The Monetary Approach to the Balance of Payments : A Collection of Research Papers by Members of the Staff of the International Monetary Fund

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1977
• eBook ISBN: 9781557752772

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1. Introductory Survey

R. RHOMBERG RUDOLF and H. ROBERT HELLER

THE METHODS EMPLOYED in analyzing the effects of economic changes on a country’s balance of payments have undergone drastic revision in the course of the last 50 years. The evolution of economic ideas and analytical methods generally follows, although sometimes with a considerable lag, the emergence of economic problems requiring solution. Balance of payments analysis, too, has been influenced directly by the changing character of international economic problems; in addition, however, it has also been affected by changing methodological fashions in the mainstream of economic thought.

In the period following World War I, when the problems of resource allocation occupied the center of the stage, the tools of value theory—demand and supply schedules and their elasticities—were applied to the then new problem of exchange devaluation.¹ After World War II, economic theory was dominated by the memory of the Great Depression of the 1930s and by Keynes’s method of analyzing it. In particular, partial equilibrium analysis of the labor market and of the determination of wage rates had come to be regarded as faulty and misleading, since a change in the wage rate—the most important price in the economy—would have macroeconomic repercussions leading to shifts in the labor demand and supply schedules. Applying this methodological point to balance of payments analysis, it was easy to see that the “elasticities approach” to analyzing the effects of a change in the exchange rate—for many economies, another very important price—was subject to a similar criticism. A devaluation tends to affect not only the relative prices of traded and domestic goods but also aggregate income and expenditure. The second effect induces shifts in the demand and supply schedules and thus invalidates the basic supposition of the simple “elasticities approach,” namely, unchanging demand and supply schedules.

This difficulty was avoided by following a method that was much more in keeping with the Keynesian framework of macroeconomic analysis. This approach, which developed largely on the basis of research in the Fund conducted under the guidance of E.M. Bernstein, views the balance of payments on current account as the difference between national income and national expenditure (or absorption).² The effect of any economic change—for instance, a devaluation—on the current balance is, therefore, best assessed by ascertaining its effects on output (income) and on absorption, and by subtracting the latter from the former. This “income-absorption approach” has been criticized on two grounds: first, like the elasticities approach, it does not deal with the balance of payments as a whole but only with the current account; second, while it lends itself readily to an analysis of the effects on the current account of changes directly affecting income and absorption—for instance, of an increase in government expenditure—it is much less suited for an assessment of changes affecting, in the first instance, exchange rates and prices.

As public preoccupation with the insufficiency of aggregate demand and with unemployment gave way during the postwar period to concern about inflation, the Keynesian analytical tools were supplemented, and in some instances replaced, by the simple, if somewhat old-fashioned, instruments of monetary analysis. While there is still controversy about the role of monetarism in solving problems of inflation and unemployment, the monetary approach—all the proponents of which are not necessarily “monetarists” in the narrower sense—has come to occupy a central place in the analysis of balance of payments problems. Several features of this approach, besides the growing popularity of monetarism in general, help to explain its recent ascendancy. Its supporters could argue that “the balance of payments is essentially a monetary phenomenon”; ³ that it is relatively easy to apply, especially if certain plausible simplifications are accepted; and that its strength lies precisely where the other approaches falter, namely, in the analysis of the overall balance of payments-of current and capital transactions taken together. It may be worth elaborating briefly on these aspects of the monetary approach.

Some Characteristics of the Monetary Approach

What is ordinarily called “the balance of payments surplus or deficit,” or the “overall balance of payments,” refers to the net balance of certain financing items in the double-entry bookkeeping system of the external accounts that reflects the net monetary impact of the other transactions recorded in the balance of payments statement. Since it is often the objective of balance of payments analysis to ascertain the effect of some economic change—the imposition of a tax or tariff, a rise in the rate of inflation, a change in the exchange rate, an increase in the price of an important raw material, etc.—on the overall balance, it is plausible to approach the problem by analyzing the “money account” rather than the numerous accounts recording transactions of various goods, services, and capital items. The change in the money account—in most instances simply the change in international gross reserves—is directly linked to monetary balance in the national economy by the condition that the change in external reserves must equal the difference between the change in the demand for money and the change in the supply of money of domestic origin.

