Introduction

Globalization
has played a significant role in promoting economic relations among countries
all over the world. In this era of globalization, it is fair to say that no
country in the world is “an island” or self-sufficient. One of the key benefits
of globalization is the ease of movement of goods and services across or among
nations. Like the computation of GDP, countries keep records of its
transactions with external economies over a given period usually quarterly or
yearly. This record of transactions is referred to as Balance of Payment (BOP).

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The balance
of payments which is also referred to as the balance of international payments is
a record of all international or financial transactions that are undertaken
between residents of one country and residents of other countries during the year.
These transactions include payments relating to imports and exports of goods and services, financial capital, and financial transfers (Saylor, n.d.; Riley, n.d.).
A country’s balance of
payments expresses the equilibrium between international commercial and
financial inflows and outflows (Paun, et al., 2010). The balance of Payment
can also be defined as a statistical record of all the economic transactions
between residents of a reporting country and the rest of the world during a
given period of time. Balance of payment is one of the most important
statistical statement as well as economic indicator of a country. It reveals
the number/ quantity of goods and services a country has exported or imported
over a period of time. It also reflects whether a country has been borrowing
money or lending to the rest of the world (Pilbeam, 2013, p. 31). The BoP can be defined
using different measures depending on the circumstance, thus, BoP can be
defined using the Official Settlement, Current Account or Basic Balance
definitions.

 

However,
for many countries, the focus of attention is on the balance of payment on
their current account and a lot of effort is concentrated on policies to reduce
the current account deficit by increasing and reducing the value of exports and
imports respectively. A balance of payment can be
in surplus or deficit. A country’s balance of payments is said to be in surplus
if inflows (funds from exports, and assets e.g. bonds) exceed. On the other
hand, a balance of payment is said to be in deficit if outflows are more than
the inflows.

 

Brief Description of Other Approaches

Over the
years, economists (John Keynes, Marshall Lerner, Mundell and Fleming, Polak among
others) have propounded various unique approaches in the analysis of BoP but
with varying characteristics. There
are three basic alternative theories or approaches of balance of payments adjustment
namely, the elasticities approach,
the absorptions approach and the monetary approach.

 

 

 

In
the elasticities and absorption approaches the focus of attention is on the
trade balance with resources not fully employed. The elasticities approach
emphasizes the role of the relative prices (or exchange rate) in balance of
payments adjustments by considering imports and exports as being dependent on
relative prices (through the exchange rate). A notable shortcoming of the
elasticities approach is that it does not consider capital flows. On the
contrary, the
monetary approach focuses of attention on the balance of payments (or the money
account) with full employment of resources, thus, this
balance consists of the items that affect the domestic monetary base.

 

The absorption approach shows a significant improvement over the
elasticities approach in the sense that, it views the external balance through
national income accounting. Thus, the elasticity approach relates the balance of
payment to the activities elsewhere in the economy instead of taking the
partial equilibrium view of the elasticities approach in analysing the external
sector in isolation. The monetary approach, like the absorption approach,
stresses the need for reducing domestic expenditure relative to income, in
order to eliminate a deficit in the balance of payments. (Ardalan, 2005, p.
37).

 

Background to the Monetarist Approach to BoP and
Exchange Rate

 

In
surveying the body of research dealing with the balance of payments, two major
shortcomings are immediately apparent. First, there are no widely accepted
theories of the balance of payments which simultaneously incorporate both the
current and capital account. The great majority of models used in payments
theory consider either the capital account or the current account separately.
Second, there have been very few attempts to include even the fundamentals of
portfolio choice theory in balance-of-payments models. This is particularly
surprising in view of the essentially monetary nature Balance of payments
theory.

 

The
monetarist approach to the balance of payments theory addresses both
shortcomings. Since this essentially involves an extension of the rudiments of
monetary theory to the area of the balance of payments, it is henceforth
referred to as a monetary view of the balance of payments (MBOP) (Kemp, 1975, p.
14).

 

The monetarist
approach to the balance of payments and exchange rate determination asserts that changes in a country’s balance of
payments
or the exchange value of
its currency are just a monetary phenomenon,
thus can only be corrected by monetary measures.

