The monetary theory of balance of payments: an application to the economy of Bangladesh

Abstract

There are many theories in the field of international economics that explain the balance of payments disequilibria and movements of international reserves in one way or another. One of them is known as the monetary approach to the balance of payments. Researchers have been increasingly using this theory to understand and explain the balance of payments fluctuations. The present paper employs the monetary model of balance of payments in its attempt to explain the relationship among monetary policy, domestic credit policy, and flow of international reserves in the context of balance of payments for a small open economy, such as Bangladesh. As such, the specific objective of this paper is threefold. First, it explores the determinants of money demand and money supply functions to predict, in general, the impact of domestic credit policy and monetary policy on the balance of payments. Second, it explains the current account, particularly the flow of international reserves and its repercussion on balance of payments. Finally, it tests the validity and prediction of the monetary theory of balance of payments using quarterly data pertaining to Bangladesh.