Monetary Theory - Balance of Payments


Monetary Theory was one of the most interesting Economics courses I have ever taken because it gives you a window, a clear view into how the government operates financially, it helps one more easily understand how the government keeps its books and how everything has to balance out with other various parts of the monetary chain, also including trade imbalances and foreign policy. In the end, all of these various policies revolve around one thing - money. In the article below RoW simply signifies Rest of World while US conveniently signifies us, or the United States.

Given the United States is currently printing and borrowing more money than has ever been heard of in the history of mankind, I thought it would be good to shine a light on how things work, what enables the United States to borrow so much at such low yields for such extended periods of time and why the United States is constantly trying to keep the dollar weak. I've heard many people over the years expressing disappointment that the US has had such a weak dollar compared to other currencies such as the Euro, especially if you're travelling abroad. And I always attempt to explain that it's not by accident and that most countries would love to be in the position of power in which the US finds itself - to be able to dictate trade terms and to constantly weaken the dollar in an attempt to pay back less of what you borrowed, in foreign debt (in real terms) and to greatly help the many US Multinationals to get a pricing advantage overseas, on their goods and services, allowing them to book hundreds of billions of dollars in combined essentially free profits, every year, due to favorable exchange rates.

I feel the following is as important to understand as understanding the three branches of power in the United States and how they were made with foresight to keep each other in check and balance. Because if anyone lacks this basic understanding in Economics or politics then it makes it much more difficult to understand things from a broader perspective or to see things ahead of time, before they occur. And I'm not referring to just the US. A lot has been happening in Europe and other countries which has to do with their balance of payments, negative trade balance and the sheer fact that most of these countries are too small to be able to help themselves via their central banks, the way the Unites States can, and has done, which in part is because America is such a large country in every sense of the word. As an American citizen I hope America can keep staying strong and keep staying on top but knowing a bit about history tells me that one day it's simply not going to be able to keep playing the same games and get the same results. And that's the time when it is crucial for every American to be armed with some knowledge about how our government works and also, equally important, how Economics works in and outside of the United States.

Effect of Trade on Balance of Payments

The balance of payments or BoP is the SUM of US sales to RoW minus purchases from RoW. Things we sell and things we buy can be put into two categories: 1) The current account balance which consists of Goods and Services sold minus purchases of goods and services such as cars, movies or interest payments. 2) The Capital Account which is U.S. sales of assets to RoW minus our purchases of assets from RoW which include things like Bonds and T-bills. The relationship between BoP and the forex market is the assumption that residents in both countries hold balances in their own currency - therefore every transaction requires a foreign exchange transaction. More particular, the relationship between BoP and the forex market under a floating rate regime is the fact that if a country lets its currency float then exports will become either more or less attractive which will in turn create a current account surplus or deficit. For example if the U.S. dollar gets weaker then as the price of foreign currency rises our demand for foreign goods declines. In essence, when we demand foreign goods we also demand their currency.1)

The supply side of this equation is in the foreign country - as the Euro gets stronger their demand for U.S. goods increases which means that the U.S. will export more goods which will give us a current account surplus. Greater exports for the U.S. mean more jobs and higher incomes which results in lower interest rates relative to RoW. Higher rates abroad will result in a capital outflow from the U.S. to RoW as investors seek higher rates of return. This capital outflow gives us a negative capital account balance and it will be in the same amount as our current account surplus so they offset each other giving us a BoP of zero or equilibrium. There is one caveat to this scenario and that is the Marshall-Lerner condition. This condition states that for a currency devaluation to have a positive impact in trade balance, the sum of price elasticity of exports and imports, in absolute value, must be greater than 1. The ML condition has to hold in order to have forex equilibrium and BoP equal to zero. In real life a falling $ will initially make the BoP go negative as empirical data shows that goods tend to be inelastic in the short term, as it takes time to change consuming patterns so the ML condition initially does not hold and devaluation will worsen the trade balance, but in the long run consumers adjust to new prices and the trade balance will improve. This effect is called the J-Curve effect. (See below)


Effect of Central Banks on Balance of Payments

A country's central bank can become a counter weight by pegging their exchange rate to another currency. Pegs don't have to be fixed in absolute terms, there is some flexibility and in essence, the central bank promises to supply an unlimited amount of their currency at the predetermined upper limit. The central bank is also committed to buying their own currency off the market by using their reserves if the exchange rate drifts too far below the desired rate. Forex (Foreign Exchange) reserves are essentially the central banks ammunition with which to stabilize or peg their currency and if they run out of these reserves, as the bank of England did in the late 90s, the currency can collapse. For example, if the dollar is weakening the Central Bank would buy dollars off the market, driving demand back up, by using its Forex reserves.

