Monetary Approach to Balance of Payment – by Harry G. Johnson in 1977
The monetary approach to balance of payment (developed by Harry G. Johnson in 1977) is also known as the ‘Small Country Model of Balance of Payment’ that shows an automatic adjustment between change in money supply (∆Ms) and money demand (∆Md) through the change in the position (deficit/surplus) of Balance of Payment. According to the approach, Balance of Payment is always and everywhere a monetary phenomenon so that there is a significant role of both money supply and money demand in the position of Balance of Payment. The approach is based on given assumptions:
a. The country is small and open economy
b. All countries are functioning with full employment economy
c. There is a fixed exchange rate regime
d. There is no money illusion
e. There is a strong desire of people for adjustment between Ms = Md
f. There is a perfect mobility of goods/s and financial assets from a country to others
g. There is equal prices and interest rate in all countries
The monetary approach to balance of payment (developed by Harry G. Johnson in 1977) is also known as the ‘Small Country Model of Balance of Payment’ that shows an automatic adjustment between change in money supply (∆Ms) and money demand (∆Md) through the change in the position (deficit/surplus) of Balance of Payment. According to the approach, Balance of Payment is always and everywhere a monetary phenomenon so that there is a significant role of both money supply and money demand in the position of Balance of Payment. The approach is based on given assumptions:
a. The country is small and open economy
b. All countries are functioning with full employment economy
c. There is a fixed exchange rate regime
d. There is no money illusion
e. There is a strong desire of people for adjustment between Ms = Md
f. There is a perfect mobility of goods/s and financial assets from a country to others
g. There is equal prices and interest rate in all countries
Under the given assumptions, if there is an excess money
supply over money demand (Ms > Md) in an economy that
lead to outflow of foreign currency to abroad. Because, people use the excess
money supply in purchase of foreign products (goods and services) and securities
for which the central bank has to provide foreign currency at the given fixed
exchange rate regime and thereby eliminate the excess money supply from the
money market. Hence, there is a proportional amount of decrease in foreign
asset reserve of the central bank and thereby deteriorate Balance of Payment
and vice-versa.
Likewise, if money demand is excess than money supply (Ms
< Md) in an economy that leads to inflow of foreign currency from
abroad. Because, people collect their excess money demand by selling domestic
products (goods and services) and securities to foreigners and the foreign
currency has to be purchased by the central bank at the given fixed exchange
rate and thereby increase in money supply to eliminate the excess money demand
o f people. Hence, there is a proportional amount of increase in foreign assets
reserve of the central bank and thereby improved Balance of Payment and vice
versa. Hence, the position of Balance of Payment along with the desired speed (λwhich is usually constant) of
adjustment between Ms and Md can be shown as:
If λ(Ms - Md) = 0, it provides balanced Balance of
Payment. – Neutral effect
If λ(Ms - Md) > 0, it provides deteriorate Balance of Payment. – Negative BOP
If λ(Ms - Md) < 0, it provides improved Balance of
Payment. – Positive BOP
However, the position of BOP can be expressed on the basis of
the position of NFAR of the central bank that can be mathematically derived
with money market equation like If Ms = Md . The money
supply function is specified as Ms = m.H
Or, Ms = m(NFAR + NDC) with constant net non-monetary
liabilities (NNML)
Where, Ms =
money supply
m = value of money multiplier
H = high powered money
NFAR = net-foreign assets reserve held by the central bank
NDC = net-domestic credit (assets) made by the central bank to
government, government enterprises, BFIs, PSs i.e. (NCG + CGEs + CBIs + CPS)
Similarly, the money demand function is specified as Md = f(P, r, Yαp, eβπ˟)
Where, Md =
money demand
P = domestic price level
r = domestic interest rate
Yp = permanent income
α = income elasticity of
money demand
e = opportunity cost of holding money as an exponential
variable
β = opportunity cost of
elasticity of money demand
π˟ = expected rate of
inflation
Hence, we have,
m(NFAR + NDC) = (P, Yαp, r, eβπ˟)
Taking log on both sides,
Log m + log (NFAR +
NDC) = log P + αlog Yp + log
r, βπ˟log
e
Differentiating on both sides with respect to time period ‘t’
we get,
Δ log m + Δ log (NFAR + NDC) = Δ log P + αΔ log Yp + Δ log r + βΔπ˟
(Where,
log e = 1 as it is exponential variable)
Δ log m + ΔNFAR (NFAR + NDC) + ΔNDC (NFAR + NDC) = Δ log P + αΔ log Yp + Δ log r + βΔπ˟
ΔNFAR (NFAR + NDC) = Δ log P + αΔ log Yp + Δ log r + βΔπ˟ - Δ log m – ΔNDC (NFAR + NDC)
ΔNFAR/H = Δ log P + αΔ log Yp + Δ log r + βΔπ˟ - Δ log m – ΔNDC/H (as H = NFAR + NDC)
As the model assumes equal domestic prices and interest rate
in all countries, the growth rate of internal price, interest rate and
inflation do not affect the growth rate of NFAR of the central bank. Then, the
basic equation of the model becomes,
ΔNFAR/H = αΔ log Yp - Δ log m – ΔNDC/H,
Which shows that there is a positive role of permanent income
to increase the growth rate of NFARs held by the central bank and thereby
improve the position of balance of payment while there is a negative role of
the value of money multiplier and net domestic credit of central bank to
increase the growth rate of NFARs held by the central bank and thereby improve
the position of balance of payment.