1. The monetary approach

The monetary approach to the balance of payments, as was largely developed in the Fund and the University of Chicago at the end of the 1950s, stresses the essentially monetary nature of balance of payment imbalances. “its essence is to put at the forefront of analysis the monetary rather than the relative price aspects of international adjustment ….” ^6/ “Accordingly, surpluses in the trade account and the capital account respectively represent excess flow supplies of goods and of securities, and a surplus in the money account reflects an excess domestic flow demand for money. Consequently, in analyzing the money account, or more familiarly the rate of increase or decrease in the country’s international reserves, the monetary approach focuses on the determinants of the excess domestic flow demand for, or supply of, money ….” ^7/ In the original formulation, the theory is framed in a long-run perspective with the crucial assumption that the monetary authorities cannot sterilize balance of payments surpluses or deficits, and, therefore, they will be channeled into the money supply. ^{8/ 9/}

The fundamental behavioral equation of the model is the money demand function:

where money demand (M_d) is equal to the domestic price level (p), times a function of real income (Y) and nominal interest rate (i). The money demand function is assumed to be stable, and the incremental demand for money is a function of the growth of nominal income. If the economy considered is a small, open economy it would face prices and interest rates determined at the world level. Perfect international capital mobility and perfect substitutability between domestic and foreign bonds are also usually assumed. Perfect international capital mobility implies that the interest rate on domestic bonds is equalized with the interest rate on foreign bonds, plus the forward premium on the exchange rate—that is, covered interest parity; it should not be overlooked that perfect capital mobility is based on the assumption that there is no differential risk of default nor differential risk regarding possible changes in financial markets rules and the exchange rate regimes. ^10/ Perfect bond substitutability implies that the agent—behaving according to rational expectations—will allocate their portfolio shares indifferently between domestic and foreign bonds with the same expected rate of return, when expressed in the same currency.

Finally, it is assumed that purchasing power parity (PPP) holds. PPP relies, in turn, on the assumption that prices are perfectly flexible, and, therefore, any change in the nominal exchange rate will not be reflected in the real exchange rate. Perfect flexibility of prices and, in particular of the price of labor, ensures that output will be at its full employment level.

In a system of a fixed exchange rate, we can summarize the assumptions in the model as follows:

where i (i*) refers to domestic (world) nominal interest rate, p (p*) to domestic (world) price level, and y $\left(\overline{y}\right)$ to domestic (full employment) output.

Given that the money supply equals the sum of international reserves (R) and domestic credit (DC), ^11/ equilibrium in the money market requires

Thus,

An increase in the demand for money raises international reserves, while an increase in domestic credit by the central bank reduces international reserves.

Therefore, in a fixed exchange rate system, balance of payments disequilibria can be adjusted through a reduction of domestic credit to a level consistent with the evolution of the money demand.

In a flexible exchange rate system, the uncovered interest parity, i - i*, is equal to the expected depreciation of domestic currency:

where e is the nominal exchange rate, defined as units of domestic currency in terms of foreign currency.

The depreciation expectation is formed rationally and corresponds to the expected inflation differential, if PPP holds:

For the monetary approach to be able to explain the determination of the balance of payments or the exchange rate in its original formulation, all the above assumptions should hold, together with a stable demand-for-money function. Available empirical evidence has shown, however, that all these assumptions generally do not hold. Moreover, the relationship between the exchange rate and the various components of the balance of payments, and in particular the current account, cannot be easily explained by the monetary approach. Within the narrow version of the monetary approach one can explain that relationship only through price shocks (such as the two oil shocks of 1973 and 1979, which raised the world demand for dollars) or through announcement effects of unexpected outturns in the trade balance. ^12/

Therefore, a new generation of models has been originated, still in the tradition of asset-demand models of the balance of payments, but some of the original assumptions of the monetary approach have been relaxed. These are the so-called portfolio-balance models, which are able to offer explanations of the relationship between the current account and the exchange rate by taking into consideration the capital account and, thus, the real (wealth) effects of the current account imbalances. The counterpart of current account surpluses is a shift of wealth from foreigners to residents. The increase in wealth for residents raises money demand and also the demand for domestic bonds if these are not perfect substitutes for foreign bonds. Preferences for domestic bonds can derive from special tax treatment of government bonds as well as from political risk attached to the foreign bonds.

