has played a significant role in promoting economic relations among countries
all over the world. In this era of globalization, it is fair to say that no
country in the world is “an island” or self-sufficient. One of the key benefits
of globalization is the ease of movement of goods and services across or among
nations. Like the computation of GDP, countries keep records of its
transactions with external economies over a given period usually quarterly or
yearly. This record of transactions is referred to as Balance of Payment (BOP).
of payments which is also referred to as the balance of international payments is
a record of all international or financial transactions that are undertaken
between residents of one country and residents of other countries during the year.
These transactions includes
imports and exports of goods and services, financial capital, and financial transfers (Saylor, n.d.; Riley, n.d.).
A country’s balance of
payments expresses the equilibrium between international commercial and
financial inflows and outflows (Paun, et al., 2010). The balance of Payment
can also be defined as a statistical record of all the economic transactions
between residents of a reporting country and the rest of the world during a
given period of time. Balance of payment is one of the most important
statistical statement as well as economic indicator of a country. It reveals
the number/ quantity of goods and services a country has exported or imported
over a period of time. It also reflects whether a country has been borrowing
money or lending to the rest of the world (Pilbeam, 2013, p. 31).
The BoP can
be defined using different measures depending on the circumstance, thus, BoP
can be defined using the Official Settlement, Current Account or Basic Balance
for many countries, the focus of attention is on the balance of payment on
their current account and a lot of effort is concentrated on policies to reduce
the current account deficit by increasing and reducing the value of exports and
imports respectively. A balance of payment can be
in surplus or deficit. A country’s balance of payments is said to be in surplus
if inflows (funds from exports, and assets e.g. bonds) exceeds outflows on
imports. On the other hand, a balance of payment is said to be in deficit if
outflows are more than the inflows.
Brief Description of Other Approaches
years, economists (John Keynes, Marshall Lerner, Mundell and Fleming, Polak among
others) have propounded various unique approaches in the analysis of BoP. There are three basic alternative
theories or approaches of balance of payments adjustment namely, the elasticities approach, the absorptions approach
and the monetary approach.
the elasticities and absorption approaches the focus of attention is on the
trade balance with resources not fully employed. The elasticities approach
emphasizes the role of relative prices (or exchange rate) in balance of
payments adjustments by considering price sensitivities to imports as well as
government policy implications such as currency devaluation on exports. A
notable shortcoming of the elasticities approach is that it does not consider
capital flows. On the contrary, the monetary approach focuses attention on the
balance of payments (or the money account) with full employment of resources.
The absorption approach shows a significant improvement over the
elasticities approach in the sense that, it views both the external and
internal through national income accounting. The monetary approach, like the
absorption approach, stresses the need for reducing domestic expenditure
relative to income, in order to eliminate a deficit in the balance of payments.
(Ardalan, 2005, p.
Background to the Monetarist Approach to BoP and
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
monetarist approach to the balance of payments theory addresses both
shortcomings. Since this essentially involves an extension of the rudiments of
monetary theory to the area of the balance of payments, it is henceforth
referred to as a monetary view of the balance of payments (MBOP) (Kemp, 1975, p.
approach to the balance of payments and exchange rate determination asserts that changes in a country’s balance of
or the exchange value of
its currency are just a monetary phenomenon,
thus can only be corrected by monetary measures.
fundamental thinking underpinning the Monetary Approach is that a country’s
balance of payment deficit is as a result of its money supply being greater
than the demand for money, thus an excess supply of money is the only cause of
the BoP deficit. When a country increase its money supply faster than other
countries or than it is required, the result is a worsening of the country’s
Assumptions underlying the Monetarist Approach:
monetary approach is based on a number of assumptions:
The demand for money is stable and has a
positive relation on income, prices and interest rate. The supply of money of a country is made up of
two components: domestic credit and
foreign exchange reserves.
The law of one price applies. This law assumes
that it should cost the same amount of money to purchase a particular basket of
goods irrespective of the country of purchase, thus, the price of a basket of
goods in Ghana should be same as the price of a similar/identical item in the
UK after converting to a common currency, after allowing for transport costs. There
is perfect substitution in consumption in both the product and capital markets.
The level of output of a country is determined
by exogenous factors.
All countries resources are assumed to be at
summarizing the assumptions, the stable demand for money and the fixed
aggregate supply sets the standard quantity theory of money principle that a
change in money supply leads to a proportionate change in price level, which
also results in an increase in nominal income. However, given the assumption
that income (output) is fixed, then price remains the only determinant.
However, the purchasing power parity (PPP) assumptions challenges the price
changes in the quantity theory of money. PPP assumes perfect substitution in
consumption of goods/services on the international market where price levels
are exogenous. As a result, the foreign exchange reserve component of the money
supply is the key determinant of the BoP deficit or surplus.
above assumptions, the relationship between the demand for and supply of money and
BoP can be expressed in the following six (6) step approach:
for money (Md) is a stable function of income (Y), prices (P) and rate of
i) ……… (1)
supply (Ms) is made up of two components: Domestic money (credit) (DC) and foreign
exchange reserves (R).
