RDP 1978-01: Two Essays in Monetary Economics 5. Balance of Payments Adjustemt

Apart from models which ignore money altogether, or in which money is affected by but does not affect output, existing macroeconomic models can be classified according to whether the links between money and the balance of payments are indirect, direct, or contain both direct and indirect channels from monetary disturbances to the balance of payments.

Models with indirect links between money and the balance of payments include all models which have significant links between money and economic activity and between economic activity and the balance of payments, which must now include every macroeconometric model which claims to be relevant for an open economy.

As discussed in section 3, there are many ways for money to influence economic activity in existing models. Direct effects of the excess demand for money and the other channels for the effect of money on prices and output produce several ways for money to influence the balance of payments. With the usual equations for exports (x), imports (i) and capital flows (DF) determining the change in international reserves (DR),

the effect of excess money on domestic prices, output and interest rates will produce a strong indirect influence on the balance of payments.

If the identity relating money (M), international reserves (R), and domestic credit (C) is written as:

and included in the model, feedback from the balance of payments to the money supply is established. It is worth repeating that the above identity, included for example in the RBA76 model of the Australian economy, is consistent with a view that economic agents are not in general on their long run demand functions for money. Indeed, the quantity of money will not even necessarily adjust to the demand for money with the traditional convergent first order adjustment process, although in the long run money demand and supply will both adjust to equilibrate the money market. Until the money market is in equilibrium, expenditure, prices, wages, interest rates and the balance of payments will all continue to adjust.

There are several models in the literature which include a direct link between money, or the assumed determinants of the demand for money, domestic credit expansion and the change in international reserves, or some component of the balance of payments, typically capital flows. The monetary identity discussed above, and emphasised by Johnson (1972) in the following form:

has been directly used in several empirical tests, with the supplementary hypotheses that the change in the demand for money depends on changes in income and prices, that the quantity of money is demand determined, and that domestic credit expansion is exogenous.^[1] The identity is one equation in the monetary model of the U.K. economy developed by Jonson (1976). Kouri and Porter (1974) obtain a reduced form equation for capital flows (ΔF) which depends on changes in nominal income (ΔY), world interest rates (Δr_w), and expected exchange rate changes (ΔE), (the assumed determinants of asset demands),^[2] domestic credit expansion (ΔC) and the trade balance (P_xx − EP_ii). The estimating equation, in the current notation, is:

Although this equation is obtained as the reduced form of a model of asset choice, it is interesting that if α₃ = −α₄ = 1, the equation can be rewritten as a discrete time analogue of equation (9):

where

On this interpretation, what could be called the flow demand for money (M^d) is equal to the change in the stock demand,^[1] and it is clear that the money market is assumed to be in equilibrated within the observation period. Helliwell and Lester (1976) use the RDX2 model of the Canadian economy to examine the same question as Kouri and Porter (1974). Although the RDX2 model produces a sizeable short run offset to a domestic monetary disturbance by the reactions of capital flows, important domestic price and quantity responses also occur and it is not assumed that the money market returns to equilibrium within the observation period following a disturbance.

Another interesting approach with a direct link between money and the balance of payments is developed by Sassenpour and Sheen (1978), who also relax the assumption that the money market is in equilibrium within the observation period. These authors relate the change in international reserves or capital flows directly to excess stock demand for money, and find a significant direct monetary disequilibrium effect on both French and German balance of payments.

This brief discussion illustrates that there are several approaches to the interaction of money and the balance of payments in the literature. These have been developed and tested for a variety of data sets and estimation techniques.

When this occurs – as is usually the case when a new theoretic insight is presented – there is always the danger that each author will claim too much for a result which has been demonstrated to “work” in some sense. In order to provide a first step towards discriminating among the various hypotheses, a recent study^[1] has therefore examined several specifications of the balance of payments in the consistent framework provided by a long run model of the U.K. economy and the more detailed RBA76 model of the Australian economy. There are several important findings: models with direct effects of monetary disequilibrium in asset markets perform better than those in which the effect is entirely indirect; the indirect effect of monetary disequilibrium working through the adjustment of aggregate expenditure is also important, and the estimate of its effect is robust in the different models;^[2] models m which the quantity of money is not constrained to adjust directly to the stock demand for money appear to perform better than those which use the traditional demand determined money stock. The latter result supports the view that money is a buffer stock, and that it will not in general be rational for economic agents always to be adjusting directly towards the long run money demand function.

A somewhat negative result from this study is that it is difficult to discriminate between models in which the direct effect of monetary disequilibrium is on the change in international reserves from those in which the direct monetary effect is on a specific component of the balance of payments, such as international capital flows.^[1] The difficulty of determining the precise channels for the transmission of money to the balance of payments in this study is somewhat frustrating, although we were warned of this possibility by Hume two centuries ago when he said:

“But … the money always finds its way back again, by a hundred canals, of which we have no notion or suspicion.”^[2]

The question of the precise specification of the channels from excess money to the balance of payments may in any case be relatively unimportant. This is illustrated by the fact that in the version of the RBA76 model whose simulation properties are discussed in Jonson and Butlin (1977) there is a rapid outflow of international reserves in response to an increase in domestic credit expansion even though there is no direct link between excess money and the balance of payments. This result illustrates that if the effects on domestic output, prices and interest rates of monetary disequilibrium are strong enough, the balance of payments will respond in a way which eliminates the excess money. The offset is stronger in models with a direct link between excess money and the balance of payments, as suggested in several studies, but the results of the monetary approach to the balance of payments will be achieved in any model with a well determined demand for money and channels whereby excess money importantly influence other variables. And the evidence suggests that there are important domestic effects during the adjustment period.

Footnotes

See for example the empirical studies in Frenkel and Johnson (1976). In some studies (e.g. Girton and Roper (1977)), the coefficient on domestic credit expansion is estimated and a value of less than unity is interpreted as indicating the presence of frictions which prevent monetary equilibrium from occuring instantaneously. [1]

The theoretical equation includes changes in domestic and world wealth, and the change in world income, although these were dropped “after some experimentation”, apparently because of possible measurement errors. In addition, ‘“money” is defined as “base monev” in this study. [2]

With the world interest rate representing the usual interest rate effect on money demand. [1]

Jonson, Rankin and Taylor (1977). [1]

More generally, estimates of the parameters in the non-monetary sector of the model are fairly robust with respect to the different specifications of the monetary sector. [2]

More precisely, in the more detailed Australian model, the specification with monetary disequilibrium directly influencing capital flows performs better on several criteria, but for the U.K. it is difficult to choose between the alternative specifications. [1]

Rotwein (1955), p.77. [2]