The portfolio-balance models allow for a more complex view of the adjustment mechanism. First, they take into account that the assets market reacts more quickly than the goods market, thus generating risks of overshooting and cumulative destabilizing effects. Second, they take into account the existence of nontraded goods and securities, that is, imperfect goods and financial markets. ^13/ This implies, in turn, that any change in financial policy affects not only the balance of payments but also prices and the domestic interest rate. Under these circumstances, the financial crowding out of private firms can be brought about by fiscal expansion by affecting domestic interest rates. This mechanism was not an option in the original version of the monetary approach applied to small, open economies.

The monetary approach’s focus on “the direct connection between the money market and the balance of payments, rather than working through the implied changes in the goods or financial assets markets” ^14/ gives simple and comprehensive indicators for the economic stance; however, it gives few instruments to suggest and monitor adjustment policies where the intermediate targets often move in the short period in a direction opposite to the final result. Therefore, in devising a theoretical underpinning for the use of fiscal targets in adjustment programs such as those of the Fund, a so-called fiscal approach has been proposed. ^15/

2. The fiscal approach

In contrast to the absorption approach, the fiscal approach, developed by the Cambridge Economic Policy Group (CEPG) in the mid-1970s, focuses on the public sector saving as the only variable relevant to determining the current account of the balance of payments. In common with the monetary approach, the fiscal approach extends the theories of the balance of payments of the 1960s in order to consider stocks demand for assets together with expenditure decisions. The fiscal approach lumps together the private expenditure for consumption and for investment:

where the nominal private expenditure, E, at time t, is a stable proportion of the nominal disposable income at t and one year lagged, $Y_t^P$ and $Y_{t-1}^P$. From their econometric work on the U.K. economic model, Cripps, Fetherston, and Godley (1976) found the coefficients of disposable income to sum to almost unity; thus, they decided to disregard any multiplier/accelerator mechanism in favor of a pure stock adjustment model: the private sector holds a given assets portfolio, determines expenditure to maintain it at the desired level, ^16/ and adjusts quickly its expenditure to changes in income. The stock adjustment can be modeled as follows:

where W*t is the desired wealth of time t and $Y_t^P$ is the private disposable income in the same period. The actual increases in wealth are

As the wealth increase is equal to the period saving, we can also write

or

The demand for the net stock of financial assets is assumed to be a “small and stable” proportion of the disposable income of the private sector. ^17/ Interest rates are fixed and investment demand is totally interest-inelastic. Hence, the fiscal approach (which ignores net income and transfers from abroad) models the current account of the balance of payments, X - Z, as determined by the fiscal balance, T - G, and private balance, S - I, as follows:

Under certain conditions, the fiscal and the monetary approaches can be considered mirror images of each other. In their simplest version—with only one financial asset and the private expenditure depending solely upon asset stock disequilibrium—the monetary approach concentrates on the official settlement accounts and lumps everything else into the category of “items above the line.” The fiscal approach concentrates on the current account and lumps everything else into the category of “items below the line.” ^18/

The flow equilibrium conditions for the commodity and money markets can be written as:

	Foreign Sector		Government Sector		Private Sector
Fiscal approach	(X - Z)	=	(T - G)	+	(S - I)	(15)
Monetary approach	ΔR	=	− ΔDC	+	ΔMd	(16)

View Table

	Foreign Sector		Government Sector		Private Sector
Fiscal approach	(X - Z)	=	(T - G)	+	(S - I)	(15)
Monetary approach	ΔR	=	− ΔDC	+	ΔMd	(16)

With capital movements equal to zero, the sums by column equal zero, showing the perfect similarity of the theoretical form of the fiscal and monetary approach.

