IntroductionGlobalizationhas played a significant role in promoting economic relations among countriesall over the world. In this era of globalization, it is fair to say that nocountry in the world is “an island” or self-sufficient. One of the key benefitsof globalization is the ease of movement of goods and services across or amongnations.
Like the computation of GDP, countries keep records of itstransactions with external economies over a given period usually quarterly oryearly. This record of transactions is referred to as Balance of Payment (BOP). The balanceof payments which is also referred to as the balance of international payments isa record of all international or financial transactions that are undertakenbetween residents of one country and residents of other countries during the year.
These transactions include payments relating to imports and exports of goods and services, financial capital, and financial transfers (Saylor, n.d.; Riley, n.d.).
A country’s balance ofpayments expresses the equilibrium between international commercial andfinancial inflows and outflows (Paun, et al., 2010). The balance of Paymentcan also be defined as a statistical record of all the economic transactionsbetween residents of a reporting country and the rest of the world during agiven period of time. Balance of payment is one of the most importantstatistical statement as well as economic indicator of a country. It revealsthe number/ quantity of goods and services a country has exported or importedover a period of time. It also reflects whether a country has been borrowingmoney or lending to the rest of the world (Pilbeam, 2013, p. 31). The BoP can be definedusing different measures depending on the circumstance, thus, BoP can bedefined using the Official Settlement, Current Account or Basic Balancedefinitions.
However,for many countries, the focus of attention is on the balance of payment ontheir current account and a lot of effort is concentrated on policies to reducethe current account deficit by increasing and reducing the value of exports andimports respectively. A balance of payment can bein surplus or deficit. A country’s balance of payments is said to be in surplusif inflows (funds from exports, and assets e.g. bonds) exceed.
On the otherhand, a balance of payment is said to be in deficit if outflows are more thanthe inflows. Brief Description of Other ApproachesOver theyears, economists (John Keynes, Marshall Lerner, Mundell and Fleming, Polak amongothers) have propounded various unique approaches in the analysis of BoP butwith varying characteristics. Thereare three basic alternative theories or approaches of balance of payments adjustmentnamely, the elasticities approach,the absorptions approach and the monetary approach. Inthe elasticities and absorption approaches the focus of attention is on thetrade balance with resources not fully employed. The elasticities approachemphasizes the role of the relative prices (or exchange rate) in balance ofpayments adjustments by considering imports and exports as being dependent onrelative prices (through the exchange rate).
A notable shortcoming of theelasticities approach is that it does not consider capital flows. On thecontrary, themonetary approach focuses of attention on the balance of payments (or the moneyaccount) with full employment of resources, thus, thisbalance consists of the items that affect the domestic monetary base. The absorption approach shows a significant improvement over theelasticities approach in the sense that, it views the external balance throughnational income accounting. Thus, the elasticity approach relates the balance ofpayment to the activities elsewhere in the economy instead of taking thepartial equilibrium view of the elasticities approach in analysing the externalsector in isolation. The monetary approach, like the absorption approach,stresses the need for reducing domestic expenditure relative to income, inorder to eliminate a deficit in the balance of payments.
(Ardalan, 2005, p. 37). Background to the Monetarist Approach to BoP andExchange Rate Insurveying the body of research dealing with the balance of payments, two majorshortcomings are immediately apparent. First, there are no widely acceptedtheories of the balance of payments which simultaneously incorporate both thecurrent and capital account. The great majority of models used in paymentstheory consider either the capital account or the current account separately.Second, there have been very few attempts to include even the fundamentals ofportfolio choice theory in balance-of-payments models. This is particularlysurprising in view of the essentially monetary nature Balance of paymentstheory. Themonetarist approach to the balance of payments theory addresses bothshortcomings.
Since this essentially involves an extension of the rudiments ofmonetary theory to the area of the balance of payments, it is henceforthreferred to as a monetary view of the balance of payments (MBOP) (Kemp, 1975, p. 14). The monetaristapproach to the balance of payments and exchange rate determination asserts that changes in a country’s balance ofpaymentsor the exchange value ofits currency are just a monetary phenomenon,thus can only be corrected by monetary measures.
