The Empirical Evidence on the Monetary Approach to the Balance of Payments and Exchange Rates

Abstract

This paper is a critical review of the empirical evidence on the operation of the international mechanism under both fixed and floating exchange rates. I limit the discussion to recent studies on the to balance of payments (BOP) and foreign exchange rate (EX rate) determination for individual countries. The monetary approach contrasts with the to the BOP (see, e.g., Martin Prachowny); according to the latter, the BOP is determined by combining behavioral equations for all of the components of the BOP with the BOP accounts identity. The two approaches can be reconciled in a general equilibrium framework with goods, assets and money. But reduced-form estimates of equilibrium in any one of the three markets should include the exogenous determinants of equilibrium in the other two markets. On this score, some of the monetarists err, just as some trade flow and capital flow empiricists, in estimating only a single structural equation rather than a reduced-form equation. This error notwithstanding, research efficiency dictates that if we want a simple (Occam's razor) explanation of the BOP and FX rates, then we should examine international money markets directly rather than the international markets for eggs, potatoes and AAA bonds. Critics counter that the monetarists actually apply Occam's scimitar to the research victim and that while they succeed in getting down to bare bones, the skeletal remains sustain insufficient life to be worthy of continued scientific interest. This critique misses the point that the is a macro theory and that simplicity is an important criterion for any theory which must be understood and used by policy makers. A second virtue of the is that it avoids the error easily made by component analysts of identifying movements in the BOP components with identical movements in the BOP. For example, increases in home income and prices reduce trade balances and decreases in interest rates cause capital account deterioration. However, all three of these phenomena lead to increases in the demand for money, and hence improvements in the BOP (or appreciation of the FX rate) according to the monetarists. We turn to the empirical evidence on these pre* Associate Professor, Graduate School of Business, University of Chicago. The author is indebted to the National Science Foundation for research support and to Robert Aliber, John Bilson, Paul Evans, Jacob Frenkel, Harry Johnson, Richard Karplus, Arthur Laffer, Aris Protopapadakis and Myles Wallace for useful discussions. They are absolved from any responsibility for the views expressed and for errors.

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