International Business Chapter 22 Bop Toward Surplus The Portfolio Balance Approach The Result The Rise Income

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CHAPTER 22

THE MONETARY AND PORTFOLIO BALANCE APPROACHES TO

EXTERNAL BALANCE

Learning Objectives:

■ Show how the supply and demand for money can affect a country’s balance of payments

under a fixed exchange rate.

■ Show how the supply and demand for money can affect a flexible exchange rate.

I. Outline

Introduction

– International Interdependence of Money

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

II Special Chapter Features

In the Real World: Relationships between Monetary Concepts in the United States

Titans of International Economics: Rudiger Dornbusch (1942-2002)

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,

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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 sizeably and that such changes can have

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).

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

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

V. Answers to End-of-Chapter Questions and Problems

1. The balance of payments will move toward surplus because the rise in income increases

the demand for money and the money supply is unchanged. With excess demand for money,

2. The statement is true, as is explained in the section early in the chapter that discusses the

demand for money.

3. From expression [12] in the chapter on page 541, it can be seen that a rise in k in country

A leads to a proportional fall in e (an appreciation of A’s currency). If, other things equal, people

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wish to hold more money, there is an excess demand for money. This excess demand leads to

attempts to build up cash balances, an incipient surplus in the balance of payments, and an

appreciation of the home currency.

4. PPP is more likely to hold in a hyperinflationary period because the money supply is

usually out of control. With continual excess supply of money and expectations of continuing

5. This is obviously an opinion question. Utilizing Dornbusch’s sample and test (as

discussed in the Appendix), only the interest rate variables were of the correct sign and

statistically significant. However, during much of the 1973-1979 period that he was examining,

6. The issuance of foreign government bonds will affect the perceived risk (and hence RP)

associated with investment in the foreign country. The relationship between RP and the

exchange rate can be seen by utilizing equations [13] and [14] in the chapter (page 543). Noting

7. Following the framework used in Question #6 above, an increase in id will lead to an

inflow of short-term capital into the home country. As investors acquire the domestic currency

to make these investments, the demand for the home currency will increase and the exchange

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country currency depreciation, not appreciation.

8. This statement can be defended using either the Dornbusch model or the Melvin model

spelled out in the last section of the chapter.

9. With the huge volume of mobile short-term assets in existence, and with the huge amount

of information available virtually immediately, actors in asset markets can respond quickly and

10. The answer to this question is developed at the end of the chapter. The basic idea is that

11. Students might respond to this question by indicating that the asset approach offers

plausible explanations of instability in exchange rates and of overshooting, that it integrates

financial markets with the exchange rate, that it reflects the reality of the large influence of

VI. Sample Exam Questions

1. Explain the implication for a country’s exchange rate in the monetary approach and in the

2. Why do the monetary approach and the portfolio balance approach have different

expected signs for the impact of a change in the domestic interest rate on the exchange rate?

3. In a situation of a fixed exchange rate, explain why, in the monetary approach, an excess

supply of money leads to a balance-of-payments deficit. Why is the deficit only temporary?

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How might advocates of the monetary approach explain a long-lasting deficit in the balance of

payments?

4. Describe a scenario that will make the current three-months forward rate on a foreign

currency equal to the expected spot rate in three months for that currency. What might prevent

this result from occurring?

5. (a) Could there be “overshooting” of the exchange rate in the Dornbusch model if goods