Chapter 22

THE MONETARY
AND PORTFOLIO
BALANCE
APPROACHES TO
EXTERNAL
BALANCE

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
22-1
LEARNING OBJECTIVES
• SHOW HOW THE SUPPLY AND
DEMAND FOR MONEY CAN AFFECT A
COUNTRY’S BALANCE OF PAYMENTS
AND EXCHANGE RATE.
• DESCRIBE HOW OTHER FINANCIAL
ASSETS BESIDES MONEY CAN
INFLUENCE EXCHANGE RATES AND
INTERNATIONAL PAYMENTS
POSITIONS.
• EXPLAIN HOW A CHANGING
EXCHANGE RATE CAN OVERSHOOT
ITS NEW EQUILIBRIUM VALUE.

22-2
THE MONETARY APPROACH
TO THE BALANCE OF
PAYMENTS
 THE MONETARY APPROACH TO THE BALANCE OF
PAYMENTS ARGUES THAT THE BOP IS MAINLY A
MONETARY PHENOMENON.
 THIS APPROACH REQUIRES US TO CONSIDER A
COUNTRY’S SUPPLY OF AND DEMAND FOR MONEY.

22-3
MONETARY APPROACH TO
THE BOP: THE SUPPLY OF
MONEY
 THE MONEY SUPPLY (MS) CAN BE SEEN EITHER IN
TERMS OF CENTRAL BANK LIABILITIES:
MS = A(BR + C), WHERE
BR = RESERVES OF COMMERCIAL BANKS
C = CURRENCY HELD BY NONBANK PUBLIC
A = THE MONEY MULTIPLIER
 OR CENTRAL BANK ASSETS
MS = A(DR + IR), WHERE
DR = DOMESTIC RESERVES
IR = INTERNATIONAL RESERVES

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MONETARY APPROACH TO
THE BOP: THE SUPPLY OF
MONEY
 THE MONEY MULTIPLIER REFERS TO THE NOTION OF
MULTIPLE DEPOSIT CREATION.
 IF THE RESERVE REQUIREMENT IS 10%, A NEW DEPOSIT
OF $1,000 CREATES $900 OF EXCESS RESERVES, WHICH
CAN BE LENT OUT.
 THE LOAN RECIPIENT DEPOSITS THE $900 IN HER BANK;
THIS CREATES $810 OF EXCESS RESERVES WHICH CAN
BE LENT, ETC.
 THE MONEY MULTIPLIER IS 1/R OR 10.

22-5
MONETARY APPROACH TO
THE BOP: THE SUPPLY OF
MONEY
 ANYTHING THAT INCREASES THE ASSETS OF THE
CENTRAL BANK (OR EQUIVALENTLY, ITS LIABILITIES)
ALLOWS THE MONEY SUPPLY TO EXPAND VIA THE
MULTIPLIER PROCESS.
 SUPPOSE THE CENTRAL BANK BUYS GOVERNMENT
SECURITIES OR FOREIGN EXCHANGE – IN EITHER CASE
THE MONEY SUPPLY IS EXPANDED.

22-6
 MONETARY APPROACH TO
BOP: THE DEMAND FOR
MONEY
 MONEY DEMAND (L) IS A FUNCTION OF SEVERAL
VARIABLES:
L = F[Y, P, I, W, E(P), O], WHERE
Y = LEVEL OF REAL INCOME IN ECONOMY
P = PRICE LEVEL
I = INTEREST RATE
W = LEVEL OF REAL WEALTH
E(P) = EXPECTED % Δ IN PRICE LEVEL
O = OTHER VARIABLES THAT MAY AFFECT L

22-7
 MONETARY APPROACH TO
BOP: THE DEMAND FOR
MONEY
 L IS A POSITIVE FUNCTION OF Y, DUE TO THE
TRANSACTIONS DEMAND FOR MONEY.
 L IS A POSITIVE FUNCTION OF P, SINCE MORE
CASH IS NEEDED TO MAKE PURCHASES
WHEN P RISES.
 L IS A NEGATIVE FUNCTION OF I; I IS THE
OPPORTUNITY COST OF HOLDING MONEY.
 L IS A POSITIVE FUNCTION OF W; AS A
PERSON’S WEALTH RISES SHE WILL WANT TO
HOLD MORE MONEY.
 L IS A NEGATIVE FUNCTION OF E(P); IF A
PERSON EXPECTS INFLATION HE WILL HOLD
LESS MONEY.