It has often been pointed out that each of the three approaches could in principle produce the right answers if it were correctly applied, that is to say, if proper allowance were made for all the repercussions throughout the economy of the change whose effect is being analyzed.⁴

It has, however, proved difficult in practice to set forth a suitable framework for use with either the elasticities approach or the incomeabsorption approach within which the requisite information would be marshaled in a comprehensive and consistent manner. For applied research and background work for policy discussion on balance of payments problems, the monetary approach suggested itself, therefore, as apparently simpler and more manageable than the other approaches. It is based on the postulates of a stable demand function for money and of a stable process through which the money supply is being generated.⁵ The demand for money, it is argued, depends on a relatively small number of economic factors, and the effects of economic changes on the demand for money are therefore easy to assess because they can operate only through one or several of these few factors. A similar argument can be made with respect to the determination of the supply of money. By focusing directly on the relevant monetary aggregates, this approach eliminates the intractable problems associated with the estimation of numerous elasticities of international transactions and of the parameters describing their interdependence, which are inherent in other approaches.

The apparent simplicity of the monetary approach to the balance of payments is, however, somewhat deceptive. Even though for many purposes the demand for money can be conveniently expressed as a function of a small number of variables, it is still just as much the resultant of all the influences that come to bear on the economy as are national income and national expenditure. Again, domestic credit creation, which is often taken as being determined exogenously, may in fact be systematically influenced by factors determining the demand for money or by some of the events whose monetary effects are being examined. These considerations do not invalidate the monetary approach; they merely draw attention to the possibility that it will be seen, on further examination, to be not quite so superior in terms of simplicity of application as had first been thought.

The elasticities approach and the income-absorption approach are best applied to the analysis of changes in the merchandise trade balance and the balance of net exports of goods and services, respectively. If more comprehensive balance of payments concepts are to be analyzed, for example, the basic balance or the overall balance, the analysis has to be supplemented so as to cover the additional balance of payments categories (for instance, capital movements), usually in a manner that does not fully conform to the approach in question. The monetary approach, by contrast, leads directly to the determination of the overall balance of payments as the difference between the change in the demand for money and the change in the net domestic assets of the banking system (domestic credit creation). If the effect of some economic event on other balance of payments components, say, on the current account balance, is to be ascertained, the simple model based on the demand for and supply of money, and the factors directly influencing them, can be extended by the inclusion of the requisite additional relationships. In this connection it is well to remember that the choice of the monetary approach to the analysis of the balance of payments does not confine the analyst to a small and simple model. As Johnson has urged in his recent significant extension of the monetary approach,

the general thrust of the new approach ought not to be identified with, and assessed according to the plausibility of, the particular simple models that its proponents have employed to derive some of the central conclusions that differ from those implied by the conventional models, or to express those conclusions as logical consequences of general equilibrium models constructed with full use of the mathematical and economic expertise now required of scientific model construction.⁶

Development of Monetary Balance of Payments Models at the Fund

While the monetary approach to balance of payments analysis in a sense dates back to David Hume and the classical specie-flow mechanism, two developments contributed to the renewed interest in this approach in the period following World War II. One important factor was the renaissance of academic interest in monetary problems, which was spearheaded by members of the University of Chicago. For the last quarter century, Professor Milton Friedman has been the main contributor to the rehabilitation of the quantity theory of money; and during the last decade, Professors Robert Mundell and Harry Johnson have intro-duced the monetary approach to the balance of payments in academic circles. The other factor, which preceded the emergence of academic interest in this topic, was the development of a direct concern with monetary policy questions that were encountered by central bankers and by other national and international officials. As is clearly brought out in the paper by J.J. Polak (Ch. 2 of this volume), written in 1957, acceptance of the Keynesian analytical framework by the economics profession had left a gap between problems that could easily be solved with the help of Keynesian tools and those frequently encountered by officials concerned with monetary and balance of payments questions. In the construction of a theoretical basis for solving such problems and in the design of procedures for quantitative analysis in this area, much of the innovative work was done by the staff of the International Monetary Fund. The studies contained in this volume represent a collection, albeit not a complete one, of contributions to this field by Fund staff members written between 1957 and 1974.

The initial impetus toward this research came from the staff’s work on problems of less developed countries. There were, perhaps, four reasons for this. First, in the 1950s, many less developed countries lacked the detailed national income and product accounts necessary for an analysis of national income and balance of payments determination along Keynesian, or income-absorption, lines; nor was it feasible to apply the elasticities approach in an adequate manner. However, monetary statistics were usually obtainable as a result of the central bank’s exercise of its supervisory authority over the banking system. Similarly, balance of payments data were available as a by-product of the customs administration and from banking sources. In view of the availability of these two sets of data in a large number of countries for which other statistical information was scarce, the thought naturally presented itself to develop a framework of analysis that could take full advantage of this data base.

