The Monetary Approach to the Balance of Payments

Jacob Frenkel, Harry Johnson, Jacob Frenkel, Harry Johnson, Jacob A. Frenkel, Harry G. Johnson, Jacob A. Frenkel, Harry G. Johnson

• Publisher: Routledge
• Year: 2013
• eBook ISBN: 9781135043483
• Edition: 1
• Topic: Economics
• Subtopic: Business General
• Index: Economics

This book collects together the basic documents of an approach to the theory and policy of the balance of payments developed in the 1970s. The approach marked a return to the historical traditions of international monetary theory after some thirty years of departure from them – a departure occasioned by the international collapse of the 1930s, the Keynesian Revolution and a long period of war and post-war reconstruction in which the international monetary system was fragmented by exchange controls, currency inconvertibility and controls over international trade and capital movements.

PART ONE

Theoretical

I. INTRODUCTORY ESSAY

1

The Monetary Approach to the Balance of Payments

Essential Concepts and Historical Origins

JACOB A. FRENKEL AND HARRY G. JOHNSON

1 ESSENTIAL CONCEPTS

The main characteristic of the monetary approach to the balance of payments can be summarised in the proposition that the balance of payments is essentially a monetary phenomenon. The term ‘the balance of payments’ refers to items that are ‘below the line’ in the over-all balance of payments (which must balance exactly, by the principles of double-entry accounting); the items in question constitute the ‘money account’. In general, the approach emphasises the budget constraint imposed on the country’s international spending and views the various accounts of the balance of payments as the ‘windows’ to the outside world, through which the excesses of domestic flow demands over domestic flow supplies, and of excess domestic flow supplies over domestic flow demands, are cleared. Accordingly, surpluses in the trade account and the capital account respectively represent excess flow supplies of goods and of securities, and a surplus in the money account reflects an excess domestic flow demand for money. Consequently, in analysing the money account, or more familiarly the rate of increase or decrease in the country’s international reserves, the monetary approach focuses on the determinants of the excess domestic flow demand for or supply of money.

Clearly, a consistent use of the budget constraint implies that the money account—the current rate of change of reserves—can be analysed in terms of the determinants of all the other accounts—at the simplest level of aggregation, the goods account and the capital account. The monetary approach, however, recommends an analysis in terms of the behavioural relationship directly relevant to the money account, rather than an analysis in terms of the behavioural relationships directly relevant to the other accounts and only indirectly to the money account via the budget constraint. Since the money account is determined by the excess flow demand for money, it is clear why the balance of payments is regarded as a monetary phenomenon and this approach is referred to as ‘the monetary approach’. To repeat, the monetary approach should in principle give an answer no different from that provided by a correct analysis in terms of the other accounts. The main reason for preferring the monetary approach is that less direct alternative approaches have almost invariably attempted to explain the behaviour of the markets they concern themselves with, by analytical constructs in which the role of money in influencing behaviour, and the connection between these other markets and the money markets, are neglected as being ‘of the second order of smalls’, which may be a legitimate procedure for many economic problems, but cannot be so for an analysis which aims to explain or predict behaviour in the money market.

The surplus or deficit in the goods account (more generally the current account) measures the extent to which the economy’s income is greater than consumption (‘absorption’) and the economy is therefore accumulating claims on future income (assets) from abroad or vice versa. By virtue of the budget constraint, the sum of the deficit on the capital account (net purchase of foreign securities) and the surplus on the money account equally represents the accumulation of foreign assets (decumulation if negative). The so-called ‘absorption approach’ to the balance of payments, associated with Sidney Alexander [1], emphasises the rate of accumulation or decumulation of foreign assets (securities plus money). In so doing, it constitutes an improvement over at least the cruder versions of the ‘elasticity approach’, which emphasises relative-price-induced substitution of domestic demand away from or towards imports and of foreign demand towards or away from exports, on the implicit assumption that such substitutions are matched by equal increases or decreases in absorption. The monetary approach selects for emphasis a subset of the spectrum of foreign assets whose accumulation or decumulation is emphasised by the absorption approach. The main reasons for this are, firstly, that the accumulation of foreign assets does not necessarily imply the accumulation of money through the balance of payments—it may mean the opposite, as for example when a monetary policy of lowering interest rates leads domestic asset-holders to move their funds from domestic to foreign securities. Secondly, the monetary authorities in their role as stabilisers of the exchange rate in a fixed rate system are concerned with what causes the stock of international reserves to change and how to prevent such changes. Thirdly, the monetary authority, as the ultimate source of domestic money, controls the rate of change of the domestic credit component of the monetary base—the other component being international reserves—and thereby the flow supply of money. It should be noted that control of the flow supply of money does not mean control of the stock supply of money, or of ‘the quantity of money’, since in an open economy the public can and does determine the total stock of money through its ability to convert domestic money into goods and securities in the international markets. The assumption that the residents of the country have a demand for money which depends on variables at least in part different from those that determine the quantity of domestic credit extended by the banking system, or alternatively that the rate of change of money demanded (the rate of hoarding) is independent of the rate of change of the domestic credit source component of the monetary base, implies that the money account of the balance of payments is influenced directly by monetary policy.

The accumulation or decumulation of assets depends on the aggregate relationship between domestic expenditure and income and does not depend on the composition of expenditure between exportables and importables, or between goods that, given the price structure, are classifiable into tradeable and non-tradeable goods. Consequently, though relative prices do influence the composition of expenditures, they play a secondary or negligible role in the monetary approach (as in the absorption approach). On the other hand the general price level does play a central role, since it determines the real value of nominal assets—money, and possibly fixed-interest debt traded internationally—and this role is emphasised along with the roles of other macro-economic aggregate magnitudes.

This brief account of the monetary approach to balance of payments theory, and comparison of it with the alternative elasticity and absorption approaches, implicitly disposes of various, and often ill-informed, criticisms that have tended to be made of it, and which amount essentially to red herrings across the trail of scientific study and understanding.

To begin with, the approach is described as ‘monetary’, and not ‘monetarist’, precisely to avoid confusion with recent domestic policy debates in which the term ‘monetarist’ has been used by the debaters to represent alternatively attaching ‘appropriate’ and ‘too much’ importance to money, and specifically to the use of monetary as contrasted with fiscal policy in economic stabilisation. The monetary approach to the balance of payments asserts neither that monetary mismanagement is the only cause, nor that monetary policy change is the only possible cure, for balance of payments problems; it does suggest, however, that monetary processes will bring about a cure of some kind—not necessarily very attractive—unless frustrated by deliberate monetary policy action, and that policies that neglect or aggravate the monetary implications of deficits and surpluses will not be successful in their declared objectives.

Secondly, the essential assumption of the monetary approach, like the restated quantity theory of money according to Friedman, is that there exists an aggregate demand function for money that is a function of a relatively small number of aggregate economic variables. In this respect it makes exactly the same assumptions as the Keynesian theory, except for the extreme versions of the latter theory, not to be found in the writings of Keynes himself, in which the demand for money as a function of interest rates is subject to a ‘liquidity trap’, or the supply of (domestic) money is made completely elastic by monetary policy itself; and these extre...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Original Copyright Page
• Dedication
• CONTENTS
• Preface
• List of Contributors
• PART ONE—THEORETICAL
• PART TWO—EMPIRICAL
• Index