Furthermore, by reducing its Forex reserves on the asset side the central bank debits, by equal amounts, bank reserves on its liabilities side creating monetary contraction. Therefore, a trade deficit which weakens the dollar due to higher demand for the Euro would result in a monetary contraction should our central bank choose to keep the exchange rate pegged. This is where the IMF comes in - its main purpose is to lend exchange reserves to countries who get into Balance of Payment trouble. Trying to use monetary expansion under a fixed rate regime is ineffective, as the currency cannot weaken so you get the exact opposite effect as a floating rate system. Fiscal policy is effective however, in a fixed rate regime, as the IS curve moves to the right due to an increase in Government spending and since the $ doesn't rise the LM responds by moving to the right as well giving you an effective policy and increased income (Y) with lower interest rates (i).2)

Effect of a Country's size on Balance of Payments

A large country, such as the U.S., can ignore its BP curve – our policy (large country) is determined by our own domestic policy. Conversely, the small country, for example Canada, is affected by the fiscal and monetary policy of the larger country, the U.S. As the diagram above shows, if the large country initiates fiscal expansion then the BP curve for the small foreign country shifts up. From a Canadian point of view interest rates went up from point A to point B – BoP went from equaling zero to being < 0. Canadian capital then came to the U.S. looking for higher rates of return which results in a BoP deficit. If the Canadian $ is floating then the BoP deficit drives the C$ down while the $ goes up in value. The weaker C$ results in an export bonanza for Canada. Therefore, fiscal expansion by a large country has the locomotive effect, due to export bonanza, on its neighboring small country, if the small country has a floating rate resulting in increased output and increased employment.

If however, the small country has a pegged rate (which is what really happened with Canada) then their capital account tips over in favor of the U.S. This is the result of selling off foreign reserves to keep the C$ strong which has a monetary contraction effect. Automatic monetary contraction shifts the LM curve left pushing interest rates up to U.S. level but through monetary contraction. The result of this policy is beggar-thy-neighbor, which is lower output and higher unemployment.

If the U.S. were to take on monetary expansion policy, then in the Canadian economy the $ interest rates fall. With the lower $ interest rates Canadian interest rates are higher, relatively speaking, which reverses the capital outflow. Canada enters BoP surplus as money is flowing north. If Canada has a fixed rate policy BoP surplus would have experienced a monetary expansion shifting the LM curve. The automatic monetary expansion would push interest rates down equal to U.S. rates. Therefore, under a fixed rate system, monetary expansion by the large country would have the locomotive effect on the small country resulting in higher output and increased employment.3)

In reality, at this time, Canada had a floating rate system. They experienced Capital inflow – BoP surplus on Capital side, Canadian $ gets stronger making the trade balance even worse due to less competitive Canadian $. Is curve then shifts back where interest rates fall to U.S. levels but result in higher unemployment and lower output. Therefore, under floating rate, monetary expansion by the large country would result in beggar-thy-neighbor for the small country. Canada mismatched policies both times which resulted in reduced output and higher unemployment for its citizens.

