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CHAPTER 9
Monetary and Portfolio Approaches
to Exchange-Rate and
Balance-of-Payments Determination
CHAPTER OVERVIEW
Chapter 9 is devoted to explaining the monetary and portfolio approaches to exchange rate and balance of
payments determination. The chapter begins with a discussion of central banks’ balance sheets, and then
follows with a discussion of the way in which central bank operations can affect the national stock of money via
the money multiplier effect. The section also explains how foreign currency operations of the central bank
impact the domestic money stock. The chapter then addresses how central banks can affect the exchange rate of
its currency by leaning with or against the wind. The chapter distinguishes between sterilized and unsterilized
interventions. Examples are given for a simplified balance sheet of the U.S. Federal Reserve Bank and the Bank
of England.
Next, the chapter studies the monetary approach, beginning with the Cambridge equation for money demand
based on the transactions demand for money. Absolute purchasing power parity and the balance of payments
accounting identity are then used to derive the international monetary equilibrium condition. The equilibrium
condition is in turn used to study the consequence of changes in money demand on the balance of payments
under both fixed and flexible exchange rates. The model is then extended to a two-country setting to provide an
example of how it can be used as a model of exchange rate determination.
The final section of the chapter briefly describes the portfolio approach based on the wealth identity for the
household’s allocation of wealth among both monetary and non-monetary financial instruments. The chapter
ends with a discussion of whether or not foreign exchange rate interventions should be sterilized. According to
the monetary approach, such sterilization will be ineffective, since it does not alter the total stock of money. By
contrast, the portfolio approach predicts that sterilization has the potential to be effective, since it will alter the
relative holdings of domestic and foreign bonds.
OUTLINE
I.
Central Bank Balance Sheets
A. Nation’s Monetary Base
1. Domestic Credit
2. Foreign Exchange Reserves
B. Nation’s Money Stock
1. Open-Market Transaction
2. Money Multiplier
C. Relationship Between Monetary Base and Money Stock
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II. Managed Exchange Rates: Foreign Exchange Interventions
A. Mechanics
1. Intervention Transactions
2. Financing Interventions
B. Foreign Exchange Intervention and the Money Stock
C. Sterilizing Interventions
III. Monetary Approach to Balance of Payments and Exchange Rate Determination
A. Cambridge Approach to Money Demand
B. The Role of Money in an International Context
1. Balance of Payments
2. Spot Rate
3. Monetary Equilibrium
C. Monetary Approach to Fixed Exchange Rate Arrangement
D. Monetary Approach to Flexible Exchange Rate Arrangement
IV. Application of Monetary Approach in a Two-Country Setting
V. Portfolio Approach to Exchange Rate Determination
A. Household Wealth Allocation
B. Sterilization
C. Benefit of Sterilization
VI. Summary
FUNDAMENTAL ISSUES
1.
What are the main assets and liabilities of central banks?
2.
How do a central bank’s foreign exchange market interventions alter the monetary base and the money
stock?
3.
What is the monetary approach to balance-of-payments and exchange-rate determination?
4.
How is the monetary approach a theory of exchange rate determination in a two-country setting?
5.
What is the portfolio approach to exchange-rate determination?
6.
Should central banks sterilize foreign exchange interventions?
CHAPTER FEATURES
1.
Policy Notebook: “The Global Equities Explosion”
This management notebook considers the extremely rapid increase in global trade of equities. Consequently,
these equity markets are having an increasingly large influence on foreign exchange values. Given expectations
of equity markets growing faster than world output, the impact of equity markets on exchange values is
expected to increase.
For Critical Analysis: If foreigners are net investors in the U.S., all else constant, the U.S. dollar should
appreciate and U.S. exports will fall while U.S. imports will rise, all else constant.
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ANSWERS TO END OF CHAPTER QUESTIONS
1.
The balance sheet for the Bank of Japan would be similar to that of the Federal Reserve as shown in Figure
10-2. The change in foreign reserves and bank reserves is ¥87,500,000. The balance sheet for Australia’s
central bank is also similar to that of the Federal Reserve in Figure 10-2. The change in foreign reserves
and bank reserves is A$1,000,000.
2.
The money multiplier in this example is 1/(rr + b).
a.
b.
m = 1/.10 = 10.
m = 1/(.10 + .25) = 1/.35 =2.86.
