Thebasic assumption of the monetary approach to the balance of payment is thatdeficit/ surplus in the balance of payment is result of disequilibrium in themoney market.

According to monetarists approach, balance of payment deficit isthe phenomena of excess money supply and therefore, equilibrium can only beattained through monitory measures or policies. The monitoryapproach to the balance of payment is based on the following three key assumptions:1)     Velocity of money is constant:  from the simplified money theory, theequation of exchange (MV=PY) where M is money supply, V is velocity of money, Pis the price level and Y is real income or output. According to monetarists,velocity of money (V) and real income/ output (Y) is fixed i.e. assumes thecountry is at full employment. Therefore, any change in money supply will onlychange the price level proportionately. For example, a percentage change inmoney supply will only change the price level by a percentage level as velocityof money and real income/output are zero. 2)     The aggregate supply in theproduct market is fixed: here it is assumed that the economy is always at fullemployment so real income/ output is assumed to be constant and change in pricewill not affect the real output (aggregate supply remain the same) even ifaggregate demand increase due to increase in price level.

3)     The Purchasing Power Parity (PPP)theory holds. Monetarist asserts that exchange rate and price level aredetermined by PPP.   Withthese basic assumptions in mind, I will try to explain and demonstrate theeconomic outcome of the monetarist assertions on small country balance ofpayment under fixed and floating exchange rate regimes. Before that, I wouldlike to use the monetarist concept that balance of payment (BP) consist ofcurrent account (CA), capital count (K) and forging reserve (R) and in otherform BP = CA+K+R=0 and from this we can drive CA+K= -R. This implies that whena country’s authorities purchase domestic currency with foreign reserve, itwill result in decrease in R so implies deficit to the balance of payment andwhen the country’s authorities purchase foreign currency, R increases and resultsin current account surplus. So, what happens when the country’s authorities interveneto increase or decrease the money supply under fixed exchange mechanism is discussedbelow. Underfixed exchange regime, assume at the beginning the economy is at equilibriumand monetaryapproach is expressed in the form of relationship between demand for money andsupply for money.  So, the demand formoney(MD) equals the money supply (MS), this can be represented by MD= MS.

Asin a simplified form, money supply consists of two main components that are domesticcredit (DC) and foreign reserve (R) MD=MS can be expressed as MS= DC+R. Now, let’sassume that government/ central bank of a small country wants expansionary monetarypolicy. When authorities want to increase domestic money supply, they will buydomestic currency in an Open Market Operation (OMO). This measure will increasethe money supply and people will have excess money balance. People will thenkeep proportion of the money and spend the excess balance more on importedgoods and foreign securities. This tends to increase in the aggregate demand onimported goods and assets.

The increase in demand results in pushing the levelof price up. When the level of price increase (given world price unchanged) thecountry’s export goods and services with regard PPP becomes less competitive. Thisleads to aggregate demand for import exceeding export which will be reflected onboth current and capital account by creating a balance of payment deficit. To correctthe deficit and to prevent devaluations of its currency, authorities of thiscountry has to purchase the domestic currency with their foreign reserve.

ThisOMO results in reducing the money stock from the market. The decrease in moneysupply starts to reduce the aggregate demand and the price to the original PPPlevel and this eliminates the deficit and balance of payment equilibrium willbe attained i.e. MD=MS. This shows that the balance of payment deficit is only transitoryeffect. There are though circumstances when balance of payment deficit is prolonged.When a country’s authorities practice sterilization of their foreign exchangeoperation and if a surplus countries decide to purchase domestic current the deficitcountry and keep it.

On theother hand, if money supply is less that money demand, (MS

 Inprinciple, that is what would happen when authorities implement expansionary orcontractionary monitory policy. However, I do think that in real world, especially,once small country starts to take expansionary monetary measures and increasesmoney supply, it is will be hard for them to control the money supply by purchasingdomestic currency using their foreign currency reserve because I assume that smallcountries’ foreign exchange market is not strong and naturally they are net importersso that their foreign reserve base is very small and it would be difficult for themimplement monetary policy effective. And monetary policy alone may prolong theperiod of the deficit and even may lead to higher level of inflation. Whereas,the monetarist asserts that under floating exchange rate, there is nothing assuch thing balance of payment deficit and surplus. The reason being is the authoritiesdon’t intervene to buy or sell domestic currency. Under floating exchange rates,when the balance of payment is in equilibrium, there is no change in foreign exchangereserve (R). in the circumstances of balance of payment disequilibrium i.

e. deficitor surplus, changes in the demand for money and exchange rates play the role inthe adjustment of the balance of payment.  


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