The design of appropriate stabilization policies to meet short-run and long-run balance of payments objectives under fixed exchange rates requires analysis of how fiscal and credit policies affect the balance of payments. A starting point for such an analysis is often thought to be the monetary approach to the balance of payments, which, over the past two decades, has made important contributions to the analysis of the behavior of open economies under fixed exchange rates. As is known, however, the fundamental equation of the monetary approach is one that should be satisfied by any well-specified macroeconomic structural model of an open economy. The monetary approach is not itself a structural model, but rather a framework of analysis that is compatible with diverse macroeconomic models, which in turn may each possess quite different implications for the effects of stabilization policies on the balance of payments and on other macroeconomic variables.
To demonstrate this point in general terms, consider an economy in which the central bank is the only financial institution, and suppose that its balance sheet is given by
F + D = M,
where F is the domestic currency value of the bank’s net foreign assets, D is the domestic credit extended by the bank, and M is its stock of monetary liabilities, which represents the stock of money in this simple economy. Then, letting a dot over a variable denote its time derivative, the economy’s balance of payments, measured in domestic currency, is by definition:
BOP = Ḟ = Ṁ - Ḋ.
Assuming that the domestic money market is in continuous flow equilibrium, and denoting by P and L the domestic price level and real demand for money respectively, yields
Combining this equation with the balance of payments identity immediately above gives
which is the fundamental equation of the monetary approach. Since the only structural assumption used in deriving this equation was that of flow equilibrium in the money market, any macro-economic model using this assumption must be capable of generating the fundamental equation of the monetary approach. Because this assumption is not very restrictive, a broad class of models (including Keynesian variants) must be amenable to analysis under the monetary approach to the balance of payments, and the different properties of these models with regard to the effects of stabilization policies on macroeconomic variables must all be compatible with the monetary approach. In particular, the monetary approach merely describes the effects of stabilization policies on the balance of payments in terms of effects on the flow demand for money, on the flow supply of domestic-source money, or on both; the monetary approach does not, however, commit one to any particular view about the effects of such policies on the balance of payments.
The purpose of this paper is to illustrate these points in the context of a particular model. The structural model most frequently associated with the monetary approach is that of “global monetarism.”1 In such models, credit policy has a uniquely powerful effect on the balance of payments. The function for the public’s flow demand for money (hoarding) depends on the behavior of the price level, real output, and the nominal interest rate, all of which are exogenous. Because the money market is in continuous flow equilibrium, this hoarding function determines the flow supply of money. Credit policy then determines the composition of this change between foreign-source money (the balance of payments) and domestic-source money.2
This view has clear implications for stabilization policy. To hit a balance of payments target, it is necessary to forecast the flow demand for money. Subtracting from this estimate the desired increase in net foreign assets yields the flow of credit that is consistent with the desired balance of payments outcome. To the extent that this outcome entails a change in the flow of domestic credit to the public sector, adjustments will have to be made in either external borrowing by the public sector or in public sector savings.
By changing the structure of this familiar model slightly, one can illustrate the compatibility of the monetary approach with the different effects of credit and fiscal policies generated by different macroeconomic structures.
The particular structural specifications that are analyzed in this paper are the assumptions that the demand for money depends on wealth in addition to current income and that saving can be described by a conventional life-cycle savings function.
There are strong arguments for these specifications. The money demand and savings functions are linked through the private sector’s budget constraint. Although the demand for money refers to a stock to be held at every instant, whereas saving refers to a flow, the flow of saving must be accumulated in some form; that is, the act of saving must have as its counterpart a flow demand for assets. Money is, of course, one of the forms in which savings may be held. To the extent that savers choose to accumulate some of their assets in the form of money, one would expect to observe a flow demand for money that is consistent with the demand for money as a stock.
This link between saving and the demand for money proves troublesome for the analysis of economies in which the commercial banking system represents the primary vehicle for the accumulation of private savings. For such economies, conventional money demand and savings functions would in some instances predict that all savings would be accumulated in the form of non-money assets. For example, suppose that money demand and saving were both linked to current income, that saving is positive at this level of income, and that income does not change from this period to the next. Because the private sector is content to hold the current stock of money at the current level of income, then, other things being equal, the demand for money will remain unchanged at the end of the period, and there will be no hoarding during the period. Thus, all current savings must be accumulated in the form of nonmoney assets. Alternatively, suppose that the demand for money and the level of consumption both depend on permanent income, so that all transitory income is saved. Then, if the current period is one in which transitory income is positive, saving will be positive. But, since the demand for money remains unchanged during the period, once again all current saving must take the form of purchasing nonmoney assets. In both of these cases, the specifications of the money demand and savings functions are inconsistent with the view that the commercial banking system is an important vehicle for the mobilization of private saving.