 

The
fundamental thinking underpinning the Monetary Approach is that a country’s
balance of payment deficit is as a result of its money supply being greater
than the demand for money, thus an excess supply of money is the only cause of
the BoP deficit. When a government of one country expands its money supply
faster than other countries or its required, the result is a worsening of the
country’s BoP position.

 

 

Assumptions underlying the Monetarist Approach:

 

The
monetary approach is based on a number of assumptions:

 

The demand for money is stable and has a
positive relation on income, prices and interest rate. The supply of money of a country is made up of
two components:  domestic credit and foreign
exchange reserves. 

Purchasing
Power Parity holds- The law of one price assumes that it should cost the same
amount of money to purchase a particular basket of goods irrespective of the
country of purchase, thus, the price of a basket of goods in country A should
be same as the price of an similar/identical item in country B after converting
to a common currency, after allowing for transport costs. There is perfect
substitution in consumption in both the product and capital markets.

 

 

The level of output of a country is determined
by exogenous factors. AA1 

 

All countries resources are assumed to be at
fully employment.

 

In
summarizing the assumptions, the stable demand for money and the fixed
aggregate supply sets the standard quantity theory of money principle that a
change in money supply leads to a proportionate change in price level, which
also results in an increase in nominal income. However, given the assumption
that income (output) is fixed, then price remains the only determinant. However,
the purchasing power parity (PPP) assumptions challenges the price changes in
the quantity theory of money. PPP assumes perfect substitution in consumption
of goods/services on the international market where price levels are exogenous.
As a result, the foreign exchange reserve component of the money supply is the
key determinant of the BoP deficit or surplus.

 

Given these
assumptions, the monetary approach can be expressed in the form of the
following relationship between the demand for and supply of money:

 

The demand
for money (Md) is a stable function of income (Y), prices (P) and rate of
interest (i)

 

Md=f(Y, P,
i) ……… (1)

 

The money
supply (Ms) is a multiple of monetary base (m) which consists of domestic money
(credit) (DC) and country’s foreign exchange reserves (R).

Ms = DC + R
……….. (2)

 

Since in
equilibrium the demand for money equals the money supply,

 

Md
= Ms ………. (3) and thereby;

 

Md
= DC + R as MS = DC + R ….…(4)

 

A balance
of payments deficit or surplus is represented by changes in the country’s
foreign exchange reserves. Therefore;

 

R = ?Md – ?DC
…….. (5)

 

or R = B …………..  ( 6)

 

where B
represents balance of payments which is equal to the difference between change
in the demand for money (?Md) and change in domestic credit (?DC).

 

A balance
of payments deficit reduces the foreign exchange reserve (R) and the money
supply. On the other hand, a surplus increases R and the money supply. When B =
O, it means BoP equilibrium.

 

The
automatic adjustment mechanism in the monetary approaches could be demonstrated
below under both the fixed and flexible exchange rate systems using a
hypothetical small country as an example

 

Balance of Payment Analysis under the Fixed
Exchange Rate System

 

Under the
fixed exchange rate system, a country’s monetary authorities intervene to
regulate the value of exchange rate. It is assumed that under fixed exchange
rates the government’s control/regulation of currency flows is not possible on account
of the law of one price globally. An attempt by the monetary authority to
increases domestic money supply under the fixed exchange regime, results in a BoP
deficit. People who have large money balances increase their purchase of more
foreign goods and securities.

 

This tends
to raise their prices and increase imports of goods and foreign assets. This
leads to increase in expenditure on both current and capital accounts in BoP,
thereby creating a BOP deficit. To correct the BoP deficit, monetary authorities
need to buy back the currency on the foreign exchange market. Thus, the outflow
of foreign exchange reserves means a fall in Foreign Exchange Reserve in
domestic money supply. This process will continue until there will be BoP
equilibrium.

 

On the
other hand, a fall in money supply over money demand will result in a BOP
surplus. Consequently, people acquire the domestic currency by selling goods
and securities to foreigners. They will also seek to acquire additional money
balances by restricting their expenditure relatively to their income. The
monetary authority on its part, will buy excess foreign currency in exchange
for domestic currency. There will be inflow of foreign exchange reserves and
increase in domestic money supply. This process will continue until money
supply equals demand and BoP equilibrium will be restored. Thus, a BoP deficit
or surplus in the fixed exchange regime is a temporary phenomenon and is self-correcting
in the long-run (Ardalan, 2009).

