Keywords

Base money; macroeconomics; monetary approach to balance of payments; monetary approach to exchange rates; monetary policy; official settlements balance; open economy; sterilization; sterilized intervention

Specie-Flow Mechanism

The monetary approach has a long and distinguished history, so the recent popularity of the approach can be viewed as a rediscovery rather than a modern innovation. In fact, the recent literature often makes use of a quote from Of the Balance of Trade, written by David Hume in 1752, to indicate the early understanding of the problem. Hume wrote:

Hume’s analysis is a strict monetary approach to prices and the balance of payments. If England’s money stock suddenly was reduced by four-fifths, we know from principles of economics that the price level would fall dramatically. The falling price level would give England a price advantage over its foreign competitors, so that its exports would rise and its imports fall. As the foreign money (gold in Hume’s day) poured in, England’s money supply would rise and its price level would follow. This process continues until England’s prices reach the levels of its competitors, after which the system is back in equilibrium.

The Monetary Approach

Before turning to the model, we should consider some basic concepts and assumptions. In principles of macroeconomics we learn that the Federal Reserve controls the money supply by altering base money (currency plus commercial bank reserves held against deposits). As base money changes, the lending ability of commercial banks changes. Increases in base money tend to result in an expansion of the money supply, whereas decreases in base money tend to contract the money supply. For our purposes, it is useful to divide base money into domestic and international components. The domestic component of base money is called domestic credit, whereas the remainder is made up of international reserves (money items that can be used to settle international debts, primarily foreign exchange).

The international money flows that respond to excess demands or excess supplies of goods or financial assets at home affect base money and then the money supply. For instance, if a US exporter receives payment in foreign currency, this payment will be presented to a US commercial bank to be converted into dollars and deposited in the exporter’s account. If the commercial bank has no use for the foreign currency, the bank will exchange the foreign currency for dollars with the Federal Reserve (the Fed). The Fed creates new base money to buy the foreign currency by increasing the commercial bank’s reserve deposit with the Fed. Thus, the Fed is accumulating international reserves, and this reserve accumulation brings about an expansion of base money. In the case of an excess supply of money at home, either domestic credit falls to reduce base money, or international reserves will fall in order to lower base money to the desired level.

Now we are ready to construct a simple model of the monetary approach. The usual assumption is that we are analyzing the situation of a small, open economy. A country is defined as “small” when its activities cannot affect the international price of goods or the international interest rate. Openness implies that this country is an active participant in international economic transactions. We could classify nations according to their degree of openness, or the degree to which they depend on international transactions. The United States would be relatively closed, considering the size of the US GDP relative to the value of international trade, whereas Belgium would be relatively open.

A strong assumption of the monetary approach is that there is a stable demand for money. This means that the relationship among money demand, income, and prices does not change significantly over time. Without a stable demand for money, the monetary approach will not provide a useful framework for analysis. We can begin our model by writing the demand for money as

$M^d=kPY$ (14.1)

(14.1)

where M^d is the demand for money, P is the domestic price level, Y is real income or wealth, and k is a constant fraction indicating how money demand will change given a change in P or Y. Eq. (14.1) is often stated as “money demand is a function of prices and income,” or “money demand depends on prices and income.” The usual story is that the higher the income, the more money people will hold to buy more goods. The higher the price level, the more money is desired to buy any given quantity of goods. So, the demand for money should rise with an increase in either P or Y.

Letting M^s stand for money supply, R for net international reserves (our official holdings of foreign assets less the foreign official holdings of our assets), and D for domestic credit, we can write the money supply relationship as¹

$M^s=R+D$ (14.2)

(14.2)

Letting P stand for the domestic price level, E for the domestic currency price of foreign currency, and P^F for the foreign price level, we can write the law of one price, defined in Chapter 7, Prices, Exchange Rates and Purchasing Power Parity as

$P=E{P}^F$ (14.3)

(14.3)

Finally, we need the assumption that equilibrium in the money market holds so that money demand equals money supply, or

$M^d=M^s$ (14.4)

(14.4)

The adjustment mechanism that ensures the equilibrium of Eq. (14.4) will vary with the exchange rate regime. With fixed exchange rates, money supply adjusts to money demand through international flows of money via balance of payments imbalances. With flexible exchange rates, money demand will be adjusted to a money supply set by the central bank via exchange rate changes. In the case of a managed float, where theoretically we have floating exchange rates but the central banks intervene to keep exchange rates at desired levels, we have both international money flows and exchange rate changes. All three cases will be analyzed subsequently.

