BALANCE OF TRADE & BALANCE
OF PAYMENT
BOPs is a statistical record of all
economic transactions b/n residents of
the reporting country & ROW during a
given time period
…the usual reporting period for all the
statistics included in the accounts is a
year
…..some of the statistics that make up
the BOPs are published on a more
regular monthly & quarterly basis
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….it reveals how many goods & services
the country has been exporting &
importing, & whether the country has
been borrowing from/lending money to
the ROW
• The term resident comprises
individuals, households, firms & the
public authorities
• There are some problems that arise
with respect to the definition of a
resident
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These problems include for example:
• MNCs are by definition resident
in more than one country
For the purpose of BOPs reporting,
the subsidiaries of a multinational
are treated as being resident in the
country
…in which they are located even if
their shares are owned by foreign
residents
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The treatment of international
organizations such as the IMF, the
WB, UN & so forth
…these institutions treated as
foreign residents even though
they reside in USA
Tourists are regarded as being
foreign residents if they stay in
the reporting country for less than
a year
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Balance of payments accounting &
accounts
• In an Accounting sense, a country's
BOPs statistics is always balance
Each receipt of currency from
residents of the ROW is recorded as a
credit item (a plus in the accounts)
Each payment of currency to residents
of the ROW is recorded as a debit item
(a minus in the accounts)
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The statistics are divided into 2 main
sections:
1) The current account (income flows)
2) The capital account (changes in assets
& liabilities)
Each part is further sub divided into
sub-accounts:
A) Current account
The current account can be divided
into 2 sub accounts: visible &
invisible accounts
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Visible sub-account records
the values of imported &
exported goods
Invisible sub-account records
values of imported & exported
services; interests, profits &
dividends received; interests,
profits & dividends paid;
unilateral receipts &
payments
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The balance on the visible accounts is
termed as the Trade Balance
Trade Balance = Receipts for exported
goods –
Payments on imported
goods
Trade Balance: referred as visible
balance…
...b/c it is the difference b/n receipts
for X of goods & expenditure on M of goods
which can be visibly crossing frontiers
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The receipts for X are recorded
as a credit in the BOP…
…while the expenditure for M is
recorded as a debit
When the Trade Balance is in
surplus, a country has earned
more from its X of goods than
it has paid for its M of goods
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Current Account
Balance=
Trade balance +
Invisible Balance
The invisible balance shows the
difference b/n revenue received
for X of services & payments
made for M of services such as
shipping, tourism, insurance &
banking
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…in addition, receipts & payments of
interest, dividends & profits are
recorded in the invisible balance
…because they represent the
rewards for investment in overseas
companies, bonds & equity
While payments reflect the
rewards to foreign residents for
their investment in the domestic
economy
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Receipts & payments
represent a redistribution of
income b/n domestic & foreign
residents
• Unilateral payments can be
viewed as a fall in domestic
income due to payments to
foreigners & recorded as a
debit
• Unilateral receipts can be
viewed as an increase in income
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B) Capital account
• Capital account records
transactions concerning the
movement of financial capital
into & out of the country
• Capital comes into the country by
borrowing, sales of overseas
assets, & investment
These items are referred to as
capital inflows & are recorded as
credit
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Capital inflows are, in effect, a
decrease in the country's
holding of foreign
assets/increase in liabilities
to foreigners
Capital Account Balance = Capital
Inflows
–Capital
Out flows
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Table 6.1. The balance of payments of a hypothetical country
Current Account
1) Exports of goods +150
2) Imports of goods -200
3) Trade Balance -50 = 1+2
4) Exports of services +120
5) Imports of services -160
6) Interest, profits and dividends received + 20
7) Interest, profits and dividends paid - 10
8) Unilateral receipts + 30
9) Unilateral payments - 20
10) Invisible Balance - 20 = 4+5+6+7+8+9
11) Current account balance - 70 = 3+10
Capital Account
12) Investment Abroad - 45
13) Short-term lending - 65
14) Medium- and long-term lending - 75
15) Repayment of borrowing from rest of the world -55
16) Inward Foreign investment +170
17) Short-term borrowing + 40
18) Medium- and long-term borrowing + 30
19) Repayments on loans received from rest of the world + 50
20) Capital account balance + 50 sum (12) to (19)
21)Statistical error +5 (Zero minus [11 + 20 + 25]
22)Official settlements balance -15 =11 + 20 + 21
23)Change in reserves rise (-), fall (+) +10
24)IMF borrowing from (+) repayments to (-) +5
25)Official financing balance +15 = 23 + 24
26) Overall balance of payments 0 = 22+25
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C) Official settlements balance
Given the huge statistical problems involved
in BOPs statistics,..
