## Abstract

The Monetary Approach to the balance of payments has proven to be a very attractive way to organize thinking about the balance of payments and stabilization policy in open economies operating under fixed exchange rates.1 Among the desirable features of the monetary approach are that data on the macro-economic variables on which it focuses—the supply of money and the stock of domestic credit—are widely available in a timely and reliable fashion, and that the behavioral equation at the heart of the approach—the demand for money—has been the subject of extensive empirical research in many countries. Thus the monetary approach is probably widely used as a basis for the formulation of short-run stabilization policies in many of the countries that continue to maintain an exchange rate parity.2

The Monetary Approach to the balance of payments has proven to be a very attractive way to organize thinking about the balance of payments and stabilization policy in open economies operating under fixed exchange rates.^{1} Among the desirable features of the monetary approach are that data on the macro-economic variables on which it focuses—the supply of money and the stock of domestic credit—are widely available in a timely and reliable fashion, and that the behavioral equation at the heart of the approach—the demand for money—has been the subject of extensive empirical research in many countries. Thus the monetary approach is probably widely used as a basis for the formulation of short-run stabilization policies in many of the countries that continue to maintain an exchange rate parity.^{2}

The “fundamental equation” of the monetary approach expresses the balance of payments as the difference between the demand for money, which is a function of a few key macro-economic variables, and the flow supply of credit, which is under the control of the authorities. Because the derivation of this equation relies only on a balance-sheet identity and the assumption of flow equilibrium in the money market, this equation does not in itself constitute a model of the balance of payments. As Rhomberg and Heller (1977, p. 4) have put it:

The apparent simplicity of the monetary approach to the balance of payments is… somewhat deceptive. Even though for many purposes the demand for money can be conveniently expressed as a function of a small number of variables, it is still just as much the resultant of all the influences that come to bear on the economy as are national income and national expenditure.… These considerations do not invalidate the monetary approach; they merely draw attention to the possibility that it will be seen, on further examination, to be not quite so superior in terms of simplicity of application as had first been thought.

In other words, an explanation of how the variables that affect the demand for money are themselves determined is also required—that is, implementation of the monetary approach to the balance of payments requires that a structural general equilibrium model of the economy be appended. Without such a model, the “approach” is underdetermined as a theory. The important operational consequence is that it is the underlying structural model, not the “approach” per se, that determines how the balance of payments and other endogenous macroeconomic variables will respond to stabilization policy and to exogenous shocks.

In practice, the monetary approach to the balance of payments has come to be identified with a particular structural model—that of “global monetarism” (Whitman (1975) seems to have coined the expression). In this model, the underlying determinants of the flow demand for money—the domestic rate of inflation, changes in the level of real output, and changes in the domestic interest rate—are all exogenous for a small economy defending an exchange rate parity. The rate of inflation is determined by the external inflation rate and changes in the exchange rate because purchasing power parity holds continuously. Changes in real output are determined by exogenous supply considerations because flexible nominal wages ensure full capacity utilization. Finally, continuous interest rate parity pegs the domestic interest rate to the world level. Much of the empirical work on the monetary approach has been implicitly based on this underlying structure.^{3}

Nonetheless, adopting the monetary approach to the balance of payments does not commit one to a specific choice of a structural model. One purpose of this paper is to illustrate this point by undertaking a “monetary” analysis of a Keynesian model. This particular model is of interest for at least two reasons. On an operational level, although the model presented below exhibits “global monetarist” properties of neutrality in the long run, the presence of nominal wage rigidity permits short-run fluctuations in the real exchange rate and deviations of output from capacity. Such phenomena have been important features of several prominent stabilization programs in the Southern Cone of Latin America (see Ardito Barletta, Blejer, and Landau (1983)). On a more theoretical level, several early writers in the tradition of the monetary approach drew strong contrasts between this new approach to balance of payments analysis and an earlier “Keynesian” approach. It is therefore important to demonstrate, by way of achieving a synthesis, that a quite traditional Keynesian model fits readily into the framework of the monetary approach. The analysis will examine how the interpretation of the fundamental equation of the monetary approach is affected when a specific Keynesian structure is imposed on the economy.^{4} In particular, the focus is on comparing the effects of stabilization policies on the balance of payments with those that would be generated by a “global monetarist” model. It is found in the more general model analyzed here that, as Rhomberg and Heller (1977) speculated, much of the simplicity of the monetary approach is unavoidably lost. Whether this is a necessary price to pay can only be determined by empirical work designed to identify the structure of the economy under review.

The particular structural model analyzed here has several interesting properties. First, the short-run balance of payments and output effects of changes in the fiscal deficit depend on the composition of these changes. To the extent that a reduction in the fiscal deficit, for example, entails a curtailment of spending on nontraded goods or a tax increase that is offset by a reduction in the flow of credit to the public sector, output will fall, and the improvement in the balance of payments will fall short of the change in the flow of credit to the government.

Second, changes in external *nominal* interest rates affect only the balance of payments and leave output undisturbed. External *real* interest rate shocks, however, have magnified effects on the domestic real interest rate.

Third, the output effects of an exchange rate devaluation are shown to depend on the response of nominal wages, a critical determinant of the extent to which a change in the nominal exchange rate can affect the real exchange rate.

The remainder of the paper proceeds as follows. In the next section the Keynesian model of a small open economy is described. Its internal equilibrium is analyzed in Section II, whereas in Section III the determination of the balance of payments is examined. Section IV discusses the consequences of a conventional demand-oriented stabilization program formulated under an assumed “global monetarist” structure when the true structure is as described below. The final section presents the paper’s conclusions.

