The Monetary and Portfolio Balance Approaches to External Balance

1
The Monetary and Portfolio Balance Approaches to
External Balance
2
Monetary Approach to the Balance of Payments

• Emphasizes that the balance of payments are
  essentially a monetary phenomenon
• Important issues are the supply and demand for
  money
• Attention on category IV of the B of P, Official
  Short-term capital Account
• B of P surplus excess demand for a countrys
  money
• B of P deficit excess supply for a countrys
  money

3
Supply of Money

• Ms a (BRC) a (DRIR)
• Ms money supply
• BR reserves of commercial banks --? central
  
• (depository institutions) ?
  bank
• C currency held by the nonbank
  public?liabilities
• a the money multiplier
• DR Domestic reserves ? Central bank
• IR international reserves ? assets

4
Money Supply

• Definitions
• M1
• currency held by nonbank public, travellers
  cheques and chequing accounts in financial
  institutions
• M2
• M1 savings and time deposits (except large time
  deposits of 100,000 or more

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• Money multiplier a
• The process of multiple expansion of bank
  deposits, derives from the reserve ratio lending
  system
• Example a 10 reserve ratio leads to a money
  multiplier of 10 (simplistic calculation due to
  leakages from currency held, etc.)
• Monetary base (BRC)
• Liabilities side of the balance sheet of the
  central bank
• Includes currency issued, commercial bank
  deposits in central bank
• Monetary base (DRIR)
• Asset side of the central bank balance sheet
• Includes loans and security holdings by the
  central bank and international reserves (foreign
  exchange and foreign international assets

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The Demand for Money

• This is the demand for currency or chequable
  deposits, not the demand for wealth
• People either hold wealth in liquid form (money,
  etc.) or in a longer term asset (stocks and
  bonds, etc)
• Demand for money sometimes broken into
• Transactions demand for money demand for
  purchases, and payments
• Asset demand for money demand for money as a
  way to hold wealth

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The Demand for Money
?

• L fY,P,I,W,E(p),0)
• Y level of real income in the economy
• P price level
• i interest rate
• W level of real wealth
• E(p) expected percentage change in the price
  level (inflation rate)
• O all other variables that can influence the
  amount of money balances a countrys citizens
  wish to hold

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Demand for money

• Signs of effects
• Y positive the more real income there is in the
  economy the more people require cash balances and
  chequing deposits (reflects the transaction
  demand for money)
• P positive the higher is the price level in the
  economy the more people require cash balances and
  chequing deposits (reflects the transaction
  demand for money)

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Demand for Money

• i negative as the rate of return on
  alternative stores of wealth (bonds, etc.)
  increase, the demand for cash as a store of
  wealth decreases (reflects the asset demand for
  money)
• W positive as the level of wealth rises, a
  person is expected to want to hold more assets of
  all types, including money
• E(p) negative -- if people expect prices to
  rise, that means they expect the buying power of
  their cash to fall. They will switch assets out
  of money into an asset that will maintain its
  buying power (something that earns a return).

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Demand for Money

• O dont know depends on things like the
  frequency of paycheques (the more frequently
  people are paid, the less cash they need to
  keep),
• the availability and popularity of credit cards
  vs. cash cards (if all purchases on credit, may
  use less cash)
• not significant for short time periods because
  they dont vary that much

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Monetary Equilibrium and the BOP

• The money market is in equilibrium when MsL
• there is also a simple form of the money demand
  that is often used for this
• L kPY so that in equilibrium MskPY
• P is the price level, Y is the level of income
  and,
• k is a constant embodying all other variables.
• Note k is inversely related to the speed with
  which money changes hands in the economy.
• we refer mostly to this demand for money equation
  when analyzing the effects of changes in money
  supply and demand on the balance of payments.