Monetary Expansion and Inflation

Under a floating exchange system, temporary and expected monetary expansion will not change expectations and behavior and therefore the expansion will not be effective. If however, the expansion is not expected by anybody, then in the short run expectations and behavior will be affected and the expansion will have some effect, although not a maximum effect due to prices eventually rising. In the long run, temporary monetary expansion will not have an effect as consumers will have time to adjust to the policy. Permanent monetary expansion, in the long run will also not have an effect because in the long run the economy is expected to be at full employment, the velocity of money and interest rates are stable/constant and at a long run equilibrium. The long run quantity theory of money says that in the long run if you increase the quantity of money its effect will only be on prices, real output will not be affected. Therefore if you increase money by 3x, prices will also increase by 3x, resulting in a weaker dollar and inflation. This effect was witnessed by Spain when they had a huge influx of gold. In the short run a permanent monetary expansion will have a temporary boost on the economy but in the long run it will not be sustainable and prices will rise which will deflate the quantity of money back to its real level. In the long run, since we have to be at full employment, the dollar will have fallen in value which would cause the DD curve to shift back due to an increase in exports offset by lower consumption of foreign goods due to a weaker dollar.4)

Purchasing Power Parity (PPP)

The purchasing power parity (PPP) theory, based on the law of one price, uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. The theory states that, in ideally efficient markets, identical goods should have only one price. Over time, in the long run, one currency will appreciate or depreciate over another currency depending on inflation. One could expand the formula to include real growth in output which also has a direct effect on long term currency exchange rates. The formula to demonstrate this theory is: %∆ e = %∆M (US money supply) - %∆M* (RoW money supply) + %∆Y* (RoW real output) - %∆Y (US real output). Evidently, this formula also includes change in real growth/output (Y/Y*) to also predict what will happen if rates of real growth between the two countries are different.5)

Ignoring real output for a moment, and focusing on just the change in money supply – if the US money supply is growing 10% faster than the RoW money supply then in the long run the US dollar will lose 10% of its value against the RoW currency. Now assuming that the money supply for both countries is growing at the same rate but growth in real output varies such that the growth in the US is 5% higher than the growth in RoW then long term one could accurately predict that the $ would strengthen against the RoW currency. Cleary then, paying attention to the money supply and growth rates of any particular country will lead to an accurate prediction to the future exchange rate of that country. Therefore, any country which consistently practices loose monetary policy while having low growth in real output will, in the long run, see its currency depreciate against competing currencies.


As demonstrated above, the United States can only be the big dog on the block for so long. They have a lot of room to borrow and print because the market and size of the United States is so large and being the world's currency also gives it wiggle room as many large investors, countries and central banks hold US dollars which means there's that much less US dollars in the market to dilute the real value of the dollar as the US keeps printing and borrowing. But as one would guess, this game cannot go on forever and as I also demonstrated in the last section of the Article - if the money supply grows by 10% the real value of the dollar will, in time, fall by 10% so any “rich” effect felt by printing new money is only temporary as in the long term equilibrium is found as inflationary pressures take hold and bring the dollar down to where it should be. While the US enjoys having a weak dollar, getting too weak can become problematic as many nations, investors and central banks may get nervous holding the dollar or dollar denominated debt, such as US bonds, not knowing how low the dollar may go and then if everybody were to start dumping the dollar it would create a massive drop in value of the dollar and the US would no longer be able to borrow at today's rate of roughly 3% and would have to pay a considerably higher interest rate and given we are talking trillions of dollars in existing debt which would then have to be refinanced at the higher rate - simply put, the US would probably find it very difficult to make even the interest payments on the existing debt, let alone be able to continue borrowing more.

And this is a big reason why many top renowned Economists, such as Nouriel Roubini, Jim Rogers and Marc Faber, are calling not just for inflation, but rather hyperinflation.6) But as I pointed out in one of my other papers, Economics is like a science experiment without the convenience of a laboratory or variables which you can control. There are many unkown variables in this Economic equation, and this truly is a one-off experiment which nobody knows for sure how it will end. There are also additional variables we cannot easily predict, such as when the rest of the world will decide they've had enough and start selling the dollar, and so it really is up in the air and the US just may end up landing on its feet like it has so many times in the past. But one should at least be aware of how the system works just in case this will be the one time the US doesn't make out like a bandit, borrowing and paying back much less than it borrowed, via intentional inflation, while all of its trade partners don't say a word, well - except for China, because the US has been and still is the number one player in the world and without our consumers to sell their goods to and our military Superpower to ensure the safety of most of these global players, most would go down a few notches in their standard of living without America, which is precisely why the US has been enjoying such favorable deals while getting to make and sometimes break all the rules for so many years.

- Maximilian Wilhelm


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