Page 155 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Dilfraz Singh, Lovely Professional University Unit 13: BOP Adjustment : Monetary Approach

Unit 13: BOP Adjustment : Monetary Approach Notes

CONTENTS
Objectives
Introduction
13.1 Monetary Approach to BOP Adjustments
13.2 Elasticity Approach
13.3 Summary
13.4 Key-Words
13.5 Review Questions
13.6 Further Readings

Objectives

After reading this Unit students will be able to:
• Understand BOP Adjustment.
• Explain the Monetary Approach to BOP Adjustment.
Introduction

The BOP adjustment has been a theoretically complex and practically complicated issue for both the
economists and the policy maker. The economists have suggested variety of approaches and measures
to correct the BOP disequilibrium. Correcting disequilibrium in the BOP has been, as noted above, a
knotty problem for both economists and policy-makers. However, efforts continued to find a general
solution to the problem of BOP adjustment. In the process, there emerged another important approach
to BOP adjustment, called monetary approach. It must be borne in mind that the monetary approach
developed by these economists is different from monetary-policy approach. The monetary approach
to BOP adjustments is discussed below.
13.1 Monetary Approach to BOP Adjustments

According to the modern monetary approach. BOP, disequilibrium is a monetary phenomenon. The BOP
disequilibrium (deficit or surplus) arises because of inbalance between the demand for and supply of money.
The BOP deficits arise because money supply exceeds the demand for money and BOP surplus is the
outcome of the excess of demand for money over the supply of money. The monetary approach is
based on the premise that BOP disequilibrium arising out of discrepancy between the demand for
and supply of money is a transitory phenomenon and is self-correcting in the long run.
Another important feature of the monetary approach is that it looks at the BOP “bottoms up.” That is,
it begins the analysis of BOP disequilibrium by looking at the bottom of the BOP accounts, i.e., the
change in the official foreign exchange reserves. Rather than analyzing ‘above the line’ entries in the
BOP accounts, monetary approach lumps together all the transactions in the current and capital
accounts and looks at the changes in the final outcome of the international transactions. The final
outcome is reflected by the change in the official reserves of foreign exchange.
Pending the details, let us first look at the process of self-correction. The self-correction process begins
with the change in the official reserves. In case there is deficit in the BOP, it causes a decline in the
official reserves of foreign exchange. Decline in the foreign exchange reserves leads to a decline in the
money supply. The decrease in money supply leads to decrease in domestic prices, increase in exports,
decrease in imports, and decrease in trade deficits. These trends automatically correct the BOP
disequilibrium. On the other hand, a surplus in the BOP increases money supply which causes rise in

LOVELY PROFESSIONAL UNIVERSITY 149