Now, we develop the model in a manner that will allow us to analyze the balance of payments and exchange rates in a monetary framework. We begin by substituting Eq. (14.3) into Eq. (14.1).

$M^d=kE{P}^{F}Y$ (14.5)

(14.5)

Substituting Eqs. (14.5) and (14.2) into (14.4) we obtain

$kE{P}^{F}Y=R+D$ (14.6)

(14.6)

Finally, we want to discuss Eq. (14.6), money demand and money supply, in terms of percentage changes. Since k is a constant, the change is zero, and thus k drops out of the analysis and we are left with

$\widehat{E}+{\widehat{P}}^F+\widehat{Y}=\widehat{R}+\widehat{D}$ (14.7)

(14.7)

where the hat (^) over a variable indicates percentage change.²

Since the goal of this analysis is to be able to explain changes in the exchange rate or balance of payments, we should have $\widehat{R}$ and $\widehat{E}$ on the left-hand side of the equation. Rearranging Eq. (14.7) in this manner gives

$\widehat{R}\text{−}\widehat{E}={\widehat{P}}^F+\widehat{Y}\text{−}\widehat{D}$ (14.8)

(14.8)

This indicates that the percentage change in net reserves (the balance of payments) minus the percentage change in exchange rates is equal to the foreign inflation rate plus the percentage growth in real income minus the percentage change in domestic credit.

With fixed exchange rates, $\widehat{E}=0$, and we have the MABP. With the exchange rate change equal to zero, the monetary approach Eq. (14.8) simplifies to:

$\widehat{R}={\widehat{P}}^F+\widehat{Y}\text{−}\widehat{D}$ (14.9)

(14.9)

At the other extreme, a completely flexible exchange rate with no central bank intervention results in a reserve flow $\widehat{R}$ equal zero, because there will not be any changes to reserves. In this case the general Eq. (14.8) is now written for the MAER as

$\text{−}\widehat{E}={\widehat{P}}^F+\widehat{Y}\text{−}\widehat{D}$ (14.10)

(14.10)

The Monetary Approach to the Balance of Payments

We may draw the line in the balance of payments accounts (see chapter: The Balance of Payments for a review of balance of payments concepts) so that the current and private capital accounts are above the line and only those items that directly affect the money supply are below the line. This balance is often referred to as the official settlements balance and refers to net official holdings of gold and foreign exchange, special drawing rights, and changes in reserves at the International Monetary Fund. This allows us to concentrate on the monetary aspects of the balance of payments.

With fixed exchange rates, $\widehat{E}=0$, and we have the MABP. Recall that with the exchange rate change equal to zero, the MABP equation is given in Eq. (14.9). This equation indicates that the change in reserves is equal to the foreign inflation rate, plus the percentage growth of real income, minus the change in domestic credit. Therefore, with fixed exchange rates, an increase in domestic credit with constant prices and income (and thus constant money demand) will lead to a decrease in net international reserves. This means that if the central bank expands domestic credit, creating an excess supply of money, reserves will flow out, or there will be a balance of payments deficit. Conversely, a decrease in domestic credit will lead to an excess demand for money, since money demand is unchanged for a given ${\widehat{P}}^F$ and $\widehat{Y}$; yet because D is falling, R will increase by the central bank buying up foreign currency injecting domestic currency, to bring money supply equal to money demand.

Given the framework just developed, we can now consider some of the implications and extensions of the monetary approach. First, the assumption of purchasing power parity (PPP) implies that the central bank must make a policy choice between an exchange rate or a domestic price level. Since P=EP^F, under fixed exchange rates, E is constant. Therefore, maintaining the pegged value of E implies that the domestic price level will correspond to that of the rest of the world. This is the case in which people discuss imported inflation. If the foreign price level is increasing rapidly, then our price must follow to maintain the fixed E. On the other hand, with flexible rates E is free to vary to whatever level is necessary to clear the foreign exchange market, and so we can choose our domestic rate of inflation independent of the rest of the world. If we select a lower rate of inflation than foreigners do, then PPP suggests that our currency will tend to appreciate. This issue of choosing between the domestic inflation rate or a preferred exchange rate has important economic as well as political implications and is not made without much thought and consultation among central bankers.

We might mention at this point that there are two views of how PPP operates in the short run, and these two views imply a different mechanism of adjustment to a change in the world economy like a change in the foreign price level. One view is that PPP holds strictly, even in the short run. In this case, a change in the foreign price induces an immediate change in the domestic price and a corresponding change in money demand or money supply. The other view is along the lines of the Hume quote cited previously. The idea here is that prices adjust slowly through the balance of payments effects on the money supply. Thus, if foreign prices rise relative to domestic prices, we tend to sell more to foreigners and run a larger balance of trade surplus. Since we gain international reserves from these goods sales, over time our money supply rises and our prices increase until PPP is restored.

