Page 146 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes 3. R = (1 / mm) P γ θ ( *r + ) τ + ε Y − Dsc
 −


An increase in the demand for money, given by the P times the expression in the square brackets
[..], leads to an increase in the stock of official foreign exchange reserves as the authorities act to
maintain the fixed exchange rate. A reduction in the money multiplier increases the stock of
base money required to support the existing quantity of money, requiring in an increase in the
stock of reserves to provide the additional base money demanded. An increase in Dsc leads to
an equal decline in the stock of foreign exchange reserves as the authorities are forced to keep
the stock of money unchanged at its desired level to maintain the exchange rate parity.
The authorities are forced to maintain a stock of reserves that will provide domestic residents
with their desired money holdings, given the domestic source component. This implies that the
commercial banks and the public will have their desired stock of base money. It also means that
the authorities can effectively control the stock of official foreign exchange reserves by
manipulating the domestic source component---such changes in the stock of reserves can be
brought about at no cost in terms of price level changes, or output and employment changes
when the price level is fixed. As you should have learned in the previous two lessons, output,
income and prices are determined by the conditions of flow equilibrium.
It is evident from Equation 3 above that we must distinguish between two types of balance of
payments disequilibria---stock and flow. A one-shot adjustment of the domestic source
component or shift in the demand for base money holdings at a moment in time will lead to a
shift in the stock of official reserves at that moment in time. The stock of official reserves will
typically also be growing or declining at some rate through time---it is this flow of increases or
decreases in the stock of reserves that is commonly referred to as the balance of payments
surplus or deficit, which can be expressed as

 −
4. ∆ R =   (1/mm ) P γ θ ( *r + ) τ + ε Y   − ∆ Dsc
∆


where ∆ is the change per unit time. Official reserve holdings change through time because the
levels of income, prices, and the real interest rate and the money multiplier change through
time---the effects of these changes are captured by the major collection of terms in the square
brackets to the right of the equal sign. They also change as a result of a change in the domestic
source component Dsc∆ through time.
Notice that the presence of balance of payments equilibrium is completely independent of the
condition of flow equilibrium---indeed, we did not have to include the IS equation in the above
discussion. This is the case as long as people are free to buy and sell assets in the international
market. There is no relationship of balance of payments equilibrium to equilibrium in the balance
of trade---balance of payments equilibrium is entirely a monetary phenomenon. All this changes
when we assume that there is zero private international mobility---that private residents are
prohibited from purchasing assets from or selling them to foreign residents. In this case, the
only domestically held foreign assets are official foreign exchange reserves and the condition of
balance of payments equilibrium becomes
∆ R = B T
where B is the balance of trade---the balance of payments surplus or deficit becomes equal to
T
the balance of trade surplus or deficit. To maintain balance of payments equilibrium the
government has to bring about changes in the balance of trade by bringing about changes in the
price level or income and employment or allowing the nominal exchange rate to change.
When there is international private capital mobility, the government can control the time-path
of foreign exchange reserves simply by controlling the time-path of Dsc. But shocks to the
demand for money are unpredictable and the main adjustment to these shocks will necessarily
be the day-to-day purchases and sales of foreign exchange reserves in return for domestic
currency necessary to keep the exchange rate at its fixed parity. Changes in the domestic source
component perform the role of providing for long-run growth in the money supply to match
the growth in demand as income and the volume of transactions rise with time.

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