Dornbusch, Rudiger (1973 a), “Currency Depreciation, Hoarding, and Relative Prices,” Journal of Political Economy, Vol. 81 (July/August 1973), pp. 893–915.
Dornbusch, Rudiger (1973 b), “Devaluation, Money, and Nontraded Goods,” American Economic Review, Vol. 63 (December 1973), pp. 871–80.
Johnson, Harry G., “The Monetary Approach to Balance-of-Payments Theory,” Ch. 9 in Further Essays in Monetary Economics (Harvard University Press, 1973), pp. 229–49.
Mundell, Robert A., Monetary Theory: Inflation, Interest, and Growth in the World Economy (Pacific Palisades, California, 1971).
Mussa, Michael, “A Monetary Approach to Balance-of-Payments Analysis,” Journal of Money, Credit and Banking, Vol. 6 (August 1974), pp. 333–51.
Stolper, Wolfgang F., “Internal Effects of Devaluation,” Appendix I in Africa and Monetary Integration, ed. by Rodrique Tremblay (Montreal, 1972), pp. 411–19.
Mr. Johnson, economist in the Stabilization Policies Division of the Exchange and Trade Relations Department, received his doctorate from the University of California, Los Angeles. He has been a member of the faculty of Fourah Bay College, University of Sierra Leone, and a visiting faculty member of the University of Michigan. His technical writings deal mainly with the economic problems of less developed countries.
In long-run stock equilibrium, no one is trying to add to or subtract from his existing holdings of real balances, and the balance of payments is in equilibrium (that is, there is no net loss or gain in the flow of foreign reserves).
This point is not usually brought out explicitly in the monetary models.
If there is significant price and wage rigidity, the cost-price and relative-price structures of the economy may have become distorted as a result of prolonged inflationary pressures. Relative prices of commodities, for instance, no longer represent relative marginal social costs, even in the absence of external economies and diseconomies and of increasing returns. The structure of production no longer reflects long-run comparative advantage, given tastes, techniques, resource endowment, and world prices. Given monetary policy, a devaluation, in this case, can correct some of this distortion, as elaborated later.
We are not talking here about devaluation merely to augment a country’s share of world reserves when there is no balance of payments problem. We are concerned here with a country that finds itself, for various historical reasons, with a structure of production and techniques that is not consistent with efficient allocation of resources. The exchange rate is one tool that can be used to alter the structure of the economy and indeed can help to raise world real income, by better allocation of world resources. This is discussed further in the text.
We know, given real income, that real absorption must decline for the price of domestic goods to fall relative to the price of traded goods in the short-run flow equilibrium after the devaluation. The monetarists made this clear, but it was implicit in the absorption approach. If so, then the essence of the monetary approach is the implicit assertion that real absorption will decline if, and only if, real money balances decline after the devaluation. Suppose that A is real absorption; Y is real income; DH is net real dishoarding; ms and mD are the stocks of real money balances actually held and demanded, respectively; k is the desired ratio of money to income; and j3 is the coefficient of adjustment of actual to desired real balances. Then we have the following relationships in the short run:
Equation (1) says that real absorption is equal to real income (or disposable income, as the case might be) plus net real dishoarding. Equation (2) gives net dishoarding. Equation (3) then gives what may be called the implicit fundamental monetarist relation. Since Y and k are both constant in the monetarist models, and, by implication, β, as well, it follows that real absorption will decline if, and only if, ms declines. Given Ms (the nominal quantity of money), this of course implies that the general price level, P, must rise.
The technical difficulties arise because rapid downward adjustments of the money supply may affect not only aggregate demand for real goods but also supply (i.e., real output) because of distributive effects, and these effects may be inconsistent with government objectives. Some enterprises depend heavily on bank credit for their working capital requirements. This is often true for government (public) enterprises and numerous small and medium-sized firms in the so-called modern sector, especially those without significant access to world money markets. Trying to adjust the growth of the money supply downward, by, for instance, higher bank reserve requirements, tends to affect such enterprises relatively more than it does, say, large international firms as a result of the short-run adjustment costs imposed by bank credit restrictions. In addition, the government itself may suffer adversely from such money supply restraint. Thus, the government’s reduced ability to borrow from the central bank in an attempt to reduce the rate of growth of the domestic component of high-powered money may have short-run favorable effects on prices and the balance of payments; but the government may feel that the long-run effects on growth are rather detrimental.
It is implicitly assumed throughout this analysis that the interest rate is held constant. Nevertheless, raising the rate of interest is an alternative way to increase the demand for money at given price and income levels, when money is defined to include some interest-bearing assets, such as time and savings deposits in financial institutions. In this regard, where the elasticity of money demand with respect to the rate of interest is “large,” variation of deposit rates becomes a policy with effects that are similar to those of exchange rate variation.
With a balance of payments deficit, the money supply will tend to decline unless the monetary authorities replace the reserves lost with domestically created high-powered money. Thus, throughout the adjustment period, with reserve loss the ratio of net foreign assets to net domestic assets of the banking system will be falling.
For instance, in the simple example where Ms is held constant during the adjustment period and Md(t) = Md(0)egt,
We can obtain tn by setting
simplify to get
is the desired rate of increase of domestic price level, that is, the rate of tax on cash balances, at time t = 0. Finally, we have
as the desired rate of devaluation, ė, where αF is the share of traded goods in the price-index basket.
Not too long ago, Professor Stolper (1972) tried to show that, in the sort of economy with which we are concerned, a devaluation can have favorable internal effects. In particular, he stressed the proposition that a devaluation will have the desirable effect of shifting the internal terms of trade in favor of agriculture and against urban consumers, and, generally, in favor of domestic producers and against importers. The monetary approach casts doubt on this sort of relative price approach because it does not properly explain why the relative price changes came about and because the relative price changes induced by a devaluation will not generally persist in the new long-run equilibrium. Here we have tried to reformulate the Stolper-type approach so as to correctly incorporate the fundamental point that a devaluation is a monetary weapon and, thus, the real balance effect is important in the transmission process. As a result, we have stressed the wealth effects produced by the short-run changes in relative prices.
Moreover, in a country with such power, αF in footnote 9 will generally be smaller than for a small country with no such power. This implies that ė will be greater for any given desired ṗ.