### Monetary Approach to Balance of Payment

**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

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 (M

^{s}> M^{d}) 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 (M

^{s}< M^{d}) 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 M^{s}and M^{d}can be shown as:*If*

*λ*

*(M*

^{s}- M^{d}) = 0, it provides balanced Balance of Payment. – Neutral effect*If*

*λ*

*(M*

^{s}- M^{d}) > 0, it provides deteriorate Balance of Payment. – Negative BOP*If*

*λ*

*(M*

^{s}- M^{d}) < 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 M

^{s}= M^{d}. The money supply function is specified as M^{s}= m.H
Or, M

^{s}= m(NFAR + NDC) with constant net non-monetary liabilities (NNML)
Where

*, M*^{s}= 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

**M**^{d}= f(P, r, Y^{α}_{p}**, e**^{βπ˟}**)***Where, M*

^{d}= money demand*P = domestic price level*

*r = domestic interest rate*

*Y*

_{p}= 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, Y**

^{α}

_{p}**, r, e**

^{βπ˟}**)**

Taking log on both sides,

**Log m + log (NFAR + NDC) = log P +**

**α**

**log Y**

_{p}+ 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 Y**

_{p}+**Δ**

**log r +**

**βΔπ˟**

(Where,
log e = 1 as it is exponential variable)

**Δ**

**log m +**

**Δ**

**NFAR (NFAR + NDC) +**

**Δ**

**NDC (NFAR + NDC) =**

**Δ**

**log P +**

**αΔ**

**log Y**

_{p}+**Δ**

**log r +**

**βΔπ˟**

**Δ**

**NFAR (NFAR + NDC) =**

**Δ**

**log P +**

**αΔ**

**log Y**

_{p}+**Δ**

**log r +**

**βΔπ˟ - Δ**

**log m –**

**Δ**

**NDC (NFAR + NDC)**

**Δ**

**NFAR/H =**

**Δ**

**log P +**

**αΔ**

**log Y**

_{p}+**Δ**

**log r +**

**βΔπ˟ - Δ**

**log m –**

**Δ**

**NDC/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,

**Δ**

**NFAR/H =**

**αΔ**

**log Y**

_{p}**- Δ**

**log m –**

**Δ**

**NDC/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.

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