1 Chapter Three: Balance of Payments

Outline
 Definition and Purposes of Balance of Payments
 Balance of Payments Accounting Principle
 The Components of Balance of Payments
 Balance of Trade and Balance of Payments
 Balance of Payments Disequilibria
 Balance of Payments Surpluses and Deficits
 Financing Balance of Payments Deficit
 Exchange Rates and the Balance of Payments
 Approaches to Balance of Payments
 Elasticity Approach to Balance of Payments
 Absorption Approach to Balance of Payments
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 Monetary Approach to Balance of Payments
2 Definition and Purposes of Balance of Payments
 According to Kindle Berger, "The balance of payments of
a country is a systematic record of all economic
transactions between the residents of the reporting country
and residents of foreign countries during a given period of
time".
 It is a double entry system of record of all economic
transactions between the residents of the country and the rest
of the world carried out in a specific period of time
 when we say “a country’s balance of payments” we
are referring to the transactions of its citizens and government.

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3 Cont’d…
 The balance of payments is the most important statistical
statement for any country because of the following reasons:
 It reveals how many goods and services the country has
been exporting and importing,
 Whether the country has been borrowing from or
lending money to the rest of the world,
 Whether or not the monetary authorities (usually the
central bank) has added to or reduced its reserves.
Features of BOP
 It is a systematic record of all economic transactions
between one country and the rest of the world.

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4 Cont’d…
 It includes all transactions, visible as well as invisible.
 Visible items which include all types of physical goods
exported and imported.
 Invisible items which include all those services whose export
and import are not visible. e.g. transport services, medical
services etc.
 Capital transfers which are concerned with capital receipts
and capital payment.
 It relates to a period of time. Generally, it is an annual
statement.
 It adopts a double-entry book-keeping system. It has two sides:
credit side and debit side. Receipts are recorded on the credit side
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and payments on the debit side.
5 Cont’d…
Purposes of the Balance of Payments
1. BOP records all the transactions that create demand for and supply of
a currency.
2. Judge economic and financial status of a country in the short-term
3. BOP may confirm trend in economy’s international trade and
exchange rate of the currency. This may also indicate change or
reversal in the trend.
4. This may indicate policy shift of the monetary authority (RBI:
Reserve Bank of India) of the country.
5. BOP may confirm trend in economy’s international trade and
exchange rate of the currency. This may also indicate change or
reversal in the trend.

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6 Cont’d…
Balance of Payments Accounting Principle
 An important point about a country's balance of payments statistics is
that in an accounting sense it always balances.
 This is so because it is based upon double entry book keeping principle.
That is, transactions are classified as credits or debits.
 Credits: Represent inflows of funds (e.g., exports, foreign investments).
 Debits: Outflows of funds (e.g., imports, domestic investments abroad).
 Thus, the total amount of debits must equal to the total amount of credits.
 Credit transactions are those that involve the receipts of payments from
foreigners (a plus in the accounts); while the debit transactions are those that
involve the making of payments to foreigners (a minus in the accounts).

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7 Cont’d…
 Generally, Double-entry accounting assumes only that
the total of all entries on the left-hand side of the
statement matches the total of the entries on the right-
hand side.
 Example-1: Suppose ABC Plc. (an Ethiopian company
involved in coffee export) sells Br. 2 million worth of
coffee to a U.S. importer. Payment is made in a bill of
exchange. This increases the dollar holdings of Ethiopian
banks.
 Since export involves a transfer of Ethiopian assets
abroad for which payment is to be received, it is entered
in the Ethiopian BOPs as a credit transaction.
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8 Cont’d…
 ABC’s receipt of payment held in the US bank is classified a short-term capital
movement.
 This is because the financial claims of Ethiopia against the U.S. bank have
increased. The entries on the Ethiopian BOPs would appear as follows
Credit(+) debit(-)
Merchandise exports----------------- Birr 2 million
Short term capital out flow ----------------------------------birr 2 million
 Example-2: The US government donates a birr amounting 30 million for the
rehabilitation of civil war victim peoples in Ethiopia. Thus, the Ethiopian
government will, at the end of the year, record this transfer (called unilateral
transfer) as a credit. This value is again a claim against the US banks so that it will
be debited as a short –term capital out flow in the Ethiopian BoPs. We summarize it
as follows:
Credit (+ ) Debit ( - )
Unilateral Transfers................................ Br.30,000,000
Short-term Capital Outflow ..............................................Br. 30,000,000
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9 Cont’d…
The Components of a BOP statement
 The Balance of Payments (BOP) consists of Four main components: the
Current Account, the Capital Account, Financial Account and Errors
and Omissions. Each component tracks different types of economic
transactions between a country and the rest of the world.