## I. The Model

In this section a specific Keynesian model of a small open economy is presented. Its key feature is that the nominal wage changes only gradually over time. Although the nominal wage is predetermined in the short run, its rate of change is endogenously determined by an expectations-augmented Phillips curve. Firms in the nontraded-goods sector engage in markup pricing, which fixes the product wage in this sector (that is, the nominal wage divided by the price of nontraded goods) and gives rise to the possibility of disequilibrium in this market. Variations in output and employment will therefore reflect changes in real aggregate demand, as will the domestic rate of inflation. Through its effects on output and inflation, real aggregate demand will affect the flow demand for money and therefore the balance of payments, in accordance with the fundamental equation of the monetary approach to the balance of payments.

### Wages and Prices

Production in this model takes place in two distinct sectors, those producing traded and nontraded goods. Both sectors employ labor and a fixed sector-specific factor. The sectoral production functions are

where *y ^{T}* and

*y*are the levels of output,

^{N}*L*and

^{T}*L*the levels of employment, and

^{N}The factors *W*. The key characteristic of this model that defines it as Keynesian is that the nominal wage moves sluggishly over time (technically, it is a state variable of the system). The rate of change of the nominal wage is given by an expectations-augmented Phillips curve, of the form:

where π is the expected rate of inflation and ^{5} Wage earners are assumed to exhibit perfect myopic foresight, so that

where *P* is the domestic price level.

The traded-goods sector faces a perfectly elastic demand for its product at the domestic currency price *P _{T}*, with

where ē is the (fixed) nominal exchange rate (the price of foreign currency in terms of the domestic currency) and

Because the nontraded-goods sector is not exposed to international competition, price behavior in this sector differs from that in the traded-goods sector. The output price in this sector, denoted *P _{N}*, is assumed to be set as a markup over the nominal wage; that is,

The markup, α, is a parameter of the model. This assumption has two effects. First, by pegging the product wage in the nontraded-goods sector, the fixed markup forces firms in this sector off their short-run labor demand curves. Given the capital stock, firms will hire only the number of workers required to produce the amount of output demanded, even if at this level of employment the marginal product of labor exceeds the nominal wage. Thus the demand for labor in this sector is derived by solving the production function (1b) for *L ^{N}*, producing

The second consequence of the markup pricing assumption in the nontraded-goods sector is to peg the domestic price level in the short run. The domestic price level is given by

where θ, a parameter with 0 < θ < 1, is the share of consumption spending devoted to nontraded goods. Because *P _{T}* is exogenous and

*P*is pegged to

_{N}*W*,

*P*will change gradually over time according to the external rate of inflation and the domestic rate of wage inflation:

The real exchange rate *e _{R}* is defined as

The product wage in the traded-goods sector can be expressed as a function of the real exchange rate, since ^{-1}. Substituting this in equation (9) permits one to express the domestic rate of inflation as a function of the real exchange rate:

Note that, according to equation (11), as long as employment in this economy deviates from its “natural” rate

### Asset Markets

Three asset markets exist in this economy: those for domestic money (*M*), domestic credit (*D*), and foreign securities *F* (one-period bonds).^{6} Domestic credit and foreign securities are assumed to be perfect substitutes. Only the foreign security is traded internationally.

Assets are held by three sectors—the private sector, the government, and the central bank (to simplify matters, the last represents the entire financial system). The private sector’s net financial wealth (*N*) consists of money (*M*), holdings of foreign securities (*eF _{p}*) and a liability for credit extended by the central bank (D

_{p}):

Money will be assumed to pay no interest. Since domestic bank credit and foreign securities are perfect substitutes, the nominal interest rate on bank credit must be *r*^{*}, the external interest rate that is exogenous to the model because of the small country assumption. The supply of bank credit to the private sector is a monetary policy decision of the central bank. The private sector’s real demand for money is given by

where *y* is the economy’s level of real output. Empirical work on the demand for money in many countries has in general found that the private sector is unable to achieve its desired portfolio composition instantaneously. Thus the private sector moves gradually to its desired money stock given by equation (13). A typical specification of this adjustment path is

with m =M/P^{7}. Substituting equation (13) into this expression and rearranging yields the “hoarding function”:

This equation indicates that the public accumulates money so as to move to its desired level of real cash balances and to restore the real value of its cash balances in the face of inflation.^{8}

The rate at which the private sector accumulates financial assets is given by its budget constraint:

where *t _{p}* and

*c*denote, respectively, the real values of taxes paid by the private sector and private consumption. Finally, the private sector’s flow demand for foreign securities is found by differentiating equation (12) with respect to time and using equations (14) and (15):

The first two terms represent the sector’s gross accumulation of financial assets, whereas the last term deducts the portion of financial asset accumulation that is held in the form of money.

The government’s net worth, *N _{g}*, is given by

where *eF _{g}* is the domestic currency value of the government’s holdings of foreign securities and

*D*

_{g}is the amount of bank credit extended to the government.

*N*may be either positive or negative; it evolves over time according to the government’s budget constraint:

_{g}where *t _{b}* is the real value of central bank profits transferred to the government and

*g*and

_{N}*g*are, respectively, the government’s purchases of nontraded and traded goods. With Ḋ

_{T}_{g}determined by the central bank, the government’s choices of

*g*,

_{N}*g*,

_{T}*t*and eḞ

_{p}_{G}are constrained by equation (18).