Several modifications of the money demand function have been proposed that would avoid this result. To allow for the possibility that some of the transitory income is saved in the form of money, Darby (1972) and Barro (1977) included transitory income as an additional variable in the demand for money. Likewise, recent descriptions of money as a “buffer stock” (Carr and Darby (1981)) have allowed for the possibility that individuals may wish to retain some portion of unexpected cash receipts in the form of money even when the fundamental determinants of the long-run demand for money remain unchanged. Finally, Tobin’s (1969) “general equilibrium” approach to the demand for money achieved a similar result by incorporating wealth explicitly in the demand for money. Empirical support for this approach has been provided by Goldfeld (1976), Friedman (1978), Butkiewicz (1979), and Laumas and Ram (1980) for the United States, and by Hunt and Volker (1981) for Australia.
The remainder of the paper investigates the implications, for the effects of credit and fiscal policies, of incorporating Tobin’s specification in a “global monetarist” model. The model is described in Section I; the two succeeding sections describe its short run and long-run equilibria; and some conclusions follow in Section IV.
I. A Simple Monetarist Model of the Balance of Payments
The articulated “global monetarist” model of the balance of payments described in this section is “monetarist” in the sense that the analytical framework chosen is similar to that utilized by Johnson (1972) and Mundell (1971) in their early papers in the tradition of the monetary approach to the balance of payments. Specifically, the economy in question is a small, growing, open economy with a fixed exchange rate. Because the domestic price level and the nominal wage are flexible, the economy always operates at full capacity. A single, internationally traded commodity is produced. The level of real output per capita, y, is given by:
where k is the stock of capital per worker.3 It is assumed that purchasing power parity holds continuously. Given the fixity of the exchange rate, this parity effectively pegs the domestic price level to the level of world prices, which are taken to be growing at the rate
Note that the assumptions about world inflation and population growth mean that the domestic price level and population are continuous functions of time. Although the domestic price level is flexible—and thus, in principle, susceptible to discontinuous shifts—it is prevented from behaving in that way by the condition of purchasing power parity, which pegs it to the continuously changing foreign price level. Thus, domestic prices and population are effectively predetermined at any instant of time.
The private sector holds four assets: domestic money, foreign interest-bearing assets, domestic credit extended to the private sector, and real capital. The real per capita values of private holdings of these assets are given by m, fP, dP, and qk, respectively, where q is the relative price of installed capital goods in terms of consumption goods (that is, Tobin’s q). The subscript P (for private sector) is omitted from m and k because it is assumed that only this sector holds domestic money and real capital. The private sector’s real per capita net worth (wP) is thus given by
It is convenient to define
where aP can be interpreted as the real per capita value of the private sector’s net stock of nominal (financial) assets. Thus, wP becomes
It is assumed that only the foreign asset is held internationally; therefore, all asset swaps with foreigners are ruled out. In implementing the policy of pegging the exchange rate, however, the central bank stands ready to buy and sell foreign assets in exchange for domestic money in discrete amounts. Because such swaps are of the form dm = -dfP, by equation (2) the total of gross nominal assets held by the private sector remains unaffected by these transactions. Furthermore, because credit policy involves setting the rate of growth of credit to the private and public sectors
The private sector faces a problem of portfolio allocation. Assuming that all nonmoney assets are considered to be perfect substitutes, the sector will be in portfolio equilibrium when
Equation (4) states that the per capita real demand for money increases with the own real return on money (the nominal return on money is set at zero), the per capita level of real gross domestic product, and private sector wealth. Per capita real demand for money decreases with the real rate of return on competing assets, which, given the assumption of perfect substitutability, must be ρF for all nonmoney assets. This condition is stated by equation (5) for the real capital stock. It is derived from
where y′ is the marginal product of capital. This equation states that the real rate of return on physical capital, consisting of the marginal product and the expected capital gain
In addition to deciding how to allocate its portfolio, the private sector has to choose the rate at which it wishes to accumulate assets, subject to the budget constraint
where i is investment, tP is (lump-sum) taxes paid by the private sector, and cP is private consumption, all in real per capita terms. The term
To complete the description of private sector decisions, let asset-accumulation behavior be governed by
Equation (7) is a conventional life-cycle consumption function in which yL is real per capita labor income, which in turn is an increasing function of k. Consumption depends positively on household resources but negatively on the rate of return to saving. Equation (8) is a “q “-type investment function that states that the private sector will seek to change its endowment of capital per person when q does not equal 1. Per capita real investment is given by
The function j captures the adjustment costs associated with changes in the stock of capital per worker. This “Penrose-Uzawa” effect explains why the stock of capital per worker can be such that the marginal product of capital y′(k) differs from the real rate of interest ρF for periods of finite length and provides the underlying rationale for the function h introduced in equation (8) (see Uzawa (1969)).