1. Current Account
 The current account records the flow of goods, services, income, and
current transfers into and out of the country. It reflects a country's trade
balance and income flows.
 It includes the value of export and imports of both visible and invisible
goods. There can be either surplus or deficit in current account.
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10 Cont’d…
 The current account includes:- export & import of services,
interests, profits, dividends and unilateral receipts/payments from/to
abroad.
 BOP on current account refers to the inclusion of three balances
of namely – Merchandise balance, Services balance and Unilateral
Transfer balance
 Trade Balance
 Merchandise: exports - imports of goods
 Services: exports - imports of services
 Income Balance
 Net investment income: net income receipts from assets
 Net international compensation to employees: net compensation of
Employees
 Net Unilateral Transfers
 Gifts from foreign countries minus gifts to foreign countries
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11 Cont’d…
2. Capital Account Balance
 Capital transactions in the BoPs include all international purchases or sales of
assets.
 Asset - include items such as titles to real estate, corporation stocks and bonds,
government securities, and ordinarily commercial bank deposits.
Components of Capital Account
(i) Long Term Capital: Long-term capital flows include direct investments by
multinational firms, purchases or sales of bonds and common stocks, as well as
loans with maturities of over 1 year.
It may consist of the following categories:
Private Direct Investment. These investments are done by home country citizens
and firms in foreign countries (debit) and by foreigners in the home country (credit).
 This type of capital movement is induced by differences in profit rate between the
home country and the rest of the world.
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12 Cont’d…
Private Portfolio investment. These are done by home country
citizens and firms in foreign securities or stocks or bonds or
shares (debit) and by foreigners in home country’s assets (credit).

 Such an investment is induced by differences in interest rate,

dividends or rate of return on capital between the home country’s
financial assets and those of foreign nations.
Government Loans to Foreign Governments. These are loans
given by home country’s government (debit) and to the home
government by foreign governments (credit).
ii) Short-term capital: includes money coming into or going out
of asset forms such as Treasury bills, commercial paper, and bank
accounts, as well as the short-term financing of export sales.
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13 Cont’d…
3. The Reserve Account
 The summation of the current account balance, capital account balance
and the statistical discrepancy gives the official settlements balance.
 The balance on this account is important because it shows the money
available for adding to the country's official reserves or paying off the
country's official borrowing.
 Official reserves constitute the nation’s gold holdings, special drawing
rights, and official foreign currency holdings.
*Special Drawing Rights are international reserves created by the
IMF to supplement other international reserves and distributed to
member nations according to their quotas in the fund*
 Such reserves are held primarily to enable the central bank to purchase its
currency should it wish to prevent it depreciating.
 Any official settlements deficit has to be covered by the authorities drawing
on the reserves, or borrowing money from foreign central banks or the IMF
(recorded as a plus in the accounts).
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14 Cont’d…
 If, on the other hand, there is an official settlements surplus then this can
be reflected by the government increasing official reserves or repaying
debts to the IMF or other sources overseas (a minus since money leaves
the country).
4. Statistical Discrepancy or Net Errors and Omissions
 Given the huge statistical problems involved in compiling the balance of
payments statistics, there will usually be a statistical discrepancy.
 Thus, to ensure that the credits are equal to the debits, it is necessary to
incorporate a statistical discrepancy for any difference between the sum of
credits and debits.
What are the possible sources of error?
 It is impossible to keep track of all the transactions between domestic and
foreign residents;
 Many of the reported statistics are based on sampling estimates and, thus
do not reflect the actual transactions;
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15 Cont’d…
 The desire to avoid taxes means that some of the transactions in the
capital account are underreported. Some dishonest firms may
deliberately under-invoice their exports and over-invoice their imports to
artificially deflate their profits;
 There could be “leads and lags.” For example, the good has already
been imported, but the payment could be delayed.