The central bank has no net worth. Its balance sheet is given by

where *eF _{b}* is its net holdings of foreign securities and

*D*≡

*D*+

_{p}*D*. Note that the central bank is assumed to hold its reserves in the form of foreign securities. Its income is transferred to the government, so that

_{g}Finally, the economy’s net international creditor position is given by *eF*, where

### Goods Market

Aggregate real output is aggregate nominal output divided by the price index *P*:

Because all nontraded goods must be purchased by domestic residents, *y ^{N}* must satisfy the equilibrium condition in the market for nontraded goods:

where *c _{N}* is private consumption of nontraded goods. Output of traded goods

*y*

^{T}, however, is fixed in the short run and may be found by substituting equation (5) into equation (1a):

Recall that *b* is the excess supply of traded goods:

where *c _{T}* is private consumption of traded goods. Because the market for traded goods is international,

*b*will not in general be zero.

Total private consumption is the sum of consumption of traded and nontraded goods:

The parameter θ is the share of nontraded goods in total consumption—that is, θ = *P _{N}c_{N}*/

*P*. The share of traded goods is 1 – θ =

_{c}*P*/

_{T}c_{T}*P*. These definitions can be manipulated to yield

_{c}Consumption of each type of commodity thus depends on the relative price *e _{R}* and total real consumption

*c*. Total real consumption in turn depends on real output net of taxes, the real interest rate, and the real value of net private financial wealth:

where *n = N/P _{T}*.

## II. Short-Run Internal Equilibrium

The economy’s short-run internal equilibrium is described by the following three equations:

Equation (22a) is the result of substituting equation (24) into equation (22), whereas substituting equations (27b) and (28) in equation (23) yields equation (23a). Equation (11) is reproduced above for convenience. The endogenous variables in these equations are *y*, and *y ^{N}*—that is, the domestic rate of inflation, the level of real output, and the output of nontraded goods. The state variables are real private net worth

*n*and the real exchange rate

*e*. The remaining variables are either constants (θ, β,

_{R}*r*

^{*}and

*g*and

_{N}*t*). Equation (11) is a Phillips-type aggregate supply relation that links the domestic rate of inflation

_{p}*y*and the external inflation rate

^{N}^{*}–

*y*that are consistent with equilibrium in the market for nontraded goods (see below).

^{N}Before analyzing the short-run internal equilibrium further, it is possible to make three observations.

Proposition 1. *Monetary policy has no effect on the economy’s internal equilibrium in the short run*.

Monetary policy takes the form of changes in the credit flows Ḋ_{g} and Ḋ_{p} in this model. To separate monetary from fiscal policy, a change in Ḋ_{g} is considered a “pure” change in monetary policy if it is associated with an offsetting change in eḞ_{g}, leaving the fiscal deficit unchanged in equation (18). Because none of the variables Ḋ_{p}, Ḋ_{g}, and eḞ_{g} enters the three equations above, the short-run output-inflation outcome is invariant with respect to changes in these variables. This is simply a restatement of Mundell’s (1963) demonstration of the impotence of monetary policy under fixed exchange rates with perfectly mobile capital.

Proposition 2. *Deficit-financed changes in government spending can affect output and inflation in the short run only to the extent that they involve changes in spending on nontraded goods*.

This point has been made by several writers, including Boyer (1978) and Cuddington (1984). It is demonstrated by the absence of *g _{T}* in the equations above. Such expenditure changes will be reflected directly in an increased current account deficit. As will be shown in the next section, the net effect of these changes on the balance of payments will depend on how the expenditure is financed.

Proposition 3. *As a corollary of proposition 2, the fiscal deficit is a poor indicator of the effect of fiscal policy on the economy’s internal equilibrium*.

Even without consideration of the well-known complications arising from endogeneity of tax revenues (not present in this model) and balanced-budget multiplier effects, a given fiscal deficit could have varying effects on the levels of output and inflation, depending on the composition of government spending between traded and nontraded goods.

A more detailed analysis of the short-run internal equilibrium can now ensue. As shown in the Appendix, after substitution of equation (22a) in (23a), the two resulting equations can be represented by the loci

Equation (29) describes all the combinations of real interest rates and nontraded-goods output that are consistent with zero excess demand in that market, whereas equation (30) describes the relation between the domestic level of economic activity and the domestic rate of inflation. These equations can be depicted as loci in ^{N} space. Because *y ^{N}* are determined by the intersection of the two loci. This figure can be used to illustrate several properties of the short-run equilibrium.

Proposition 4. *An increase in the world rate of inflation (as measured by ${\hat{P}}_{T}$), with a constant world real interest rate, will increase the domestic rate of inflation by the same amount while leaving the level of output unchanged*.

^{9}

Because ψ depends on *d**r*^{*} and ^{*} – *r*^{*} offset by an equal increase in *y ^{N}*. Since

*dr*

^{*}= d

**Effects of Increase in Foreign Nominal Interest Rate on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

**Effects of Increase in Foreign Nominal Interest Rate on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

**Effects of Increase in Foreign Nominal Interest Rate on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

Proposition 5. *An increase in the world real interest rate will lead to a larger increase in the domestic real interest rate and depress the level of economic activity*.