The two approaches differ primarily with regard to timing. The first case assumes that PPP holds in the short run because international reserves flow quickly in response to new events and prices adjust quickly to new equilibrium levels. This fast adjustment is supposedly due to an emphasis on the role of financial assets being bought and sold, resulting in international capital flows. Since financial assets are easily bought and sold, it is easy to understand why many believe that PPP should hold in the short run (ignoring any relative price effects, which we are not discussing in this section). The second case also assumes that PPP holds, but only in the long run. This approach emphasizes the role of goods markets in international adjustment. Since goods prices are supposedly slow to adjust, short-run deviations from PPP will occur that give rise to the balance of trade effects previously discussed. The truth most likely lies between these two extremes. It is reasonable to expect goods prices to adjust slowly over time to changing economic conditions, so it may be reasonable to doubt that PPP holds well in the short run. On the other hand, PPP is not strictly dependent on goods markets. To ignore international capital flows is to miss the potential for a faster adjustment than is possible strictly through goods markets.

We can summarize the policy implications of the MABP as follows:

The Monetary Approach to the Exchange Rate

Thus far we have only discussed the MABP, which is fine for a world with fixed exchange rates or a gold standard. For a world with flexible exchange rates, we have the MAER. The dichotomy between fixed and floating exchange rates is an important one. When exchange rates are fixed between countries, we will observe money flowing between countries to adjust to disequilibrium. With floating exchange rates, the exchange rates are allowed to fluctuate with the free-market forces of supply and demand for each currency. The free-market equilibrium exchange rate occurs at a point where the flow of exports just equals the flow of imports so that no net international money flows are required. International economists refer to this choice of money flows or exchange rate changes as the choice of an international adjustment mechanism. With fixed exchange rates, the adjustment to changes in international monetary conditions comes through international money flows; whereas with floating rates, the adjustment comes through exchange rate changes.

The MAER equation comes directly from Eq. (14.8). A free-market exchange rate means that no central bank intervention takes place, we have $\widehat{R}$ equal zero, so the MAER approach becomes:

$\text{−}\widehat{E}={\widehat{P}}^F+\widehat{Y}\text{−}\widehat{D}$ (14.11)

(14.11)

With the MAER, an increase in domestic credit, given a constant ${\widehat{P}}^F$ and $\widehat{Y}$ (so that money demand is constant), will result in $\widehat{E}$ increasing. Since $\widehat{E}$ is domestic currency units per foreign currency unit, an increase in $\widehat{E}$ means that domestic currency is depreciating. Under the MAER, domestic monetary policy will not cause flows of money internationally but will lead to exchange rate changes. The fact that ${\widehat{P}}^F$ and $\widehat{Y}$ have signs opposite that of $\widehat{E}$ in Eq. (14.11) indicates that changes in inflation and income growth will cause changes in exchange rates in the opposite direction. For instance, if ${\widehat{P}}^F$ and/or $\widehat{Y}$ increase, we know that money demand increases. With constant domestic credit, we have an excess demand for money. As individuals try to increase their money balances, we observe a decrease in $\widehat{E}$ or an appreciation of the domestic currency.

The Monetary Approach for a Managed Floating Exchange Rate

So far, we have discussed the case of fixed or flexible exchange rates, but what is the framework for analysis of a managed float? Remember, a managed float means that although exchange rates are theoretically flexible and determined by the market forces of supply and demand, central banks intervene at times to peg the rates at some desired level. Thus, the managed float has the attributes of both a fixed and a floating exchange rate regime, because changing supply and demand will affect exchange rates, but the actions of the central bank will also allow international reserves to change. To allow for reserve changes, as well as for exchange rate changes, we can simply return to the initial Eq. (14.8). Thus, we can see that given money demand or money supply changes, the central bank can choose to let $\widehat{E}$ adjust to the free-market level; or, by holding E at some disequilibrium level, it will allow $\widehat{R}$ to adjust.

Sterilization

Sterilization is the offsetting of international reserve flows by central banks that wish to follow an independent monetary policy. Under the MABP (with fixed exchange rates), if a country has an excess supply of money, this country would tend to lose international reserves or run a deficit until money supply equals money demand. Central banks often have reasons for desiring either a high money supply growth or a low money supply growth. For example, if the central bank wants to stimulate the economy it might want a high money supply growth. If for some reason the central bank desires a higher money supply and reacts to the deficit by further increasing the money supply, then the deficit will increase and persist as long as the central bank tries to maintain a money supply in excess of money demand. With an excess demand for money, the concept is reversed. The excess demand results in reserve inflows to equate money supply to money demand. If the central bank tries to decrease the money supply so that the excess demand still exists, its efforts will be thwarted by further reserve inflows, which will persist as long as the central bank tries to maintain the policy of a money supply less than money demand.

