RDP 1977-07: Money and the Balance of Payments 1. Introduction

Considerable interest has been generated in recent years by the so-called “monetary approach to the balance of payments”. The central message of this approach is that the balance of payments cannot be in equilibrium over time until asset markets, and in particular the money market, are also in intertemporal equilibrium.

In its most simplified form,^[1] with the demand for money assumed to be given, the monetary approach emphasises the balance-sheet identity between money, international reserves and domestic credit in a way which requires that the level of international reserves adjusts to offset any imbalance between the demand for money and the (exogenously determined) supply of domestic credit. Unlike closed-economy theory, which assigns domestic monetary policy a role in generating fluctuations in output, employment and prices, this simple open-economy model allows domestic monetary policy to influence only the balance of payments, with no domestic effects.

The assumptions of this simple model, however, make it clear that it applies only in the long run, and much of the subsequent development of the monetary approach has attempted to relax these assumptions, by investigating the “transmission mechanisms” through which a domestic monetary disturbance affects the balance of payments. The nature of these channels, and the speeds with which they operate, are important issues, both for the problems of policy assignment and for any attempt to reconcile closed- and open-economy monetary theory. In the case where the direct balance-of-payment offset to a monetary disturbance is complete within a short time, no excess money will remain in the economy to influence the behaviour of domestic variables; conversely, if this direct effect is slow acting or absent, the primary effects of a monetary disequilibrium will be on domestic output and prices, and the balance of payments will respond indirectly through interest rate effects on capital flows and the adjustment of trade flows to changes in domestic prices and output.

Since the investigation of these short-run processes has been conducted with a variety of models, each with different aims and assumptions, the issues are far from resolved. It is the main aim of this paper to evaluate several alternative adjustment mechanisms in a consistent whole-model framework, allowing for the short-run disequilibrium which is characteristic of the economy. The strategy is to estimate the parameters of several models, each with a common core but with different equations for the quantity of money, the balance of payments, and net capital flows, representing a variety of hypotheses about balance of payments adjustment. It should be emphasised that the paper is concerned to evaluate the relative performance of alternative models, rather than to demonstrate that a particular theory “works” in some sense.

The tests are carried out with two macroeconomic models. The first is based on the small model of the U.K. economy developed by Jonson (1976); since this model is highly aggregated and estimated with a long run of annual data, it abstracts from much of the detail found in larger models and focuses on medium to long term economic mechanisms. The second core framework is provided by the RBA76 model of the Australian economy developed by Jonson, Moses, and Wymer (1976); this is a less aggregated model estimated with recent quarterly data, and provides a more detailed picture of the short-run state of the economy.

The inclusion, in both models, of strong direct and indirect monetary effects on the behaviour of the balance of payments and domestic variables, make these models well suited as a basic framework for tests of alternative adjustment mechanisms. Furthermore, the theoretical structure of the models can be adapted readily to encompass the alternative treatments of the monetary sector which are to be tested, and the resulting models are small enough to use a Full Information Maximum Likelihood estimation technique.^[2] This latter feature is potentially important since the close interdependence of the private sector relations and policy reactions mean that tests carried out with single equation methods may be unreliable.

To state the major conclusions in advance: the results support the existence of a direct short-run influence of excess money on the balance of payments, as well as on domestic variables. However, in both models, adjustment to an initial monetary disequilibrium is slow, and the lags in the response of the balance of payments need to be measured in years rather than weeks or months.

Footnotes

As presented in Johnson (1972). [1]

The estimation programme used is RESIMUL, written by C.R. Wymer. This programme estimates the approximate discrete-time analogue of the underlying continuous-time model, and allows the imposition of within- and across-equation restrictions. See Wymer (1972). [2]