22-8
 MONETARY APPROACH TO
BOP: THE DEMAND FOR
MONEY
 FREQUENTLY A GENERAL EXPRESSION FOR MONEY
DEMAND IS USED:

L = KPY, WHERE

P AND Y ARE AS DISCUSSED, AND K IS A CONSTANT

EMBODYING ALL OTHER INFLUENCES ON MONEY
DEMAND.

22-9
 MONETARY APPROACH TO
BOP: MONETARY EQUILIBRIUM
 MONEY MARKET EQUILIBRIUM OCCURS WHEN

MS = L OR

A(DR+IR) = A(BR+C) = F[Y,P,I,W,E(P),O]

OR

MS = KPY.

22-10
 MONETARY APPROACH TO
BOP: MONETARY EQUILIBRIUM
 HOW CAN WE UNDERSTAND BALANCE OF PAYMENTS
ADJUSTMENTS USING MONEY SUPPLY AND DEMAND?
 LET US ASSUME A FIXED EXCHANGE RATE SYSTEM.
 WHAT HAPPENS WHEN THE CENTRAL BANK INCREASES
MS, PERHAPS BY PURCHASING GOVERNMENT
SECURITIES (INCREASING DR)?
 BR AND/OR C WILL INCREASE, AND THERE WILL NOW
BE AN EXCESS SUPPLY OF MONEY.

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 MONETARY APPROACH TO
BOP: MONETARY EQUILIBRIUM
 CURRENT ACCOUNT
 EXCESS CASH BALANCES IMPLY INDIVIDUALS SPEND MORE,
BIDDING UP P.
 Y AND W MAY RISE.
 HIGHER P AND Y WILL LEAD TO LOWER EXPORTS (X) AND
HIGHER IMPORTS (M).
 THEREFORE, THE EXCESS SUPPLY OF MONEY LEADS TO A
CURRENT ACCOUNT DEFICIT.
 PRIVATE CAPITAL ACCOUNT
 EXCESS CASH CAUSES INDIVIDUAL TO BID UP PRICE OF
FINANCIAL ASSETS; THIS DRIVES DOWN I.
 IN THE END, THIS CAUSES A DEFICIT IN THE PRIVATE CAPITAL
ACCOUNT.

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 MONETARY APPROACH TO
BOP: MONETARY EQUILIBRIUM
 TOGETHER, THESE EFFECTS INDICATE THAT A MONEY
SUPPLY INCREASE LEADS TO A BALANCE OF PAYMENTS
DEFICIT.
 TO SUMMARIZE:
 INCREASE IN MS CAUSES INDIVIDUALS TO SHIFT TO NON-
MONEY ASSETS, INCLUDING FOREIGN GOODS AND ASSETS.
 THIS CREATES A BOP DEFICIT.

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 MONETARY APPROACH TO
THE EXCHANGE RATE
 WHEN EXCHANGE RATES ARE FIXED, AN INCREASE IN MS
LEADS TO A BOP DEFICIT.
 IF THE EXCHANGE RATE IS NOT FIXED, BOP DEFICITS AND
SURPLUSES WILL BE ELIMINATED BY EXCHANGE RATE
ADJUSTMENTS.
 LET’S LOOK AT EXCHANGE RATE CHANGES IN TERMS OF
MONEY DEMAND AND SUPPLY
 WHAT HAPPENS IF MS IS INCREASED?

22-14
 MONETARY APPROACH TO
THE EXCHANGE RATE
 IF MS IS INCREASED
 INDIVIDUALS WISH TO PURCHASE NON-MONEY ASSETS,
INCLUDING FOREIGN GOODS AND ASSETS.
 THIS CREATES AN “INCIPIENT” BOP DEFICIT.
 THE HOME COUNTRY’S CURRENCY WILL DEPRECIATE TO
ELIMINATE THE BOP DEFICIT.
 IF MS IS DECREASED
 INDIVIDUALS WISH TO SELL NON-MONEY ASSETS, INCLUDING
FOREIGN GOODS AND ASSETS.
 THIS CREATES AN “INCIPIENT” BOP SURPLUS.
 THE HOME COUNTRY’S CURRENCY WILL APPRECIATE TO
ELIMINATE THE BOP SURPLUS.

