Finance

Outline
Explanation of the Balance of payment
Evolution of the monetary approach to the balance of payments theory
Key assumptions of the monetary approach to the balance of payments
Characteristics of the monetary approach to the balance of payments
Implications of the monetary approach to the balance of payments

Introduction
Balance of payments is a breakdown of transactions made by a country with other countries duringspecific period of time. It is used as a mechanism to indicate the level of political and economic stability in a country, for instance a country possessing a positive balance of payments would mean that there is considerable foreign investment ( i.e. high influx of imports) and that this country has low exports.

Over the years, various approaches have been applied to the balance of payments (BOP) system but the monetary approach remains the most appropriate by far. Under the monetary approach, balance of payments is determined based on the fixed exchange rate system.

Evolution of the Monetary Approach to the Balance of Payments (MBOP) System
Methods used in analysis of effects of economic changes on the balance of payments have undergone considerable revision in the last century. For instance, after World War I, there were issues of resource allocation and exchange devaluation which paved the way for the application of value theory which revolved around demand and supply and their respective elasticities. Similarly, during the Great Depression in the 1930s, John Keynes came forward with his version of economics to resolve issues with the elasticities approach, known today as Keynesian economics.

Income-absorption approach
Keynesian economics paved the way for further research on different approaches to the balance of payments, for instance the income-absorption approach which was put forward by E.M.Bernstein. Under this approach, balance of payments on a current account was viewed as the difference between national income and expenditure (termed as absorption). In case there was a devaluation of the current account balance, the subsequent effect was shown by subtracting expenditure from the income.

This approach faced a similar criticism to the elasticities approach since it did not consider balance of payments on the whole but only the current account. Secondly, its analysis of effects of current account changes was also not considered suitable.

Monetary Approach
Owing to problems with existing approaches, a monetary analysis of the balance of payments was encouraged. Although it met severe criticism from various quarters over its efficiency to resolve issues of inflation and unemployment but was found to be quite appropriate since the balance of payments were itself monetary in nature. Furthermore, it was easier to apply than other approaches since it analyzed the effects of changes in both current and capital account balances.

Monetary approach has long been associated with David Humes specie flow analysis which was the first original contribution to this approach. Later, Professor at the University of Chicago Milton Friedman has also made valuable contribution to the quantity theory of money. During the last decade of the 21st century, Professors Mundell and Johnson made the monetary approach more familiar in academic circles and hence highlighted the usefulness of the approach.

Frenkel and Johnson Monetary Model for Balance of Payments System
Key contributions with regard to the monetary approach have been made by two leading economists of their time Frenkel and Johnson. They postulated a theory on this approach which was later formulated into a simple to implement monetary model which was originally drafted for a small open economy.

Their model was based on the following assumptions
Real income is considered to be fixed at its ultimate level known as the full employment or natural level.
The law of one price was considered to be valid in both commodity and financial markets.
Both domestic price level and domestic interest rate are pegged with the reserve currency.

This model also proposed that the demand for real balance of payments was also dependant on real income and the prevalent interest rate. Moreover, supply of money is equivalent to domestic credit (i.e. monetary balance created through domestic transactions) in addition with changes in foreign monetary reserves.

J.J.Polaks Quantity Theory of Money
Another renowned economist and an employee of the IMF J.J.Polak also made significant contribution to the monetary approach through his article which was published in 1957. The concepts he put forward were in contrast with that of Milton Freidman. He proposed the assumption constant income velocity of circulation which was different for each country but was equal to a corresponding change in money supply.

According to Polak, the relation between income and money was not necessarily an identity but had a behavioral aspect to it which he considered to be a demand function responsible for determination of current income through income of previous periods and changes in money supply in prior periods.

Polak, in his theory, utilized the import function as another behavior equation and assumed both exports and movements in capital along with domestic money supply to be determined exclusively. He further assumed that the current values taken for income, import function and money demand would be the result of a history of changes in domestic money supply and external factors in the balance of payments. Polaks work has been increasingly compared to Tiffins analysis but his work has been more appreciated probably because it does not require income forecasting which is usually determined internally.

