Chap022 - Chapter 22 The Monetary and Portfolio Balance...

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Chapter 22 – The Monetary and Portfolio Balance Approaches to External Balance CHAPTER 22 THE MONETARY AND PORTFOLIO BALANCE APPROACHES TO EXTERNAL BALANCE Learning Objectives: To know how the supply and demand for money can affect a country’s balance of payments and exchange rate. To grasp how other financial assets besides money can influence exchange rates and international payments positions. To understand how a changing exchange rate can overshoot its new equilibrium value. I. Outline Introduction - The New Globalized Capital The Monetary Approach to the Balance of Payments - The Supply of Money - The Demand for Money - Monetary Equilibrium and the Balance of Payments The Monetary Approach to the Exchange Rate - A Two-Country Framework The Portfolio Balance Approach to the Balance of Payments and the Exchange Rate - Asset Demands - Portfolio Balance - Portfolio Adjustments Exchange Rate Overshooting Summary Appendix: A Brief Look at Empirical Work on the Monetary and Portfolio Balance Approaches - Empirical Testing on the Monetary Approach - Testing of the Portfolio Balance Model II Special Chapter Features In The Real World: Relationships between Monetary Concepts in the United States In The Real World: Money Growth and Exchange Rates in the Russian Transition Titans of International Economics: Rudiger Dornbusch (1942-2002) 22-1
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Chapter 22 – The Monetary and Portfolio Balance Approaches to External Balance III. Purpose of Chapter The purpose of this chapter is to consider the role played by money and asset relationships in establishing and maintaining equilibrium in the external sector. In particular, students should learn how money and asset markets influence and are influenced by the balance of payments and exchange rates. With this material in hand, the reader will be better able to understand why exchange rates change so frequently and sizably in situations where they are not pegged. IV. Teaching Tips A. From their study of Chapter 20 in particular, the students should now have grasped the ideas that exchange rates can change quickly and sizably and that such changes can have important effects. The opening paragraphs in this chapter reiterate these ideas and pave the way for exploration of the underlying causes and consequences of exchange rate changes. You should emphasize that this chapter and the next two are devoted to this exploration. B. In the discussion of the monetary approach, point out that a rise in income improves the balance of payments in this model (because of the resulting increase in the demand for money). This may seem peculiar to students who remember from the principles course that a rise in income in a Keynesian model worsens the current account because of induced imports. However, the situations are not really directly comparable, because the monetary approach is dealing not just with the current account but with the overall BOP (official reserve transactions balance). C. The point that, in the monetary approach, a fall in the interest rate leads to an improvement in the BOP (because the interest rate reduction increases money demand relative to money supply) needs to be stressed. Students (probably rightly so) will rebel against this, in that their intuition suggests that the lower interest rate will cause a financial capital outflow and a deterioration in the BOP. The students’ intuition is validated in the later discussion of the portfolio balance approach. D. The material on exchange rate overshooting will probably be difficult for many students to follow – if you can think of a better way to present it, by all means please do so. It may help to point out that the Dornbusch and Melvin models are very similar, with the only substantive difference being that Dornbusch uses the expected exchange rate and uncovered interest parity while Melvin uses the forward rate and covered interest parity.
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