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The
basic assumption of the monetary approach to the balance of payment is that
deficit/ surplus in the balance of payment is result of disequilibrium in the
money market. According to monetarists approach, balance of payment deficit is
the phenomena of excess money supply and therefore, equilibrium can only be
attained through monitory measures or policies.

The monitory
approach to the balance of payment is based on the following three key assumptions:

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1)     Velocity of money is constant:  from the simplified money theory, the
equation of exchange (MV=PY) where M is money supply, V is velocity of money, P
is the price level and Y is real income or output. According to monetarists,
velocity of money (V) and real income/ output (Y) is fixed i.e. assumes the
country is at full employment. Therefore, any change in money supply will only
change the price level proportionately. For example, a percentage change in
money supply will only change the price level by a percentage level as velocity
of money and real income/output are zero.

2)     The aggregate supply in the
product market is fixed: here it is assumed that the economy is always at full
employment so real income/ output is assumed to be constant and change in price
will not affect the real output (aggregate supply remain the same) even if
aggregate demand increase due to increase in price level.

3)     The Purchasing Power Parity (PPP)
theory holds. Monetarist asserts that exchange rate and price level are
determined by PPP.   

With
these basic assumptions in mind, I will try to explain and demonstrate the
economic outcome of the monetarist assertions on small country balance of
payment under fixed and floating exchange rate regimes. Before that, I would
like to use the monetarist concept that balance of payment (BP) consist of
current account (CA), capital count (K) and forging reserve (R) and in other
form BP = CA+K+R=0 and from this we can drive CA+K= -R. This implies that when
a country’s authorities purchase domestic currency with foreign reserve, it
will result in decrease in R so implies deficit to the balance of payment and
when the country’s authorities purchase foreign currency, R increases and results
in current account surplus. So, what happens when the country’s authorities intervene
to increase or decrease the money supply under fixed exchange mechanism is discussed
below.

Under
fixed exchange regime, assume at the beginning the economy is at equilibrium
and monetary
approach is expressed in the form of relationship between demand for money and
supply for money.  So, the demand for
money(MD) equals the money supply (MS), this can be represented by MD= MS. As
in a simplified form, money supply consists of two main components that are domestic
credit (DC) and foreign reserve (R) MD=MS can be expressed as MS= DC+R. Now, let’s
assume that government/ central bank of a small country wants expansionary monetary
policy. When authorities want to increase domestic money supply, they will buy
domestic currency in an Open Market Operation (OMO). This measure will increase
the money supply and people will have excess money balance. People will then
keep proportion of the money and spend the excess balance more on imported
goods and foreign securities. This tends to increase in the aggregate demand on
imported goods and assets. The increase in demand results in pushing the level
of price up. When the level of price increase (given world price unchanged) the
country’s export goods and services with regard PPP becomes less competitive. This
leads to aggregate demand for import exceeding export which will be reflected on
both current and capital account by creating a balance of payment deficit. To correct
the deficit and to prevent devaluations of its currency, authorities of this
country has to purchase the domestic currency with their foreign reserve. This
OMO results in reducing the money stock from the market. The decrease in money
supply starts to reduce the aggregate demand and the price to the original PPP
level and this eliminates the deficit and balance of payment equilibrium will
be attained i.e. MD=MS. This shows that the balance of payment deficit is only transitory
effect. There are though circumstances when balance of payment deficit is prolonged.
When a country’s authorities practice sterilization of their foreign exchange
operation and if a surplus countries decide to purchase domestic current the deficit
country and keep it.

On the
other hand, if money supply is less that money demand, (MS

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