The central bank is the only financial institution in the model. Its balance sheet takes the form
where the subscript B identifies central bank holdings of foreign assets (international reserves). As indicated before, at a given moment d is a predetermined variable, the result of past credit policy. The variables fB and m are endogenous, determined by the public’s portfolio decisions as long as the fixed exchange rate regime remains in effect.
Note that, according to equation (10), the central bank has no net worth. We assume that all its current income is transferred to the treasury. Thus, its flow transactions are subject to separate constraints on current and capital accounts:
Equation (11) determines the income transferred to the treasury, tB, which is the sum of the bank’s net real interest earnings and the inflation tax extracted from the private sector. Equation (12) defines the real per capita value of the balance of payments or the real per capita value of the change in the bank’s foreign assets, which in turn is equal to the real per capita value of the difference between the flow of monetary liabilities and the flow of credit. The basic tools of credit policy are the rates of growth of credit extended to the private and public sectors (
Fiscal policy consists in setting real per capita taxes, tP and real per capita public consumption, cG. (The public sector is assumed to undertake no investment.) In addition, the public sector determines the real per capita value of its rate of accumulation of foreign assets,
According to equation (13), the public sector’s accumulation of foreign assets equals current public saving plus the flow of credit to the public sector.
The model is completed by specifying how the economy’s stock of foreign assets evolves over time. Summing the budget constraints (6), (11), (12), and (13) yields
Thus, the current account is defined as the real per capita value of the economy’s accumulation of foreign assets, which in turn is the difference between national income (y + rFf) and absorption (cP + i + cG).
II. Short-Run Equilibrium
In the short run, the values of aP, k, and f are determined by past values of equations (6), (9), and (14) respectively. The current values of dP dG and fG are determined directly by past policy choices. Given these predetermined variables and the current policy stance, in the form of the vector (
The examination of this issue is simplified by working with a special case of the model at hand. If new capital can be installed without cost, q = 1 must hold at every instant. In this case investors will adjust the capital stock continuously so as to satisfy
Let k* denote the value of k that satisfies equation (5a). In the frictionless world now under consideration, the equation for private investment becomes
Finally, the private sector’s real per capita net worth becomes
The remainder of the paper will consider only the special case in which new capital can be costlessly installed and in which equations (5a), (8a), and (3a) replace their corresponding, earlier versions.
Before analyzing the determination of the balance of payments in short-run equilibrium, we must solve for the short-run equilibrium values of certain endogenous variables. First, substituting equations (1) and (3a) in equation (4), the stock demand for money can be expressed as
Finally, define s, the real per capita value of private saving in the form of nominal assets, as
An increase in taxes paid by the private sector reduces s because it reduces disposable income more than it does consumption. An increase in the net nominal wealth of the private sector has an effect on s that is ambiguous in principle. Private consumption increases according to equation (7a), but so does private disposable income, since fP is an increasing function of aP. The consumption effect will be assumed to dominate, so that s2 is less than zero. Note that the private sector’s budget constraint can be written in the form
The condition that s2 is less than zero is sufficient (although not necessary) to guarantee the stability of equation (17). An increase in π has an ambiguous effect on s for the case in which (fP - dP) is positive (that is, in which the private sector is a net creditor) because disposable income is augmented by an increase in interest receipts while consumption increases. Finally, the direct effect of an increase in ρF is to increase s (through increased disposable income in the net creditor case and reduced consumption), but its indirect effects through k* are ambiguous. Because k* falls, disposable income is reduced by ρFdk*. Simultaneously, however, both consumption and investment fall, by (c4 + n)dk*. The first effect tends to reduce the accumulation of nominal assets; the second tends to increase it. The positive sign associated with s4 in equation (16a) reflects the supposition that ρF is not “too large,” so that the second effect is dominant.
We now turn to the determination of the balance of payments in short-run equilibrium. Writing equation (12) in the form
supposing that the world rate of inflation and the foreign real interest rate are constant over time, and then differentiating equation (4a) with respect to time and substituting above, yields
Finally, using equation (17), and recalling that with q = 1, then
Equation (12a) is the reduced-form expression for the real per capita balance of payments in the model. The expression in square brackets is the real per capita value of the flow demand for money. Equation (12a) can be used to establish the propositions that follow.
