Monetary Approach to The Balance of Payments

Monetary Approach to The Balance of Payments refers to the key ideas and subsequent research of David Hume conducted in the late 1950s, the 1960s and early 1970s. David Hume presented the price-specie flow mechanism against the Mercantilist approach that stated favorable balance of trade is always optimal public policy. Hume's work is concerned with the determination of the Balance of Payments under a system of fixed exchange rates. The monetary approach considers disequilibrium in the balance of payments to be a monetary phenomenon. It accounts for the influence of real variables such as levels of income and interest rates on the behavior of the balance of payments. Hence, the surpluses (or deficits as the case maybe) in the current account provide an accurate measure of the rate at which money balances are accumulated (reduced) domestically.
The monetary approach stresses that money must be viewed as a stock, and not a flow variable,as monetary equilibrium and disequilibrium require an analysis of stock equilibrium conditions and stock adjustments processes. In this way it considers inter-relationships among various markets and,therefore, the inter-relationship between stock and flow equilibrium.
The Monetary Approach to Balance of Payments reflects of an automatic adjustment process. According to this theory, any Balance of Payments disequilibrium reflects the a disparity between actual and desired money balances, which is temporary and will eventually correct itself. To tackle deficits, the monetary approach, stresses the need for reducing domestic expenditure relative to income, by concentrating on deficient or excess nominal demand for goods and securities, and the resulting accumulation or decumulation of money. The monetary approach essentially defines the balance of payments as the change in the monetary base less the change in the domestic component.
The model
Premise: An autonomous increase in the money supply (MS)of country 'Y' leads to an increase in the demand for goods, services, and securities in that country. The increase in domestic demand results in rise in prices of domestic real
and financial assets in country 'Y'in the short run, relative to those in foreign markets. A system of fixed exchange rates is assumed. Now, to tackle this price hike, economic units in 'Y' will react by decreasing their demands for domestic real and financial assets in favor of foreign assets while domestic suppliers of these assets will seek to sell more at home and less abroad. Consequently, Y's foreign trading counterparts will decrease their demands for the assets of country 'Y' and will in turn increase the import intake of the 'Y' by to sell more of their own assets in country 'Y'. These factors will eventually contribute to an increase in imports and a decrease in exports in country 'Y'. This will trigger off a cyclic reaction characterized by the deterioration of the Balance of Payments of Y, increase in exports of the trading partner, which they will then convert into their own currencies at their respective central banks. The currency will then be presented by the foreign central banks to the central bank in country in return for international reserves. Since International reserves are one of the components of a country’s monetary base, the effect of this transaction in turn a decrease in the money supply of country 'Y' towards its level prior to the autonomous increase and an increase in the money supplies of its surplus trading partners. Hence, the BOP records the exchange of money balances for real and financial assets by economic units of country 'Y'and its subsequent effect on its foreign trading partners.
'The Pound in Your Pocket' debacle
The Prime Minister, Harold Wilson, devalued the pound in March,1967, saying it will tackle the "root cause" of Britain's economic problems. The British government lowered the pound down to $2.40, from $2.80, a cut of just over 14%. The decision came after weeks of increasingly feverish speculation and panic in the markets and a day in which the Bank of England spent £200m trying to shore up the pound from its gold and dollar reserves. The government took the drastic step in an attempt to boost its exports, gain a comparative advantage in the global markets, and hence leading to increased production and more jobs at home. However, the move failed.
Alternative approach to devaluation
The new approach was formulated and adopted during the policy orientation of the British Government under pressure from the International Monetary Fund after the devaluation of the British pound in 1967 failed to improve their balance of payments.
International Monetary Fund’s research department under Jacques J. Polak, and by Harry G. Johnson, Robert A. Mundell, and their
students at the University of Chicago pioneered this as an evolutionary development of the Kahn/Keynes multiplier model in an open economy.
Illustration
The monetary approach can be illustrated through a simple model linking the balance of payments to developments in the money market.
Premise: The money market is in equilibrium when the real money supply equals real money demand, that is, when
M(s)/P = L(R, Y).
F* denotes the central bank’s foreign assets (measured in domestic currency)
A denotes its domestic assets (domestic credit).
μ is the money multiplier that defines the relation between total central bank assets and the money supply,μ(F* + A)
M(S)= μ(F* + A)

ΔF* the change in central bank foreign assets over any time period; equals the balance of payments (for a nonreserve currency country).
Combining the two equations; we get the central bank's foreign assets as
F* = 1/μ /PL(R, Y) - A
If we assume that μ is a constant, the balance of payments surplus is
ΔF* = (1/μ) Δ [PL(R, Y)] - ΔA
The last equation summarizes the monetary approach.
The first term on its right-hand side reflects changes in nominal money demand. It signifies that ceteris paribas, an increase
in money demand will bring about a balance of payments surplus and an accompanying increase in the money supply that maintains money market equilibrium. The second term in the balance of payments equation reflects supply factors in the money market. An
increase in domestic credit raises money supply relative to money demand, all else equal: So the balance of payments must go into deficit to reduce the money supply and restore money market equilibrium.

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