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Monetary Approach and the BOP

• Effects of an excess supply of money (fixed
  exchange rate)
• Current Account
• people spend too much money on goods and services
• this causes prices to rise
• if economy is not at full employment, greater
  demand causes real income to increase (Y)
• if part of real income is saved, W also rises
• all of these increase the demand for imported
  goods, which would lead to a current account
  deficit

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Excess supply of money

• Capital account (private)
• excess cash leads to an increase in demand for
  other financial assets (i may fall), including
  foreign financial assets
• this means capital will flow out of the country,
  leading to a BOP deficit
• Category IV must be in a net credit position to
  finance the demand for foreign currency
• Note as Y,P,W increase and i falls, the demand
  for money increases, eliminating the excess
  supply of money

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Excess supply of money

• Expectations
• If the excess supply of money is a result of
  long-standing central bank ineptitude,
• and people expect the money supply to continue to
  expand, then
• E(p) will be positive, it will have a negative
  effect on money demand, and this effect may swamp
  all others.
• In this case, the problem may not be
  self-correcting, and the BOP deficit can grow
  until all reserves are wiped out.
• Barring this problem, long-run excess supply or
  demand for money are self-correcting under fixed
  exchange rates

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Excess supply of Money Flexible Rates

• Monetary approach to the exchange rate
• In this case there can be no BOP deficit or
  surplus
• any movement away from demandsupply of currency
  leads directly to a change in the value of the
  currency
• for this reason we talk about an incipient BOP
  surplus or deficit. This means there is a push
  in that direction which change the price of the
  currency

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Excess supply of money

• the excess supply working through Y,P,W,i leads
  to an incipient BOP deficit and therefore a
  depreciation in the value of the currency,
• changes in these variables will also lead to an
  increase in the demand for money, which should
  correct the excess supply problem
• the increase in demand for money (from the above
  variables) needed to return to equilibrium will
  be higher if inflationary expectations decrease
  the demand for money (or offset some of the
  increase above)

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Two countries

• Assume that there is purchasing price parity
  between the two countries, that is
• PAePB , or ePA/PB
• where PA is the price level in country A and
  ditto for country B
• We can use this and the equilibrium in the money
  market to derive the exchange rate as a function
  of the money supply and income

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Exchange rate

• MsAkAPAYA
• MsBkBPBYB
• e kBYBMsA/kAYAMsB
• Derive this

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Exchange rate

• MsAkAPAYA
• MsBkBPBYB
• MsA/MsB kAPAYA/ kBPBYB
• PA/PB MsA/( kAYA ) /(MsB/kBYB)
• e kBYBMsA/kAYAMsB

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Effects of changes in the economy on the exchange
rate

• Using the equilibrium exchange rate
• we can analyze the effect of an increase in
  velocity, income, price and/or money supply in
  either country on the exchange rate.
• For example, if income rises in country A, the
  exchange rate decreases, meaning the country A
  currency appreciates!! (because there is an
  excess demand for money (and the money effect
  swamps the import effect))

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Empirical work on the monetary Approach

• Does this analysis hold in the real world?
• Tests
• 1. Testing the monetary approach to the BOP with
  fixed exchange rates Ujiie (1978)
• Data Japan 1959 to 1972 on BOP, change in
  domestic credit , change in foreign
  interest rates i, and change in income
• performed linear regression analysis, to see the
  effects of the independent variables on BOP

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Empirical Tests

• Regression
• Expect
• b to be negative, (excess supply of money)
• c to be positive, (excess supply of money
  overseas)
• f to be positive, (excess demand for money)
• Results
• b was negative
• c,f were not significant
• Summary Money supply has expected effect, we
  are not sure of sign of other variables

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Empirical Tests with Ex. Rate

• Frenkel (1978) using German data in the 1921 to
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• Equation
• variables are as defined elsewhere in the chapter
• the coefficients are elasticities (and if you
  took 18.253 you would know why)
• Expected signs b positive, c positive
• Both variables turned out as expected
• b should in fact be close to 1 if the exchange
  rate moves proportionally to the money supply and
  it was 0.975.
• So, monetary approach works during periods of
  hyperinflation.

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Empirical Tests with Ex. Rate

• Problem with Frenkels test
• during a period of hyperinflation, we would
  expect monetary phenomena to overpower all other
  effects.
• The question must be, Does the monetary approach
  give us information during somewhat normal
  periods of economic behaviour?
• Rudiger Dornbusch (who is one of the major names
  in international finance) decided to test this.

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Dornbusch test

• Tested 5 countries (Canada, France, Japan, UK and
  US) against West Germany using 1973-79 data
• Used difference in the logarithms of variables,
  so that we compare Y with Y (log
  (Y/Y)logY-logY)
• Estimated
• where refers to the foreign country, and all
  variables are in logs.
• The subscripts S and L refer to short and long
  term interest rates.