Second, the nature of the Fund’s work on balance of payments problems of member countries made it desirable to have available a framework for quantitative analysis that was sufficiently manageable (in the days before long-distance access to computers) to be serviceable during staff missions to foreign capitals. The monetary approach permits a meaningful approximate analysis of the relevant aggregates with the help of models that are small enough to be calculated with pencil and paper.

The third reason is more fundamental. Less developed countries typically have a simpler financial structure than do more developed countries. In the absence of well-developed asset markets and financial instruments, there are relatively few alternatives to either holding funds in monetary form or spending them on domestic or foreign goods and services or on foreign financial instruments. In these circumstances, the implication for the external balance of a difference between the amount of money newly supplied through domestic credit creation and the additional amount that residents wish to hold is more obtrusive than it is in countries with a more complex financial structure.

Finally, a monetary framework for analyzing the balance of payments effects of economic policy was particularly appropriate for many developing countries, particularly in Latin America, in which control over domestic credit was in fact relied on as a major instrument—perhaps the most important one—of demand management and balance of payments control.

The Fund’s approach to monetary management—or, as it came to be called, to financial programming—for the purpose of achieving balance of payments equilibrium evolved during the 1950s, initially in staff work on Latin American member countries. It emerged from the need to discuss with the authorities of a member requesting financial assistance from the Fund the adequacy of the policy program proposed by them and the quantitative conditions (“credit ceilings”) under which the member would continue to have access to the Fund’s resources made available in a stand-by arrangement.

This approach rested on Professor Triffin’s analysis in terms of “money of external and internal origin”—concepts that correspond to net foreign assets and net domestic assets of the banking system, respectively—and the relation of the former to the overall balance of payments. ⁷ The central element of this approach was the estimation of the prospective demand for money on the basis of forecasts of real gross domestic product (GDP), an assumption about future price inflation, and any other relevant information. By controlling domestic credit creation during the period under review so as to equal the estimated change in the demand for money, the authorities could keep the external accounts in balance and the change in international reserves to zero. If an external surplus was to be achieved, perhaps in order to permit repayment of indebtedness, domestic credit creation would to that extent have to be kept below the forecast change in the demand for money; and if a deficit could be temporarily tolerated, domestic credit creation could be allowed to exceed the anticipated change in the demand for money.

There was a theoretical difficulty in the initial formulation of this scheme: the growth of output and the change in the price level had to be assumed to be known without prior knowledge of the magnitude of domestic credit creation. But this shortcoming can be—and has been—surmounted by iterative calculation carried to the point at which sufficient consistency is obtained between the estimated changes in output and prices, on the one hand, and the calculated value of domestic credit creation, on the other hand. A source of greater concern was the difficulty of forecasting the national price level. In many instances, this difficulty was resolved by assuming that the national price level would move in conformity with the world price level, which could be forecast more easily. This means that the “law of one price,” a prominent postulate in much of current balance of payments theorizing, was used as a standard element of this approach. In other instances, where the importance of prices of nontraded goods and services made reliance on the law of one price obviously inappropriate, the national price level was forecast on the basis of an appraisal of the government’s announced wage policy and its probable implications for the general price level. Although price forecasting was always a troublesome aspect of the application of this procedure, forecasting the demand for money on the basis of a given nominal GDP was generally a more important source of error.

Selections Contained in This Volume

This general procedure, of which there were a number of variants, was taken as a point of departure for a small model designed for monetary analysis of income formation and payments problems, which was constructed by J J. Polak in 1957 (Ch. 2 of this volume). This marked the beginning of formal research on monetary balance of payments models in the Fund. The first seven papers in this volume (Chs. 2-8) illustrate the further development of this research and its application by Polak himself and by other staff members. The last three papers (Chs. 9-11) are contributions by staff members whose university training had exposed them to the new academic approach to monetary balance o...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Foreword
• List of Contributors and Acknowledgments
• Contents
• 1 Introductory Survey
• 2 Monetary Analysis of Income Formation and Payments Problems
• 3 Monetary Analysis of Income and Imports and Its Statistical Application
• 4 Money Supply and Imports
• 5 Some Mathematical Notes on the Quantity Theory of Money in an Open Economy
• 6 Money, Income, and the Foreign Balance
• 7 Monetary Variables and the Balance of Payments
• 8 Credit Policy and the Balance of Payments
• 9 Credit Versus Money as an Instrument of Control
• 10 The Determination of the Balance of Payments and Income in Developing Countries
• 11 The Monetary Approach to Balance of Payments Determination: An Empirical Test
• Footnotes