This increase can be described by an increase in the nominal interest rate *r ^{*}* with constant

*r*has no effect on ψ = 0. Because an increase in

^{*}*r** reduces the excess demand for nontraded goods (Φ

^{r*}< 0), a reduction in

*y*is required to preserve equilibrium in this market. This locus thus shifts

^{N}*left*to Φ = 0, reducing both

*y*

^{N}and

**Effects of Increase in Foreign Real Interest Rate on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

**Effects of Increase in Foreign Real Interest Rate on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

**Effects of Increase in Foreign Real Interest Rate on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

Proposition 6. *Expansionary fiscal policy in the form of increased government spending on nontraded goods or a reduction in taxes paid by the private sector (or both) will stimulate economic activity and increase the rate of inflation*.

Because an increase in government spending on nontraded goods or a reduction in taxes (or both) increases excess demand for nontraded goods, the Φ = 0 locus must move to the *right*, increasing both *y ^{N}* and

Proposition 7. *A depreciation of the real exchange rate is expansionary*.

Before this point is discussed, note that the depreciation under consideration is one that holds *n* = *N/P _{T}* constant. Since

*N*is fixed,

*P*is also held constant—that is, the depreciation in

_{T}*e*comes about through a reduction in

_{R}*P*(and thus in the general price level) rather than through a depreciation of the nominal exchange rate. Consequently, there is simultaneously a change in relative prices and a reduction in the general price level (the case of a nominal devaluation is considered below). In the Appendix, the depreciation of

_{N}*e*is seen to increase the excess demand for nontraded goods through three channels. First, the reduction in

_{R}*P*increases demand for nontraded goods. This result is simply the familiar substitution effect in consumption. Second, as

_{N}*P*falls, the nominal wage falls in proportion. Thus the product wage falls in the

_{N}*traded*-goods sector, increasing employment and production there. This results in an increase in the real income of consumers, which increases their demand for nontraded goods. Finally, the reduction in the price level increases the real value of net private financial wealth, stimulating an increase in consumer spending on nontraded goods. For these reasons, the Φ = 0 locus shifts to the right. Since the increased level of employment in the traded-goods sector increases labor market pressure, nominal wage inflation is increased, which translates into a higher domestic rate of inflation. In other words, the ψ = 0 locus shifts upward. Figure 4 demonstrates that the result of these shifts is to increase domestic output and inflation.

Proposition 8. *An increase in real net private financial wealth is expansionary*.

**Effects of a Real Exchange Rate Depreciation on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

**Effects of a Real Exchange Rate Depreciation on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

**Effects of a Real Exchange Rate Depreciation on Nontraded-Goods Output and Inflation**

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A001

This is the equivalent of a real balance effect in our model. Because the nominal exchange rate, and therefore *P _{T}*, is held constant in this exercise, the increase in

*n*comes about through a change in nominal wealth,

*N*. Since

*n*is a state variable in the model, it changes gradually over time as the result of private saving, in accordance with equation (15). As discussed above, an increase in

*n*shifts Φ = 0 to the right. Because this shift leaves ψ = 0 unaffected, the economy moves to the northeast along ψ = 0, with increases in both

*y*.

^{N}Proposition 9. *The response of nominal wages determines whether a devaluation of the nominal exchange rate is expansionary or contractionary*.

According to the expectations-augmented Phillips curve (equation (2)), workers will accept a reduction in the expected real wage only when the level of employment falls below its natural rate. Equation (2) does not tell us, however, how workers will react to a *discrete* change in the price level, such as that brought about by a discrete change in the nominal exchange rate. The reaction of the nominal wage will determine the extent to which the impact of the devaluation falls on relative prices rather than on the absolute price level. The greater is the effect on relative prices, the smaller is the effect on the absolute price level and the more expansionary is the effect of the devaluation.

Consider two extreme cases. At one extreme, if workers seek to maintain their real wage unchanged, the nominal wage will increase in proportion to the devaluation. According to equation (6), the price of nontraded goods will rise in the same proportion, and *e _{R}* will remain unchanged. Instead, the price level will increase in proportion to the devaluation, and the real value of net private financial wealth will fall by the same proportion. As shown for proposition 8 above, this has a contractionary effect on the economy’s short-run equilibrium. In essence this mechanism is the one at work in monetary analyses of devaluation.

^{10}

At the other extreme, suppose that the nominal wage *falls* by an amount sufficient to keep the absolute price level constant (the required decrease would depend on the expenditure shares in consumption, θ and 1–θ). Because the price of nontraded goods would *fall, e _{R}* would increase more than in proportion with the devaluation; as in proposition 7 above, this change in relative prices is expansionary. In between these two extremes are cases in which the nominal wage is unchanged or increases less than in proportion to the devaluation. Whether the net effect of the devaluation is expansionary or contractionary will then depend on the magnitude of the nominal wage response and on various parameters of the system, such as the expenditure shares, the elasticity of the demand for labor in the traded-goods sector, and the properties of the Phillips curve and the consumption function.

## III. Short-Run External Balance

“External balance” can refer either to the economy’s net international creditor position (the variable *eF* in the model) or to the viability under existing policies of the particular exchange rate established by the authorities. The latter depends on the net foreign assets of the central bank, *eF _{b}*. Policymakers are typically concerned both with the

*levels*of these variables (the economy’s net international creditor position and the stock of net international reserves, respectively) and with the rates of change of these variables (the level of net foreign investment

*eḞ*and the balance of payments

*eḞ*). In the short run, stabilization policy can affect the level of net foreign investment (which is simply the current account) but not the economy’s net international creditor position. Similarly, under gradual portfolio adjustment, short-run stabilization policy can affect the balance of payments but not the level of net international reserves.

