause of deficit in the balance of payment of Pakistan, but some other factors are also responsible for it like export which mainly consists of raw materials, agriculture products, cotton and rice etc. The second factor is that, the growth of industrial sector in Pakistan are very slow, which hardly fulfill the domestic requirements. Third the domestic and foreign investments are also very low. The study reveals that disequilibrium in the money market, emanating from monetary variables such as domestic credit, interest rate, exchange rate and the price level translates into balance of payments disequilibrium. Specifically, increased domestic credit and interest rate deteriorates the balance of payments while nominal exchange rate depreciation improves the balance of payments, all being in the contemporaneous sense. Increase in the price level deteriorates the balance of payments not in the same period however but with lags. Moreover, the negative effect of interest rate on the balance of payments is reversed over time.


Department of Economics

Chapter 5 Recommendations

The monetary authorities should also pay special attention to domestic credit creation when controlling the country‟s balance of payments. It is important that the country achieves sufficient economic growth through money demand to correct the balance of payments deficit. Further the study suggests that Pakistan should take steps of anti-inflation (control inflation) increase the net foreign assets, improve the quality of their products which should compete with the international market products, increase the local

production,(agriculture as well that of industrial sector), like textile, machinery, plants, garments, and construction sectors etc. Fluctuation in the exchange rate needs to be removed and a sustained exchange rate is required for minimizing the deficit in balance of payment in economy.


Department of Economics


Adamu, P.A (2004) “The dynamics of Balance of Payments in Nigeria: An Error Correction. Approach”. West African Financial and Economic Review. Vol. 1 No.2. Alexander, S.S (1952). “Effects of Devaluation on Trade Balance”. IMF Staff Papers 2(2):263-78.19 Bangura A and Jackson A ( 2005). “Determinants of Inflation in Sierra Leone 1981-2003”, in Economic Bulletin of Ministry of Finance, Sierra Leone. January to June 2005, PP1425. Bickerdike, J.F.O (1920), “The Instability of Foreign Exchanges”. The Economic Journal Vol 30. PP118-122 Dhliwayo, R (1996), "The Balance of Payments as a Monetary Phenomenon: An Econometric Study of Zimbabwe's Experience", African Economic Research Consortium, Research Paper 46. Engle, R.F and C.W.F Granger (1987). “Co-integration and Error Correction: Representation and Testing”. Econometrical 55:251-76. International Monetary Fund (1977). The Monetary Approach to the Balance of Payments. Washington, DC, International Monetary Fund. Johansen, S (1988), “Statistical Analysis of Counteraction Vectors”. Journal of Economic Dynamics and Control. Vol 12. pp 231-254. Johnson, H.G (1972). “The Monetary Approach to the Balance of Payments theory, in H. Johnson (Ed), Further Essays in Monetary Economics, London: Allen and Unwin. Kallon, K.M (1994). “An Econometric Analysis of Inflation in Sierra Leone”. Journal of African Economies, Vol.3, Issue 2, PP199-230.

Department of Economics

Laursen, S. & L.A Metzler,(1950). “Flexible Exchange Rates and the Theory of Employment”. Review of Economics and Statistics, Vol 32. PP 281-299. Lerner, A.P (1944). The Economics of Control. New York. Macmillan. Marshall, A (1923), Money, Credit and Commerce. London, Macmillan. Metzler, L (1948). A Survey of Contemporary Economics, Vol I, Richard D. Irwin, INC, Homewood, IL. Mussa, M (1974), "Ä Monetary Approach to Balance of Payments". Journal of Money, Credit and Banking, Vol. 6 pp 333-352. Polak, J.J (1957), "Monetary Analysis of Income Formation and Payments Problems", IMF Staff Papers 4(4):1-50. Robinson, J (1947). Essays in the Theory of Employment. Oxford, Basil Blackwell.


Sign up to vote on this title
UsefulNot useful