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16 Cont’d…

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17 Cont’d…
Balance of Trade and Balance of Payments
 The Balance of Payment takes into account all the transaction with the rest of the
worlds
 The Balance of Trade takes into account all the trade transaction with the rest of the
worlds
Balance of Trade
 The difference between a country's imports and its exports. Balance of trade is the largest
component of a country's balance of payments.
 Debit items include imports, foreign aid, domestic spending abroad and domestic
investments abroad.
 Credit items include exports, foreign spending in the domestic economy and foreign
investments in the domestic economy.
 When exports are greater than imports than the BOT is favorable and if imports are
12/21/2024 greater than exports then it is unfavorable.
18 Cont’d…
Balance of Trade Vs Balance of Payments
Balance of Payment Balance of Trade
It is a broad term It is a narrow term.
It includes all transactions related to It includes only visible items
visible, invisible and capital transfers.
It is always balances itself. It can be favorable or unfavorable.
BOP = Current Account + Capital BOT = Net Earning on Export - Net
Account + or – Balancing item (Errors payment for imports.
and omissions)
Following are main are factors which Following are main factors which
affect BOP Conditions of foreign affect BOT: cost of production,
lenders, Economic policy of the Gov’t availability of raw materials,
and all the factors of BOP. Exchange rate and Prices of goods
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19 Balance of Payments Disequilibria
Balance of Payments Surpluses and Deficits
 Balance of Payments Disequilibrium refers to a situation where a
country's Balance of Payments (BOP) is not in equilibrium, meaning
that the total credits (inflows) do not equal the total debits (outflows).
Disequilibrium in the BOP can manifest as either a surplus or a deficit,
both of which can have significant economic implications for a country.
 A Surplus in the BOP occurs when Total Receipts exceeds Total
Payments. Thus,
BOP Surplus = CREDIT > DEBIT
 A Deficit in the BOP occurs when Total Payments exceeds Total
Receipts. Thus,
BOP Deficit= CREDIT < DEBIT
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20 Cont’d…
 There are a number of factors that may cause disequilibria in the balance
of payments. These factors can broadly be categorized into:
 Economic factors
 Political factors
 Sociological factors
I. Economic Factors
These are further categorized into:
 Development Disequilibrium,
 Cyclical Disequilibrium,
 Secular Disequilibrium, and
 Structural Disequilibrium.

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21 Cont’d…
1. Development Disequilibrium
 large scale development expenditures → increased purchasing power →
increased aggregate demand and prices → substantially large imports,
especially capital goods imports for development programs in the case of
developing countries leading to a deficit in the balance of payments.
2. Cyclical Disequilibrium
 These refer to cyclical fluctuations of the general business activities (recall
business cycles: peak, recession (depression is severe or prolonged or
protracted recession), trough, and recovery). For example, depression
always brings about a drastic shrinkage in world trade while prosperity
stimulates it.
 A country enjoying a boom will ordinarily experience a more rapid growth
in its imports than in its exports, while the opposite will be true of other
countries. But production in the other countries will be activated as a result
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3. Secular Disequilibrium
 The balance of payments disequilibria may persist for longer periods
due to secular trends (sustained increases) in the economy.
 For example, in a developed country, the disposable income is generally
very high where aggregate demand is also high. At the same time
production costs are very high due to higher wages, resulting in higher
prices. These two factors, high aggregate demand and higher domestic
prices result in imports being higher than exports.
4. Structural Disequilibrium
 Structural changes in the economy may also cause a balance of payments
disequilibria. Such structural changes include, for example, development
of alternative sources of supply, development of better substitutes,
exhaustion of productive resources or changes in transport routes and
costs.
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23 Cont’d…
II. Political Factors
 For example, if a country is plagued with political instability, this will
cause large capital outflows (because of security reasons) → inadequacy
of domestic investment and production. Furthermore, factors like war or
changes in the world trade routes could also produce similar difficulties.
III. Social Factors
 changes in tastes, preferences, and fashions may affect imports and exports
and thereby affect the balance of payments.