 

Balance of Payment Analysis under the Floating
Exchange Rate System

 

Under a floating exchange rate regime, the country’s monetary
authorities do not intervene to affect the valuation of the exchange rate. This
theory assumes that an appreciation of the domestic currency makes domestic
goods and assets more expensive on international markets and, thus, applies
downward pressures on the BOP.

 

According
to the theory, an imbalance in the BOP will automatically alter the exchange
rate in the direction necessary to obtain BOP equilibrium.  When there is a BoP deficit or
surplus, changes in the demand for money and exchange rate play a major role in
the adjustment process without any inflow or outflow of foreign exchange
reserves. Suppose the monetary authority increases the money supply, there is a
BOP deficit. People having additional cash balances buy more goods thereby
raising prices of domestic and imported goods. This results in the depreciation
of the domestic currency and a rise in the exchange rate. Consequently, the
rise in prices increases the demand for money thereby bringing the equilibrium
of money demand and supply without any outflow of foreign exchange reserves.
The reverse occurs when the demand for money exceeds supply in that it results
in fall in prices and appreciation of the domestic currency which automatically
eliminates the excess demand for money. “The exchange rate will fall until the
demand for money is equal to money supply and BOP is in equilibrium without any
inflow of foreign exchange reserves” (Meghana, n.d.).

 

For example, it is argued that the Asian crisis prompted most investors
to move to USD denominated assets. As a result, there is a large positive net
portfolio investment in the U.S., leading to a surplus of the Current Account
and of the BOP. According to the theory, this excess demand for U.S. assets
should lead to an appreciation of the USD. This would, in turn, make U.S. goods
and assets more expensive, and generate downward pressure on the Current
Account and the Capital Account (University of Colorado, n.d.).

 

Empirical
evidence

 

Much of the empirical evidence tries to measure the extent to which a
rise in the domestic money supply base results in a fall in the foreign
exchange reserve in the fixed exchange regime. Pilbeam (2013) presents
empirical estimates for some countries for the period 1976 to 1990 (Pilbeam,
2013, pg. 120). This evidence suggests mixed results. Studies from 1974-1976
confirms that the offset coefficient is correct.

 

However, researches conducted after 1982 suggests that earlier studies
may have been over estimated because of the frequency of sterilisation. This
mixed position is as a result of certain assumptions such as price level and
interest rates not holding in the real-world scenario.

 

Limitations of the Monetary Approach

 

While
the monetary approach has been widely accepted as more realistic in that it
takes into consideration both domestic money and foreign money as it does not
lay emphasis on relative price changes unlike the Elasticity Approach, the
monetary approach has been criticized by several economists and experts. Some
of these criticisms are mentioned below.

 

1. A survey
of the monetary conducted by Boghton (1988) argued that almost all the assumptions propounded are open to empirical questions.
Critics argue that the demand for money function can be highly unstable. Again,
economies rarely obtain full employment due to involuntary unemployment in
countries. There is also the argument of market imperfections which challenges
the assumption of   the law of one price.
There may be price differentials resulting from to the lack of information about
prices, knowledge of identical goods and trade regulations in other countries.

 

These
assumptions hold well in the long run but are rarely fulfilled in the short
run.

 

2. Some
critics have also argued that it is
quite wrong to view countries balance of payment deficit or surplus as purely a
monetary phenomenon. BoP adjustments may sometimes be as a result of
expenditure-switching decisions operating through real flows and government
budget rather than money demand.

 

3.
There is weak link between BOP and Money
Supply. The monetarist assumption of the direct link between BoP of an
economy and its total money supply has been criticized as overly simplified and
does not hold in a real-world phenomenon. For such an assumption to be valid, the
monetary authority will have to offset the inflows and outflows of foreign
exchange reserves in a deficit or surplus situation. This requires some level
of sterilization of external flows which is not possible due to globalization
of financial markets.  

 AA1Check if its same as saying level of output is assumed exogenously