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LECTURE 9: The Monetary Approach to the Balance of Payments Sterilization definitions Price-specie flow mechanism Income-money flow mechanism Brief history.

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Presentation on theme: "LECTURE 9: The Monetary Approach to the Balance of Payments Sterilization definitions Price-specie flow mechanism Income-money flow mechanism Brief history."— Presentation transcript:

1 LECTURE 9: The Monetary Approach to the Balance of Payments Sterilization definitions Price-specie flow mechanism Income-money flow mechanism Brief history of the Gold Standard Appendix: China sterilizes inflows, ITF Prof.J.Frankel

2 The Monetary Approach to the Balance of Payments (MABP) Defining assumption: Reserve flows are not sterilized. Another assumption sometimes associated with MABP: Goods prices are flexible => PPP holds.

3 ITF Prof.J.Frankel Sterilization: Changes in reserves (i.e., BP) offset by NDA, NDA = - R, so MB unchanged. Non-sterilization : MB = R. Definitions: Monetary Base: Liabilities of CB assets held by CB MB Res + NDA where Res International Reserves & NDA Net Domestic Assets Broad Money Supply (M1): Liabilities of entire banking system M1 = a multiple of MB <= fractional reserve banking

4 ITF Prof.J.Frankel David Humes Price Specie-Flow Mechanism But if England has a more productive economy (Industrial Revolution), its demand for money will be higher, in proportion to its higher GDP. If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level. Initially, Spain piles up gold, from the New World (mercantilism).

5 ITF Prof.J.Frankel Humes Price Specie-Flow Mechanism If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. continued

6 ITF Prof.J.Frankel Mundells Income-Flow Mechanism MB => M1 => (via i => I ) => A => Y But A => TB<0 => Res then falling gradually over time + nonsterilization MB falling over time A falling over time. In the long run, TB=0 and everything is back to where it was.

7 ITF Prof.J.Frankel Mundells Income-Flow Mechanism, continued A Monetary Expansion, and Its Aftermath Y NS-I i LM IS NS-I´ LM´ TB As long as BP<0, reserves continue to flow out, i rises, and spending falls. In the long run BP=0; we are back where we were before the monetary expansion.

8 ITF Prof.J.Frankel Example: response to the 1994 tequila crisis i LM´ IS M A Y Argentina was on a currency board => no sterilization. In 1995 allowed reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A. Mexico sterilized reserve outflows in Stayed at point M, but ran out of reserves in December..

9 ITF Prof.J.Frankel The Gold Standard Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other). Pros and Cons Pro: prevents excess money creation and inflation. Cons: prevents response to cyclical fluctuations long-term drag on world economy, e.g., , no gold discoveries => prices fell 53% in US, 45% in UK.

10 Capsule History of the Gold Standard 1844 – Britain adopts full gold standard US restores gold convertibility. From , the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices ill-fated UK return to gold <= misplaced faith in flexible prices Bretton Woods system, based on gold as the reserve asset de facto: based on $ Start of US BoP deficits. US growth Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $. Solutions: raise price of gold, or create SDRs Nixon suspends convertibility & devalues. ITF Prof.J.Frankel

11 Appendix -- Example of sterilizing money inflows: China, & 2010

12 12 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 The Balance of Payments rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows Reserves ITF Prof.J.Frankel

13 FX reserves of the PBoC climbed higher than any central bank in history ITF Prof.J.Frankel

14 Sterilization of foreign reserves: Peoples Bank of China sold sterilization bills, thereby taking RMB out of circulation. Data: CEIC Source: Zhang, 2011, Fig.4, p.45. ITF Prof.J.Frankel

15 => The MB growth rate was kept down to the growth rate of the real economy ( 10%/year), so there was little inflationary pressure. In , forex inflows accelerated rapidly. Initially, the PBoC had no trouble sterilizing the inflows.

16 ITF Prof.J.Frankel In China had more trouble sterilizing the reserve inflow PBoC began to have to pay higher domestic interest rates –and to receive lower interest rate on US T bills –=> quasi-fiscal deficit or negative carry. Inflation became a serious problem in Also a bubble in the Shanghai stock market.

17 ITF Prof.J.Frankel Sterilization faltered in 2007 & 2008 Growth of China s monetary base & its components: Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 Money growth accelerated sharply,

18 ITF Prof.J.Frankel China s CPI accelerated in Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Inflation 1999 to 2008

19 Sterilization of foreign reserves: Decreases in PBoCs domestic assets offset increases in foreign assets Source: Zhang, 2011, Fig.7, p.47. ITF Prof.J.Frankel

20 China s inflation broke sharply in 2009, (<= big one-year loss of Chinas exports due to global recession), But took off again in Inflation 2001 to 2011

21 ITF Prof.J.Frankel After the interruption of mid-2008 to mid-2009 overheating resumed: rapid rise of land prices in 2010 Real Beijing land prices

22 When house prices rise relative even to rents, that suggests a bubble or easy money ITF Prof.J.Frankel Scott Reeve blog

23 China in 2010 resumed attempts to sterilize money inflows by raising banks reserve requirements -- to slow M1 growth even while MB is growing rapidly. ITF Prof.J.Frankel


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