International Finance

Third edition

by Keith Pilbeam

Chapter 5 - The Monetary Approach to the Balance of Payments

Jump to Revision Questions for chapter 5

In this chapter, we shall look at one of the most influential policy analyses of the balance of payments known as the monetary approach. This approach to balance of payments analysis was pioneered by Marina Whitman (1975), Jacob Frenkel and Harry Johnson (1976). The fundamental basis of the monetary approach is that the balance of payments is essentially a monetary phenomenon. Not only is the balance of payments a measurement of monetary flows, but such flows can only be explained by a disequilibrium in the stock demand for and supply of money. There are several variants of the monetary approach to the balance of payments and not all advocates of the application of monetary concepts to balance of payments analysis necessarily accept all the assumptions used. We shall outline a simple model that captures the essential message of the monetary approach – that disequilibrium in the balance of payments reflect disequilibrium in the money market. Consequently, balance of payments analysis needs to focus on both the supply of and demand for money.

Within the context of the monetary model, we shall examine how a devaluation will impinge upon the balance of payments. We then proceed to examine how the model can be used to highlight some fundamentally different implications of fixed and floating exchange rates. We compare and contrast the effects of a money supply shock, a rise in domestic income and a foreign price shock under fixed and floating rates. We then summarize the policy implications of the monetary approach and consider how the model differs from the Keynesian model examined in Chapter 4.

Revision Questions
  1. "Excessive monetary growth leads to balance of payments problems under fixed exchange rates, and a currency problem under floating exchange rates." Discuss this statement with reference to the monetary approach to the balance of payments.
  2. Examine separately the effects of (i) a decrease in domestic income and (ii) a rise in the foreign price level under both fixed and flexible exchange rates within the context of the monetary approach to the balance of payments. Discuss the contribution and limitations of this model.
  3. a) What are the assumptions underlying the monetary approach to the balance of payments?

    b) Discuss the effects of a devaluation in the context of the monetary model.

    c) Using the monetary model discuss the effects of an increase in domestic income under both fixed and floating exchange rates.
  4. "A one off monetary expansion will lead to a transitory balance of payments deficit under fixed exchange rates but a permanent depreciation of the exchange rate under floating exchange rates." Discuss.