NAME: PANASHE HONZERI

REG NUMBER: R188644C

COURSE: INTERNATIONAL ECONOMICS

ASSIGNMENT 1

QUESTION 1: Excessive monetary growth leads to a balance of payments problem under

fixed exchange rate and a currency problem under floating exchange rates. Discuss this
statement with reference to balance of payments. [25 MARKS]
Balance of payment refers to the transaction of a country and the rest of the world.
Monetary approach is the overall approach to the balance of payments whose central point to
balance of payments policy is that deficits and surplus reflect stock disequilibrium between
demand and supply in the market for money. It states that a BOP deficit or surplus is always
and everywhere a monetary phenomenon and therefore corrected by monetary measures.
However, excessive monetary growth can lead to a balance of payments problems under
fixed exchange rates and a currency problem under floating exchange rates as shall be
elaborated further as the essay unfolds. First and foremost it is important to note that the
Monetary approach holds true under the assumptions which include perfect substitution in
consumption in both the product and capital market which ensures one price for each
commodity and a single interest rate across countries; the level of output of a country
assumed exogenously; the demand of money is a stock demand and is a stable function of
income, wealth and interest rates and the supply of money is a multiple of a monetary base
which includes domestic credit and a country’s foreign exchange reserves, to mention but a
few.
First and foremost excessive monetary growth leads to a balance of payment problems that is
deficits and surplus under a fixed exchange rate, where fixed exchange rate refers to the
exchange rate system whereby a country government decrees what its currency will be worth
in terms of something else such as gold standard or reserve bank currency standard and also
sets up the rules of exchange. Under fixed exchange rate, where originally the money demand
will be equal to the money supply, if the monetary authority that is the Central Bank changes
the money supply that is an expansion in the money supply without any change in money
demand, it then leads to a BOP deficit whereby the money supply will be greater than the
money demand. This expansionary monetary policy worsens the BOP problem in number of
ways, the real interest rate falls causing an outflow of capital, real income rises leading to
more imports going up. Also the price levels rises causing imports to rise and exports going
down. Moving on, this deficit caused by more supply of money will encourages individuals
with large cash balances to start buying foreign goods and securities leading to more imports
and foreign assets which in turn will be worsening the BOP problem of deficit. This deficit
may slowly develop difficulties over time and can lead from developments such as a
progressive loss of key markets, declining capital inflows, unsustainable current account
deficits. However to maintain a fixed rate exchange rate or to correct this BOP deficit, the
Central Bank will have to sell foreign exchange reserves and buy domestic currency, thus the
outflow of reserves and domestic money supply leading to an equilibrium of money demand
and money supply eliminating the BOP problem. It is important to note that this process
continue until money supply is equal to money demand and they will again be in BOP
equilibrium.
On the other hand, under the fixed rate exchange another problem mentioned in the monetary
approach is the BOP surplus where the money supply is less than money demand. This
situation will enable individuals to acquire domestic currency by selling goods and securities
to foreigners, and also seek to acquire additional money by restricting their expenditure
relative to their income. To curb this problem away, the authority which is the Central Bank
will buy excess foreign currency in exchange for domestic currency. There will be inflow of
foreign exchange reserves and increase in domestic money supply. This process continues
until money supply is equal to money demand and BOP will again be restored. Thus the BOP
problems of deficit and surplus is a temporary phenomenon and is a self-correcting in the
long run.

Furthermore excessive monetary growth leads to currency problem under floating exchange
rates, where floating exchange rates refers to the exchange rate system whereby the value of a
country’s currency is determined by the supply and demand for that currency in exchange for
another in a private market operated by major international banks. Under the floating
exchange rate the government has no responsibility to peg the exchange rate and the increase
is monetary growth leads to a currency under the monetary approach. When the government
uses monetary policy to increase the money supply, this increase our income and our demand
for imports and ultimately leads to fall in exchange rate that is currency loosing value and
higher prices domestically which is a currency problem of hyperinflation. More supply of
money also leads to consumer spending which will result in a demand pull inflation, a
currency problem. This increase in inflation would reduce the value of bonds in a bank,
makes the economy inefficient as it will be unable to solve its problems using the reserves on
stock. Also the decrease in a currency value leads to few national currency being exchanged
for stronger currency.

In conclusion is important to note that excessive monetary growth leads to BOP problems of
deficit and surplus under the fixed exchange rate as elaborated above and also these problems
are temporary phenomenon which are self-correcting in the long run under the monetary
approach. Also this monetary growth under floating exchange rates creates currency
problems of fall in currency value as the result from a fall in exchange rate and also
hyperinflation.

REFERENCES
Baldwin, R. (1952), "The New Welfare Economics and Gains in International
Trade", Quarterly Journal of Economics, 91-101. 
Baldwin, R.E. (1960), "The Effects of Tariffs on International and Domestic
Prices", Quarterly Journal of Economics, 74(1) 65-70. 
Bergsten, C.F. (1975), "On the Non-Equivalence of Import Quotas and Voluntary Export
Restraints", in Toward a New World Trade Policy: The Maidenhead Papers, C.F. Bergsten
(ed), Chapter 15, Lexington Books, Lexington
Bhagwati, J., V.K. Ramaswami and T.N. Srinivasan (1969), "Domestic Distortions, Tariffs,
and the Theory of Optimum Subsidy: Some Further Results", Journal of Political Economy,
77(6) 1005-1013.