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Dornbusch test

• e is the number of the other currency required to
  purchase 1 mark. If e rises, the mark has
  appreciated. Germany is treated as the foreign
  country in these equations.
• Expected signs
• b, d, and f should be positive. If the home
  money supply rises faster than foreign (Ger.)
  then the home currency should depreciate (e
  should rise), ditto for interest rates.
• c should be negative. An exogenous increase in
  home income should cause an excess demand for
  money and an appreciation of the currency

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Dornbusch test

• Results
• b was negative, but not significant
• c negative, but also not significant
• d and f were positive, but not significant
• Note PPP underlies these models
• Tests of PPP show that relative PPP holds with
  countries currencies moving toward relative PPP
  at a rate of about 15 percent per year.

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Portfolio Balance Approach

• Also called asset market approach
• Models differ, but have common characteristics
• 1. financial markets are integrated, people hold
  both home and foreign assets
• 2. home and foreign assets are imperfect
  substitutes
• 3. asset holders react to changes, and the
  portfolio shifts affect the BOP or exchange rate
  (as appropriate to exchange rate regime)
• 4. rational expectations individuals use all
  information available to form forecasts

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Portfolio Balance Approach

• Types of assets in simple model
• money (L),
• home bonds (Bd) ,
• foreign bonds (Bf)
• Relationship between interest rates implied by
  imperfect substitution
• id if xa RP
• RP can be either positive (if foreign asset is
  riskier than home asset) or negative (if foreign
  asset is less risky than home asset)

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Asset demands Money

• The demand for money equation looks like
• L f(id , if , xa , Yd , Pd , Wd)
• What are the signs of the effect of the six
  independent variables on the demand for money?

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Asset demands Money

• The demand for money equation looks like
• -- -- --
• L f(id , if , xa , Yd , Pd , Wd)
• Or, money demand
• increases with income, price and wealth, and
• decreases with rises in home and foreign
  interest rates, and with an expected appreciation
  of the foreign currency

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Asset demand Domestic bonds

• The demand for domestic bonds looks like
• Bd h(id , if , xa , Yd , Pd , Wd)
• Signs on independent variables?

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Asset demand Domestic bonds

• The demand for bonds looks like
• -- -- -- --
• Bd h(id , if , xa , Yd , Pd , Wd)
• demand rises with home interest rate,but falls if
  foreign interest rate increases.
• demand falls if the foreign currency is expected
  to appreciate,
• demand also falls if home income or price rise
  (due to need for cash), but
• rises if wealth increases.

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Asset demands Foreign bonds

• The demand for foreign bonds looks like
• Bf j(id , if , xa , Yd , Pd , Wd)
• Signs on independent variables?

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Asset demands Foreign bonds

• The demand for foreign bonds looks like
• -- -- --
• Bf j(id , if , xa , Yd , Pd , Wd)
• foreign asset demand depends inversely on home
  interest rate, home income and home price level
• foreign asset demand depends positively on the
  foreign interest rate, an expected appreciation
  of the foreign currency and wealth

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Asset demands

• Comparing the three asset demands
• -- -- --
• L f(id , if , xa , Yd , Pd , Wd)
• -- -- -- --
• Bd h(id , if , xa , Yd , Pd , Wd)
• -- -- --
• Bf j(id , if , xa , Yd , Pd , Wd)

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Portfolio Balance

• The wealth of home country citizens must be held
  in one of the three assets.
• Wd Ms Bh eBo
• Note Bo is the amount of foreign bonds held by
  home country residents Bo Bf in equilibrium
• Therefore the financial market is in balance at
  home when all three asset markets are in
  equilibrium
• that is, the amount of assets held equals the
  amount of each asset desired.

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Portfolio Adjustments

• Examine the effects of each of the following
• sale of government securities
• increase in expected inflation at home
• increase in real income at home
• purchase of government securities
• decrease in expected inflation at home
• decrease in real income at home.