Sterilization would allow the monetary authorities to stabilize the money supply in the short run without having reserve flows offset their goals. This would be possible if the forces that lead to international arbitrage are slow to operate. For instance, barriers to international capital mobility might exist in a country. In such a case, we might expect international asset return differentials to persist following a change in economic conditions. If the central bank wants to increase the growth of the money supply in the short run, it can do so regardless of money demand and reserve flows. In the long run, when complete adjustment of asset prices is possible, the money supply must grow at a rate consistent with money demand. In the short run, however, the central bank can exercise some discretion.

The actual use of the word sterilization derives from the fact that the central bank must be able to neutralize, or sterilize, any reserve flows induced by monetary policy if the policy is to achieve the central bank’s money supply goals. For instance, if the central bank is following some money supply growth path, and then money demand increases, leading to reserve inflows, the central bank must be able to sterilize these reserve inflows to keep the money supply from rising to what it considers undesirable levels. This is done by decreasing domestic credit by an amount equal to the growth of international reserves, thus keeping base money and the money supply constant.

Recall again the fixed exchange rate MABP in Eq. (14.9). Given money demand, an increase in domestic credit would be reflected in a fall in $\widehat{R}$. Thus, the causality works from $\widehat{D}$ to $\widehat{R}$. If sterilization occurs, then the causality implied in Eq. (14.9) is no longer true. Instead of the monetary approach equation previously written, where changes in domestic credit ($\widehat{D}$, on the right-hand side of the equation) lead to changes in reserves ($\widehat{R}$, on the left-hand side), with sterilization we also have changes in reserves inducing changes in domestic credit in order to offset the reserve flows. Sterilization means that there is also a causality flowing from reserve changes to domestic credit, as in

$\widehat{D}=\alpha -\beta \widehat{R}$ (14.12)

(14.12)

where β is the sterilization coefficient, ranging in value from 0 (when there is no sterilization) to 1 (complete sterilization). Eq. (14.12) states that the percentage change in domestic credit will be equal to some constant amount (α) determined by the central bank’s domestic policy goals, minus the coefficient β, times the percentage change in reserves. The coefficient β will reflect the central bank’s ability to use domestic credit to offset reserve flows. Of course, it is possible that the central bank cannot fully offset international reserve flows, and yet some sterilization is possible, in which case β will lie between 0 and 1. Evidence has in fact suggested both extremes as well as an intermediate value for β. It is reasonable to interpret the evidence regarding sterilization as indicating that central banks are able to sterilize a significant fraction of reserve flows in the short run. This means that the monetary authorities can likely choose the growth rate of the money supply in the short run, although long-run money growth must be consistent with money demand requirements.

Sterilized Intervention

We have, so far, discussed sterilization in the context of fixed exchange rates. Now let us consider how a sterilization operation might occur in a floating exchange rate system. Suppose the Japanese yen is appreciating against the dollar, and the Bank of Japan decides to intervene in the foreign exchange market to increase the value of the dollar and stop the yen appreciation. The Bank of Japan increases domestic credit in order to purchase US dollar-denominated bonds. The increased demand for dollar bonds will lead to an increase in the demand for dollars in the foreign exchange market. This results in the higher foreign exchange value of the dollar. Now suppose that the Bank of Japan has a target level of the Japanese money supply that requires the increase in domestic credit to be offset. The central bank will sell yen-denominated bonds in Japan to reduce the domestic money supply. The domestic Japanese money supply was originally increased by the growth in domestic credit used to buy dollar bonds. The money supply ultimately returns to its initial level because the Bank of Japan uses a domestic open-market operation (the formal term for central bank purchases and sales of domestic bonds) to reduce domestic credit. In this case of managed floating exchange rates, the Bank of Japan uses sterilized intervention to achieve its goal of slowing the appreciation of the yen while keeping the Japanese money supply unchanged. Sterilized intervention is ultimately an exchange of domestic bonds for foreign bonds.

It is possible for sterilized intervention with unchanged money supplies to have an effect on the spot exchange rate if money demand changes. The intervention activity could alter the private market view of what to expect in the future. If the intervention changes expectations in a manner that changes money demand (for instance, money demand in Japan falls because the intervention leads people to expect higher Japanese inflation), then the spot rate could change.

Summary

Exercises