Money, Capital Flows and the Open Economy

Abstract

In an open economy high-powered money issued by the central bank must be backed by either foreign exchange reserves, FR, or government debt, DC. Therefore $$H \equiv FR + DC$$ ((10.1)) where H is high-powered money. That portion of H which is backed by government debt represents the central bank’s creation of domestic credit, DC. Any increase, ΔH, in the stock of high-powered money must be matched by an increase in foreign reserves, FR, or an increase in central bank domestic credit, DC, or both. Therefore $$H \equiv \Delta FR + \Delta DC$$ ((10.2)) When the central bank purchases (sells) domestic currency in the foreign exchange market, foreign exchange reserves fall (rise) by an equivalent amount. Thus the change in foreign reserves, ΔFR, for any period must equal the balance for official financing (BOF). Therefore $$\Delta FR = BOF$$ ((10.3)) and $$\Delta H = BOF + \Delta DC$$ ((10.4))