Professional Documents
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of Payments
Three Approaches
Three Approaches
The Elasticities Approach to the Balance
of Trade
The Absorption Approach to the Balance
of Trade
The Monetary Approach to the Balance of
Payment (MABOP)
The Elasticities Approach to BOT
d = elasticity of demand
= the responsiveness of quantity
demanded to changes in price
d = (%Qd)/(%P)
which is usually negative
Elasticities
| d | > 1 the demand is elastic
| d | < 1 the demand is inelastic
If the demand is elastic, the 1% rise in
price leads to more than 1% decline in
quantity demanded.
If the demand is inelastic, the 1% rise in
price leads to less than 1% decline in
quantity demanded.
Devaluation and BOT
Does the devaluation of a currency
improve the countrys balance of trade?
So, MB by $1 billion.
Money Supply
Recall: MS = mMB (2)
where m = money multiplier
M = CU + D
where D = deposits
MB = CU + R
So, M/MB = (CU + D)/(CU + R)
= (1 + c)/(c + r) m
where c = currency-deposit ratio
r = reserve ratio
Money supply and Money
demand
Substituting (2) in (1), we obtain
MS = m (DC + IR) (3)
Consider Money demand function:
Md = kPL (4)
where P = price level at home and L is the
liquidity preference function, which
depends on income and the interest rate.
k is a constant.
PPP again
Now assume PPP
P = EP* (5)
where E = home currency price of the
foreign currency
P* = price level in the foreign country
Substituting (5) into (4), we have
Md = kEP*L (6)
Monetary equilibrium
In equilibrium, Md = MS.
So, from (3) and (6), we have
kEP*L = m (DC + IR)
In terms of % changes (or growth rates),
E^ + P*^ + L^ = wDC^ + (1-w)IR^
where k^ = m^ =0 because they are
constants. w = DC/(DC + IR).
Finally,
Rearranging, we obtain
(1-w) IR^ - E^ = P*^ + L^ - wDC^ (7)
Monetary approach to Balance of
payments (MABOP)
With a fixed exchange rate (E^ = 0),
BOP^ = IR^ = [1/(1-w)](P*^ + L^)
- [w/(1-w)]DC^ (8)
Fed increases MS (Excess money supply)
DC IR BOP
Fed decreases MS
DC IR BOP
Monetary approach to exchange
rate (MAER)
With a flexible exchange rate (BOP=0),
-E^ = P*^ + L^ - wDC^ (9)
Fed increases MS
DC E (depreciation)
Fed decreases MS
DC E (appreciation)
Managed float
Although exchange rates are market
determined in principle, central banks
intervene at times to peg the rates at
some desired level.
When MS or Md changes, the central bank
can choose either E^ or IR^ to adjust.
Implication of PPP
Recall PPP again: P = EP*.
With a fixed ex rate, E^ = 0, so
P^ = P*^
In other words, when the foreign price
level is increasing rapidly, then the home
price must follow if we are to maintain the
fixed E. Imported Inflation
Implication of PPP (contd)
With flexible rates, E is free to vary so that
even when P*^ > 0, P^ can be zero by
letting E^ = - P*^, or letting the home
currency to appreciate by the same
amount as the foreign inflation rate.
Views based on MABOP
BOP disequilibria are essentially monetary
phenomena.
Devaluation is a substitute for reducing
the growth of domestic credit.
Appreciation is a substitute for increasing
domestic credit growth.