The fiscal and the monetary approaches, however, are rooted in substantially different views about the working of the labor market and of price and output flexibility. While most versions of the monetary approach usually assume a situation of continuous full employment, output and employment are considered flexible by the fiscal approach. Therefore, a fiscal expansion raises output, which is not assumed at its full employment level, and thus tax revenue. The fiscal deficit will be less than the initial fiscal expansion. In addition, there will be no crowding out of the private sector because of the assumption of perfect open financial markets, which implies i = i*, and of a marginal private propensity to spend that is assumed to be unity for both consumption and investments.

Accordingly, the policy recommendations of the two approaches to achieve equilibrium of the external balance are far apart: the key policy recommendations of the New Cambridge school for the U.K. economy was the introduction of import restrictions. This would offset the government expenditure that should continue to play a role in supporting domestic demand. The monetary approach, instead, puts the burden of adjustment on the domestic credit creation and on the government deficit, which is considered the main cause of the domestic credit increases.

The differences in the policy recommendations depend on the sensitivity of exports to changes in domestic prices and on the sensitivity of prices to changes in demand. In the monetary approach framework, the parameter that measures the price sensitivity of exports tends toward plus infinity because of the assumption of a small, open economy for which PPP holds and the demand for exports is infinite. In the fiscal approach, instead, this parameter has a positive but finite value. In the monetary approach, the parameter that measures the price effect of changes in demand in the price equation is equal to plus infinity, as the labor supply curve is vertical; for the fiscal approach, the same parameter is equal to zero, because any change in demand will change the output—not at the full employment level—rather than the prices. The sensitivity of prices to changes in the exchange rate is assumed equal to unity by both schools because they exclude money illusion. However, the fiscal approach allows for lags in the real wage resistance (that is, the exchange rate elasticity of prices is less than unity in the short run) so that, to offset the effects of government expenditure on the current account of balance of payments, the CEPG proposed import quotas or an increase in import tariffs, arguing that increasing tariffs would have the same result as an autonomous reduction in the import propensity of the U.K. economy. ^19/

Despite these unorthodox policy recommendations, which depend on the assumption of (stationary) quasi-steady state where private saving equals zero and interest rates are fixed, the model was extended by Milne (1977) and Kelly (1982) from the industrial countries’ framework in order to be applied to the analysis of Fund-supported stabilization programs in developing countries. The fiscal approach to the balance of payments determination is based upon the national accounts identity, which states that the current account of the balance of payments is equal to the government balance and the private sector balance between investment and saving (equation 14). However, Milne’s estimates of equation (14), quoted also by Kelly, ^20/ are not very different from estimating a national accounts identity; given the current account identity and treating the private balance as a constant, the parameter of the public balance is bound to be not significantly different from unity.

3. An alternative fiscal approach model

A model that can explain changes in the current account of the balance of payments can be built within the fiscal approach framework once the behavioral content of private and public saving and of investment is specified and once the criticisms to the rather simple behavioral relation between income and private expenditure of the private sector that characterize the fiscal approach are taken into account. The direct effect of government spending and of different kinds of taxes on aggregate demand, and therefore on the current account, should not be overlooked nor the effect on private consumption of an increase in debt, in the monetization of debt (inflation tax), and in taxes. The full exogeneity of the private sector on the determination of the current account stated by the fiscal approach can be relaxed without swinging to the full exogeneity of the public sector on determining the same as in a neutral framework à la Barro.

