Monetary approach to BOP

Question 1

Assumptions of monetary approach to BOP?

Answer 1

• Assumptions:
• 1. Stable money demand function
• 2. Vertical aggregate supply
• 3. Purchasing Power Parity

Question 2

Demand for money relation with price

Answer 2

• 1. positively related to the price level
• Demand for real money balances: M/P

A rise in the domestic price level will reduce the
money balances M/P and lead to an
equiproportional increase in the demand for
money.

Question 3

Demand for money relation with income

Answer 3

2. Positively related to the domestic income: a
   rise in Y, ceteris paribus, leads to an increase in
   transactions demand for money.

Question 4

Vertical aggregate supply schedule Assumption:

Answer 4

-labour market is sufficiently flexible:
economy is constantly at full employment level of output

• Wages: flexible: labour supply = labour demand
• A rise in domestic price level does not lead to a higher Y because wages increase immediately

• Producers don’t take on more labour:

• Vertical aggregate supply at the full employment level of
the economy

• Aggregate supply shifts to the right or left if there’s a
productivity improvement due to technological progress

Question 5

left/right of ppp

Answer 5

left overvalued, right undervalued

Question 6

7 implications of the approach

Answer 6

• Distinctive feature: money market disequilibrium:
crucial factor in provoking BP disequilibrium

• Agents decide firstly upon the size of their
money balances they with to hold and then
spend accordingly. (not the other way round)

• Demand for money: stable, predictable function
of few variables

• Does not regard demand elasticities as
important in determining the demand for money

• Fixed exchange rate: authorities lose control
over monetary policy: any attempt of expanding
domestic money supply leads to BP deficit and
the need to purchase domestic currency with
foreign reserves.

• If foreign prices rise, so will domestic prices.

• Both: OMO and FXO can bring disequilibrium to
the money market because they affect real
money balances.

Question 7

Criticism of the monetary approach

Answer 7

• Demand functions can be unstable
  • Economies are rarely in full employment

• PPP: bad guide for exchange rate movements in the
short run

• Assumptions hold in the long run, but not in the short run

• Pays no attention to the composition of surplus and
deficit because they are supposed to be transitory:
Ignores the dangers of increasing indebtedness due to
CA deficits financed by capital inflows