22-15
 MONETARY APPROACH TO THE
ER: A SIMPLE MODEL

• IF WE ASSUME THAT ABSOLUTE

PURCHASING POWER PARITY
HOLDS, THEN
E = PA/PB
• SIMILARLY, FOR COUNTRY B,
MSB = KBPBYB
• IT MUST BE M
TRUE THAT
k A PAYA
sA

M sB k B PBYB

22-16
 MONETARY APPROACH TO THE
ER: A SIMPLE MODEL

• FOR COUNTRY A, MONETARY

EQUILIBRIUM MEANS THAT
MSA = KAPAYA
• THIS MEANS THAT
M sA k AYA
 e
M sB k BYB
• REARRANGING YIELDS
k BYB M sA
e
k AYA M sB
22-17
MONETARY APPROACH TO THE
ER: A SIMPLE MODEL

k BYB M sA
e
k AYA M sB
 THIS EXPRESSION DEMONSTRATES THAT AN
INCREASE IN MS BY COUNTRY A WILL LEAD TO A
DEPRECIATION OF THE CURRENCY.
 INFLATIONARY MONETARY POLICY ONLY CAUSES
CURRENCY DEPRECIATION.

22-18
 PORTFOLIO BALANCE APPROACH
TO THE BOP AND THE EXCHANGE
RATE
 THE APPROACH EXTENDS THE MONETARY APPROACH TO
INCLUDE OTHER FINANCIAL ASSETS BESIDES MONEY.
 IN A TWO COUNTRY MODEL THERE WILL CONTINUE TO BE
DEMAND FOR MONEY BY EACH COUNTRY’S CITIZENS.
 NOW THERE WILL ALSO BE DEMAND FOR HOME-COUNTRY
BONDS (BD) AND FOR FOREIGN BONDS (BF).
 BD YIELDS INTEREST RETURN OF ID; BF YIELDS A RETURN
OF IF.

22-19
 PORTFOLIO BALANCE APPROACH
TO THE BOP AND THE EXCHANGE
RATE
 THE RELATIONSHIP BETWEEN INTEREST RATES IS AS
FOLLOWS:
ID = IF + XA – RP, WHERE

RP IS THE RISK PREMIUM ASSOCIATED WITH THE

IMPERFECT INTERNATIONAL MOBILITY OF CAPITAL
XA IS THE EXPECTED PERCENTAGE APPRECIATION OF
THE FOREIGN CURRENCY, OR [E(E)/E] – 1

22-20
PORTFOLIO BALANCE APPROACH
TO THE BOP AND THE EXCHANGE
RATE
 DEMAND BY HOME COUNTRY INDIVIDUAL FOR HOME
MONEY
L = F(ID, IF, XA, YD, PD, WD), WHERE
ID = RETURN ON HOME-COUNTRY BONDS
IF = RETURN ON FOREIGN-COUNTRY BONDS
XA = EXPECTED APPRECIATION OF FOREIGN CURRENCY
YD = HOME COUNTRY REAL INCOME
PD = HOME COUNTRY PRICE LEVEL
WD = HOME COUNTRY REAL WEALTH

22-21
 PORTFOLIO BALANCE
APPROACH TO THE BOP AND
THE EXCHANGE RATE

 HOME MONEY DEMAND (L) WILL BE

 INVERSELY RELATED TO ID.
 INVERSELY RELATED TO IF.
 INVERSELY RELATED TO XA.
 POSITIVELY RELATED TO YD.
 POSITIVELY RELATED TO PD.
 POSITIVELY RELATED TO WD.