Thefundamental thinking underpinning the Monetary Approach is that a country’sbalance of payment deficit is as a result of its money supply being greaterthan the demand for money, thus an excess supply of money is the only cause ofthe BoP deficit. When a government of one country expands its money supplyfaster than other countries or its required, the result is a worsening of thecountry’s BoP position. Assumptions underlying the Monetarist Approach: Themonetary approach is based on a number of assumptions: The demand for money is stable and has apositive relation on income, prices and interest rate. The supply of money of a country is made up oftwo components: domestic credit and foreignexchange reserves. PurchasingPower Parity holds- The law of one price assumes that it should cost the sameamount of money to purchase a particular basket of goods irrespective of thecountry of purchase, thus, the price of a basket of goods in country A shouldbe same as the price of an similar/identical item in country B after convertingto a common currency, after allowing for transport costs. There is perfectsubstitution in consumption in both the product and capital markets. The level of output of a country is determinedby exogenous factors.
AA1 All countries resources are assumed to be atfully employment. Insummarizing the assumptions, the stable demand for money and the fixedaggregate supply sets the standard quantity theory of money principle that achange in money supply leads to a proportionate change in price level, whichalso results in an increase in nominal income. However, given the assumptionthat income (output) is fixed, then price remains the only determinant. However,the purchasing power parity (PPP) assumptions challenges the price changes inthe quantity theory of money. PPP assumes perfect substitution in consumptionof goods/services on the international market where price levels are exogenous.As a result, the foreign exchange reserve component of the money supply is thekey determinant of the BoP deficit or surplus.
Given theseassumptions, the monetary approach can be expressed in the form of thefollowing relationship between the demand for and supply of money: The demandfor money (Md) is a stable function of income (Y), prices (P) and rate ofinterest (i) Md=f(Y, P,i) ……… (1) The moneysupply (Ms) is a multiple of monetary base (m) which consists of domestic money(credit) (DC) and country’s foreign exchange reserves (R). Ms = DC + R……….. (2) Since inequilibrium the demand for money equals the money supply, Md= Ms ..
… (3) and thereby; Md= DC + R as MS = DC + R ..
..…(4) A balanceof payments deficit or surplus is represented by changes in the country’sforeign exchange reserves. Therefore; R = ?Md – ?DC……..
(5) or R = B ………….. ( 6) where Brepresents balance of payments which is equal to the difference between changein the demand for money (?Md) and change in domestic credit (?DC). A balanceof payments deficit reduces the foreign exchange reserve (R) and the moneysupply. On the other hand, a surplus increases R and the money supply. When B =O, it means BoP equilibrium. Theautomatic adjustment mechanism in the monetary approaches could be demonstratedbelow under both the fixed and flexible exchange rate systems using ahypothetical small country as an example Balance of Payment Analysis under the FixedExchange Rate System Under thefixed exchange rate system, a country’s monetary authorities intervene toregulate the value of exchange rate. It is assumed that under fixed exchangerates the government’s control/regulation of currency flows is not possible on accountof the law of one price globally.
An attempt by the monetary authority toincreases domestic money supply under the fixed exchange regime, results in a BoPdeficit. People who have large money balances increase their purchase of moreforeign goods and securities. This tendsto raise their prices and increase imports of goods and foreign assets. Thisleads to increase in expenditure on both current and capital accounts in BoP,thereby creating a BOP deficit. To correct the BoP deficit, monetary authoritiesneed to buy back the currency on the foreign exchange market. Thus, the outflowof foreign exchange reserves means a fall in Foreign Exchange Reserve indomestic money supply. This process will continue until there will be BoPequilibrium.
On theother hand, a fall in money supply over money demand will result in a BOPsurplus. Consequently, people acquire the domestic currency by selling goodsand securities to foreigners. They will also seek to acquire additional moneybalances by restricting their expenditure relatively to their income.