Barro’s (1974) neutrality hypothesis states that financing government expenditure by taxes or by debt has the same impact on the intertemporal allocation of national consumption because, to fulfill the intertemporal budget constraint, the agents discount the value of the present government debt with the equivalent future tax liabilities necessary to service such a debt. ^21/ Assumptions necessary for this hypothesis to hold are the absence of distortionary taxes (i.e., only lump-sum taxes are allowed), perfect capital markets, and infinitely-lived agents (or perfect intergenerational chains). Infinite horizons of the agents make the intertemporal budget constraint of individuals equal to that of the government; with perfect financial markets this amounts to the same discount rate for the individual and the government. In this framework, financing policy has no consequences on the current account of the balance of payments because every fiscal expansion is offset one-to-one by the private sector. It has been demonstrated that once other than lump-sum taxes are introduced in the model (Barro (1979)), or allowances are given for borrowing constraints (Tobin and Buiter (1976)), or myopia or finite horizons of the agents are introduced, the neutrality hypothesis does not hold.

To obtain real effects from current and anticipated financing policy, one or more of the equivalence assumptions must be relaxed. The three sectors considered in the model are households, firms, and government.

The private saving function is based on the Blanchard-Yaari model, ^22/ which allows for finite horizons of the agents and thus keeps the distinction between individual and government discount rates. In this model, agents face a probability of death, w, which is constant throughout the agent’s life. The existence of insurance companies allows a transfer of wealth from those who die: thus total financial wealth, W, accumulates at the rate r, the interest rate, while individual—financial and human—wealth accumulates at a rate r + w.

The aggregate consumption function is a linear function of aggregate financial and human wealth:

where ω is the constant probability of death and θ is the discount factor (pure time preference rate). Accumulation of human wealth is given by

where Y is noninterest income; financial wealth is given by

If the government and the foreign sectors are introduced, where government spending is financed either by lump-sum taxes, T, or by debt, D, the consumption function becomes

where nonhuman wealth has been substituted by government debt and net foreign assets. ^23/ The dynamic foreign budget constraint is

which amounts to net income from foreign assets and the total saving of the economy. The government dynamic budget constraint is

$\stackrel{\cdot }{D}$ equals zero because D, G, and T are assumed to be constant. Only at time t_o do D and T increase permanently.

In a steady state, a change in foreign assets is a decreasing function of government debt as well as of consumption:

When r = θ the change in foreign assets will offset one-to-one the change in debt, that is, F = -D.

When agents have infinite horizons, w = 0, the foreign assets are independent from changes in D—that is, we are in the case of debt neutrality.

This result is quite different from that predicted by Barro’s neutrality hypothesis. According to the hypothesis, a zero increase in consumption is to be expected when debt increases. This corresponds to an increase in private savings equal to -D, with no effects on foreign assets in an open economy framework. Indeed, with ω = 0, that is, infinite lives, the individual has the same budget constraint—the same horizon and the same interest rate—of government, and is thus indifferent to the timing of taxes.

In a two-period framework, households maximize a two-period utility function subject to an intertemporal budget constraint. ^24/

where

As usual, the first-order condition for intertemporal utility maximization requires that the marginal rate of substitution between consumption in two consecutive periods equals the reciprocal of the market discount rate to the private sector.

Whether consumption will be rising over time will depend on the ratio between the real interest rate, on the one hand, and the sum of the discount rate and the probability of death, on the other.

Human and nonhuman wealth must be equal to the discounted value of household consumption:

where human wealth, H, is equal to the discounted value of labor income minus taxes:

The hypothesis of utility maximization implies that the consumer at any age allocates resources according to his life resources, that is, the present value of his labor income and the stock of wealth in his possession. ^25/

Private savings are equal to private disposable income less private consumption:

Thus, from equation (31) and equation (32), the two-period private saving function will be

Changes in the interest rate on financial assets will change the intertemporal allocation of resources because of the intertemporal substitution effect as well as the wealth effect.

The investment function is a stock adjustment one: firms invest to achieve the optimal, desired capital stock, K*. Net investment will then be used to partially adjust the actual to the desired capital stock:

where λ is the adjustment coefficient to be comprised between 0 and 1.

Government expenditure is given and taxes are set to comply with the government budget constraint:

where the implicit initial stock of bonds is assumed to be zero. Government saving is defined as

The macroeconomic equilibrium is achieved when private and public savings minus total domestic investment equal the current account.