…discrepancy b/n the sum of all items
recorded in current account, capital
account & balance of official financing;
which in theory should sum to zero
To ensure the credits & debits are equal, it
is necessary to incorporate a statistical
discrepancy for any difference b/n the sum
of credits & debits
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Several possible sources of this
error
Impossible to keep track of all
transactions b/n domestic & foreign
residents; many of the reported statistics
are based on sampling estimates, ..
….so that some error is unavoidable
Another problem is that the desire to avoid
taxes means that some of the transactions in
the capital account are underreported
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Some dishonest firms may
deliberately under-invoice their X
& over-invoice their M to
artificially deflate their profits
Since the M is recorded by the
customs authorities & the payment
by the banks, the time discrepancy
may mean that the 2 sides of the
transaction are not recorded in the
same set of figures
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The summation of the current
account balance, capital
account balance & the
statistical discrepancy gives the
official settlements balance
Any official settlements deficit has
to be covered by the authorities
drawing on the
reserves,/borrowing money from
foreign CB/the IMF
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Any official settlements
surplus has to be
increasing government
official reserves/repaying
debts to the IMF/other
sources overseas
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Economists make a distinction b/n
autonomous & accommodating
items
The autonomous items are
transactions that take place
independently of the BOPs
The accommodating items are
transactions to finance any
difference b/n autonomous
receipts/payments
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A surplus in the BOPs is an excess of
autonomous receipts over autonomous
payments
A deficit in the BOPs is an excess of
autonomous payments over autonomous
receipts
Autonomous receipts > autonomous
payments= surplus
Autonomous receipts < autonomous
payments= deficit
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Disagreement & difficulty arises b/c
it is not easy to identify which
items qualify
as
autonomous/accommodating
For eg, if there is a short-term
capital inflow in response to a
higher domestic interest rate, it
should be classified an autonomous
item
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However, if there is inflow of
capital to finance imports then it
should be classified as an
accommodating item
The difficulty of deciding which
items should be classified as
accommodating & autonomous
has led to several concepts of BOPs
disequilibrium
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Alternative Concepts of BOPs
Surplus & Deficits
a) The trade account & current account
Both accounts estimates published on a
monthly basis by most DCs
Since current account balance is
concerned with visible & invisibles,
considered more important
Surplus means that the country’s
earning is more than spending vis-a-vis
the ROW
Deficit means that the country’s earning
is less than spending vis-a-vis the ROW 25
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b) The basic balance
The basic balance is the summation of
current account balance plus the net
balance on long-term capital flows
….a significant change in the basic
balance must be a sign of a
fundamental change in the direction
of the BOPs
The more volatile elements such as
short-term capital flows & changes in
official reserves regarded as
accommodating items
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Although a worsening of the basic
balance is supposed to be a sign of a
deteriorating economic situation,
….having an overall basic balance
deficit is not necessarily a bad thing
…however, the capital outflow will yield
future profits, dividends & interest
receipts help to generate future
surpluses on current account
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Conversely, a surplus in the basic
balance is not necessarily a good
thing.
2 interpretations
1) The country is able to borrow there is
nothing to worry about since those
foreigners who are prepared to lend it
money in the LR
2) The long-term borrowing will lead
to future interest, profits & dividend
payments which will worsen the current
account deficit
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The current & capital account items all
are induced by independent hhs,
firms, central & local government:
Autonomous items
If the sum of the current & capital
accounts is negative…
…country’s deficit has to be financed
by authorities drawing on their
reserves, borrowing from foreign
monetary authorities /the IMF
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Under floating exchange rates & no
intervention, the official settlements
balance automatically tends to zero as the
authorities do not buy/sell the home
currency
Under a fixed exchange-rate system,
country is running an official settlements
deficit will find sales of its currency
exceed purchases…
... to avert a devaluation of the currency
authorities have to sell reserves of foreign
currency to purchase the home currency
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Although in 1973, the major industrialized
countries switched from a fixed to floating
exchange-rate system, many developing
countries continue to peg their exchange rate
to the US dollar
Under dollarization, foreign currency usually
the USD, used freely as the medium of exchange
either exclusively/in parallel with local currency.
Reason:
The local population has lost all faith in the
local currency,/it may also be a policy of the govt
(usually to restraint in inflation & import
credible MP).