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Sale of Govt securities on open market

• securities are exchanged for cash Ms falls
• Bd increases, interest rate rises (PB falls)
• rise in id causes a decrease in L and drop in eBf
• both domestic and foreign asset holders buy more
  home country bonds and less foreign bonds
• movement continues until all markets are in
  equilibrium
• On the foreign exchange market e falls (currency
  appreciates) and xa increases, even if the
  forward rate is constant doesnt change. This
  means we return to equilibrium on the foreign
  exchange market with an appreciated currency

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Rise in expected inflation at home

• A rise in expected inflation will cause, as its
  first effect, a rise in xa. This implies
• L falls, because cash is expected to be worth
  less
• Bd falls, as people expect the future return from
  domestic bonds to have a decreased value
• Bf rises, as people choose to hold wealth in
  foreign assets.
• e rises, because home citizens supply home
  currency to purchase foreign bonds
• In general an expected depreciation can cause a
  depreciation

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An Increase in Real Income at Home

• The first effects of a rise in Yd are
• People increase their money holdings by selling
  home and foreign bonds
• The sale of foreign bonds leads to an improvement
  in the BOP, or an appreciation of the currency,
  both current and expected

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Increase in home bond supply to buy physical
assets

• Bh increases causing its price to fall and
  therefore id to rise.
• increase in id causes an increase in demand for
  Bd both at home and by foreigners
• this would cause an appreciation of the currency
• the increase in Bh to buy physical assets
  increases the home countrys wealth, leading to
  an increase by home country citizens in Bd , L
  and Bf , and a consequent depreciation of the
  currency
• The overall effect on the exchange rate is
  uncertain, but it is likely to be an appreciation.

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Current account surplus capital account deficit

• The current acc. surplus (cap. acc. deficit)
  means that the home country is increasing its
  wealth via investment in foreign countries.
• Again we have two possible effects on the
  currency
• effect of increase in Wd
• causes an increase in Bd , L and Bf , and a
  depreciation of the home currency
• but increase in L could push up id
• increase in Bd could push down id
• since we dont know direction of id (or if for
  that matter) we also cant be sure of overall
  effect on currency

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Empirical work

• Frankel 1984 Tested the effect of supply of
  home and foreign bonds, and home and foreign
  wealth on the exchange rate using 5 countries vs.
  the U.S.
• Expected signs
• b negative, c positive, g positive and k negative
• only Canada had the correct signs on all variable
  coefficients
• Not sure whether problem was the theory, or
  foreign exchange market intervention by other
  countries

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Other Studies

• Meese (1990)
• tested predictive capacity of portfolio balance
  model vs. a random walk for the currency, random
  walk outperformed the model
• Meese concluded Economists do not yet understand
  the determinants of short- to medium-run
  movements in exchange rates.
• Other economists disagree, and the work continues.

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Exchange rate overshooting

• Exchange Rate Overshooting occurs if
• when moving from one equilibrium to another, the
  exchange rate moves beyond the new equilibrium
  value, but then returns to it.
• First model by Rudiger Dornbusch, but simplified
  here
• (so this is NOT exactly the Dornbusch model)

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Assumptions for this model

• country is small therefore it cannot affect
  world prices or interest rates
• there is perfect capital mobility and assets are
  perfect substitutes
• therefore

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One Story

• Suppose the price level rises.
• If money supply is fixed then id rises
• An increase in id causes the exchange rate to
  appreciate. and if is
  fixed
• To restore asset market equilibrium, the exchange
  rate must appreciate high enough that investors
  expect it to depreciate.

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Look at price and exchange rate reacting to money
supply

• First relationship The exchange rate is
  negatively related to price, i.e., given a fixed
  money supply, a higher price is associated with a
  higher interest rate and a more valuable currency
  (lower exchange rate).
• Graph

A
P
A
e
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Second relationship

• The long-run PPP equilibrium dictates that an
  increase in the price level should lead to a
  depreciation in the value of the home currency.

L
P
e
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Overshooting

• Overshooting occurs because the exchange rate can
  adjust faster than prices to any external shock
  (say an increase in money supply

L
P
A
A
e
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Whats going on?

• An increase in Ms causes a surplus of money in
  the market. The surplus will eventually be
  absorbed, either because the exchange rate will
  depreciate (lower price, greater demand), or
  because the price level at home will rise, or
  both
• The currency market can adjust faster than the
  price market, therefore, because MsgtL, and id
  falls, the currency value drops fast
• It also drops so far that there is an expected
  appreciation in the currency as the prices start
  to adjust.
• This means that we can see inflation and currency
  appreciation at the same time!

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Forward market equilibrium

• If exchange markets are efficient, then efwdE(e)
• And so, an increase in the money supply, will
  cause both a decrease in id and an increase in
  efwd
• .But this means
• is out of equilibrium
• So, what happens is actually,
• the exchange rate depreciates so much right away
  that there is an expected appreciation.

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