Developing Countries: The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies.
Here is Von Mises on Balance of Payments:
The surplus of the balance of payments that is not settled by the consignment of goods and services but by the transmission of money was long regarded as merely a consequence of the state of international trade. It is one of the great achievements of Classical political economy to have exposed the fundamental error in this view. It demonstrated that international movements of money are not consequences of the state of trade; that they constitute not the effect, but the cause, of a favorable or unfavorable trade balance. The precious metals are distributed among individuals and hence among nations according to the extent and intensity of their demand for money….the proposition is as true of money as of every other economic good, that its distribution among individual economic agents depends on its marginal utility … all economic goods, including of course money, tend to be distributed in such a way that a position of equilibrium among individuals is reached, when no further act of exchange that any individual could undertake would bring him any gain, any increase of subjective utility. In such a position of equilibrium, the total stock of money, just like the total stocks of commodities, is distributed among individuals according to the intensity with which they are able to express their demand for it in the market. Every displacement of the forces affecting the exchange ratio between money and other economic goods [i.e., the supply and demand for money] brings about a corresponding change in this distribution, until a new position of equilibrium is reached.
Balance of Payments – whether this is a monetary or a real phenomenon? The Monetary approach stresses that the balance of payments is essentially a monetary phenomenon. To be specific, it claims that money plays a vital role in determining the balance of payments. This approach does not deny the importance of non-monetary factors such as productivity changes, tariffs, government spending and taxation on the balance of payments. Indeed, it stresses the links between these factors and the money market. The Monetary approach does not assert that balance of payments problems are caused solely by monetary mismanagement or that monetary policy is the only possible cure. Rather, it emphasizes that the monetary process will bring about a cure of some kind (not necessarily very attractive) unless frustrated by deliberate monetary policy action. Policies that neglect or aggravate the monetary implications of deficits or surpluses will not be successful in their declared objectives.
The Monetary approach to the balance of payments applies specifically to a fixed exchange-rate regime. In this environment, it is the money supply that adjusts to money demand through international flows of money, which brings about equilibrium in the balance of payments. In this case, the money market determines the balance of payments. In a regime of flexible exchange rates, it is the money demand that adjusts to the money supply, which in turn is determined by the central bank. In a “managed float”, or “dirty float” scenario, in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries’ exchange rates by buying and selling currencies, both international money flows and exchange rate changes are anticipated, given the nature of the central bank intervention.
The Keynesian approach focuses mainly on the merchandise trade account, with the capital account incorporated in the analysis at a later date. Disequilibrium in the balance of payments is caused by both the current account and the capital account. The current account, however, is considered to be more important than the capital account for the balance of payments disequilibrium. The relative prices and relative income levels of domestic and foreign countries are responsible for the balance of payments disequilibrium condition.
The relative prices and exchange rate of a country, vis-à-vis its trading partners, will determine the competitiveness of that country’s goods and services. An adverse movement in the relative price structure of a country, ceteris paribus, would decrease its competitiveness relative to its trading partners. Keynesians argue that a devaluation of a country’s currency will improve the trade account and enhance competitiveness. In time, equilibrium will be restored in the trade account. From the Monetary approach’s point of view, the money market is the principal vehicle, if not the only one, that is responsible for a balance of payments disequilibrium. For the Keynesians, it is differences in relative prices and domestic absorption rates that determine the balance of payments outcome. In short, real factors are more important than monetary factors in determining the balance of payments outcome.
The Monetary approach states that in the long run, monetary variables cannot affect real variables such as output, employment and, in the case of the balance of payments, the trade account. In the short run, monetary variables will affect real variables. This is true in the case of the money supply, money demand, exchange rates, and interest rates. The influence of interest rates on foreign direct investment is not made clear in the Monetary approach. This is because the approach does not distinguish between different types and durations of capital flows and the money account.
The Keynesian approach considers the balance of payments as a real phenomenon. Factors such as relative prices, devaluations, and aggregate demand affect the real variables in the short as well as the long run. In addition, capital flows are divided into short and long term. Protagonists of this approach argue that it is the short-term capital flows and long-term portfolio investments that respond to monetary factors.
For the Monetary approach, the demand for money is a stable function of a few variables. In a world of stable money demand functions, the assumptions of this approach are all valid. However, the Keynesian approach is not anchored on the premise of a stable demand function. In fact, for Keynesians, money demand functions are not considered stable since velocity is not stable. Hence, the Monetary approach’s conclusions are not valid for the Keynesians. The Monetary approach does not specifically identify whether it is the current account or the capital account that is responsible for a balance of payments deficit or surplus. However, it may be important to be able to clearly attribute the deficit or surplus to either the current account or the capital account. This would have an implication on the determination of the net worth of a country. For example, a change in the net worth of country will occur if the capital account is in deficit, ceteris paribus. However, net worth declines if the deficit is in the current account. The Keynesian approach specifically identifies which account is responsible for balance of payments deficits or surpluses. The reason for this identification is due to the importance of a country’s net worth over time.
The Monetary approach argues that the response of wages to a change in the money supply is not symmetric due to resistance from workers and unions to wage reductions following a decrease in the money supply. Conversely, with an increase in the money supply, wages rise following an increase in prices caused by the money supply expansion. Strong resistance to a drop in wages may be due to contractual agreements and institutional rigidities. According to the Monetary approach, a given change in the money supply is similar to a change in exchange rates in terms of percentage changes. For the Keynesians, however, this is not the case. It is their belief that in the real world, exchange rates are motivated in part by political reasons as well as economic and monetary factors. Keynesians argue that the reaction of wage earners and unions to a decrease in the money supply compared to their reaction to a devaluation is different. A decrease in the money supply will reduce nominal wages, and such a reduction is unacceptable to labor and labor unions. On the other hand, all other things remaining equal, a devaluation lowers the real wage rate by increasing domestic prices. However, a devaluation normally does not bring forth resistance from labor unions, despite the fact that an outcome similar to a decrease in the money supply is produced. It is possible that labor unions tend to focus on the immediate, direct effects on wages rather than on the delayed, indirect effects produced by a devaluation. In essence, the results of a decrease in the money supply or a devaluation are the same in the Keynesian view.
The Keynesian approach regards the exchange rate as a relative price of domestic and foreign goods. A change in relative prices will lead to a decrease in exchange rates. In the case of a devaluation, domestic prices of the devaluating country will decline in terms of foreign (goods) prices by the amount of the devaluation in percentage terms. In a regime of flexible exchange rates, the outcome of the current and capital accounts determines the exchange rate. According to the Keynesians, it is the capital account that exerts a more significant influence on exchange rates. This view is different from the Monetary approach, which argues that it is the money market outcome – money supply and money demand – that determines the exchange rate. The factors that influence the money supply and money demand will indirectly influence the exchange rate.
Foreign Exchange Regimes: The above map shows which countries have adopted which exchange rate regime. Dark green is for free float, neon green is for managed float, blue is for currency peg, and red is for countries that use another country’s currency.
The two approaches hold different views on currency substitution. The Monetary approach assumes the substitution of currencies and believes that in practice, this occurs to a high degree. This implies that monetary policy is independent. In the Keynesian approach, currencies of different countries are not really substitutable, and hence, monetary policies are not independent. In a managed float regime, changes in exchange rates as well as monetary flows will occur to restore equilibrium in the monetary market and in the balance of payments, because of the money flows generated by intervention, and thus central banks cannot truly be independent in conducting their monetary policies.
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