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THE LINK BETWEEN CURRENT ACCOUNT &
THE NATIONAL INCOME ACCOUNT (OPEN-
ECONOMY IDENTITY)
In an open economy the GDP is different from
that GDP of closed economy
As in open economy there is an additional
injection-export & additional leakage
Identify of an open economy
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If we deduct taxation from the NI we get DI
If we denote private savings
Rearranging equation 3.3
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Further…
Interpretation…
…a current account deficit has a counterpart in either
private dis-saving–that is private investment exceeding
private saving
...and /or in government deficits that is government
expenditure exceeding government taxation revenue
…the equation is merely an identity says nothing about
causation
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It is often argued that the current account deficit is
due to the lack of private savings &/or the government
budget deficit
That is also, the current account deficit can be
responsible for the lack of private saving or
budget deficit
…it shows that the equilibrium level of NI is determined
where injunction (the variables on the left hand side) are
equal to leakages (the variable on the right hand side)
Injunctions are all those factors that work to raise NI,
whereas leakages are those factors that work to lower
NI
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THEORIES OF THE BALANCE OF
PAYMENTS
THE ELASTICITY APPROACH TO THE BOP
It provides an analysis of what happens to the
CA balance when the country devaluates its
currency
The model makes some simplifying
assumption:-
1. The supply elasticity of the domestic export
good & foreign import good are perfectly
elastic so that the changes in demand volumes
have no effect on price
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[Link] idea of the elasticity approach is that there are 2 direct effects of
devaluation on the current balance. One of which works to reduce a
deficit, whilst the other contributes to worsen the CA deficit than before
Let us consider these two effects closely
The current account balance (CA) when expressed in
terms of the domestic currency
CA=PX-SP*M ……………………………………..
(3.15)
Where,
P is domestic price level,
X is the volume of domestic exports,
S is the exchange rate
P* is foreign price level &
M is the volume of import
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In other words Current Account (CA) equals export
minus import
For the sake of simplicity we shall set the domestic &
foreign price level at unit
The value of domestic exports (PX) will be X, while the
foreign currency value of import (P*M) will be M. using
these simplification equation (3.15) becomes.
CA=X-SM …………….……… (3.16)
3.17
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Determining Marginal Change in CA due to small
change in Exchange Rate is obtained by dividing
equation (3.17) by the change in the exchange rate (s).
This is
Now let us introduce price elasticity of
demand for export & price elasticity of
demand for import
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Price Elasticity of Demand for Export
Price elasticity of demand for export is the percentage
change in export over the percentage change in price as
represented by the percentage change in the exchange rate
Price Elasticity of Demand for Import
Price elasticity of import (Em) is the percentage change in
import over the percentage change in their price
represented by the percent change in the exchange rate
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Substituting (3-17) & (3-18) in to (3-19) we obtain
Dividing by M
Assuming that we initially have balanced trade, i.e, X = SM , we
have
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The above equation is known as the Marshall –
learner condition & says that starting from
equilibrium position in the CA; devaluation
will improve the current account
If & only if the sum of the foreign elasticity of
demand for export & the home country
elasticity of demand for import is greater than
unity
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If the sum of two elasticity’s is less than unity
then devaluation will lead to a deterioration
of the CA
Two effects occur once a county’s currency
devaluate:-
i. The Price Effect: – This effect arises
because export become cheaper measured in
foreign currency. On the other hand import
becomes more expensive after devaluation
This price effect clearly contribute to a
worsening of the CA
ii. The Volume Effect: - This effect arises due
to the fact that when export becomes cheaper,
more will be exported
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The net effect depends up on which effect
dominates
In fact economists are divided into two
groups called elasticity optimist who
believed that the sum of these two elasticity
tends to exceed unit
The other group called elasticity pessimists
who believed that the sum of these two
elasticity tends to be less than unit
It was argued that devaluation may work better
for industrialized countries than the developing
countries
justification is that many developing
countries are heavily dependent upon imports
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->For the industrialized countries that have to
face competitive export market, the price
elasticity of demand for their export may be
quite elastic
->The implication of the Marshal - Lerner
conditions is that devaluation may be a cure for
some countries BOP deficit but not for others;
-> there are enormous problems involved in
estimating the elasticity of demand for import
& export
A general consensus accepted by most
economist is that elasticity are lower in the SR
than in the LR in which case the Marshall-
Lerner condition may only hold in the medium45
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-> In the SR possibly the Marshall - Lerner
conditions may not be fulfilled though it may
