Keynesian and monetarist perspectives

The Mundell-Fleming model is Keynesian; that is, the labour market is not at equi­librium, the price level is given and nominal and real wage rates are determined by the level of income.

Expansive monetary policy gives rise to an increase in imports and a decrease in the interest rate, both causing an excess supply of domestic currency on the exchange market. This causes a fall in the exchange rate if exchange rates are flexible, and a shrink­age of the money supply if they are fixed. In the first case, the exports are favoured, bringing about an increase of income, therefore strengthening the efficiency of monetary policy. In the second case, there will be a reduction in the quantity of money, which lasts until this quantity reaches its initial level, thus negating the efficiency of monetary policy.

The effects of expansive budgetary policy are more contrasted. On the one hand, this policy gives rise to an increase in imports, thereby increasing the supply of domestic cur­rency on the exchange market. On the other hand, it brings about an increase in the inter­est rate, which favours entries of capital, thereby increasing the demand for domestic currency on the exchange market.

Elsewhere, the sustainability of the Bretton Woods system, a gold-dollar exchange standard with pegged but adjustable exchange rates was questioned. In his 1953 article “The case for flexible exchange rates”, Milton Friedman argued that this system encourages speculation as soon as an adjustment of the exchange rate is envisaged; a speculation that is risk-free. Speculators sell the domestic currency and buy dollars, then wait for devaluation. If it occurs, they make a profit, but they do not make a loss in the opposite case. Furthermore, Rueff (1961) brought to light a weakness of the gold exchange standard that he had already understood in 1931, along with Hawtrey in 1932, Kemmerer in 1944 and Robert Triffin in 1960. A country which is on the gold bullion standard is not limited in the accumulation of its bank debt, so that it takes a liquidity risk when countries on the gold exchange standard ask for the payment of their claims in gold. In this case, it would be obliged to suspend convertibility, bringing about a fall in its exchange rate. Therefore it appears that countries that are on the gold exchange standard face an exchange risk.

The monetary approach to the balance of payments, developed later by monetar­ist authors - Mundell (1968, 1971), Harry G.

In a fixed exchange rate regime, an increase in the demand for money gives rise to a decrease in the demand for goods, thereby inducing a decrease in imports and an increase in exports which clear the market for goods, finally resulting in a balance of payments surplus. Therefore, in order to clear the exchange market, the supply of money increases, also clearing the market for money. A symmetrically opposite result occurs in the case of a fall in the demand for money. Referring to Ricardo, the authors concluded that the choice concerning money causes the balance of payments surplus or deficit, that is, that the balance of payments is a monetary phenomenon. In the case of flexible exchange rates, an increase in the demand for money results in a rise in the exchange rate, which clears the exchange market and brings about a fall in price levels. Therefore, the real supply of money increases, clearing the market for money. A fall in the exchange rate and the real supply of money occurs when the demand for money decreases.

Even if, in itself, the monetary approach to the balance of payments does not imply a choice between fixed and exchange rate regimes, the authors adhered to Friedman’s arguments and favoured a flexible exchange rate. However, Rudiger Dornbusch (1976) called this conclusion into question by reintroducing the assets market and showing that the adjustment process in the exchange rate does not occur gradually. The level of the domestic interest rate is connected with the foreign rate according to the law of interest rate parity: a negative (positive) differential between domestic and foreign interest rates is hedged by an anticipated exchange rate appreciation (depreciation). Now, in the case of a domestic excess demand for money, the prices of goods decrease slowly, whereas the prices of assets decrease quickly. Then the interest rate rises, bringing about a rise in current and anticipated exchange rates. However, the positive differential between domestic and foreign interest rates must be compensated for by depreciation of the exchange rate. This means that the rise in the current exchange rate has to be higher than the rise in its anticipated equilibrium level. The exchange rate overshoots.

Jerome de Boyer des Roches and Rebeca Gomez Betancourt