Page 157 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 13: BOP Adjustment : Monetary Approach

On the other hand, the international balance (IB) is supposed to be a variable factor. Therefore, the Notes
international component of money supply changes with the change in the international balance (IB).
It equals m × IB. The international component of money supply schedule thus obtained is given by
the schedule m(IB). The m(IB) schedules in our example is based on s(IB). The aggregate money
supply schedule. M , is the vertical sum of schedules m(DB) and m(IB). This is precisely the monetary
s
approach model. Let us now look at the self-correcting mechanism of the BOP disequilibrium as
envisaged by the monetary approach to the problem.
The Self-Correcting Mechanism

The self-correcting mechanism under monetary approach is illustrated in Figure 13.2 assuming a
fixed exchange rate. Panel (a) of this figure is reproduction of Figure 13. 1 and panel (b) is a derivation
from panel (a). As shown in panel (a) the total money supply schedule (M ) and the total money
s
demand schedule (M ) intersect at point E where M equals M at Rs. 300 billion and, at the equilibrium,
d d s
international reserves equals Rs. 40 billion. It implies that if international reserves equal Rs. 40 billion,
then M will always be equal to M and the monetary sector will be in equilibrium.
d s
The point that needs to be noted here is that, according to the monetary approach, when total demand
for money equals total money supply, then BOP is in equilibrium—there is neither surplus nor deficit
in the BOP. As shown in panel (a) of Figure 13.2, at no point other than point E money supply equals
money demand. Therefore, at all other points along the M and M schedules, there is either deficit or
s
d
surplus in the BOP. This phenomenon is illustrated in panel (b) of Figure 13. 2. The payments imbalance
schedule represents the vertical difference between the M and M schedules in panel (a). Point E’ in
d s
panel (b) shows zero BOP balance corresponding to point E in panel (a).
The Self-Correcting Process : According to the monetary approach, the self-correcting process is an
in-built system. When demand for money exceeds the supply of money, it means that there is surplus
in the BOP. As Figure 13. 2 shows, at all the points below point E along the schedule M in panel (a),
s
demand for money exceeds supply of money. It means that, in accordance with Eq. 1, there is BOP
surplus, that is, increase in the foreign exchange reserves. For example, at foreign exchange reserves
of Rs. 20 billion, the demand for money equals Rs. 300 billion and money supply equals Rs. 200
billion. It means that money demand exceeds money supply by JK = Rs. 100 billion. This means a
BOP surplus of Rs. 100 billion, which enhances the foreign exchange reserves. This rise in the foreign
exchange reserves pushes the money supply up over time along the schedule M towards point E. At
s
point E, demand for money equals the supply of money. Therefore, there is neither surplus nor
deficit in the BOP. That is, the BOP is automatically restored to equilibrium.

billon) 600 M s

(Rs. 500 m(IB) 300
Demand 400 200

and 300 M d Payments Imbalance (bn. Rs) 100 Surplus A E
Supply 200 m.DB=5×20 m(DB) 0 20 40 60 Deficit 80 100

Money 100 m.DB=5×20 –100 L Payment
Imbalance
0
–200 Schedule
20 40 60 80 100
Foreign Exchange Reserves (bn. Rs)
International Reserves (bn. Rs)
(a) (b)

Figure 13.2 : Self-Correcting Monetary Mechanism

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