Establish Money Market Equilibrium
Predict Changes in the Euro–Dollar Exchange Rate
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The Monetary Approach to Balance of Payment

Following is a discussion regarding the assumptions and the general setup of the Monetary Approach to Balance of Payment (MBOP). You also compare the MBOP’s approach to the demand–supply model. In Economics, alternative theories explain the determination of a relevant variable.

Looking at the approach of competing theories to a variable such as the exchange rate, you can see how and why each theory provides a certain prediction. Comparing the predictions of different theories and identifying the common factors in the determination of a variable, such as the exchange rate, is important for the empirical verification of these theories.

The basic assumptions of MBOP

As in the case of the demand-supply model, the MBOP has its own assumptions:

  • No government intervention: The MBOP assumes flexible exchange rates. In other words, the currencies in question are traded in foreign exchange markets with minimal or no government intervention.

    The MBOP also provides insights into the credibility of currency pegs and the possibility of a currency crisis.

  • International investor behavior: The most important characteristic of the MBOP is its exclusive focus on the behavior of international investors. The MBOP considers an international investor who is trying to decide between securities denominated in two different currencies. Therefore, it is not surprising that the MBOP is also called the Asset Approach to Exchange Rate Determination.

  • Changes in real returns: The term monetary in the MBOP emphasizes the relevance of the changes in monetary policy and the resulting changes in real returns on securities denominated in different currencies. After investors observe these changes in real returns, they express their preference for a security, which leads to buying or selling certain currencies and, therefore, changes in the exchange rate.

What sets the MBOP apart

When comparing the assumptions of the MBOP to those of the demand–supply model, you notice that the MBOP focuses exclusively on investors’ decisions between two securities. The MBOP considers investment-related factors in exchange rate determination compared to the demand-supply model, which considers both investment- and trade-related factors. Since the interest rate is an international investment-related factor, both theories use this factor in explaining the changes in exchange rates.

In fact, investors in both theories compare the real interest rates in two countries. The difference between these theories regarding real interest rates lies whether the source of the change in the real interest rate is explicitly discussed. The demand–supply model doesn’t explicitly consider the source of the change in interest rates. It just assumes that the real interest rate in a country changes.

However, as the beginning of this chapter notes, the MBOP relates the changes in the money markets of countries to the changes in exchange rates. Because money markets determine the real interest rates of countries in the MBOP, this theory explicitly shows how the changes in the market markets of both countries affect these countries’ real interest rates and subsequently the exchange rate.

Therefore, you see that the MBOP consists of the combination of two models: the money market and the foreign exchange market. Basically, the changes in the money market lead to changes in real returns on securities denominated in different currencies. Then investors’ subsequent reaction to the changes in real returns leads to changes in the relevant exchange rate.

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