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Monetary approach to the Balance of Payments chap 18

Monetary approach to the Balance of Payments chap 18 - FA...

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Monetary approach to the Balance of Payments The close link discussed in Chapter 18 between a country’s balance of payments and its money supply suggests that fluctuations in central bank reserves can be thought of as the result of changes in the money market. This method of analyzing the balance of payments is called the monetary approach to the balance of payments . The monetary approach can be illustrated through a simple model linking the balance of payments to developments in the money market. Recall that the money market is in equilibrium when the real money supply equals real money demand, that is, when M s /P = L ( R*,Y ) Let F A denote the central bank’s foreign assets (measured in domestic currency) and D A its domestic assets (domestic credit). If μ is the money multiplier that defines the relation between total central bank assets (FA + D A ) and the money supply, then M s = μ ( F* + A ) The change in central bank foreign assets over any time period, Δ
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Unformatted text preview: FA , equals the balance of payments (for a nonreserve currency country). By combining the preceding two equations, we can express the central bank’s foreign assets as FA = (1/μ) PL(R,Y) – DA If we assume that μ is a constant, the balance of payments surplus is Δ F A = (1/μ) Δ PL(R,Y) – ΔD A This equation summarizes the monetary approach. The first term on its right-hand side reflects changes in nominal money demand: all else equal, an increase in money demand will bring about a balance of payments surplus and an accompanying increase in the money supply that maintains money market equilibrium. The second term in the balance of payments equation reflects supply factors in the money market: all else equal, an increase in domestic credit raises money supply relative to money demand. So the balance of payments must go into deficit to reduce the money supply and restore money market equilibrium....
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