An increase in the flow of credit to the private sector will cause the balance of payments to deteriorate by the same amount.
An increase in the flow of credit to the public sector that is offset by reduced public sector borrowing abroad will cause the balance of payments to deteriorate by the same amount.
Recall that a change in the flow of credit to the public sector must be offset by a change in [ḟG + (π + n)fG], tB, or cG, owing to the government budget constraint. Obviously, if the first of these terms changes—that is, if the public sector turns from foreign to domestic borrowing—in the short run the capital account, and thus bop, will deteriorate by the amount of the reduced capital inflow to the public sector.
An increase in the flow of credit to the public sector used to finance an increase in public expenditure will cause the balance of payments to deteriorate by an equal amount.
From equation (12a), d(bop)/d(
An increase in the flow of credit to the public sector used to finance a reduction in taxation will cause the balance of payments to deteriorate by less than the change in the flow of credit.
From equation (12a) one knows that
since m1 > 0, s1 < 0, and dtP/d(
as indicated above.
Changes in public consumption that are financed by changes in taxes on the private sector, as well as changes in private taxation that are financed by public sector borrowing abroad, will affect the balance of payments in the short run, even though domestic credit policy remains unaltered.
This proposition follows directly from equation (12a), since tP appears within the term in square brackets. Regardless of whether the change in taxation is offset in equation (13) by changes in public consumption or in public external borrowing, the effect on bop of a change in taxes on the private sector is given by
d(bop) = m1 S1dtp.
As in previous cases, it is possible to determine the extent to which the effect operates through the current and capital accounts.
The results of this section may be summarized as follows. Consider a forecast of the flow demand for money that is conditional on unchanged fiscal and credit policies. Call this forecast
The reason is that
III. Long-Run Equilibrium
The previous section analyzed the short-run impact of credit and fiscal policies on the balance of payments in the modified “global monetarist” model. But it also is important to ascertain whether fiscal policy can have a permanent impact on the balance of payments. To this end, the present section analyzes the long-run properties of the model. Three propositions are established about the long-run role of credit and fiscal policies in the model of Section I.
The first proposition is that credit policy determines whether a steady-state equilibrium with a fixed exchange rate exists. Second, if such an equilibrium does exist, credit and fiscal policies will determine the steady-state stock of reserves and the long-run balance of payments. Credit and fiscal policies can be used to achieve a desired stock of reserves in the long run. Third, if no such equilibrium exists, credit and fiscal policies determine the timing of the crisis that results in the collapse of the fixed parity. These policies also determine certain characteristics of the economy under the successor regime of flexible rates.
The evolution over time of the private sector’s stock of physical capital and net nominal assets is governed by equation (17). The steady-state value of aP is defined implicitly by setting
If an increase in the rate of inflation reduces saving (s3 < 0 in equation (16a)), we have aP3 < 0, and attention shall be restricted to this case below. The assumptions made so far ensure that the equilibrium
it follows that the credit policy consistent with a steady-state equilibrium is unique—that is,
As shown above, if a fixed rate steady state is to exist, credit policy must be conducted so as to keep d constant. But d will be constant whenever
Thus, given an initial value of d(0), the long-run equilibrium stock of reserves depends on fiscal policy in the form of tP and on the trajectory followed by credit policy between the present and the moment when it is brought to its long-run equilibrium value,
In the long run, therefore, the balance of payments depends on fiscal policy in the form of tP, on the initial stock of domestic credit, and on the path of credit policy on the way to long-run equilibrium.
It may be concluded that, in the model under discussion, fiscal and credit policies jointly determine the balance of payments, both in the short run and the long run.