In this framework, the role played by intertemporal substitution effects suggest that fiscal policy can modify the current account balance indirectly, through its effects on investment and saving behavior. Therefore, a cut in the budget deficit through an increase in taxes can improve or deteriorate the current account according to the substitution effect. The same uncertain effect will result from a cut of public investment expenditure, once the assumption of fixed output is relaxed. The following section estimates empirically the model discussed here, specifying the above equations to take into account historical and institutional characteristics of the countries examined. Moreover, the hypothesis of a direct effect of government expenditure, revenue, and deficit on the current account will be tested.

1. Specification and estimates

An empirical approximation of the equations described above are estimated for ten South American countries, using annual data for the period 1973-83. ^27/. The period chosen includes the two oil shocks, the increase in world interest rates, and the appearance of the debt crisis in the developing countries. The limited availability of data prompted the adoption of pooled time-series and cross-sectional data to estimate the model. To avoid the heteroskedasticity problems often connected with pooled time series, all variables are deflated by a measure of size: most of the variables used in the regressions are scaled to gross domestic product (GDP) at market prices and some variables are scaled to total population. To take into account the different institutional characteristics, ten country dummies replace the constants in the estimates. The sources of the data are the United Nations’ National Accounts, the World Bank Debt Tables, the International Financial Statistics Yearbook and the General Finance Statistics Yearbook. To ensure the consistency between public revenue and expenditure and private investments and savings with the current account of the balance of payments, the United Nations’ National Accounts are the source also of fiscal data, whenever possible. An attempt has been made to construct a coherent set of information and of classification rules, which are especially important when working with cross-country data. ^28/

The model estimated in this section is a five-equation system of government current expenditure, government current revenue, total investment, private saving, and the current account of the balance of payments. The equations have been estimated with ordinary least squares because the model is recursive. The following notations are used:

• CE = government current expenditure

• CR = government current revenue

• I = total investment

• S^P = private saving

• S^G = government saving = CR - CE

• CA = current account balance of the balance of payments

• GDPPC = GDP per capita

• RGDPG = real GDP growth

• RFIR = real foreign interest rate

• RIR = real domestic interest rate

• INF = inflation rate

• XZ = exports plus imports (that is, the trade component of total output)

• GCF = government capital formation

• INFTAX = inflation tax computed on government outstanding domestic debt at the end of the year.

A bar over a variable denotes ratio to GDP, and the suffix t-1 denotes a year lag. According to the definition of a recursive model, the structural equations can be ordered in the following way:

Equations (40)-(42) consist of only exogenous variables on the right-hand side. Equation (43) includes two previously estimated endogenous variables, and all the previous equations enter in the current account equation. In this recursive system, the error terms are assumed to be independent. Thus, each equation has been estimated with ordinary least squares without incurring a simultaneous bias (see Summary Table).

Summary Table.

Specifications and Estimates for the Model

The t-tests are in parentheses.

^1/Equation chosen for derivation of the reduced form for the current account of the balance of payments on page 26.

Summary Table.

Specifications and Estimates for the Model

$\begin{array}{cc}\text{Current Expenditure}\left(\overline{CE}\right)& \left(40\right)\end{array}$
	GDPPC	RFIR	RIR	CEt-1	INF	${\overline{R}}^2$	SEE
(a) 1/	0.05	0.02	0.06	0.36	0.02	0.92	0.02
	(2.60)	(1.25)	(1.12)	(2.10)	(2.7)

$\begin{array}{cc}\text{Current Revenue}\left(\overline{CR}\right)& \left(41\right)\end{array}$
	GDPPC	XZ	$\overline{{CR}_{t-1}}$	INF	${\overline{R}}^2$	SEE
(a)1/	0.09	0.15	0.22		0.90	0.02
	(3.76)	(2.09)	(1.90)
(b)	0.09	0.15	0.20	−0.003	0.90	0.02
	(3.74)	(2.15)	(1.76)	(-.81)

