Balance of payment determination: the monetary approach

Project Abstract

The balance of payments (BOP) is a crucial indicator of a country's economic health, reflecting its transactions with the rest of the world. The monetary approach to BOP determination focuses on the role of money supply in influencing a country's balance of payments. This research delves into the theoretical framework and empirical evidence surrounding the monetary approach to BOP determination. The monetary approach posits that changes in a country's money supply can affect its balance of payments equilibrium through various channels. One key mechanism is the impact of money supply on exchange rates. An increase in the money supply can lead to inflation, which in turn depreciates the domestic currency, making imports more expensive and exports more competitive. This adjustment in exchange rates helps to rebalance the BOP by reducing the trade deficit. Additionally, the monetary approach considers the role of interest rates in influencing capital flows and the BOP. Higher interest rates attract foreign capital inflows, which can help finance a current account deficit. However, this influx of capital may also lead to currency appreciation, making exports more expensive and imports cheaper, thereby affecting the BOP. Empirical studies have provided mixed evidence regarding the effectiveness of the monetary approach to BOP determination. While some studies support the link between money supply, exchange rates, and the BOP, others find that other factors, such as income levels, trade policies, and external shocks, also play significant roles in shaping a country's BOP position. The research also explores the policy implications of the monetary approach to BOP determination. Central banks can use monetary policy tools, such as interest rate adjustments and open market operations, to influence money supply and, consequently, the BOP. By managing money supply growth and exchange rate movements, policymakers can aim to achieve a more sustainable balance in the BOP. In conclusion, the monetary approach to BOP determination provides valuable insights into the relationship between money supply, exchange rates, and the balance of payments. While this framework offers a useful perspective on how monetary factors can impact a country's BOP position, it is essential to consider the broader economic context and other influencing factors when analyzing and managing balance of payments issues.

Project Overview

<p> </p><div><p><strong>1.1. &nbsp; &nbsp;HISTORICAL BACKGROUND OF THE STUDY</strong></p><p>The monetary approach to balance of payments (MABP) has been a dominant view in the International Monetary Economics, particularly; the theory is believed to’ have a long historical background. Which can be traced back to the writings of the classical economists who conceived a system of integrated world capital market and mobility? It is linked to the origin of balance of payments theory in the work of David Hume, and more specifically, to this theory of price-specie-flow mechanism (Johnson, 1976). While criticizing the objective of mercantilism in accumulating precious metals, David Hume pointed out that the amount of money in a country would be adjusted automatically to the demand for it. In Hume’s analysis, the process in which this adjustment takes place is through surpluses and adjustment deficits in the balance of payments brought about by changes in relative national money price levels. However, while drawing heavily from Humes theory of balance of payments, and this analysis of price-specie­ flow mechanism, the monetary approach places emphasis’ on monetary considerations in the interpretation of external balance problems rather than on changes in relative national price levels (Dornhusch and Fischer, 1990, 764).</p><p>The balance of payments account in Nigeria since political independence has undergone periods of boom and doom at different stages. The period of boom has been short-lived and is essentially attributed to the unprecedented increase in the oil price of 1973 – 1974. Apart from this period, Nigeria has continued to experience serious problems In the balance of payments position and the problem became severe in the early 1980′ s. From an overall surplus of about N2A billion in 1980 in Nigeria’s balance of payments, the country recorded a persistent deficits of (N3 billion), (Nl.4billion) and (0.3billion) in 1981, 1982 and 1983 respectively.</p><p>The internal factors that are responsible for the adverse balance of payments position inNigeria include among other things, excessive demand for foreign products, heavy reliance base, political instability and structural rigidities in the domestic production process. The weaknesses, in the domestic macroeconomic policies have tended to the problem. Moreover, the trade and exchange rate policies pursued during the oil boom era of 1970s and early 1980s failed to generate the required incentives for earning or saving foreign exchange. Rather, they resulted in several macroeconomic distortions and entrenched import-oriented consumption and production patterns in Nigeria which widened the trade gap.</p><p>With respect to the monetary approach to balance of payment under a fixed exchange rate regime, this studies focused on the influence of changes or growth in determination of money demand as well as domestic component of money supply in changes or growth in external reserves.