Page 156 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes prices, decrease in exports, and rise in imports. This decreases the trade surplus. Thus, the surplus in
BOP is automatically eliminated and BOP disequilibrium is corrected. These conclusions can be
established through the basic model of the monetary approach.

The monetary approach was developed by Robert A. Mundell in 1968 and 1971 and
Harry G. Johnson in 1972.

The Model of Monetary Approach

According to the monetary approach, BOP imbalance (B) equals the difference between the demand
for money (M ) and the supply of money (M ).
d s
B = M – M ... (1)
d s
The relationship between the BOP and money demand and supply is illustrated in Figure 1. In this
figure, the demand for money, M , is assumed to be exogenously determined and to remain constant.
d
This assumption can be explained as follows. We know that,
M = M + M ... (2)
d t sp
where, M = transaction demand, and M = speculative demand for money.
t sp
We know also that M = f (Y) and M = f (i). where Y = national income, and i = interest rate. The
sp
t
monetary approach to BOP adjustment assumes that both Y and i are exogenously determined. It
implies that so long as Y and i remain constant, the demand for money remains constant as shown by
the schedule M in Figure 1.
d
As regards the supply of money, monetary approach assumes that money supply in an open economy
equals domestic component of money supply plus external component of money supply. The domestic
component of money supply equals money multiplier times the commercial bank reserves with the
central bank (i.e., the domestic component of the monetary base). The external component of money
supply equals money multiplier times the ‘international reserves’ (i.e., the external component of the
monetary base). Given these components of money supply, M , in Eq. l can be defined as :
s
M = m (DB + IB) ... (3)
s
where, m = money multiplier; DB = domestic base (commercial banks’ deposits with the central
bank); and IB = international base (international reserves).
The monetary approach to BOP adjustment assumes DB and money multiplier (m) to remain constant.
Therefore, domestic component of money supply remains constant. The constant domestic component
of money supply has been shown in Figure 13.1 by the horizontal schedule m(DB) by assuming mDB =
Rs. 100 billion. The schedule m(DB) has been drawn by assuming m = 5 and DB = Rs. 20 billion (constant).
Money Supply and Demand (Rs. billon) 500 m.DB = 5 × 20 m(IB) d
M
600
s

400
M
300
200
m(DB)
100
0
60
20 m.DB = 5 × 20 80 100
40
International Reserves (Rs. billion)
Figure 13.1 : Money Demand and Supply and International Balance

150 LOVELY PROFESSIONAL UNIVERSITY