The monetary approach to the balance of payments is associated with the names of R. Mundell and H. Johnson. The other writers who have made contribution to it include R. Dornbusch, M. Mussa, D. Kemp and J. Frankel. The basic premise of the approach is the recognition that the BOP disequilibrium is fundamentally a monetary phenomenon. It attempts to explain the BOP deficits or surpluses through demand for and supply of money.
Assumptions of Monetary Approach:
This approach rests upon the following main assumptions:
(i) There is the existence of a single price for identical products in different countries, after allowing the transport costs.
(ii) The level of output in a given country is exogenously determined.
(iii) There is full employment of resources in all the countries.
(iv) There is no possibility of sterilisation of currency flows under a system of fixed exchange rates on account of single price assumption.
(v) The demand for money is a direct function of income and an inverse function of the rate of interest.
(vi) The supply of money is determined by the high powered money and money multiplier.
(vii) The demand for nominal money balances is stable.
The monetary approach, given the above assumptions, holds that the excess of money supply over money demand reflects the balance of payments deficit. The excessive money holdings are utilised by the people in the purchase of foreign goods and securities.
The excess supply of money may be offset by the central bank under a system of fixed exchange rates through the sale of foreign exchange reserves and the purchase of domestic currency. As the excess supply conditions in the money market are removed, the balance of payments equilibrium gets restored.
On the opposite, if the supply of money falls short of the demand for money, the country will have a balance of payments surplus. In such a situation, people try to acquire the domestic- currency through the sale of goods and securities to the foreigners. For meeting the shortage of domestic currency, the central bank will buy excess foreign currency in addition to the purchase of domestic securities. Such measures will remove the BOP surplus and restore the BOP equilibrium.
The monetary approach to BOP can be expressed through the following relations:
The supply of money (Ms) consists of domestic component of the nation’s monetary base (H) and international or foreign component of the nation’s monetary base (F).
Ms = H + F
The demand for money (MD) is a stable and direct function of income and inverse function of the rate of interest. The monetary equilibrium is determined by the equality between the demand for money and the supply of money.
MS = MD
H + F = MD
F = MD -H
From this relation, it follows that the excess of money demand over the domestic monetary base is offset by an inflow of reserves from abroad or international monetary base in the event of a BOP surplus. On the opposite, if there is a BOP deficit reflected by the excess of money supply over money demand, the adjustment can be possible through an outflow of foreign reserves.
The monetary approach also explains that the BOP disequilibria, under a flexible exchange system, are corrected immediately through automatic changes in exchange rate without any international flow of money or reserves. A deficit in the BOP resulting from the excess of money supply over money demand, causes an automatic depreciation in country’s currency. This leads to a rise in domestic prices and also the demand for money.
As a consequence, there is an absorption of the excess supply of money and the BOP deficit gets adjusted.
On the opposite, a surplus in the BOP, caused by the excess of demand for money over its supply, results automatically in the appreciation of nation’s currency. It leads to a fall in domestic prices. As a consequence, the excess money demand and the BOP surplus get offset.
The monetary approach to the BOP situation has an important policy implications. It suggests that the policies like devaluation can have effectiveness in the short period only if the monetary authority does not increase the supply of money to match exactly the increase in the demand for money resulting from devaluation or other adjustment policies.
Criticism of the Monetary Approach:
The monetary approach to BOP adjustment has been subjected to criticism on the following grounds:
(i) Stability of Money Demand Functions:
This approach, assumes the demand function of money to be stable. Such an assumption may be valid in the long run. But there is a strong opinion among the economists that money demand function is unstable in the short period.
(ii) Assumption of Full Employment:
In this approach, an assumption has been taken that there is the existence of full employment. This assumption does not hold valid in actual life.
(iii) Invalidity of Single Price:
The monetary approach to BOP adjustment rests upon the assumption of single price for identical products. Even this assumption is not true. When the productive factors are diverted to sectors producing non-traded commodities, the excess demand for non-traded goods can spill over into the reduced supply of traded goods. That can cause an increase in imports. Consequently, the principle of single price for all traded goods stands violated.
(iv) Neglect of other Influences on Money Demand:
In this approach, the demand function for money is related only to income and rate of interest. In fact, the money demand function is related to several other variable connected with both domestic economy and foreign trade and exchange.
(v) Possibility of Sterilisation of Currency:
The critics have not accepted the validity of the assumption of impossibility of sterilisation of currency under a system of fixed exchange rates. They have referred to circumstances in which the sterilisation of currency can become possible. In their opinion, the currency flow can become sterile, if the private sector is willing to adjust the composition of its wealth portfolio with regard to the relative importance of bonds and money balances.
Another situation in which sterilisation of currency flow can be possible occurs if the government is prepared to have a higher budget deficits whenever the country has to deal with the problem of BOP deficit.
(vi) Market Imperfections:
The principle of single price for identical products is vitiated by the market imperfections. The price differentials between different trading countries do exist on account of market imperfections and various restrictions or regulations enforced by the governments on the domestic and international trade.
(vii) Neglect of Monetary Lags:
The monetary approach is conceptually suited to long term balance of payments adjustment. The prolonged monetary lags between the recognition of the problem of BOP deficit and ultimate BOP adjustment have been generally neglected in this approach.
(viii) Neglect of Other Economic Policies:
In this approach, the emphasis is essentially upon the variation in credit flows. The BOP equilibrium can be achieved also through the alternative economic policies of expenditure-switching which can work through domestic real and money flows as well as the government budgetary variations.
Despite its weaknesses, the monetary approach is superior to the traditional price-specie flow theory of D. Hume. That theory had stressed upon the BOP adjustments through the gold flows and consequent effects upon prices, international trade and payments. The modern monetary approach, in contrast, suggests the correction of BOP deficits or surpluses through changes in domestic and international monetary base and their effects upon production, income and expenditure.