</p><p>The: results of these studies in most cases support the propositions of the monetary approach. For instance, Courechence and Youssefs (1967) study of the relative influence of imports and money supply on the demand foreign exchange reserves for a group of nine countries(Switzerland, Netherlands, Denmark, Sweden, Germany, Belgium, Italy, Japan and Australia) indicates that money supply is superior to the level of imports in determining the level of foreign reserves. Their empirical ‘results indicate that money supply and long-term interest rate are arguments in the demand function for individual country’s foreign exchanges reserves. From their study, Courchence and Youssef conclude that “the application of the concepts of monetary theory to the field of international payments can be very fruitful.</p><p>The basic concepts of the monetary approach can be found in the works of Frenkel and Johnson (1976), Musa (1974, 1976), Johnson (1958, 1972, 1976a, 1976b and 1977). Copppock (1978), Melvin (1984) and Uddin (1985). Other contributions to the development of the monetary approach to balance of payments (MABP) theory include. Mundell (1968), Dornbusch (1971), Tsiang (1977) and Bilson (1978). The central argument of the MABP is that external balance problems are essentially (but not exclusively) Monetary in nature. As such, the proponents of the monetary approach argue that the:</p><p><em>“Balance of payments problems in a monetary world should</em></p><p><em>be analysed by models that explicitly specify monetary behaviour</em></p><p><em>and integrate it with the real economy rather than by models</em></p><p><em>that concentrate on real relationships and real monetary behaviour as a residuance of real behaviour”.</em></p><p><strong>1.2 &nbsp; &nbsp; INTRODUCTION</strong></p><p>Monetary approach exerts its influence on the economy through changes in money supply and interest rates. These variables also tend. to effect the position of the balance of payments at any point in time. Monetary approach deals only with the ultimate effect and not with the channels through which this effect occurs. Thus monetary approach is essential for sensible discussion of the balance of payments and that the money demand function and money supply process should play a central role in the balance of payments analysis, particularly for the long-run.</p><p>The monetary approach to the balance of payments dates back to David Hume’s refutation by use of the analysis of the price-specie-flow mechanism of the mercantilist belief that a country could achieve a persistent external surplus by import-substitution and export promotion approach.</p><p>The reveal of the monetary approach was brought about through the growing reluctance of countries to resort to either-devaluation or appreciation of their domestic currencies to current external imbalance, together with the imposition of restraints on the ability of countries to use exchange controls and trade interventions respectively through the restoration of European currency convertibility in 1958 and successive common markets among ‘countries. The restoration of the monetary-theoretic aspects of the balance of payments and included in the work of Hahn (1959), Kemp (1970) and Khan and Argy (1971).</p><p>With the continuous application of monetary approach in Nigeria coupled with the other economic policies aimed at solving the imbalance in the international trading and payments position, Nigeria has not been able to achieve viability and precision in its external reserve position. Among these studies are Gray (1963) which examined the effects of credit creation for investment purposes on the balance of payment for Nigeria’s first- National Development Plan Period, Olofin et al 1986 which examined the effects of devaluation on the macro economy, Omobitan (1995), which concentrated on the study of the trends, issues and determinants of the balance of payments.</p><p><strong>1.3 &nbsp; &nbsp; STATEMENT OF THE PROBLEM</strong></p><p>‘The monetary approach to the balance of payments has been related to the asset market ‘approach. This analysis changes in the balance of payments position in terms of stock adjustments in the money market in which the supply and demand for money balances are eventually willingly held.</p><p>Since the global economic crisis of the 1980s, many developing countries like Nigeria has been grappling with numerous economic problems. Such problems include growing unemployment, unsustainable fiscal deficits, high inflationary pressures, mounting debt burden, adverse balance of payments, under-utilization of capacity and exchange rate misalignment. In Nigeria, the adverse balance of payments which could be attributed to a number of factor (both internal and external), reflect the deep-seated problems in the economy.</p><p>Amount the external factors contributing to the deterioration in the Nigeria’s balance of payments are the economic recession experimented by most industrialized countries following the oil price shocks of 1973/74 and 1972/80. The rapid increase in the price of crude oil during this period made these industrialized countries adopt various energy conserving policies as well as restrictive monetary and fiscal policy measures which all the culminated the global economic recession and consequently- resulted in the collapse of the world oil market in the early I 980s. Other external factors include-the decline in capital flows, deterioration in Nigeria’s terms of trade and rising (but floating) rate. interests in international capital and money markets, all of which worsened the country’s external debt burden,.</p><p>These internal and external factors are however not mutually exclusive. They are in most cases, interrelated and tend to reinforce one another. Most often, policies needed to maintain external balance conflict within the required to restore internal balance, thereby making the problem intractable. The huge external debt burden and the dwindling foreign exchange reserves confronting most development countries tend to constrain their efforts to respond adequately to balance of payment shocks.