The original contribution of the monetary approach to the balance of payments was to focus on conditions in the money market in explaining developments in the external sector of the economy. Payments’ surpluses or deficits were seen as arising from imbalances between the supply of and demand for money at a given exchange rate. Alternatively, under a free float, the exchange rate was viewed as varying to balance the demand for money with a fixed supply of money. Subsequent elaboration of this approach has broadened its perspective: alternative assets, including bonds and foreign currencies, have been introduced into the analysis together with more complex treatment of the formation of expectations and of differing rates of adjustment in asset and product markets. Using this asset-market approach, it has been possible to model the current and capital accounts separately and to analyze such phenomena as exchange rate overshooting.1 But money itself is still usually treated as merely cash balances and noninterest-bearing demand deposits. This fact seems curious, as the proportion of such narrow money in total liquidity has declined with the increasing attraction of quasi-money and the widening spectrum of near-money.
Less attention has been paid to improving the analysis of the liability side of the balance sheet. The standard assumption has been that all domestic assets are issued directly by the monetary authorities. The supply of money or bonds varies only if the authorities intervene in bond or foreign exchange markets, or indulge in “helicopter” operations. This view provides no role for the domestic private borrower in generating the basic demand for credit, or for the banking system in intermediating between borrower and lender.
This paper argues for a more sophisticated treatment of the supply of money. The simplifications that all money bears no interest and that all assets are claims on the government clearly limit the richness of the asset-market approach. The approach does not permit the analysis of the joint determination of money interest and exchange rates, or of how shifts in banking behavior or the demand for credit affect equilibrium. Such limitations may perhaps be forgiven at the early stages of development of a theory: some abstraction is, of course, necessary to facilitate the analysis of a complex situation. However, if the simplifications lead to policy conclusions that are seriously misleading or incomplete, the incorporation of a more satisfactory treatment becomes urgent.
The body of this paper has four main sections. Section I discusses ways in which recent institutional changes make the simplified treatment of money increasingly unrealistic and argues in favor of an approach in which the demand for credit is given the same prominence as the demand for monetary assets. Section II develops a Keynesian model of monetary equilibrium in a competitive banking system that provides the basic framework for the subsequent analysis. The following two sections study the behavior of this model from different angles: Section III looks at long-run equilibria in which prices and wages have adjusted to relative values accepted by firms and unions; Section IV focuses on short-run equilibria in which prices and wages are sticky so that relative prices may be disturbed by exchange rate movements. These two sections are not intended to sum to an exhaustive study of the situations considered,2 but rather to indicate the dangers of the standard approach and to suggest a preferable way of proceeding.
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Mr. Collyns, economist in the Western Hemisphere Department, was in the Central Banking Department when this paper was prepared. It has been developed from the author’s doctoral thesis and has benefited from comments by Mr. Peter Oppenheimer and Mr. Peter Sinclair of Oxford University, as well as colleagues in the Fund.
An equivalent approach in a model featuring only high-powered money and bonds would be to introduce the government’s own demand for credit as a dependent variable rather than as a given.
There is no stock market; ownership titles to firms are not transferable.
The home country’s demand for foreign assets and liabilities is assumed to be negligible in world markets; the foreign interest rate can then be taken as exogenous.
Price stability requires that the nominal interest rate be set equal to the equilibrium real interest rate.