3.
The money multiplier for Australia is 5, so the maximum change in the monetary base is A$5 million. The
money multiplier for Japan is 12.5, so the maximum change in the monetary base is ¥1,093,750,000.
4.
The change in the monetary base is ¥887,500,000 –¥47,500,000 = ¥40,000,000.
5.
Using the formula provided on page 288, m(DC + FER) = kSP*y:
a.
b.
6.
An open market purchase of securities in the amount of $100:
a.
b.
7.
In a fixed exchange rate regime requires a decrease in foreign reserves in an equal amount. Hence, a
balance of payments deficits in the amount of $100 results.
In a flexible exchange rate regime results in a new spot exchange rate of 2.19, which is a depreciation.
A 3 percent increase in New Zealand’s domestic credit results in:
a.
b.
c.
8.
The money stock is 2($1,000 + $80) = $2,160.
The level of real income is: [2($1,000 + $80)]/[(0.20)(1.2)(2)] = $4,500.
A 10.11 percent change (increase) in the money stock.
Under a flexible exchange rate regime, a new spot rate of 0.926, which is a depreciation of the New
Zealand dollar.
Under a fixed exchange rate regime, a 3 percent decline in the balance of payments position.
The open market sale would cause an increase in the demand for the domestic currency and the domestic
currency would appreciate as a result.
MULTIPLE CHOICE EXAM QUESTIONS
1.
Which of the following is not true about a nation’s monetary base?
A.
B.
C.
D.
It is controlled by the central bank.
It is the sum of domestic credit and foreign exchange reserves.
It is the sum of foreign exchange reserves and total reserves.
It is the sum of currency and total reserves.
Answer: C
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2.
The maximum change in total deposits that can result from an open market operation is the change in
A.
B.
C.
D.
total reserves divided by the reserve requirement.
total reserves multiplied by the reserve requirement.
excess reserves.
nonborrowed reserves.
Answer: A
3.
The money multiplier will be identical to the transactions deposit multiplier only
A.
B.
C.
D.
when a closed economy is being analyzed.
when savings equal investment.
if there are no domino-like effects.
if the monetary base is comprised solely of transactions deposits.
Answer: D
4.
The transactions multiplier is equal to the
A.
B.
C.
D.
inverse of the reserve requirement.
sum of the changes in the money supply in each round of spending.
percentage of income spent on consumption.
percentage of income lost due to transaction costs.
Answer: A
5.
One reason why the final multiplier is less than the amount given by the money multiplier is that
A.
B.
C.
D.
it takes an infinite amount of time to realize the full impact.
the assumption of a closed economy rarely holds.
most people hold some money in the form of currency.
seasonal effects alter the size of the multiplier.
Answer: C
6.
The method that the Fed often uses in order to offset a foreign exchange transaction is
A.
B.
C.
D.
an adjustment of the reserve requirements.
an open-market transaction.
an adjustment to the discount rate.
to direct the Treasury to print more money.
Answer: B
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7.
Recent research has indicated that sterilized interventions
A.
B.
C.
D.
have no bearing whatsoever on exchange rates.
cannot be properly coordinated due to conflicting national policy goals.
can affect exchange rates by lowering the currency holdings of the central bank.
do affect exchange rates through a portfolio effect.
Answer: D
8.
The earliest formulation of an open economy model similar in spirit to the monetary approach to the
balance of payments can be seen in the work of
A.
B.
C.
D.
Adam Smith.
David Ricardo.
Milton Friedman.
David Hume.
Answer: D
9.
The equation relating money demand to fraction of nominal GDP is called the
A.
B.
C.
D.
Fisher equation.
money supply function.
Cambridge equation.
IS/LM diagram.
Answer: C
10. Nominal GDP can be found as the
A.
B.
C.
D.
product of the GDP deflator and real GDP.
sum of the quantities of all goods and services produced in a given country.
product of real GDP and the CPI.
division of real GDP by the GDP deflator.
Answer: A
11. Economists who use the monetary approach assume that
A.
B.
C.
D.
purchasing power parity holds in the short run.
uncovered interest parity holds.
capital markets are dominated by the actions of a few central banks.
purchasing power parity holds in the long run.
Answer: D
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12. When the domestic price level is equal to the spot exchange rate times the foreign price level then
A.