</p><p>The empirical test of the monetary approach to the balance of payment analysis on the Nigerian economy which is the subject matter of this study shall provide precise solution to the problem outline above.</p><p><strong>1.4 &nbsp; &nbsp; RESEARCH OBJECTIVES</strong></p><p>The broad objectives of this study is to examine the relevance and applicability of the monetary approach to balance of payments in Nigeria, with a view of determining the extent to which the approach can serve as a useful framework for analyzing the balance of payments problems in the country.</p><p>The specific objectives of this study are:</p><p>1. To test the propositions of the monetary approach to payments by way of analyzing the data from Nigeria.</p><p>2. To examine the impact of economic growth on the balance of payments’ position in Nigeria.</p><p>3. Determine the nature and stability of money demand function, and the relevance of other basic assumptions of the monetary approach to balance of payments determination in the Nigerian context.</p><p><strong>1.5 &nbsp; &nbsp; RESEARCH QUESTIONS</strong></p><p>1. Does monetary policy affect balance of payments in Nigeria?</p><p>2. What impact does economic growth has on the balance of payments’ position in Nigeria?</p><p>3. The determination of the nature and stability of money demand function have no effect on the balance of payments determination in the Nigerian context.</p><p><strong>1.6. &nbsp; &nbsp;RESEARCH· HYPOTHESIS</strong></p><p>Ho: &nbsp; &nbsp;That monetary policy does not affect balance of payments in Nigeria</p><p>Ha: &nbsp; &nbsp;That monetary policy affects balance of payments in Nigeria</p><p>Ho: &nbsp; &nbsp;That economic growth does not have any impact on the balance of payments’ position in Nigeria.</p><p>Ha: &nbsp; &nbsp;That economic growth has impact on the balance of payments’ position in Nigeria</p><p>Ho: &nbsp; &nbsp;The determination of the nature and stability of money demand function have no effect on the balance of payments determination in the Nigerian context.</p><p>Ha: &nbsp; &nbsp;The determination of the nature and stability of money demand function have a great effect on the balance of payments determination in the Nigerian context.</p><p><strong>1.7 &nbsp; &nbsp; MODEL SPECIFICATION</strong></p><p>GDP = F (ms, md, bop) under the hypothesis that</p><p>Ho = Bo = B1= B2=B3= 0</p><p>Ha <em>≠</em>Bo≠B1 B2≠B3≠0</p><p>From the above, the null hypothesis (Ho) states’ that the values of the estimated parameters are not significantly different from zero, while the alternative hypothesis (Ha) states that the values of the estimated parameters are significantly not equal to zero, which is our theoretical expectation.</p><p><strong>ECONOMETRIC MODELSPECIFATION</strong></p><p>This study will use a multi-regression analysis to investigate that:</p><p>GDP = Bo + B1MS + B2 BOP + B3MD + U</p><p>This win be regressed following a list wise regression in the following ways</p><p><strong>MODEL 1</strong></p><p>GDP=Bo+B1MS+U</p><p>Where GDP = Growth of the Gross Domestic Product</p><p>Bo = intercept or constant term of the relationship</p><p>Bl= coefficient of MS</p><p>The model is to test the single impact of rate of growth of money supply on Gross Domestic Product</p><p>Hypothesis of the Model</p><p>Ho &nbsp; &nbsp; = &nbsp; &nbsp; &nbsp; That monetary policy does not affect balance of payments in Nigeria</p><p>Ha &nbsp; &nbsp; = &nbsp; &nbsp; &nbsp; &nbsp;That monetary policy affects balance of payments in Nigeria</p><p><strong>MODEL2</strong></p><p>GDP =Bo + B1MS + B2 BOP + U</p><p>Where B2 &nbsp; = &nbsp; &nbsp; &nbsp; Coefficient of BOP</p><p>The model is to test the impact of money supply and balance of payments Gross Domestic Product</p><p>Hypothesis of the model</p><p>Ho &nbsp; &nbsp; = &nbsp; &nbsp; &nbsp; That economic growth does not have any impact on the balance of payment in Nigeria.</p><p>Ha &nbsp; &nbsp; = &nbsp; &nbsp; &nbsp; That economic growth have impact on the balance of payments’ &nbsp; &nbsp; position in Nigeria.</p><p><strong>MODEL 3</strong></p><p>GDP= Bo+BlMS+B2BOP+B3MD+U</p><p>Where B3 = coefficient of Md</p><p>The model is an improved fashion of (1 and 2) as it now involves money demand and money supply.</p><p>Hypothesis of the model</p><p>Ho = The determination of the nature and stability of money demand function have no effect on the balance of payments determination in the Nigerian context.</p><p>Ha = The determination of the nature and stability of money demand function have a great effect on the balance of payments determination in the Nigerian context.</p><p><strong>1.8. &nbsp; &nbsp;SIGNIFICANCE OF THE STUDY</strong></p><p>The need for this study arises from the inability of the Nigerian economy at experiencing a favourable balance of payment position for most parts of the period since independence. Fundamental surpluses are only recorded in 1974· and 1990 in Nigeria ‘s balance of payments when N3, 102.2 billion and N 18? 498.2 million overall balances are recorded respectively. For most of the other periods, surpluses have been insignificant and for only few periods, deficits have been the order.</p><p>The structural adjustment programmes embarked upon by most developing countries including Nigeria, since the 1980s device their basic analytical framework largely from the financial programming model of the International Monetary Fund (IMF).Tho</p></div><h3></h3><br> <br><p></p>