Monetarist Approach Case Study

Background to the Monetarist Approach to BoP and Exchange Rate

In surveying the body of research dealing with the balance of payments, two major shortcomings are immediately apparent. First, there are no widely accepted theories of the balance of payments which simultaneously incorporate both the current and capital account. The great majority of models used in payments theory consider either the capital account or the current account separately. Second, there have been very few attempts to include even the fundamentals of portfolio choice theory in balance-of-payments models. This is particularly surprising in view of the essentially monetary nature Balance of payments theory.

The monetarist approach to the balance of payments theory addresses

When a government of one country expands its money supply faster than other countries or its required, the result is a worsening of the country’s BoP position.

Assumptions underlying the Monetarist Approach:

The monetary approach is based on the following assumptions:

1. The demand for money is a stable function of income, prices and interest rate.
2. The supply of money is a multiple of monetary base which includes domestic credit and the country’s foreign exchange reserves. 3. The demand for nominal money balances is a positive function of nominal income.

4. The theory Purchasing Power Parity-The law of one price’ holds for identical goods sold in different countries, after allowing for transport costs. There is perfect substitution in consumption in both the product and capital markets which ensures one price for each commodity and a single interest rate across countries.

5. The level of output of a country is assumed

Some of these criticisms are mentioned below.

1. A survey of the monetary conducted by Boghton (1988) argued that almost all the assumptions propounded are open to empirical questions. Critics argue that the demand for money function can be highly unstable. Again, economies rarely obtain full employment due to involuntary unemployment in countries. There is also the argument of market imperfections which challenges the assumption of the law of one price. There may be price differentials resulting from to the lack of information about prices, knowledge of identical goods and trade regulations in other countries.

These assumptions hold well in the long run but are rarely fulfilled in the short run.

2. Some critics have also argued that it is quite wrong to view countries balance of payment deficit or surplus as purely a monetary phenomenon. BoP adjustments may sometimes be as a result of expenditure-switching decisions operating through real flows and government budget rather than money