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B) Second hypothesis
3. The long term adjustment
4.12 The Monetary Approach to Balance of Payments (MABoP): the IMF approach to macroeconomic stabilization
It is frequently suggested that an external balance problem is monetary in nature. For any given BoP deficit, a sufficient contraction of the money stock will restore the external balance by the central bank raising the interest rates and the government reducing spending. This generates a contraction in economic activity, a decline in incomes and therefore, a decline in imports. For the BoP identity, we have
BoP = ∆H – ∆DC
∆M = ∆DC + ∆R
where ∆H = high powered money
MM = monetary sector equilibrium
∆R = target variable
∆M = endogenous variable
∆DC = domestic credit
Advanced Macroeconomics
126
The open economy: Macroeconomy The above equation shows that the balance of payments is equal to the change in high powered money and domestic credit. The change in money supply is equal to the change in domestic credit and reserves.
In the external sector, the change in the money supply (∆M) is an exogenous variable. Reserves can be further stated as:
(X-Z) + ∆F = ∆R (4.12)
where ∆R is a target variable, Z is an exogenous variable, and X∆F is an exogenous variable.
A more sophisticated interpretation of the problem recognizes the link among the balance of payments deficit, foreign exchange market intervention and the money supply. The automatic mechanism is for a rise in the sale of foreign exchange in the case of a balance of payments deficit. It can reflect in an equal reduction in the stock of high powered money. To reduce a deficit in its current account, a country may sell foreign exchange and in return, receives high powered money, thereby reducing the money stock.
On the other hand, when it buys foreign exchange, expanding the money stock, a surplus in the current account increases the outstanding stock of high powered money.
4.12.1 The instrument target approach
If there is a change in domestic credit then inflation increases. The exchange rate change will lead to a similar increase in reserves.
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Advanced Macroeconomics
127
The open economy: Macroeconomy
∆DC Π
E ∆R
In figure 4.12, the change is explained as follows. The diagram shows that “a” is domestic credit. As the money supply/credit increases, inflation also increases.
00 ¨5
D
&RQIOLFWRIʌ
Dʌ ¨'& ¨'&
Figure 4.12 The money supply and domestic credit
The change in reserves is interpreted as:
∆R = ∆M – ∆DC
The change in reserves will have a positive effect on the money supply and a negative effect on domestic credit. Therefore, the monetary authority would try to keep the balance between the two. The assumption is that inflation is a function of a change in the money supply.
Π = f (∆M) (4.12)
Money supply is an independent variable. It can be further stated as follows:
Π = a ∆M Therefore ( )1 M
a ∏ = ∆ Then ∆R=∆M-∆DC
Advanced Macroeconomics
128
The open economy: Macroeconomy
If we substitute ∆M in the above equation, then we obtain R 1 DC
∆ = ∏ −∆a The policy instruments are as follows:
Π 0 a∆DC
∆R -∆DC 0
Similarly, ∆R and inflation in the economy can be explained as follows. In figure 4.13, it shows that inflation and reserves are in equilibrium at point A. But a contraction in domestic credit increases the money supply from MM0 to MM1. The change in domestic credit will reduce MM1 to a new line after the credit restriction. Thus, a change in domestic credit reduces the same reserves and at lower inflation π (A& B). For the same inflation (π), higher reserves are expected for ∆ R (B&C).
¨5 00 00
%
¨5 $
&
ʌ 3 3
Figure 4.13 Money supply and inflation
The change in foreign exchange reserves is equivalent to the flow of foreign capital and the difference in exports and imports, so that:
(X-Z) + ∆F = ∆R (4.13)
The above equation can be interpreted alternatively as exports minus imports and the change in foreign capital is equal to the change in reserves
∆R = (X-Z) +∆F
( )
X Z f E− = +Π− (4.14)
Advanced Macroeconomics
129
The open economy: Macroeconomy Here, the trade balance is positively related to the exchange rate and negatively related to inflation. If the inflation rate is higher, the trade balance is negative. It can be further stated as:
X-Z = – bπ + OE
∆R = -bπ + CE + ∆F (4.15)
This means that reserves are negatively related to inflation and positively related to the exchange rate and foreign capital. A policy framework is given as follows:
Π 0 CE F
b + ∆
∆R CE+∆F 0
The above variables are shown in the following diagram. The MM curve shifts due to the monetary policy. Capital flow is very important for macroeconomic stabilization. In the diagram, E0 is shown to be in equilibrium in both sectors. The monetary sector equilibrium is shown as an upward line.
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Advanced Macroeconomics
130
The open economy: Macroeconomy
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¨(¨) E D
(
Ȇ
¨'&D
Figure 4.14 Macroeconomic stabilization in an economy
The external sector is explained in more detail in the following diagram:
External sector equilibrium:
The external sector in equilibrium can be expressed as:
(X Z− )+ ∆ = ∆F R (4.16)
¨5
&(¨) ¨5 %
E ¨5$ &
&( ) E
' ʌ 3 3
Figure 4.15 External sector equilibrium
In figure 4.15, the Y axis is the exchange rate and the foreign capital whereas the X axis shows the inflation rate. The above figure represents the link between the exchange rate and inflation. The diagram also shows the point of equilibrium between reserves and inflation. Point A shows the devaluation phenomena. After a devaluation, inflation remains the same and it is possible to get higher reserves. The same inflation (π) and higher (R.) reserves at point B are maintained. But at point C, there are fewer reserves and more inflation. At the same reserves level, there is high inflation (Points A and C). Therefore, everything depends on the real exchange rate. The real exchange rate is defined as:
R E Pf P
= ↑
↑ (4.17)
Advanced Macroeconomics
131
The open economy: Macroeconomy where R = the real exchange rate
E = the nominal exchange rate Pf = the price in foreign countries P = prices of domestic currencies
When we superimpose the above two conditions, the figure evolves itself into the one shown in figure 4.16, which shows that the money supply exchange rate and foreign capital are in equilibrium at E with π0. If the money supply gets reduced, the MM line shifts to MM’. The new equilibrium is achieved with higher reserves and lower inflation.
¨5 00
(¶3 'G 5G
&(¨)
( 00
¨5
Ȇ&(¨)ʌ
Figure 4.16 Changes in the money supply and inflation in an economy
The above diagram shows that the reserve changes could be 15 percent. The instrument targets are explained as:
∆DC Π
E ∆R
The emphasis of monetary consideration in the interpretation of the external balance problem is called the monetary approach to the balance of payments. The monetary approach has been used extensively by the IMF in its analyses and design of economic policies for countries in balance of payments trouble.
The use of a domestic credit ceiling is a crude policy to improve the balance of payments.
Advanced Macroeconomics
132
The open economy: Macroeconomy