Given tP, if the rate of growth of domestic credit is fixed such that
Before examining the implication of credit policy for the characteristics of the transition to the new exchange regime, consider briefly the nature of steady-state equilibrium under floating rates. If we use the definition of s given by equation (16) in equation (17), it becomes evident that, for
Krugman (1979) has shown that, in an economy with perfect foresight and flexible prices (such as the one modeled here), the end of the fixed rate regime will be reached when the central bank still possesses a finite stock of reserves: a sudden speculative attack will absorb the remaining stock of reserves, making fB jump discretely from some finite value to zero rather than approach zero asymptotically. The reason for this is that, at the moment the fixed rate is abandoned, if (
To determine when the exchange crisis will take place, let
since (m -fB) represents the stock of money that would remain in the possession of the private sector if it were to suddenly acquire fB. The second equality results from equation (10). Because
one may write
Thus, given that the rate of credit growth is excessive for the achievement of a steady state with fixed rates, an increase in the rate of growth of domestic credit will advance the date for the collapse of the fixed exchange rate. An increase in
Similarly, to establish the effect of fiscal policy on tc, one may write
since L1P3 is less than zero, both
The thrust of the argument in this paper is that, in the type of economy under examination, fiscal and credit policies have separate and independent effects on the balance of payments in both the short run and the long run. In terms of the “fundamental equation” of the monetary approach to the balance of payments, fiscal policy operates through the flow demand for money, and credit policy through the flow supply of domestic-source money. The implication is that it will not, in general, be possible to reach a balance of payments target by forecasting the flow demand for money in the absence of fiscal and credit policy changes and then setting credit policy accordingly—at least not if changes in private taxation are also contemplated. Proper conduct of stabilization policy in this model requires that the effect of changes in taxation on private saving, and of these changes on the flow demand for money, be taken into account.
It is not difficult to construct alternative models in the “global monetarist” spirit in which these conclusions would need to be modified. Three examples come to mind.
For the first example, consider a Barro (1974) world in which the government is a “veil” and the cost to the private sector of financing the government budget is given by cG. Equation (7) then becomes
In this case fiscal policy retains a direct effect on the balance of payments, but this effect now operates through cG rather than through tP.
Second, in an “ultrarational” world (see David and Scadding (1974)) in which the government is a veil and public consumption is regarded as a perfect substitute for private consumption, equation (7) becomes
This restores the exclusive role of credit policy in determining the balance of payments in a “global monetarist” framework.5
Finally, the simplest way to restore the primacy of credit policy is to omit private wealth as an argument in the money demand function (4) and to revert to a pure “transactions” view of the demand for money.
These cases serve to confirm that the effects of credit and fiscal policies on the balance of payments are specific to the structure of the economy under consideration. There is simply no substitute for identifying this structure if stabilization policies are to be designed appropriately. This paper has focused on the effects of decisions about private saving and portfolio allocation in this context. In particular, if private saving behavior is affected by government fiscal measures, and if the private sector seeks to continue to accumulate some of these savings in the form of money even at constant relative rates of return and constant or declining real income, then the simple relation between credit policy and the balance of payments postulated in “global monetarist” models will fail to hold. Even within the analytical framework of these models, the achievement of external balance will involve the simultaneous interaction of fiscal and credit policies.
The purpose of this Appendix is to investigate the determination of the domestic rate of inflation at the instant of transition from fixed to flexible exchange rates. The steady-state rate of inflation under flexible rates is (
Note first that the domestic rate of inflation cannot be lower than
Figure 1.Transition to a Floating-Rate Steady State
The transition must therefore be as depicted in Figure 1. When the exchange crisis hits, the economy is at A. At time tc, the inflation rate jumps discretely to
and at time tc,
Furthermore, note that, because S′S′ has a positive slope during the transition to
Therefore, (L4 - L1P1) is greater than zero.
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Mr. Montiel, an economist in the Developing Country Studies Division of the Research Department, holds degrees from Yale University and the Massachusetts Institute of Technology.
In accordance with this analysis, early empirical tests of the monetary approach to the balance of payments involved regressing reserve flows on the determinants of the flow demand for money and the flow of domestic credit. As Kreinin and Officer (1978) have pointed out in their survey of this literature, an important test of the “global monetarist” model was whether the coefficient on the flow of domestic credit—denoted the “offset coefficient”—was approximately equal to -1. This property was considered to be a central prediction of the “global monetarist” approach. Fiscal variables were omitted from the reserve-flow equation.
For the remainder of the paper, lowercase letters will be used to denote variables measured in real per capita terms.
These conclusions about the role of fiscal policy in the Barro and ultra-rational worlds assume that the demand for money depends on private (and thus national) net worth. In these two worlds, private net worth differs from “net private marketable assets” by the amount of the government’s net worth. If the demand for money instead depended on the stock of net private marketable assets (which represents the “balance-sheet constraint” on private holdings of money), then both tax and expenditure policies would affect the balance of payments in the Barro world. Furthermore, fiscal policy would have a larger impact on the balance of payments in the ultrarational world than in either the Barro world or the model analyzed in the paper.
Note that the new stable arm cannot intersect the old. If such an intersection existed, the same combination (π, aP) would be associated with different values of m at the intersection point, since the steeper path would start with a lower m and would experience greater inflation before the intersection. Because the other determinants of the demand for money are constant, this cannot occur. Thus, if the new path is above the old at any point it must be so along its whole range.