22-22
 PORTFOLIO BALANCE
APPROACH TO THE BOP AND
THE EXCHANGE RATE
 DEMAND BY HOME COUNTRY INDIVIDUAL FOR HOME
BONDS
BD = H(ID, IF, XA, YD, PD, WD), WHERE
 HOME BOND DEMAND WILL BE
 POSITIVELY RELATED TO ID
 INVERSELY RELATED TO IF
 INVERSELY RELATED TO XA
 INVERSELY RELATED TO YD
 INVERSELY RELATED TO PD
 POSITIVELY RELATED TO WD

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 PORTFOLIO BALANCE
APPROACH TO THE BOP AND
THE EXCHANGE RATE
 DEMAND BY HOME COUNTRY INDIVIDUAL FOR FOREIGN
BONDS (MULTIPLIED BY E SO THAT IT’S IN TERMS OF
DOMESTIC CURRENCY
EBF = J(ID, IF, XA, YD, PD, WD), WHERE
 FOREIGN BOND DEMAND WILL BE
 INVERSELY RELATED TO ID
 POSITIVELY RELATED TO IF
 POSITIVELY RELATED TO XA
 INVERSELY RELATED TO YD
 INVERSELY RELATED TO PD
 POSITIVELY RELATED TO WD

22-24
PORTFOLIO ADJUSTMENTS:
EXAMPLE 1
 HOME COUNTRY CENTRAL BANK SELLS GOVERNMENT
SECURITIES (I.E., DECREASES MS AND INCREASE HOME
BOND SUPPLY).
 ID SHOULD RISE, RESULTING IN
 DECREASE IN HOME-COUNTRY MONEY DEMAND,
 DECREASE IN FOREIGN BOND DEMAND, AND
 INCREASE IN HOME BOND DEMAND.
 FOREIGN INVESTORS SWITCH TOWARDS HOLDING HOME-
COUNTRY CURRENCY.

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PORTFOLIO ADJUSTMENTS:
EXAMPLE 1
 HOME COUNTRY CENTRAL BANK SELLS GOVERNMENT
SECURITIES (I.E., DECREASES MS AND INCREASE HOME
BOND SUPPLY).
 IF SHOULD RISE.
 THE FOREIGN CURRENCY DEPRECIATES (E FALLS),
ASSUMING FLEXIBLE EXCHANGE RATES.
 XA RISES.
 THERE ARE THEREFORE SECOND-ROUND EFFECTS,
CONTINUING UNTIL A NEW PORTFOLIO BALANCE IS
ATTAINED.

22-26
 PORTFOLIO ADJUSTMENTS:
EXAMPLE 2
 HOME COUNTRY INDIVIDUAL BELIEVE HOME INFLATION
IS LIKELY IN THE FUTURE.
 ASSUME FLEXIBLE EXCHANGE RATES, XA SHOULD RISE
(THAT IS, HOME CITIZENS WILL EXPECT A DEPRECIATION OF
THE HOME CURRENCY), RESULTING IN
 DECREASE IN HOME-COUNTRY MONEY DEMAND,
 DECREASE IN HOME BOND DEMAND, AND
 INCREASE IN FOREIGN BOND DEMAND.
 THE HOME COUNTRY CURRENCY DEPRECIATES.
 SO: THE EXPECTATION OF A DEPRECIATION LEADS TO A
DEPRECIATION.

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PORTFOLIO ADJUSTMENTS:
EXAMPLE 3
 AN INCREASE IN HOME COUNTRY REAL INCOME,
LEADING TO A
 INCREASE IN HOME-COUNTRY
MONEY DEMAND.
 DECREASE IN HOME BOND DEMAND.
 DECREASE IN FOREIGN BOND
DEMAND.
 THE HOME COUNTRY CURRENCY APPRECIATES UNDER A
FLEXIBLE EXCHANGE RATE SYSTEM; A BOP SURPLUS
OCCURS UNDER A FIXED EXCHANGE RATE REGIME.

22-28
PORTFOLIO ADJUSTMENTS:
EXAMPLE 4
 AN INCREASE IN HOME COUNTRY BOND SUPPLY
CAUSES
 INCREASE IN ID, WHICH CAUSES A
CAPITAL INFLOW AND AN
APPRECIATION OF THE HOME
COUNTRY CURRENCY.
 INCREASE IN WEALTH, WHICH
(AMONG OTHER THINGS) CAUSES
AN INCREASED DEMAND FOR
FOREIGN BONDS AND AN
DEPRECIATION OF THE HOME
CURRENCY.
 ON NET, IT IS LIKELY THAT THE HOME CURRENCY
APPRECIATES.