hold in the LR leads to a phenomenon called J-
curve effect
J-Curve Effect:- in the SR export volumes &
import volume, do not change much,
-> as a result the price effect out weight the
volume effect & this lead to a deterioration in
the CA balance
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however, after a time lag
-> export volume start to increase & import
volume start to decline…
….this leads to gradual improvement of CA
balance & eventually moves to surplus
The issue is whether the initial deterioration
in the CA is greater than the future
improvement so that overall devaluation can
be said to work
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There are different explanation as to the low
responsiveness, of export & import volume in
the SR & why the response is greater in the
LR:
A time lag in the consumer’s response: - It
takes time for consumers in both the
devaluating country & the ROW to respond to
the changed competitive situation
->consumers will be worried about issues other
than the price change such as reliability &
reputation of domestic goods as compared to
the foreign import,
while foreign consumers may be reluctant to
switch away from domestically produced goods
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A time lag in producer, response: - Even if
devaluation improves the competitive position
of exports, it will take time for domestic
producers to expand production of exportable
goods
-> orders for imports are made well in advance
& such contracts are not readily cancelled in
the SR
Imperfect Competition: - penetrating the
foreign market & building market share in the
foreign market is not an easy operation & is a
time –consuming & costly business
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THE ABSORPTION APPROACH TO THE
BOP
It focuses on the fact that a CA imbalance can
be viewed as the difference between domestic
output & domestic spending
Domestic spending like (C+G+I) are called
Absorption
Define domestic Absorption as A= C+I+G
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Equation can be interpreted as current
Account (CA), represents the difference
between domestic output & domestic
absorption
-> a CA surplus means that domestic output
exceeds domestic spending
-> where as a CA deficit implies that domestic
spending is larger than the domestic output
Basic intuition,
understanding how devaluation affects both
income & absorption is the fundamental
concept of the absorption approach to the BOP
Analysis
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Absorption has two parts, these are
• A rise in income which will lead to an
increase in absorption & this is determined by
marginal propensity to absorb (a)
• A direct effect on absorption which is all the
other effects on absorption resulting from
devaluation & this is denoted by – Ad
Thus, the change in total absorption, σA, is
given by
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Change in CA can be shown as
Equation tells us the fact that three (3) factors need
to be considered when analyzing the effect of
devaluation
• Is the marginal propensity to absorb greater/less
than unity?
• Does devaluation raise or lower direct absorption?
• Does Revaluation raise or lower direct absorption?
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The condition for devaluation to improve the
CA is that (1-a) ΔY >Δad
-> any change in income not spent on
absorption must exceed any change in direct
absorption
To look at whether the above condition will be
full filled it is worth to analyze by separating
the set of economy into below full employment
so that income may raise,
…& full employment so that income may not
rise
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THE MONETARY APPROACH TO THE
BOPs
A Simple Monetary Model
Three Key Assumptions that underlie the
monetary model
A) Stable money dd function
The most basic postulate of the monetary
approach to the BOPs is that there is a stable
dd for money function that is made up of only
a few variables
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Md = kPy, where k > 0 ---------------(1)
Where Md is the dd for nominal money
balances,
P is the domestic price level
y is real domestic income
k measures the sensitivity of
money dd to changes in nominal income
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In equation 3.1, if we hold the money ss/
dd fixed,…
….an increase in Y from Y1 to Y2 requires
an equi proportionate fall in the price
level from P1 to P2
Since P1Y1 = P2Y2 the AD curve is a
rectangular hyperbola given by AD1
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A fall in price from P1 to P2 given a fixed
money ss will create excess real money
balances (M/P)…
…. & this leads to increase AD from Yl to
Y2
An increase in the money ss has the
effect of shifting the AD curve to the
right from AD1 to AD2
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B) Vertical Aggregate ss curve
The simple monetary model assumes labor
market is flexible, the economy is
continuously at full employment level of
output
A rise in domestic price does not lead to an
increase in domestic output…
…. b/c wages adjust immediately to the
higher price so that there is no advantage
for domestic producers to take more labor
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In fig 3.2, AS curve AS1 is vertical at full
employment level of output Y1, this does
not mean that output is always
constrained to be fixed at Yl
AS curve may shift to the right to AS2 if
there is an improvement in productivity…
….due to technological progress, which
means that full employment is associated
with a higher real output
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The exchange rate adjusts to keep the
following equation in equilibrium:
S =P/P* i e. P=SP*
Where S is the exchange rate as domestic
currency per unit of foreign
currency
i.e a rise is depreciation & a fall is an
appreciation of domestic currency
P is the domestic price in the
domestic currency
P* is the foreign price in the foreign