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Financing Balance of Payments Deficit
 Financing a Balance of Payments (BOP) Deficit involves finding
ways to cover the shortfall between a country's outflows (debts,
imports, or other payments) and its inflows (exports, investments,
remittances, etc.).
 Measures for correcting balance of payments disequilibria may
be grouped into two:
 Automatic Measures
 Deliberate Measures
Automatic Correction
• The theory of automatic correction is that if the market forces of
demand and supply are allowed to have free play, in course
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of time, equilibrium will automatically be restored.
25 Cont’d…
 For example, assume that there is a deficit in the balance of payments.
 This means the demand for foreign exchange exceeds its supply and
this results in an increase in the exchange rate (price) and a fall in the
external value of the domestic currency.
 An increase in the exchange rate (or a fall in the external value of the
domestic currency) will make exports of the country cheaper and
imports dearer than before.
 Consequently, the increase in exports and the fall in imports restore the
balance of payments equilibrium.
 Under the fixed exchange rate system, balance of payment disequilibria
may be corrected by adjustments in a) price, b) interest rate, c)
income, and d) capital flows.

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26 Cont’d…
 Price Adjustments: Under the gold standard, for example,
there had to be a gold outflow from a deficit country to a
surplus country.
 This results in a fall in money supply in the deficit country and
an increase in money supply in the surplus country leading to a
rise in price in the surplus country.
 A rise in prices in the surplus country encourage imports and
discourage exports, leading to restoration of balance of
payments equilibrium in due course.
 Interest Rate Adjustment: A monetary effect of BOP
surplus or deficit, besides the price effect, its impact on the
short term interest rates.
 For example: the contraction of money supply resulting from
the balance of payments deficit leads to a rise in interest rates.
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27 Cont’d…
 This will encourage investors in the deficit country where the interest rate
has risen to withdraw their funds from abroad and deposit in the home
country. Similarly, foreigners will be encouraged to send money to the
deficit country where the interest rate has risen.
 These changes will contribute to the restoration of BOP equilibrium
 Income Adjustments: Although the classical economists neglected the
effect of income adjustments, the Keynesian approach to BOP
demonstrated that under the fixed exchange rate system, changes in
income will help restore BOP equilibrium automatically.
 Capital Flows: As mentioned above, changes in interest rates will affect
capital flows between the deficit and the surplus nations which in turn
affects BOP equilibrium.

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28 Cont’d…
Deliberate measures
 These are widely employed today, and refer to correction of disequilibria through
deliberate/purposeful policy interventions.
 These include, for example, Monetary measures, Trade measures and Others
1. Monetary Measures
 Monetary Policy: The monetary policy is concerned with money supply
and credit in the economy. The Central Bank may expand or contract the
money supply in the economy through appropriate measures which will affect
the prices.
 Monetary contraction/expansion: For example, in the case of balance of
payments deficit, contraction of money supply is required. This is so because:
 Contraction of Money supply → reduction of purchasing power → reduction of
aggregate demand → reduction of domestic prices → reduction of demand for
imports. The fall in domestic prices → increase exports. Increased exports and
decreased imports will correct the BOP deficit.
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29 Cont’d…
 Fiscal Policy: Fiscal policy is government's policy on income and
expenditure. Government incurs development and non - development
expenditure. It gets income through taxation and non - tax sources.
Depending upon the situation governments expenditure may be
increased or decreased.
 Exchange Rate Depreciation: By reducing the value of the domestic
currency, government can correct the disequilibrium in the BoP in the
economy. Exchange rate depreciation reduces the value of home
currency in relation to foreign currency. As a result, import becomes
costlier and export become cheaper. It also leads to inflationary trends in
the country,
 Devaluation: devaluation is lowering the exchange value of the official
currency. When a country devalues its currency, exports becomes cheaper
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and imports become expensive which causes a reduction in the BOP deficit.
30 Cont’d…
 Deflation: Deflation is the reduction in the quantity of money to reduce
prices and incomes. In the domestic market, when the currency is
deflated, there is a decrease in the income of the people. This puts curb
on consumption and government can increase exports and earn more
foreign exchange.
 Exchange Control: All exporters are directed by the monetary authority
to surrender their foreign exchange earnings, and the total available
foreign exchange is rationed among the licensed importers. The license-
holder can import any good but amount if fixed by monetary authority.
2. Trade measures
 Include export promotion measures (measures that facilitate, for
example, horizontal diversification and vertical diversification) and
measures to reduce imports.
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31 Cont’d…
 Export Promotion: To control export promotions the country may adopt
measures to stimulate exports like:
 export duties may be reduced to boost exports
 cash assistance, subsidies can be given to exporters to increase
exports
 goods meant for exports can be exempted from all types of
taxes.
 Import Substitutes: Steps may be taken to encourage the production of
import substitutes. This will save foreign exchange in the short run by
replacing the use of imports by these import substitutes.