_{b}In this section, “external balance” refers to the behavior of the balance of payments. The focus is on this concept of exchange rate viability rather than on the alternative issue of the economy’s net international creditor position for two reasons. First, as its name implies, the monetary approach to the balance of payments was developed precisely as an approach to the analysis of that balance. Proponents of the approach typically have concerned themselves with the overall balance rather than its composition. Second, in interpreting the results of this exercise with respect to the balance of payments it will often be helpful to analyze the separate effects on the current and capital accounts. Thus an analysis of the economy’s level of net foreign investment emerges as a by-product of investigating the determination of the balance of payments.

The central bank’s stock of net international reserves has usually been expressed in one of two ways. The first focuses on the balance sheet of the economy as a whole:

where *ca** is the foreign exchange value of the current account. According to this definition, the stock of reserves is that portion of the economy’s cumulative current account surpluses which the nonbank sector (the private sector and the government) does not choose to hold in the form of foreign securities. The second focuses more narrowly on the balance sheet of the central bank itself by using equation (19); that is, *eF*_{b} *≡ M – D*.

Keynesian writers have favored the first definition, but writers in the tradition of the monetary approach have invariably used the second. They are of course equivalent, as can be shown by manipulating some accounting identities. National wealth is the sum of net claims on foreigners (the country’s net international creditor position *eF)* and the value of the sector-specific factors ^{T} and ^{N}. Net claims on foreigners are the cumulated sum of past current account surpluses, or:

At the same time, the country’s international net creditor position represents the *financial* component of national wealth. As such it must be the sum of private and public financial wealth, as expressed in equation (21).

Using these identities together with equation (12) yields

Alternative expressions for the balance of payments are derived by differentiating equations (31) and (19) with respect to time. The familiar results are, respectively:

where *ca = eca* *, and where *bop*_{k} and *bop*_{m} denote the favored expressions for the domestic currency value of the balance of payments in Keynesian and monetary models, respectively. Because the alternative expressions for the stock of international reserves are equivalent, their derivatives *bop*_{k} and *bop*_{m} must be equivalent also. This equivalence can also be demonstrated by adding the budget constraints (13), (18), and (20) and using the equilibrium condition in the market for nontraded goods in addition to the definition of the current account surplus:

The result is

which establishes that *bop*_{m} = *bop*_{k}.

The intuitive reason for this equivalence is easy to see. Re-writing the last step in the preceding argument yields an expression for the capital account:

Because *ca* is net national financial savings, the first term on the right-hand side is *gross* national financial savings. The equation says that all accumulation of financial assets that does not take the form of hoarding is devoted to purchasing foreign securities. Thus changes in national saving *(ca)* will be reflected in purchases of foreign securities, leaving the balance of payments unaffected, except to the extent that the flow demand for money differs from the supply of domestic-source money. If the flow demand for money exceeds the flow supply of domestic-source money, then a portion of national savings will be channeled away from the purchase of foreign securities, yielding a balance of payments surplus. Conversely, if the flow supply of domestic-source money exceeds the flow demand for it, then the excess will be devoted to the purchase of foreign securities, causing the capital outflow to exceed national savings and hence creating a balance of payments deficit.

The equivalence of these approaches in terms of both stocks and flows assures us that the results of the analysis in this section will be invariant to the choice of “Keynesian” or “monetary” expressions for the stock of reserves or the balance of payments. Because the purpose is to provide an illustration of the compatibility of a Keynesian structure with the monetary approach, the “monetary” expression is used below.

Before doing so, one may first rewrite equation (33) in a form that makes it amenable to the use of the results of the previous section. Substituting the relation *y = y (e _{R}, y^{N})* (equation (22d) in the Appendix) in equation (12) and the result in equation (33) produces

This expresses the balance of payments as a function of the endogenous variables *y*^{N}, the exogenous variables *r** and *e*_{R} and *M*. As described in Section II, *y*^{N} are themselves functions of exogenous and state variables. Thus, although the demand for money is, as Rhomberg and Heller (1977, p. 4) surmised, “a function of a small number of variables” (the conventional *P*, *r ^{*}*, and

*y)*, equation (33a) shows that, because “it is… the resultant of all the influences that come to bear on the economy” (both directly and through their effects on

*y*

^{N}) “the apparent simplicity of the monetary approach to the balance of payments is… somewhat deceptive.” To trace the effects of exogenous shocks (including stabilization policy measures) on the balance of payments requires that the effects of these shocks on the economy’s internal equilibrium be ascertained. If the structure of the economy is Keynesian (as opposed to “global monetarist”), for example, the internal equilibrium is unlikely to be invariant, even in the short run, to changes in certain stabilization policy variables. This makes analysis of the balance of payments using the monetary approach substantially more difficult to perform.

^{11}

By substituting equations (25), (24), (27a), (28), and (22d) into equation (33), the expression for the current account corresponding to equation (36a) for the balance of payments can be derived:

In this expression the current account depends only on the endogenous variables *y*^{N} and on exogenous and state variables.

Equations (33a) and (34a), as well as the analysis in Section II, can now be used to establish the following propositions.

Proposition 10. *An increase in the external real interest rate (again defined as an increase in the nominal rate* r^{*} *with constant* *causes a deterioration in the balance of payments*.

