International Economics II Lecture Notes 5
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International Economics II Lecture Notes 5
International Economics II Lecture Notes 5 Alper Duman July 16, 2009 Alper Duman International Economics II Lecture Notes 5 The Monetary and Portfolio Approaches to External Balance I The monetary approach to the balance of payments means that the balance of payments should be analyzed in terms of a country’s supply of and demand for money. I If a country has a BOP deficit (an official reserve transaction deficit) then there is an outflow of international reserve assets. An outflow implies that country’s supply of money exceeds its demand for money. Alper Duman International Economics II Lecture Notes 5 Ms = a(BR + C ) = a(DR + IR) where: Ms is money supply BR is reserves of commercial banks C is currency held by the nonbank public a is the money multiplier DR is the domestic reserves IR is the international reserves Alper Duman International Economics II Lecture Notes 5 (1) I The money multiplier reflects the process of multiple expansion of bank deposits, (1/r) where r is the reserve requirment ratio I Monetary base is (BR + C). This is the liability side of the central bank. I On the asset side there are (1) loans and security holdings -domestic assets and (2) international reserves -FX and gold Alper Duman International Economics II Lecture Notes 5 The demand for money (L) can be specified as : L = f (Y , P, i, W , E (p), O) where: Y is the level real income in the economy P is the price level i is the interest rate W is the real wealth E (p) is the expected percentage change in the price level O specifies all other variables Alper Duman International Economics II Lecture Notes 5 (2) I Equation 2 can be written as L = kPY (3) where k is a constant embodying all other variables I The equilibrium implies Ms = L (4) or Ms = a(BR + C ) = a(DR + IR) = L = f (Y , P, i, W , E (p), O) (5) Alper Duman International Economics II Lecture Notes 5 The effects of excess money supply (excess cash balances) will be I A rise in P, Y and W will worsen current account. I Purchase of domestic bonds will dampen the interest rate and due to portfolio diversification there will be acquisition of foreign financial assets. Both will lead to a capital outflow and a tendency for a deficit to occur in the private account. I The country will face BOP deficit (official reserve transaction balance deficit). That requires a decrease in IR (credit). I The decrease in IR will decrease Money Supply I Thus the conclusion of the monetary approach is is that markets are self-adjusting Alper Duman International Economics II Lecture Notes 5 Define exchange rate e as e = PA /PB (6) Remember equation MsA = kA PA YA and use the similar equation for country B to obtain e= kB YB MsA kA YA MsB Alper Duman International Economics II Lecture Notes 5 (7)