$\begin{array}{cc}\text{Total Investment}\left(\overline{I}\right)& \left(42\right)\end{array}$
	RCDPG	$\overline{I_{t-1}}$	$\overline{I^g}$	RIR	${\overline{R}}^2$	SEE
(a)	0.04	0.56			0.80	0.04
	(1.31)	(5.87)
(b) 1/	0.04	0.55	1.26		0.85	0.03
	(1.41)	(6.63)	(4.59)
(c)	0.04	0.61		−0.05	0.81	0.03
	(1.31)	(6.13)		(-1.61)

$\begin{array}{cc}\text{Private Saving}\left(\overline{S^P}\right)& \left(43\right)\end{array}$
	RIR	$\overline{CR}$	$\overline{RGDPG}$	$\overline{S_{t-1}^P}$	$IN\overline{FT}AX$	SG	IP	$\overline{R^2}$	SEE
(a) 1/		−0.67	0.15	0.19	−1.34	0.16		0.76	0.03
		(3.15)	(3.90)	(2.06)	(3.65)	(0.82)
(b)		−0.51	0.17	0.24	−1.38		0.28	0.78	0.03
		(-3.90)	(5.11)	(2.79)	(-3.98)		(2.82)
(c)	−0.04	−0.47	0.16	0.19	−1.24			0.76	0.03
	(-1.44)	(-3.30)	(4.69)	(2.22)	(-3.40)			0.76	0.03

The t-tests are in parentheses.

^1/Equation chosen for derivation of the reduced form for the current account of the balance of payments on page 26.

View Table

Summary Table.

Specifications and Estimates for the Model

$\begin{array}{cc}\text{Current Expenditure}\left(\overline{CE}\right)& \left(40\right)\end{array}$
	GDPPC	RFIR	RIR	CEt-1	INF	${\overline{R}}^2$	SEE
(a) 1/	0.05	0.02	0.06	0.36	0.02	0.92	0.02
	(2.60)	(1.25)	(1.12)	(2.10)	(2.7)

$\begin{array}{cc}\text{Current Revenue}\left(\overline{CR}\right)& \left(41\right)\end{array}$
	GDPPC	XZ	$\overline{{CR}_{t-1}}$	INF	${\overline{R}}^2$	SEE
(a)1/	0.09	0.15	0.22		0.90	0.02
	(3.76)	(2.09)	(1.90)
(b)	0.09	0.15	0.20	−0.003	0.90	0.02
	(3.74)	(2.15)	(1.76)	(-.81)

$\begin{array}{cc}\text{Total Investment}\left(\overline{I}\right)& \left(42\right)\end{array}$
	RCDPG	$\overline{I_{t-1}}$	$\overline{I^g}$	RIR	${\overline{R}}^2$	SEE
(a)	0.04	0.56			0.80	0.04
	(1.31)	(5.87)
(b) 1/	0.04	0.55	1.26		0.85	0.03
	(1.41)	(6.63)	(4.59)
(c)	0.04	0.61		−0.05	0.81	0.03
	(1.31)	(6.13)		(-1.61)

$\begin{array}{cc}\text{Private Saving}\left(\overline{S^P}\right)& \left(43\right)\end{array}$
	RIR	$\overline{CR}$	$\overline{RGDPG}$	$\overline{S_{t-1}^P}$	$IN\overline{FT}AX$	SG	IP	$\overline{R^2}$	SEE
(a) 1/		−0.67	0.15	0.19	−1.34	0.16		0.76	0.03
		(3.15)	(3.90)	(2.06)	(3.65)	(0.82)
(b)		−0.51	0.17	0.24	−1.38		0.28	0.78	0.03
		(-3.90)	(5.11)	(2.79)	(-3.98)		(2.82)
(c)	−0.04	−0.47	0.16	0.19	−1.24			0.76	0.03
	(-1.44)	(-3.30)	(4.69)	(2.22)	(-3.40)			0.76	0.03

The t-tests are in parentheses.

^1/Equation chosen for derivation of the reduced form for the current account of the balance of payments on page 26.