An increase in the foreign real interest rate increases *r ^{*}* and, as shown in Section II, reduces both

*y*

^{N}. The reduction of

*y*

^{N}causes a decrease in

*y*(see equation (22c) in the Appendix). Hoarding falls because of an increased opportunity cost of holding money, a reduced transactions motive, and a diminished need to replenish real cash balances owing to inflation. Note that the negative effects of higher interest rates on the balance of payments have often been used in empirical tests of the monetary approach to distinguish it from the “Keynesian approach.” It is clear that the latter cannot refer to a Keynesian

*structure*, since the same result has been derived here within such a structure.

This deterioration in the balance of payments occurs despite an improvement in the balance of trade. To see that the balance of trade must improve, note that the reduction in real income and increase in the domestic real interest rate will depress consumption, thus increasing the first term on the right-hand side in equation (34a). The total change in the current account depends on the economy’s international net creditor position *(eF)*.

Proposition *11. An increase in the nominal external interest rate, holding the real rate constant, has an ambiguous effect on the balance of payments*.

From Section II, *y*^{N} and thus *y* are unchanged. The increase in *r ^{*}* reduces the desired level of real cash balances and therefore reduces hoarding. At the same time, the higher domestic inflation rate increases the amount of hoarding required to maintain the real value of existing cash balances. Because the net effect on the flow demand for money is uncertain, balance of payments effects are also uncertain. For the current account, the effect will depend on the sign of the country’s net claims on foreigners because only the service component of the current account is affected.

Proposition 12. *With fiscal policy unchanged, the effect of an increase in the flow of domestic bank credit, regardless of its composition, is to cause an exactly offsetting effect on the balance of payments*.

This familiar “global monetarist” result also holds for the Keynesian model of Section I. As shown in Section II, changes in the flow of bank credit leave the internal equilibrium undisturbed. Because the hoarding function is thus unaffected in equation (33a), only the last term on the right-hand side of this equation *( Ḋ)* is involved. Inspection of equation (34a) verifies that the balance of payment effect operates through the capital account, since the current account is unaffected.

Proposition 13. *With credit policy and the remaining components of fiscal policy unchanged, an expansionary change in government spending on nontraded goods or in taxation will improve the balance of payments, whereas a change in government spending on traded goods will have no effect on the balance of payments*.

Increases in *g*_{N} or reductions in *t*_{p} will increase *y*^{N} and *g*_{T} has no effect, however, on the internal equilibrium and hence leaves hoarding and the balance of payments unaffected. The deterioration in the current account (equal to *g*_{T}*)* is exactly offset by the capital inflow required to finance the higher government deficit in the face of an unchanged flow of domestic credit.

Proposition 14. *A devaluation that is offset by a proportional increase in nominal wages has an ambiguous effect on the balance of payments, but a devaluation that leaves the price level unchanged must improve the balance of payments*.

If a devaluation is offset by a proportional increase in nominal wages, the price level *P* in equation (33a) will rise by the same proportion. This rise will increase the demand for nominal cash balances and thus will encourage hoarding, which will tend to improve the balance of payments. So far, this is the conventional monetary analysis of the effect of a devaluation on the balance of payments. Nevertheless, the associated reduction in the real net financial wealth of the private sector reduces aggregate demand, leading to reductions in *y*^{N} and *deterioration* in the balance of payments for the reasons discussed above. The current account improves because the reductions in real net financial wealth and real income, as well as the increase in the domestic real interest rate, all reduce absorption. Because the increase in national saving may not be offset by an increase in hoarding, the effect on the capital account and on the overall balance of payments will be ambiguous. If the devaluation leaves the price level constant (that is, nominal wages *fall)*, however, *P* will be constant in equation (33a). Since *e*_{R} will have risen, both *y*^{N} and

From the analysis in this section, it may be concluded that the Keynesian model of Section I is quite amenable to analysis through application of the monetary approach to the balance of payments.^{12} Applying the approach in this context is not trivial because exogenous variables have to be examined both for their direct effects on the balance of payments and for their indirect effects through their consequences for endogenous domestic macroeconomic variables. Only the direct effects are visible in the “fundamental equation” of the monetary approach. To determine the indirect effects, and thus the total effect on the balance of payments, a structural model is needed. Depending on the nature of this model, the total effects of exogenous variables on the balance of payments may be quite different from those that have become associated with the “global monetarist” version of the monetary approach.

## IV. A Policy Exercise

The two preceding sections have discussed separately the determinants of short-run internal and external equilibria in the model of Section I. To sharpen the contrast of the model with the “global monetarist” version of the monetary approach to the balance of payments, it may be useful to integrate these results by comparing the expected and actual effects on a small open economy of adopting a particular policy package when the authorities believe that the economy’s structure is “global monetarist,” but its true structure is Keynesian.

Consider such an economy at an initial condition of full employment, with the domestic rate of inflation equal to the world rate. Suppose, however, that the balance of payments deficit is undesirably large. The authorities design a package of credit and fiscal policies to effect a short-run reduction in the balance of payments deficit. In formulating this package, they work under the assumption that the structure of their economy is correctly described by a “global monetarist” model. Judging an exchange rate adjustment not to be politically feasible, they decide to rely primarily on a restriction in the growth of domestic credit.

