The Monetary Approach

Abstract

In the previous chapter the domestic monetary effects of the balance of payments were incorporated in the standard IS/LM paradigm, and the two-way direction of causation between changes in the domestic money supply and the balance of payments was highlighted. In this extended model full macro-economic equilibrium requires zero excess demand/supply of foreign exchange so that, with a fixed exchange rate, there are no continuing externally induced changes in the money supply, and the exchange rate is in equilibrium in the floating-rate case. It also establishes that, with a fixed exchange rate and in the absence of sterilisation, monetary policy has no long-run effect upon the level of real income irrespective of the interest-rate sensitivity of capital movements. In the identity M ≡ H + R, policy-induced changes in the domestic component of high-powered money are offset by equal and opposite changes in the external reserves and external component of the monetary base. On the other hand, monetary policy becomes potentially powerful combined with a floating exchange rate though this power derives from induced exchange-rate movements.