Themonetary authority on its part, will buy excess foreign currency in exchangefor domestic currency. There will be inflow of foreign exchange reserves andincrease in domestic money supply. This process will continue until moneysupply equals demand and BoP equilibrium will be restored. Thus, a BoP deficitor surplus in the fixed exchange regime is a temporary phenomenon and is self-correctingin the long-run (Ardalan, 2009). Balance of Payment Analysis under the FloatingExchange Rate System Under a floating exchange rate regime, the country’s monetaryauthorities do not intervene to affect the valuation of the exchange rate. Thistheory assumes that an appreciation of the domestic currency makes domesticgoods and assets more expensive on international markets and, thus, appliesdownward pressures on the BOP. Accordingto the theory, an imbalance in the BOP will automatically alter the exchangerate in the direction necessary to obtain BOP equilibrium. When there is a BoP deficit orsurplus, changes in the demand for money and exchange rate play a major role inthe adjustment process without any inflow or outflow of foreign exchangereserves.
Suppose the monetary authority increases the money supply, there is aBOP deficit. People having additional cash balances buy more goods therebyraising prices of domestic and imported goods. This results in the depreciationof the domestic currency and a rise in the exchange rate. Consequently, therise in prices increases the demand for money thereby bringing the equilibriumof money demand and supply without any outflow of foreign exchange reserves.The reverse occurs when the demand for money exceeds supply in that it resultsin fall in prices and appreciation of the domestic currency which automaticallyeliminates the excess demand for money. “The exchange rate will fall until thedemand for money is equal to money supply and BOP is in equilibrium without anyinflow of foreign exchange reserves” (Meghana, n.d.).
For example, it is argued that the Asian crisis prompted most investorsto move to USD denominated assets. As a result, there is a large positive netportfolio investment in the U.S., leading to a surplus of the Current Accountand of the BOP.
According to the theory, this excess demand for U.S. assetsshould lead to an appreciation of the USD. This would, in turn, make U.S. goodsand assets more expensive, and generate downward pressure on the CurrentAccount and the Capital Account (University of Colorado, n.d.).
Empiricalevidence Much of the empirical evidence tries to measure the extent to which arise in the domestic money supply base results in a fall in the foreignexchange reserve in the fixed exchange regime. Pilbeam (2013) presentsempirical estimates for some countries for the period 1976 to 1990 (Pilbeam,2013, pg. 120). This evidence suggests mixed results.
Studies from 1974-1976confirms that the offset coefficient is correct. However, researches conducted after 1982 suggests that earlier studiesmay have been over estimated because of the frequency of sterilisation. Thismixed position is as a result of certain assumptions such as price level andinterest rates not holding in the real-world scenario.
Limitations of the Monetary Approach Whilethe monetary approach has been widely accepted as more realistic in that ittakes into consideration both domestic money and foreign money as it does notlay emphasis on relative price changes unlike the Elasticity Approach, themonetary approach has been criticized by several economists and experts. Someof these criticisms are mentioned below. 1.
A surveyof the monetary conducted by Boghton (1988) argued that almost all the assumptions propounded are open to empirical questions.Critics argue that the demand for money function can be highly unstable. Again,economies rarely obtain full employment due to involuntary unemployment incountries. There is also the argument of market imperfections which challengesthe assumption of the law of one price.There may be price differentials resulting from to the lack of information aboutprices, knowledge of identical goods and trade regulations in other countries. Theseassumptions hold well in the long run but are rarely fulfilled in the shortrun.
2. Somecritics have also argued that it isquite wrong to view countries balance of payment deficit or surplus as purely amonetary phenomenon. BoP adjustments may sometimes be as a result ofexpenditure-switching decisions operating through real flows and governmentbudget rather than money demand. 3.There is weak link between BOP and MoneySupply. The monetarist assumption of the direct link between BoP of aneconomy and its total money supply has been criticized as overly simplified anddoes not hold in a real-world phenomenon.
For such an assumption to be valid, themonetary authority will have to offset the inflows and outflows of foreignexchange reserves in a deficit or surplus situation. This requires some levelof sterilization of external flows which is not possible due to globalizationof financial markets. AA1Check if its same as saying level of output is assumed exogenously