Monetary Approaches To The Balance Of Payments: Keynesian .

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WP/01l100IMF Working PaperThe Two Monetary Approaches to theBalance of Payments:Keynesian and lohnsonianJacques J. PolakINTERNATIONAL MONETARY FUND

2001 International Monetary FundWP/OlilOOIMF Working PaperResearch DepartmentThe Two Monetary Approaches to the Balance of Payments: Keynesian and JohnsonianPrepared by Jacques J. Polak'Authorized for distribution by Paul MassonAugust 2001AbstractThe views expressed in this Working Paper are those of the author(s) and do not necessarilyrepresent those of the IMF or nvIF policy. Working Papers describe research in progress by theauthor(s) and are published to elicit comments and to further debate.This paper emphasizes the distinction between two 'monetary approaches to the balance ofpayments', one developed in the IMF, the other under the leadership of Harry Johnson inChicago. The IMF approach is presented as an evolutionary development of the Kahn/Keynesmultiplier model in an open economy. Johnson's approach is anti-Keynesian and selfproclaimed revolutionary. It posits the 'essentially monetary character' of the balance ofpayments. The IMF model tests satisfactorily as an explanation of income and imports overtime. The long-run equilibrium approach of the Chicago model precludes statistical testing, andits short-run tests prove statistically meaningless.JEL Classification Numbers:B-22, B-31, C-51, E-12, E-51, F-40Keywords: Monetary approach to the balance of payments; monetarism; IMFAuthor's E-Mail Address: [email protected] author was the Director of the Research Department ofthe IMF from 1958 to 1979. Thispaper was prepared for a conference on "The Open Economy Model: Past, Present, and Future"at the Ben Gurion University in Beersheba and the Bar Ilan University in Tel Aviv, Israel,June 18-21,2001.I

- 2-ContentsPageI. Introduction . 3II. The Evolutionary Version of the Monetary Approach . 5A. The Multiplicand . 5B. The Marginal Propensity to Spend . 8C. The Multiplier Process over Time . 9III. Johnson's Monetary Approach to the Balance of Payments . 11IV. Empirical Evidence . 17A. Testing the Keynesian Version . 17B. Testing the Johnsonian Version . 17V. Conclusions . 20Text Boxes1.The Fund Model in Its Simplest Form . 62.Expansion of the Fund Model to Incorporate a Gradual Adjustment of Moneyto Its Desired Level as a Function of Income . 113.The Johnsonian Model in Its Simplest (Long-Run Equilibrium) Form . 14References . 22

-3-I.INTRODUCTIONIn the 1950s and 60s, a number of new approaches were developed with the aim ofunderstanding better the sequences of economic events that could lead countries intobalance of payments problems and the policy measures that could prevent or correct suchproblems. Two places in particular where these intellectual activities flourished were theResearch Department of the International Monetary Fund and the Department ofEconomics of the University of Chicago. The London School of Economics shouldprobably be mentioned in the same breath, in as much as Harry G. Johnson, with whosename these activities are inexorably linked, taught the new gospel in both places as acommuting professor.By the middle of the 1970s, a considerable body of new balance-of-payments theoryand statistical verification had been built up in both Washington and Chicago, and eachdecided that the time had come for a book that would bring together the results of theirrespective research activities. The two books appeared almost simultaneously, under theidentical title "The Monetary Approach to the Balance of Payments" (Frenkel and Johnson,(eds) 1976; Rhomberg and Heller (eds), 1977). The preface to the Chicago book mentions"recent research of the International Monetary Fund" en passant as a welcome indication ofserious research on the same general range of problems taking place outside Chicago andthe LSE-although Johnson had shed a rather different (and no doubt audience-pleasing)light on the origin of the Chicago monetary approach in a 1971 lecture in Amsterdam:"While the emergence of this new approach has been very largely the work of my colleagueR.A. Mundell and our students at the University of Chicago, . 1 believe myselLthat itsintellectual lineage can be traced back, via Mundell's period of service in the researchdepartment of the International Monetary Fund under J.J. Polak, to the 1930s work onmonetary equilibrium of the Dutch economist J.G. Koopmans and the subsequentdevelopment by M.W. Holtrop and the Netherlands Bank of its practical expression in theBank's model of monetary analysis." (Johnson 1972a, pp. 84/5.) The preface to the Fundbook concludes with a discussion of similarities and differences "between the earlier Fundwork and the approach developed in the academic literature of the last decade" (p. 12). Theemphasis in this preface is clearly on the similarities, and the inclusion in the book of threepapers by Fund staff members with a Chicago or LSE background is seen as a joining of theroots of the two approaches? The basic view that the two approaches are little more thanvariations on the same theme is continued in Blejer et aI., with the academic literature beingcredited for its 'more refined and robust formulation' (Blejer et al 1995, p. 710).After the untimely death of Johnson in 1977, a few attempts were made to reconcilethe "Washington" and the "Chicago" versions of the monetary approach to the balance ofpayments. Helliwell (1978) trawled through a large number of writings by Johnson as wellThe gentle timing references in the passages cited from the two prefaces suggest thejockeying for intellectual primacy noted by Blejer et al (1995, p. 710).2