However, there were limitations in Polaks work, for instance, exports, net capital changes and creation of domestic money supply need to be forecasted. Moreover, Polak has based his work on a small open economy and is therefore reflective of the more recent theories on the monetary approach.

Monetary Approach and Its Relationship with the Closed Concept of the Economy
Monetary approach was introduced in 1970s when the Bretton Woods system was in force and the fixed exchange rate regime was also in place, in other words the prevailing concept of economy was that of a closed one. This is perhaps a reason behind monetary approach being termed as an extension of the closed economy.

Another economist, Manuel Gutitian, placed significant emphasis that in an open economy creation of domestic money supply is largely influenced by factors outside the control of monetary authorities. He therefore concluded that domestic money supply creation was an appropriate mechanism for controlling balance of payments.

Some year later, another economist Mohsin Khan prepared a paper with extensive research on ten developing economies. He formulated a model based on continuous-time disequilibrium framework. Through this approach, he was able to anticipate time pattern adjustment with the final equilibrium values through linear differential equations system. This simulation displayed that his model was successful in explaining behavior pattern of balance of payments for a wide range of countries.

Central Themes of Monetary Approach to the Balance of Payments
The MOBP theory has four central ideas to it which have been discussed below 
BOP is a monetary phenomenon
The balance of payments is reflective of the changes made in a countrys foreign reservesby its monetary authorities and in fact provides a channel through which excess domestic demand can affect the domestic supply. Therefore, balance of payments is a crucial aspect when formulating a nations economic policy.
From a theoretical viewpoint, it can be said that balance of payments are the primary means through which private sector in an open economy can adjust money supply with the corresponding demand. The assertion that balance of payments is monetary in nature is highly dependent on an individual empirical judgment. Under the monetary approach, it is assumed that both supply and demand are usually not affected by changes and are affected in a predictable manner provided the changes do affect them. This conception further implies thatchanges in trade balances have an offsetting effect on the capital account and do not affect the current account.

It further postulates that factors such as price levels and money supply play an important role in determining the stability of demand.  (Carbaugh, 2008. p. 209)

The Law of one Price International Commodity Arbitrage
Equilibrium values of money demand variables i.e. real income, price level etc. do not always move in a pre-determined fashion. The law of one price aims to overcome this uncertainty it is of the opinion that price of goods is known with certainty in the short run as well. This is achieved by obtaining a product of exchange rate and foreign price of goods. Moreover, it also states that in full equilibrium prices of goods do not change as a result of monetary setbacks for instance, devaluation, changes in foreign price of goods, changes in domestic borrowing. etc. and therefore a set price level can be maintained. However, law of one price has faced severe criticism and was eventually put out of use when its implementation revealed incorrect outcomes.

As a result, purchasing power parity has been increasingly used in both the long run and short run. Similarly, asset arbitrage model has also been found superior to the law of one price.

Balance of Payments as a Stock Adjustment Process
BOP is reflective of the changes in equilibrium stock reserves. These changes are largely of two types, namely balanced growth and disturbance in equilibrium.

Balanced growth
A developing economy will definitely experience growth in trade and income and as a result will intend to place this inflow of money into a better performing currency, namely foreign reserves. This can simply be done by providing only a fraction of the money created from domestic trade such that the expected levels of reserves flow in hence creating a BOP surplus. Such a stock adjustment will proceed in a normal manner and will not require any difference in demand, supply or price levels.

Subsequently, this will result in normal level of demand surplus for those demanding foreign reserves and a normal level of demand deficit for suppliers of foreign reserves.

Disturbance to equilibrium
These disturbances can arise for a number of reasons, particularly due to devaluations and domestic credit fluctuations.

Money supply in a fixed rate regime
Monetary approach to the balance of payments is based on the fixed exchange rate mechanism. This is quite helpful for small countries or developing economies and can be used as monetary policy for external transactions and fiscal policy for internal transactions. Under the fixed rate regime, emphasis is made on the disequilibrium of the balance of payments.