To calculate the appropriate growth of bank credit needed to achieve the desired balance of payments outcome, the authorities begin by forecasting the flow demand for money. Because they do not contemplate an exchange rate change, they project—through an application of purchasing power parity—that domestic inflation will be equal to the expected world level. On the basis of unchanged domestic supply factors, they expect the level of real output to remain unchanged. In addition, the domestic interest rate is expected to remain constant, consistent with a constant world rate. These variables produce a forecast for the economy’s flow demand for money. Subtracting the desired balance of payments outcome from this figure, the authorities find that a substantial curtailment in the growth of bank credit will be called for. The way in which they choose to allocate the reduction in the flow of bank credit between the private and public sectors causes a significant reduction in the flow of credit to the government. To prevent an increase in the external debt of the public sector, the authorities intend to match the reduction in the flow of domestic credit to the public sector with a reduction in the fiscal deficit. They choose to achieve this reduction through cuts in expenditure. The resultant plan is internally consistent, given the analytical framework adopted. Suppose that the forecasts of world economic conditions (*r ^{*}*) prove correct, that the parameters of the hoarding function are estimated correctly, and that the plan is executed exactly as intended. If the true structure of the economy is as described in Section I, how will the actual outcomes for domestic inflation and real output compare with their projected values? How successful will the authorities be in achieving their balance of payments target?

These equations have, of course, been answered in previous sections. To the extent that the reduction in the fiscal deficit is at least partially achieved by curtailing government spending on non-traded goods, the balance of payments target will not be achieved, and the policy will have unintended side effects. As demand for nontraded goods falls, output of such goods will decrease. The consequent reduction in employment puts downward pressure on nominal wages, causing the domestic rate of inflation to drop below the world level. The domestic real interest rate rises, and this increase, together with reduced real income, causes a decrease in private spending on both traded and nontraded goods. The current account improves, but the overall improvement in the balance of payments must fall short of that anticipated by the authorities. Because the domestic rate of inflation and the level of real output have fallen, the flow demand for money will decrease, thereby inducing an increase (decrease) in the net capital outflow (inflow) that at least partially offsets (and may more than offset) the current account improvement. The precise magnitude of the decrease in hoarding will depend on all the parameters of the model. In any event, the balance of payments target of the authorities will not be met, and they will, in addition, find themselves confronted with unanticipated (and possibly undesired) effects on the domestic economy.

## V. Summary and Conclusions

The analysis in this paper has implications both for understanding the intellectual contribution made by the monetary approach to the balance of payments and for short-run macro-economic policymaking in small open economies. Although no consensus seems to have emerged about the precise nature of the intellectual contribution made by the monetary approach, a “monetary” analysis of a Keynesian structural model lends support to the following assertions.

First, Frenkel and Johnson (1976) were correct in insisting that the monetary approach was unrelated to the debate between neo-Keynesian and monetarist analyses of a closed economy, since models of each class can be accommodated in a monetary approach to the balance of payments.

Second, using the monetary expression for the balance of payments may be conducive to avoiding the analytical errors of the Mundell-Fleming models that preceded the monetary approach (Mundell (1960), Fleming (1962)). These models misspecified the determination of the capital account and ignored the intrinsic dynamics imposed on the system by a nonzero balance of payments. Nevertheless, it is not necessary for a well-specified, internally consistent model of an open economy to contain the “fundamental equation” of the monetary approach. As shown in Section III, this equation is equivalent to the Keynesian expression for the balance of payments.

With regard to the second issue, the key message is that the simplicity of application that seemed to recommend the monetary approach to the balance of payments at its inception was illusory. Adopting the monetary approach does not necessarily free those involved in formulating short-run macroeconomic policy from the need to choose and estimate what may turn out to be a very complicated structural model. To apply the monetary approach in its “simple” form, as in Section IV, is to adopt implicitly a “global monetarist” perspective of the economy under review. Such a perspective will rarely be of practical use to policymakers. As Harry Johnson (1972, p. 14) put it:

But the real practical problem… is how to marry the monetarist and Keynesian analysis in a way relevant to the short-run context… with which policy-makers are concerned, and which is characterized both by variations in production and employment as well as in money prices, and by variations in the relations among export, import, and non-traded goods prices which are assumed away in the long-run equilibrium analysis of the monetarist approach.… the achievement of such a synthesis is, to my mind, the really challenging task facing international monetary theory in its next stage of development.…

The model presented in this paper represents an attempt at this kind of synthesis. It exhibits full employment, interest parity, and convergence to the world rate of inflation in the long run. Unlike a “global monetarist” model, however, these properties do not determine the economy’s short-run response to external disturbances and stabilization policy. Because the domestic rate of inflation and level of real output are endogenous in the short run, and because these endogenous variables affect the flow demand for money, the effects of exogenous external and policy shocks are much more complicated than would be predicted from a “global monetarist” perspective. The main points of divergence between the global monetarist and Keynesian models are the following.

First, an increase in the external real interest rate will cause the balance of payments to deteriorate by *more* than would be predicted from the direct effect of that increase alone in decreasing the flow demand for money. An additional negative influence on the balance of payments will emerge as the domestic interest rate sustains a larger increase than the external rate, accompanied by decreases in the domestic level of output and rate of inflation.

Second, the favorable short-run effects on the balance of payments of a strictly nominal devaluation will be partially offset by the reduction in the flow demand for money caused by associated decreases in domestic real output and domestic inflation.

Third, the “offset coefficient” of a change in the flow of domestic credit will differ from its “global monetarist” value of -1 to the extent that the change in the supply of credit affects government spending on nontraded goods or the level of taxation. As in the case of a nominal devaluation, any improvement in the balance of payments from this source will be bought at the cost of decreased domestic output and will also yield a lower rate of inflation.