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32 Cont’d…
 Import Control: Import may be kept in check through the adoption of a wide
variety of measures like quotas and tariffs. Under the quota system, the
government fixes the maximum quantity of goods and services that can be
imported during a particular time period.
 Quotas – Under the quota system, the government may fix
and permit the maximum quantity or value of a commodity to be
imported during a given period. By restricting imports through the
quota system, the deficit is reduced and the balance of payments
position is improved.
 Tariffs – Tariffs are duties (taxes) imposed on imports. When tariffs
are imposed, the prices of imports would increase to the extent of
tariff. The increased prices will reduced the demand for imported
goods and at the same time induce domestic producers to produce
more of import substitutes
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33 Cont’d…
Other measures include:
• Foreign loans,
• Incentives for foreign investment,
• Tourism development,
• Incentives for foreign remittances, and

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34 Cont’d…
Approaches to Balance of Payments
 The basic question here is: how does the change in exchange rates impact
on the balance of payments?
• There are three approaches to address this question:
1. The Elasticity Approach
2. The Absorption Approach, and
3. The Monetary Approach

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35 Cont’d…
Elasticity Approach to Balance of Payments
 This approach provides an analysis of what happens to the current
account balance when a country devalues its currency.
 The analysis was pioneered by Alfred Marshall, Abba Lerner and latter
extended by Joan Robinson (1973) and Fritz Machlup (1955).
 It should be noted that the elasticity approach to the balance of payments
is based on partial equilibrium analysis, which assumes that income and
prices of other commodities are kept constant.
 For discussions in consecutive sections exchange rate is defined as
domestic currency per unit of foreign currency and hence
devaluation/depreciation is given by a rise in exchange rate.

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36 Cont’d…
 Furthermore, the approach deals with only the current account and ignores
the capital account of the balance of payments.

 The model makes some simplifying assumption, i.e., it focuses on demand

conditions and assumes that the supply elasticities for the domestic
export good and foreign import good are perfectly elastic, so that
changes in demand volumes have no effect on prices.
 In effect, these assumption mean that domestic and foreign prices are
fixed so that changes in relative prices are caused by changes in the
nominal exchange rate.
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37 Cont’d…
Given these assumptions, when a country devalues its currency,
the domestic prices of its imports are raised and the foreign
prices of its exports are reduced. Thus, devaluation helps to
improve BOP deficit of a country by increasing its exports and
reducing its imports.
But the extent to which it will succeed depends on the country’s
price elasticities of domestic demand for imports and foreign
demand for exports.
This is what the Marshall-Lerner condition states: when the sum
of price elasticities of demand for exports and imports in
absolute terms is greater than unity, devaluation will improve
12/21/2024 the country’s balance of payments.
38 Cont’d…
Marshall-Lerner Condition as a Theoretical Basis for the Elasticity
Approach Assumptions:
 Perfectly price elastic demand curve for export of domestic goods
and supply curve for import of foreign goods. Domestic and foreign
prices are fixed; changes in relative prices are caused by changes in
nominal exchange rate.
𝐶𝐴 = 𝑃. 𝑋𝑞 + 𝑆. 𝑃 ∗ 𝑀𝑞
Where CA – current account balance, P- export price, Xq- volume of
export, S – exchange rate, P* - Foreign price and Mq – the volume of
imports.
 𝑙𝑒𝑡 𝑝 & 𝑝 ∗ 𝑏𝑒 𝑢𝑛𝑖𝑡𝑦 𝑑𝑢𝑒 𝑡𝑜 𝑡ℎ𝑒 𝑎𝑏𝑜𝑣𝑒 𝑎𝑠𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛, 𝑤ℎ𝑖𝑐ℎ
𝑖𝑚𝑝𝑙𝑖𝑒𝑠 𝑡ℎ𝑎𝑡:
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39 Cont’d…
, CA  X  sM