Key Assumptions in the Monetary Approach
The monetary approach to the balance of payments is based on four key assumptions mentioned as follow
Monetary demand is stable function which comprises of predictable movements (if any). This assumption is considered to be quite accurate because demand is dependant on a handful of economic factors and their subsequent effects which are therefore easier to assess hence resulting in stability of the demand function.
Output and employment in an economy will eventually reach their optimum level in the long run.

Monetary authorities operating in a country cannot clear or equilibrate the effect of balance of payment surpluses or deficits.

Arbitrage ensures that prices of similar goods remain similar in the long run after provision has been made for transportation and tariff costs.

Characteristics of the Monetary Approach
The Monetary approach deals with both money supply and demand and the money supply process. It assumes that balance of payments and exchange rate movements arise due to changes in supply and demand. It has numerous characteristics which have been discussed below in detail
This approach operates in a fixed exchange rate mechanism.

Surpluses or (deficits) in the money account provide the rate at which money balances are accumulated or (reduced) on a domestic level. In other words, balance of payment (BOP) flows are among different mechanisms which adjust money balances to their requisite levels.

This approach asserts that inflow or (outflow) of international reserves are associated with BOP surpluses or deficits and these balance of payment flows cannot be cleared in the long run.

Balance of payment flows also impact the monetary base of a country and will fluctuate both money supply and demand such that it will bring the level of money balances and balance of payments into equilibrium.
This approach is largely concerned with the ultimate effect of changes in trade and capital balances and not with how those changes occur.

Under the monetary approach, balance of payments system is considered to be a reflection of economic decisions taken by a country i.e. either to accumulate money balances (surplus) or reduce them via spending (deficit).

Those transactions which affect both domestic and foreign monetary bases and supplies are considered to be below the line, whereas all other transactions are considered to be above the line.

MBOP mechanisms are based on the efficient market hypothesis (EMH) assumption, according to which markets are risk free in the long run and function in an appropriate manner. Similarly, under this approach it is assumed prices of goods in different countries might vary in the short run but would remain more or less the same in the long run.

MBOP theory comprises an automatic adjustment process according to which any disequilibrium in balance of paymentsor exchange rate movements will show a corresponding dissimilarity in actual and expected money balances and will eventually correct themselves.

This approach is focused on the long run and holds the short run analysis as insignificant, probably because it views the matters to be inconclusive and hence unfit to be analyzed.

It also has an underlying concept of a reserve currency country (RCC). A reserve currency country is a country whose currency can be used by other nations as means of accumulating international reserves. This concept helps in providing countries with a framework through which they can assess the impact of monetary disturbances which occur around the globe.

Role Played by the Monetary Approach in the Determination of Payments
Excess demand for monetary balances and balance of payments has a crucial relationship with respect to economic growth, probably because increases in growth rate for income affect demand for real income i.e. monetary balances. Hence balance of payments and economic growth always increase simultaneously once effect of changes in money supply generated from domestic sources has been taken into consideration.

Implications of the MBOP Theory
In a fixed rate regime, domestic monetary policy cannot control the countrys money supply and this is true of the monetary approach since it is based on the fixed exchange rate.

Excessive monetary expansions occur which result in an inflow of international reserves which will subsequentlyforce the money supply to return to its previous level. The levels of international reserves available are an uncontrollable aspect of a country monetary base.

Increase in international reserves which are uncontrollable will result in a BOP deficit.

Although the inflationary or deflationary effect of the domestic monetary policy on the local economy is reduced, it has an increased impact on the global economy.

On the other hand, domestic economy is more affected by economic decisions taken by other countries which might either have an inflationary or deflationary on it.

Conclusion
When using the monetary approach for the balance of payments, issues are usually analyzed through the relationship between demand and supply of the money and are therefore accurately reflective of the balance of payments system since they are themselves monetary in nature.