22-29
PORTFOLIO ADJUSTMENTS:
EXAMPLE 5
 AN INCREASE IN HOME COUNTRY WEALTH BECAUSE OF
HOME-COUNTRY CURRENT ACCOUNT SURPLUS
 INCREASE IN MONEY DEMAND,
LEADING TO AN INCREASE IN ID.
 INCREASE IN DEMAND FOR FOREIGN
BONDS AND FOR DOMESTIC BONDS,
BOTH OF WHICH LEAD TO A
DECREASE IN ID.
 ON NET, IT IS NOT CLEAR WHAT WILL HAPPEN TO THE
EXCHANGE RATE.

22-30
PORTFOLIO ADJUSTMENTS:
EXAMPLE 6
 AN INCREASE IN SUPPLY OF FOREIGN BONDS BECAUSE
OF FOREIGN GOVERNMENT BUDGET DEFICIT
 CAUSES AN INCREASE IN THE RISK
PREMIUM, AND
 AN APPRECIATION OF THE HOME
COUNTRY CURRENCY.

22-31
 EXCHANGE RATE
OVERSHOOTING
 EXCHANGE RATE OVERSHOOTING OCCURS WHEN, IN
MOVING FROM ONE EQUILIBRIUM TO ANOTHER, THE
EXCHANGE RATE GOES BEYOND THE NEW EQUILIBRIUM
BEFORE EVENTUALLY RETURNING TO IT.
 ASSUME:
 COUNTRY IS SMALL.
 PERFECT CAPITAL MOBILITY EXISTS.
 ESSENTIALLY, UNCOVERED INTEREST PARITY APPLIES.

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 EXCHANGE RATE
OVERSHOOTING
 THE RELATIONSHIP BETWEEN THE PRICE LEVEL (P)
AND THE EXCHANGE RATE (E) SHOULD BE NEGATIVE
BECAUSE
 A HIGHER PRICE INCREASES DEMAND FOR MONEY, SO ID
WILL RISE.
 THE RESULT IS AN APPRECIATION.

22-33
 EXCHANGE RATE
OVERSHOOTING: THE ASSET
MARKET
P A
If from point B prices were to rise to
P2, demand for money would rise, and
the home currency would appreciate
(i.e., e falls).
P2
F
P1 B

e2 e1 e

22-34
 EXCHANGE RATE
OVERSHOOTING
 ACCORDING TO PURCHASING POWER PARITY, IN THE
LONG RUN WHEN A COUNTRY’S CURRENCY
DEPRECIATES ITS PRICE LEVEL WILL INCREASE
PROPORTIONATELY.
 THAT IS, THERE IS A LONG RUN POSITIVE
RELATIONSHIP BETWEEN E AND P.
 LET’S PUT THIS RELATIONSHIP TOGETHER WITH THE
SHORT RUN ASSET MARKET RELATIONSHIP IN A
SINGLE GRAPH.

22-35
EXCHANGE RATE OVERSHOOTING:
THE DORNBUSCH MODEL

P A

P1

A
0
e1 e

22-36
 EXCHANGE RATE
OVERSHOOTING
 AN INCREASE IN THE MONEY SUPPLY SHIFTS THE ASSET
CURVE FROM AA TO A'A'
 THIS CAUSES A RELATIVELY RAPID DEPRECIATION OF
THE HOME CURRENCY, FROM E1 TO E2.
 PRICES EVENTUALLY WILL BEGIN TO RISE DUE TO
EXCESS DEMAND FOR GOODS CAUSED BY THE
CURRENCY DEPRECIATION.
 EVENTUALLY, WE REACH A NEW EQUILIBRIUM AT E'

22-37
EXCHANGE RATE OVERSHOOTING:
THE DORNBUSCH MODEL

A'
P A

L
E'

P1 E

A'
A
0 e3
e1 e2 e

22-38