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The Monetary Approach to
Balance-of-Payments and
Exchange-Rate
Determination
Introduction
• The Monetary Approach focuses on the
supply and demand of money and the
money supply process.
• The monetary approach hypothesizes that
BOP and exchange-rate movements result
from changes in money supply and demand.
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The Monetary Base and the
Money Stock
The Monetary Base
• A nation’s monetary base can be measured
by viewing either the assets or liabilities of
the central bank.
• The assets are domestic credit (DC) and
foreign exchange reserves (FER).
• The liabilities are currency in circulation
(C) and total reserves of member banks
(TR).
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Monetary Approach
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Simplified Balance Sheet of the
Central Bank
Assets
Liabilities
Currency
(C)
Domestic Credit
(DC)
Foreign Exchange Total Reserves
Reserves (FER)
(TR)
Monetary Base Monetary Base
(MB)
(MB)
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Money Stock
• There are a number of measures of a
nation’s money stock (M).
• The narrowest measure is the sum of
currency in circulation and the amount of
transactions deposits (TD) in the banking
system.
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Money Multiplier
• Most nations require that a fraction of
transactions deposits be held as reserves.
• The required fraction is determined by the
reserve requirement (rr).
• This fraction determines the maximum
change in the money stock that can result
from a change in total reserves.
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Money Multiplier
• Under the assumption that the monetary
base is comprised of transactions deposits
only, the multiplier is determined by the
reserve requirement only.
• In this case, the money multiplier (m) is
equal to 1 divided by the reserve
requirement,
m = 1/rr.
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Relating the Monetary Base and
the Money Stock
• Under the assumptions above, we can write
the money stock as the monetary base times
the money multiplier.
M = mMB = m(DC + FER) = m(C + TR).
• Focusing only on the asset measure of the
monetary base, the change in the money
stock is expressed as
M = m(DC + FER).
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Example - BOJ Intervention
• Suppose the Bank of Japan (BOJ)
intervenes to strengthen the yen by selling
¥1 million of US dollar reserves to the
private banking system.
• This action reduces the foreign exchange
reserves and total reserves component of the
BOJ’s balance sheet.
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BOJ Balance Sheet
Assets
DC
Daniels and VanHoose
Liabilities
C
FER
-¥1 million
TR
-¥1 million
MB
-¥1 million
MB
-¥1 million
Monetary Approach
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BOJ Intervention
• Because the monetary base declined, so will
the money stock.
• Suppose the reserve requirement is 10
percent. The change in the money stock is
M = m(DC + FER),
M = (1/.10)(-¥1 million) = -¥10 million.
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Small Country Example
A small country is modeled as:
(1) Md = kPy
(2) M = m(DC + FER)
(3) P = SP*
and, in equilibrium,
(4) Md = M.
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Small Country Model
The balance of payments is defined as:
(5) CA + KA = FER.
For example, if FER< 0, then CA + KA < 0,
and the nation is running a balance of
payments deficit.
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Small Country Model
(4) and (3) into (1) yields,
M = kP*Sy.
Sub in (2),
(6) m(DC + FER) = kP*Sy.
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Small Country Model
• Fixed Exchange Rate Regime
• Under fixed exchange rates, the spot rate, S,
is not allowed to vary.
• FER must vary to maintain the parity value
of the spot rate.
• Hence, the BOP must adjust to any
monetary disequilibrium.
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Small Country Model
• Consider what happens if the central bank
raises DC. Money supply exceeds money
demand.
m(DC + FER) > kP*Sy
• There is pressure for the domestic currency
to depreciate. The central bank must sell
FER until M = Md.
m(DC + FER) = KP*Sy
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Small Country Model
• There has been no net impact on the
monetary base and money supply as the
change in FER offset the change in DC.
• There results, however, a balance of
payments deficit as FER < 0.
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Small Country Example
• Flexible exchange rate regime:
• Under a flexible exchange rate regime, the
FER component of the monetary base does
not change.
• The spot exchange rate, S, will adjust to
eliminate any monetary disequilibrium.
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Small Country Model
• Consider the impact of an increase in DC.
• Again money supply will exceed money
demand
m(DC + FER) > kP*Sy.
• Now the domestic currency must depreciate
to balance money supply and money
demand
m(DC + FER) = kP*Sy.
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Small Country Model
• The monetary approach postulates that
changes in a nation’s balance of payments
or exchange rate are a monetary
phenomenon.
• The small country illustrates the impact of
changes in domestic credit, foreign price
shocks, and changes in domestic real
income.
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The Portfolio Approach to
Exchange-Rate
Determination
The Portfolio Approach
• The portfolio approach expands the
monetary approach by including other
financial assets.
• The portfolio approach postulates that the
exchange value is determined by the
quantities of domestic money and domestic
and foreign financial securities demanded
and the quantities supplied.
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The Portfolio Approach
• Assumes that individuals earn interest on
the securities they hold, but not on money.
• Assumes that households have no incentive
to hold the foreign currency.
• Hence, wealth (W), is distributed across
money (M) holdings, domestic bonds (B),
and foreign bonds (B*).
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The Portfolio Approach
• A domestic household’s stock of wealth is
valued in the domestic currency.
• Given a spot exchange rate, S, expressed as
domestic currency units relative to foreign
currency units, a wealth identity can be
expressed as:
W  M + B + SB*.
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The Portfolio Approach
• The portfolio approach postulates that the
value of a nation’s currency is determined
by quantities of these assets supplied and
the quantities demanded.
• In contrast to the monetary approach, other
financial assets are as important as domestic
money.
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An Example
• Suppose the domestic monetary authorities
increase the monetary base through an open
market purchase of domestic securities.
• As the domestic money supply increases, the
domestic interest rate falls.
• With a lower interest, households are no longer
satisfied with their portfolio allocation.
• The demand for domestic bonds falls relative to
other financial assets.
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Example - Continued
• Households shift out of domestic bonds.
• They substitute into domestic money and foreign
bonds.
• Because of the increase in demand for foreign
bonds, the demand for foreign currency rises.
• All other things constant, the increased demand
for foreign currency causes the domestic currency
to depreciate.
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Spot Exchange Rate
Domestic currency units/foreign currency units
SFC
S2
S1
DFC’
DFC
Q1 Q2
Daniels and VanHoose
Quantity of
foreign currency.
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