B.
C.
D.
absolute purchasing power parity holds.
uncovered interest parity holds.
covered interest parity holds.
the central bank is forced to intervene in foreign exchange markets.
Answer: A
13. The underlying principle of the monetary approach is that balance of payments and spot exchange rates are
influenced by
A.
B.
C.
D.
speculation in the foreign exchange markets.
any event that causes difference between the quantity of money demanded and the quantity supplied.
forward market prices.
only the relative money supplies among countries.
Answer: B
14. Under a fixed exchange rate, the additional purchase of foreign goods will generate a balance of payments
A.
B.
C.
D.
surplus with no change in the exchange rate.
deficit with no change in the exchange rate.
deficit with an appreciation in the exchange rate.
surplus with a depreciation in the exchange rate.
Answer: B
15. Under a flexible exchange rate, the additional purchase of foreign goods will generate
A.
B.
C.
D.
a depreciation of the domestic currency with a balance of payments surplus.
an appreciation of the domestic currency with a balance of payments deficits.
an appreciation of the domestic currency with no change in the balance of payments.
a depreciation of the domestic currency with no change in the balance of payments.
Answer: D
16. Under a fixed exchange rate, a rise in the foreign price level will result in a
A.
B.
C.
D.
balance of payments surplus.
balance of payments deficits.
devaluation of the domestic currency.
revaluation of the domestic currency.
Answer: A
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17. Under a fixed exchange rate, a fall in domestic real income will result in a
A.
B.
C.
D.
balance of payments surplus.
balance of payments deficit.
devaluation of the domestic currency.
revaluation of the domestic currency.
Answer: B
18. Under a flexible exchange rate arrangement, a rise in domestic credit will result in
A.
B.
C.
D.
a current account deficit and no change in the value of the currency.
a current account surplus and no change in the value of the currency.
a depreciation of the domestic currency.
an appreciation of the domestic currency.
Answer: C
19. The spot exchange rate is inversely related to each of the following except the
A.
B.
C.
D.
foreign money supply.
domestic marginal propensity to hold money.
domestic real GDP.
foreign real GDP.
Answer: D
20. Under flexible exchange rates, the spot exchange rate is determined by the
A.
B.
C.
D.
currency board of the nation.
relative quantities of money supplied and demanded for the two countries.
ratios of foreign exchange held by the central banks.
activity related to the two currencies in question.
Answer: B
21. The portfolio approach expands on the monetary approach by recognizing that households may desire to
A.
B.
C.
D.
hold more cash for transaction purposes.
alter their portfolios due to country risk.
alter their portfolios in response to the business cycle.
hold other financial instruments such as domestic and foreign securities.
Answer: D
22. The portfolio approach assumes households can choose to hold their wealth in
A.
B.
C.
D.
money, domestic bonds, or foreign bonds.
stocks and bonds only.
bonds only.
money only.
Answer: A
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23. The portfolio approach postulates that under floating exchange rates a decline in the domestic interest rate
results in
A.
B.
C.
D.
a devaluation of the domestic currency.
a revaluation of the domestic currency.
a depreciation of the domestic currency.
an appreciation of the domestic currency.
Answer: C
24. Regarding the issue of sterilization in foreign exchange markets, the monetary and portfolio approaches
A.
B.
C.
D.
offer similar theoretical results.
offer conflicting answers.
consider only fixed and flexible exchange rate systems, respectively.
can be reconciled by considering both domestic and foreign policy actions.
Answer: B
25. According to the monetary approach, fully sterilized foreign intervention is
A.
B.
C.
D.
ineffective.
extremely potent.
only somewhat potent.
impossible to carry out.
Answer: A
26. When a central bank intervenes in foreign exchange markets, it does so using
A.
B.
C.
D.
the reserves it has deposited at the World Bank.
a combination of foreign exchange reserves and private bank reserves.
its own reserves of assets denominated in foreign currencies.
a combination of reserve requirement and discount rate adjustments.
Answer: C
27. A central bank sterilizes its foreign exchange interventions in order to
A.
B.
C.
D.
signal its future policy intentions.
expose counterfeit currencies.
retaliate against nations who have imposed trade restrictions.
prevent the interventions from influencing the domestic money supply.
Answer: D