Ms = DC + R
equilibrium the demand for money equals the money supply,
= Ms………. (3) and thereby;
= DC + R as MS = DC + R ….… (4)
of payments deficit or surplus is represented by changes in the country’s
foreign exchange reserves. Therefore;
R = ?Md – ?DC
or R = B ………….. (6)
represents balance of payments which is equal to the difference between change in
the demand for money (?Md) and change in domestic credit (?DC).
of payments deficit reduces the foreign exchange reserve (R) and the money
supply. On the other hand, a surplus increases R and the money supply. When B =
O, it means BoP equilibrium.
automatic adjustment mechanism in the monetary approaches could be demonstrated
below under both the fixed and flexible exchange rate systems using a
hypothetical small country as an example
Balance of Payment Analysis under the Fixed
Exchange Rate System
fixed exchange rate system, a country’s monetary authorities intervene to
regulate the value of exchange rate. It is assumed that under fixed exchange
rates the government’s control/regulation of currency flows is not possible on account
of the law of one price globally. An attempt by the monetary authority to
increases domestic money supply under the fixed exchange regime, results in a BoP
deficit. The increase in money supply results in increases in the purchase of
more foreign goods and securities.
turn leads to an increase in the prices imported goods and foreign assets. The
throw on effect is an increase in expenditure on both current and capital
accounts in BoP, thereby creating a BOP deficit. To correct the BoP deficit,
monetary authorities need to buy back the currency on the foreign exchange
market with existing foreign exchange reserves. The fall in the foreign exchange
reserve will continue to reduce the BoP deficit until equilibrium is restored.
On the other
hand, a fall in money supply over money demand will result in a BOP surplus.
Consequently, people acquire the domestic currency by selling goods and
securities to foreigners. They will also seek to acquire additional money
balances by restricting their expenditure relatively to their income. The
monetary authority on its part, will buy excess foreign currency in exchange
for domestic currency. There will be inflow of foreign exchange reserves and
increase in domestic money supply. This process will continue until money
supply equals demand and BoP equilibrium will be restored. Thus, a BoP deficit
or surplus in the fixed exchange regime is a temporary phenomenon and is self-correcting
in the long-run (Ardalan, 2009).
Balance of Payment Analysis under Floating
Exchange Rate System
Under a floating exchange rate system, the country’s monetary
authorities do not interfere in any way to affect the valuation of the exchange
rate. It is assumed that, an increase in the supply of the domestic currency
will make domestic goods and assets more expensive on international markets,
leading to downward pressures on the BoP.
to the theory, an imbalance in the BoP will automatically adjust the exchange
rate in the direction necessary to restore BoP equilibrium. When there is a BoP deficit or
surplus, changes in the demand for money and exchange rate play a major role in
the adjustment process without any inflow or outflow of foreign exchange
reserves. Assuming an increase in the money supply, there will be a BoP
deficit. People having additional cash balances buy more goods thereby raising
prices of domestic and imported goods. This results in the depreciation of the
domestic currency and a rise in the exchange rate. Consequently, the rise in
prices increases the demand for money thereby bringing the equilibrium of money
demand and supply without any outflow of foreign exchange reserves. The reverse
occurs when the demand for money exceeds supply in that it results in fall in
prices and appreciation of the domestic currency which automatically eliminates
the excess demand for money. “The exchange rate will fall until the demand for
money is equal to money supply and BoP is in equilibrium without any inflow of
foreign exchange reserves” (Meghana, n.d.).
For example, it is argued that the Asian crisis prompted most investors
to move to USD denominated assets. As a result, there is a large positive net
portfolio investment in the U.S., leading to a surplus of the Current Account
and of the BOP. According to the theory, this excess demand for U.S. assets
should lead to an appreciation of the USD. This would, in turn, make U.S. goods
and assets more expensive, and generate downward pressure on the Current
Account and the Capital Account (University of Colorado, n.d.).
Much of the empirical evidence tries to measure the extent to which a
rise in the domestic money supply base results in a fall in the foreign
exchange reserve in the fixed exchange regime. Pilbeam (2013) presents
empirical estimates for some countries for the period 1976 to 1990 (Pilbeam,
2013, pg. 120). This evidence suggests mixed results. Studies from 1974-1976
confirms that the offset coefficient is correct.
However, researches conducted after 1982 suggests that earlier studies
may have been over estimated because of the frequency of sterilisation. This
mixed position is as a result of certain assumptions such as price level and
interest rates not holding in the real-world scenario.
Limitations of the Monetary Approach
the monetary approach has been widely accepted as more realistic in that it
takes into consideration both domestic money and foreign money as it does not
lay emphasis on relative price changes unlike the Elasticity Approach, the monetary
approach has been criticized by several economists and experts. 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.
assumptions hold well in the long run but are rarely fulfilled in the short
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 demand.
There is weak link between BOP and Money
Supply. The monetarist assumption of the direct link between BoP of an
economy and its total money supply has been criticized as overly simplified and
does not hold in a real-world phenomenon. For such an assumption to be valid, the
monetary authority will have to offset the inflows and outflows of foreign exchange
reserves in a deficit or surplus situation. This requires some level of
sterilization of external flows which is not possible due to globalization of