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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


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.


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