-4-as others of the Chicago school, finding many common sense observations about relationsbetween the real world of output and prices and the balance of payments, beyond the allpervasive mantra of that school which sees the balance of payments as a uniquely monetaryphenomenon. And he, together with Frenkel (Chicago) and Gylfason (IMF), produced anelegant synthesis of the prewar Keynesian with the Chicago monetary approach to thebalance of payments (Frenkel, Gylfason, and HelliweIl1980).Since then, the subject has received little critical comment. While this is no doubt inpart due to the fact that the role of monetary elements has been incorporated inconventional macroeconomic thinking (Blejer et a11995, p. 715), the lack of attention givento the monetary approach is, nevertheless, a pity. The prominence of that approach inacademic thinking for a number of decades, as well as its continued place in theconditionality of the lending policies of the IMF (Polak 1998), justify an effort to exploresomewhat further the origin of the two approaches, to compare their analytical structures,and to draw some conclusions on their validity.With these objectives in mind, this paper presents and appraises, in Section II, theevolution of the Fund's "monetary approach" from the Kahn-Keynes multiplier model ofthe 1930s, in which no monetary variables appear and which, of course, was all that theprofession had to offer in terms of macroeconomic models prior to the arrival ofTinbergen's empirically tested econometric models. This presentation acknowledges morefully than in Polak (1957) the gradual evolution of ideas on this subject in the literature ofthe 1930s and 40s. Section III then describes the nature and origin of the "monetaryapproach" as developed independently by Johnson and his followers. The result ofthiscomparative treatment is a picture of two monetary approaches that are distinct both in theirorigins and in their contents. In recognition of its historic linkages, I shall refer to the Fundapproach as the "Keynesian," or the "evolutionary," monetary approach. The "Johnsonian"monetary approach, by contrast, arose from the rejection of Keynesian economics; it was, inJohnson's own words, a "revolutionary" approach (Johnson 1971).To some extent, the differences between the two approaches may be attributable todifferent policy concerns that inspired the two seminal papers that gave rise to them. Thestated purpose of Polak (1957#, p. 15)3 was to "integrat[ e1monetary and credit factors inthe explanation of income or of payments developments." The analysis assumed a regimeof par values, which were intended to remain unchanged except in the event of a"fundamental disequilibrium." By contrast, Johnson (1958*) was a survey article on recentattempts to study the effect of devaluation on the trade balance, and devaluation remained3 Since many of the journal articles referred to in this paper have been reprinted in the twocompendia mentioned earlier, all page references are to these convenient sources. Papersmarked by an after the year of original publication were published or republished inFrenkel and Johnson (1976). Papers marked by a # after the year of original publicationwere published or republished in Rhomberg and Heller (1977).

-5-"the standard question" (Mussa 1976*, p. 187) on which the Chicago School woulddemonstrate its version of the monetary approach to the balance of payments. l That specificobjective allowed an approach that disregarded shocks originating in the balance ofpayments, an essential ingredient in the Polak model. At the same time, the view that in thepostwar context-in contrast to the 1930s-devaluation should be analyzed on theassumption of full employment of domestic factors of production was shared by economistsin the Fund who wrote on that subject. (See Polak (1948) and Alexander (1952). Johnson's1958 review paper took the latter paper, which had introduced the "absorption approach" tothe analysis of devaluation, as his starting point.)After the comparison of the two approaches, the paper presents a critical review ofthe attempts made by their proponents to provide empirical support for their theoreticalfindings. A final section summarizes the main conclusions.I.THE EVOLUTIONARY VERSION OF THE MONETARY ApPROACHThe 1957 Polak model, in its simplest form, is shown in Box 1. Our interest here isnot primarily in that model itself, but rather in its development from Kahn's 1931 mUltipliermodel through a process of "monetization." Three steps can be recognized in this process ofmonetization: (a) in the definition ofthe multiplicand-the autonomous expenditure stimulusthat sets off a cumulative process of economic expansion, (b) in the determination of themagnitude of the marginal propensity to spend, and (c) in the determination of the time lagbetween two successive rounds of spending.A. The MultiplicandKahn's presentation of the multiplier process runs in terms of an initial stimulus provided byadditional government expenditure on roads. But he makes it clear, first, that the mechanismhe analyzes is not confined to expenditure by the government or on any particular asset and,second, that it does assume monetary financing. The necessary funds are not supposed to beraised by taxation but by borrowing, and "the intelligent cooperation of the banking system"is taken for granted so that the money supply will be allowed to expand as needed (p. 174). Inthe Cambridge approach, "investment" as the autonomous domestic demand factor came tobe understood as the sum of private investment and the government deficit, with the latterennobled as "honorary investment" by Dennis Robertson (cited by Machlup 1943, p. 9).1 Johnson's posthumous paper on the subject still describes his "new approach to balance-ofpayments theory" in terms of "alternative approaches to devaluation theory" (Johnson 1977,pp.251-52)

-6-Box 1. The Fund Model in Its Simplest FormThe model consists of two behavior equations and two definitional equations:MO kY(1)(2)(3)(4)M mYLl.MO Ll.R Ll.DLl.R X-M K,whereMO money supplyY GNP;M imports:R reserves:D domestic credit of the banking system:X exports;K net capital inflow of the nonbanking sector:k the inverse of the velocity of circulation'; andm the marginal propensity to import,No explicit lags are shown in the behavior equations, but the model acquires its dynamic characterfrom the fact that while the flow variables in it (Y, M, X and K) are measured as totals over the unitperiod selected; the stock variables (MO, R and D) are measured as amounts outstanding at the endof the period. Thus, combining the four equations shown above:Ll.Y lIk[Ll.D X K-mY],(5)where the time series for the three exogenous variables Ll.D, X and K determine the development ofY, MO and M over time.As pointed out by Machlup (1943, p. 14) any statements about income-creatingdisbursements can also be expressed in terms of the monetary mechanisms involved, that isin terms of credit creation and dishoarding. But Machlup sticks to his multiplicand in nonmonetary terms. The Polak model, however, introduced the acquisition of domestic assetsby the banking system CLl.D in equation (3) below)