Fourth, balanced changes in the levels of government spending and taxation, or changes in the composition of government spending between traded and nontraded goods, will have balance of payments consequences even if domestic credit policies are unchanged.

In this setting, the formulation of stabilization policy using the monetary approach to the balance of payments becomes a much more complex task. Beyond knowing the parameters of the demand for money, quantitative knowledge of the parameters governing behavior in commodity and labor markets will also be required if the endogenous responses of domestic output and inflation are to be estimated. Such responses must, of course, be estimated both to achieve the balance of payments target and to inform policymakers about the possible costs of meeting that target through alternative measures.

### APPENDIX: Derivation of Short-Run Equilibrium

This Appendix expresses the system of equations (22a), (23a), and (11) in the text (Section II) in terms of the loci Φ = 0 andΨ = 0 and establishes the properties of these loci.

Equation (22a) in the text expresses total real output as a function of the real exchange rate and output of nontraded goods. Implicit differentiation of this equation yields

Thus *y* is an increasing function of *y*^{N}. The sign of the dependence of *y* on *e*_{R} is ambiguous in principle. The first term in equation (22c) is positive. It represents the increase in output of traded goods brought about by a reduction in the product wage in this sector as a result of the increase in *e*_{R}. This increase in output also tends to increase *y*. The second term measures the change in the real value of output at the original levels of *y*^{T} and *y*^{N}. Since the increase in *e*_{R} reflects a decrease in *P*_{N} with a given *P*_{T} (because *n* is held constant), the aggregate price level has fallen less than in proportion to *P*_{N}. Thus the real value of traded-goods output has risen while that of nontraded-goods output has fallen. The net result will depend on the size of the decrease in the absolute price level for a given decrease in *P*_{N}. This decrease, in turn, depends on θ. If the share of nontraded goods in consumption (θ) is equal to their share in production *(y*^{N}/*e*_{R}*y*), the second term in equation (22c) will be zero. This will be true if the government initially devotes a fraction θ of its spending to nontraded goods. If the government does so, the result is the inequality in equation (22c). Thus one has

Substituting this equation in equation (23a) of the text produces

with

Equation (11) can be represented as

with

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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.

^{}1

As of December 31,1984, a total of 98 member countries of the Fund pegged their currencies to a single currency or to a currency basket (International Monetary Fund (1985)).

^{}2

For a discussion of the relevance of the monetary approach to stabilization programs in the Southern Cone of Latin America in the late 1970s, see Ardito Barletta, Blejer, and Landau (1983).

^{}3

This work is surveyed by Kreinin and Officer (1978). Even within a “global monetarist” analytical framework, the effects of credit and fiscal policies on the balance of payments depend on the specification of certain key behavioral relations in the model. See Montiel (1984).

^{}4

Some of the early contributors to the monetary approach to the balance of payments demonstrated the compatibility of the approach with a Keynesian structure (see, for example, the papers by Rodriguez and Mussa in Frenkel and Johnson (1976)). Their models did not, however, incorporate nontraded goods, capital flows, or inflation. Several empirical models in the tradition of the monetary approach exist that allow for snort-run variations in output and prices. Examples are Khan (1976), Jonson (1976), and Laidler and O’Shea (1980). Unlike the model presented here, however, these models rely heavily on Archibald-Lipsey (1958) real balance effects.

^{}5

Throughout the paper, a circumflex over a variable will denote a proportional rate of change, and a dot over a variable will represent a time derivative.

^{}6

It is assumed that markets for the stocks of sector-specific assets

^{}7

A “nominal” adjustment function—that is, Ṁ = λ(*M*^{D} – M) has also been used (Goldfeld (1976)) but is much less common.

^{}8

The specific effects of exogenous and policy variables on the balance of payments discussed in Section III are quite sensitive to the specification of this “hoarding function.” In particular, if the stock demand for money depends on the domestic rate of inflation and the real interest rate available on foreign securities as separate arguments, or if private portfolios are in continuous equilibrium, many of the balance of payments effects of changes in exogenous and policy variables become ambiguous. Nonetheless, the validity of the key points— that a Keynesian structure is fully compatible with the monetary approach and that the effects on the balance of payments of changes in exogenous variables depend on the structural model assumed and not on the “approach” adopted— remains unaffected. Cardoso (1983) has recently defended the specification in equation (13) on empirical grounds for Brazil.

^{}9

World inflation is actually “superneutral” in this model. If the economy is a net international creditor, savings will increase just enough to permit domestic residents to accumulate enough additional foreign securities so as to keep their real stock of foreign securities constant, following a once-for-all shift out of domestic money and into foreign securities. This superneutrality would fail to hold if consumption were allowed to depend directly on the real return on money.

^{}10

Other possible contractionary effects of devaluation are discussed by Krugman and Taylor (1978).

^{}11

Of course it would be no simpler with a Keynesian “approach” to the balance of payments because, as argued above, *bop _{k}* and

*bop*are identical. The complexity resides in the structure of the economy, not in the accounting identity used to express the balance of payments.

_{m}^{}12

To formulate a “Keynesian approach” to the balance of payments in this model, replace the stock demand for money function (11) with a stock demand for foreign securities, and the hoarding function with a “private capital outflow” function derived similarly. This private capital outflow function, along with *eḞ _{G}* determined by equation (35) and the current account equation (34), together produce a Keynesian expression for the balance of payments, as in equation (32). If the explicit specifications of the stock and flow demands for foreign securities in that version of the model are consistent with the implicit specifications in the version given here, the results will be identical with those in this section.