CA X sM Ms CA X sM

    s  s  s  M
s s s s

M  EM s s M & M  EM s s M &

CA E X X CA
  EM  1   M E X  E M  1
Ms sM s

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40 Cont’d…
Therefore:
 Devaluation will improve the trade balance if the devaluing nation’s
demand elasticity for imports plus the foreign demand elasticity for the
nation’s exports > 1.
 If the sum of the demand elasticities < 1, devaluation will worsen the trade
balance.
 The trade balance will be neither helped nor hurt if the sum of the demand
elasticities equals 1.
 The condition may be stated in terms of the currency of either the nation
undergoing devaluation or its trading partner, but it cannot be expressed in
terms of both currencies simultaneously.
 Due to devaluation, two effects:
 Price effect: contributes to a worsening of the current account.
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 Volume effect: contributes to improving the current account
41 Cont’d…
Elasticity Approach in Practice
Empirical testing of the approach:
 the more elastic are the curves of export and import demand of
a country, the more is its balance-of-payments affected by
exchange rate changes of its currency
 demand elasticities are lower in the short run and higher in the
long run  Marshall-Lerner condition is more likely to hold in
the long run than in the short run
J – curve: current account will worsen immediately after a
devaluation, only in the longer run can we count on its
improvement

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42 Cont’d…
, Trade
Ba lance

0
A Time

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43 Cont’d…
 Reasons for bad responsiveness of the size of exports and imports on
a change in exchange rate in the short run:
 time delay in reaction of consumers,
 time delay in reaction of producers and
 imperfect competition
Elasticity approach and inflation: devaluation is most likely to result in
an increase in inflation
weaknesses of the elasticity approach:
o Only takes into account the effect of exchange rate change on prices,
but neglects its effect on change in GDP and in expenditures
o Neglects the effects of exchange rate changes on inflation
o Completely neglects the influence of monetary factors on the balance-
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of-payments
44 Cont’d…
The Absorption Approach
 This approach considers the impact of devaluation on the spending behavior of the
domestic economy and the influence of domestic spending on the trade balance.
 The value of total domestic output (Y) equals the level of total spending, and Total
spending consists of consumption (C), investment (I), government expenditure (G)
and net exports (X-M)
That is: Y = C+I +G+ (X-M)
 The absorption approach then consolidates C+I+G in to a single term A, referred
to as absorption.(X-M) is designated as B.
 Total domestic output equals the sum of absorption and the level of net exports, or
Y= A + B
B = Y - A  NX = Y - A
 TB (B) equals the difference between total domestic output (Y) and the level of
absorption (A). If Y>A TB > 0, and vice versa.
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45 Cont’d…
CA = X - M = Y – A
dCA = dY – dA
 This approach predicts that, if currency devaluation is to
improve an economy’s trade balance, national output must rise
relative to absorption.
 This means that a country must increase its total output, reduce
its absorption, or do some combination of the two.

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46 Cont’d…
The Monetary Approach
 Monetary approach to balance of payment, as a theory came up as a criticism to
earlier theories of achieving balance of payments. The purpose of this approach
was to consider money supply as an important determinant in the balance of
payment, and to understand the role of monetary policy in the adjustment of prices
at the international level or the world prices.
Basic assumptions: a small country is modeled as-
I. There are stable money demand function {Md = kPY} ; Where Md – money
demand, P- domestic price, y- domestic real income and k- the parameter that
measures sensitivity of Md to change in nominal income.
II. Money supply is a function of a nation’s monetary base
M = m(MB) = m(DC + FXR) where: DC: domestic credit, and FXR: foreign
currency reserve
III. the purchasing power parity condition holds  P = SP*
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47 Cont’d…
 If DC is decreased, the money demand outgrows supply:
k(s)(P*)(y) > m(DC + FXR)
 Households and businesses would decrease their purchase of goods and
services from other countries. current account surplus might result.
 If the price of foreign goods, and/or real income increase, the money
demand outgrows the supply
k(s)(P*)(y) > m(DC + FXR)
 Households and businesses would decrease their purchase of goods and
services from other countries.
 A current account surplus might result.

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48 Cont’d…
What happens under a floating exchange rate arrangement?
If DC is increased:
 the money supply outgrows the demand(Ms>Md)
Households and businesses would increase their purchase of goods and
services from other countries.
The domestic currency might depreciate.
WHILE…
If DC is decreased,
the money demand outgrows the supply
Households and businesses would decrease their purchase of goods and
services from other countries.
 The domestic currency might appreciate
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49 Cont’d…
If the price of foreign goods, and/or real income increase, the money
demand outgrows the supply
 The domestic currency might appreciate.
If the price of foreign goods, and/or real income decrease, the money
supply outgrows the demand.
 The domestic currency might depreciate
Criticism of the monetary approach:
Assumes absolute PPP holds.
 It is difficult to translate into a multi-country setting

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