currency
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Fig. 3.3 depicts the PPP relationship b/n
domestic price & exchange rate
The PPP curve shows combinations of the
domestic price level & exchange rate
which are compatible with PPP given the
foreign price P*
Points to the left & right of PPP curve
depict overvaluation & undervaluation of
domestic currency in relation to PPP
respectively
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Domestic monetary SS in the economy
is made up of 2 components:
Ms = D + R ---------------------------------- (3)
Where: Ms is the domestic money base
D the domestic bond holdings of the monetary
authorities
R the Reserves of foreign currencies valued
in the domestic currency
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Monetary Base come into circulation in
one of 2 ways:
1. The authorities may conduct OMO
This increases the CB’s monetary liabilities
but increases its assets of domestic bond
holdings which is the domestic component
monetary base represented by D
2. The authorities may conduct FXO
This again increases the CB's monetary
liabilities but increases its assets of
foreign currency & foreign bonds which
are represented by R
N.B. FXO= Foreign Exchange Operation
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Rewrite equation 3 in its derivative form:
dMs = dD +
dR----------------------------(4)
Equation 4 states that any
increase/decrease in the domestic money
SS can come about through either an OMO
as represented by dD, or a FXO as
represented by dR
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Relationship b/n money SS & reserves
depicted in Fig 3.4
At point D1 all the domestic money SS is
made up entirely of the domestic
component
Suppose exchange rate of domestic to
foreign currency equal to unity
An increase of 1 unit of foreign currency
leads to an increase in domestic money SS
by 1 unit
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OMO increases the domestic
component of MB from D1 to D2 shifts
the money SS curve from MS1 to MS2,…
…. & the money SS rises from M1 to M2
By contrast, an expansion of the
money SS due to a purchase of foreign
currencies through FXO,…
….. increases the country's foreign
exchange reserves from R1to R2
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The Monetarist Concept of
BOPs Disequilibrium
BOPs disequilibrium is merely a
reflection of disequilibrium in the money
market
A deficit in the BOPs is due to an excess
stock of money in relation to money dd
A surplus in the BOPs is due to an excess
money dd in relation to stock of money
SS
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i.e The monetary flows are the
'autonomous' items in the BOPs,..
…purchases & sales of goods/services
& investments viewed as
'accommodating' items
….this is completely the reverse of
Keynesian approach..
=} the current account items as the
autonomous items & capital account &
reserve changes as the accommodating
items
05/21/2025 69
Monetarists
…BOPs consisting of current account , capital
account , & change in authorities' reserves
BP = CA + K + dR = 0
----------------------------(5)
CA+K = -
dR-----------------------------------------(6)
In Equation 6,
an increase in reserves due to
purchases of foreign currencies constitute a
surplus in BOPs
a fall in reserves due to
purchases of domestic currencies constitute a
deficit in the BOPs
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If the authorities do not intervene in
foreign exchange market,..
….the currency is left to float, then
reserves do not change
Under floating exchange rate, a
current account deficit must be
financed by an equivalent capital inflow
so the BOPs is in equilibrium
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The Effects of Devaluation
Fig 3.5 depicts the effects of devaluation
The immediate effect of devaluation of the
exchange rate from S1 to S2,…
…. make domestic goods competitive in
relation to PPP at pt A
As domestic goods become more
competitive compared to foreign goods..
….there is an increase in dd for the
domestic currency as represented by a
shift of the money dd curve from Md1 to
Md2
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Competitive advantage of devaluation
leads surplus BOPs as domestic
residents dd less foreign
goods/services,..
…while foreigners dd more domestic
goods
To prevent the domestic currency
appreciating, the authorities have to
purchase the foreign currency with new
domestic MB
=} this increases reserves & leads to
an expansion of domestic money SS73
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=} AD curve shifts to the right from AD1 to
AD2 & starts pushing up domestic prices
until PPP is restored at price P2
Once the domestic price is at P2 & the
money SS has increased to M2,..
… real money balances will be at their
equilibrium level
….& the competitive advantage of the
devaluation has been offset
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Devaluation will have a transitory
beneficial effect on BOPs only the
authorities do not simultaneously engage
in expansionary OMO
If authorities immediately increase
money stock to M2 via OMO,..
…there would be an immediate rise in
AD & domestic prices to P2
=} The competitive advantage conferred
by a devaluation is eliminated
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The important point derived from the
monetary model concerning the effect
of devaluation…
….exchange rate changes are viewed as
incapable of bringing about a lasting
change in the BOPs
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c) The official settlements
balance
The official settlements balance undertake
to finance any imbalance in the current &
capital accounts
….in the settlement concept, the
autonomous items are the current &
capital account transactions including
statistical error
…accommodating items, those
transactions that monetary authorities
have undertaken as indicated by the
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