final term paper plz check it. and tell the errors

8/12/2019 Final Term Paper plz check it. and tell the errors.

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Department of Economics

4 LCWU

Chapter 1

Introduction

Balance of payment is the record of economic transaction of a country with the rest of

the world during a year. It mainly consists of three accounts; current account, capital

account and reserve account. Balance of payment keeps the complete record of a country

trade, net foreign asset, imports and exports of goods, financial transfer and financial

capital. Simply it summarizes international transaction for specific period, mainly a year.

The method of analyzing the balance of payments is called the monetary approach to the

balance of payment.

The monetary approach to balance of payment regards money as a stock, and argues that

money stock can be changed through international reserve flows. It states that a fixed

exchange rate system could work without having to resort to devaluation, provided a

country has a sound monetary policy; thus, devaluation will only occur as a result of a

failure of monetary policy (Umer, 2010). This argument stems from the fact that

disequilibrium in the balance of payments is a temporary situation that will be corrected if

the money market is in equilibrium (Plessis, 1998).

The monetary approach may be claimed to be compatible with absorption approach on the

proviso that the former stresses the need for equality in the demand for and supply of

money, while the latter stresses the need for equilibrium in the market for domestic output,

they differ however, on grounds that the monetary approach is a more general theory,

since it explains the overall balance of payments (including the capital account), whereas

the absorption approach is concerned mainly with explaining the current account

(Akpansung, 1998).


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Although the monetary approach has been commended for explaining the balance of

payments well, it has prompted criticism from other scholars as an approach that ignores

other parts of international trade in determining the balance of payments. The MABP has

been blamed for disregarding the fiscal and real factors that influence changes in the

balance of payments, whilst concentrating only on monetary factors (Umer., 2010)

Contrary to these views, it can be stated that the monetary approach does not ignore these

factors. Valinezhad (1992) contends that the MABP only asserts that the effect on the

balance of payments of a higher rate of economic growth should be analyzed with the

tools of monetary theory.An enormous number of studies have emerged throughout theyears testing the validity of the MABP empirically.

There is credible evidence that the MABP in fact applies to small open economies with

fixed exchange rates. Most parts of the empirical literature were based on the reserve-

flow equation, where a countrys international reserves, or the rates of change in reserves,

are regarded as the dependent variable. On the other hand, the independent variables vary

in the different studies. They can include domestic income, prices, the interest rate,

government expenditure, money multiplier, money stock, the exchange rate, and demand

for nominal and real money balances (Ume, 2010).

The monetary approach to balance of payment provoked sever criticism from some

economist that it only consider monetary phenomenon, ignoring other important factors of

international trade in formatting balance of payment. Though, the MABP approach has

been much-admired for the implications of balance of payment. It is also criticized for

neglecting errors transpire in balance of payment as well as responsible for disregarding tofiscal and real that manipulate changes in the balance of payments. Others are of the view

that it does not ignore other factors but mainly concentrate that balance of payment should

be analyzed and observed from monetary theory. (Valinezhad, 1992)

The main aim of this paper is to examine the monetary approach to the balance of

payments (MABP), which argues that the balance of payments is a monetary

phenomenon. Whereas the absorption and elasticitysapproaches concentrate on the


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current account balance, the MABP emphasizes the overall balance of payments

including the capital account (Coppin, 1994).

By employing the MABP, the paper intends to offer a basis for understanding the

relationship between monetary policy and balance of payments problems in Pakistan. The

research could also serve as a recommendation to monetary authorities in handling

disequilibrium in the balance of payments.

Objective of the Study

The main objectives of the study are:

What are the factors and causes that bring disequilibrium in the balance of paymentof Pakistan?

The monetary variables are responsible for creating disturbance of the balance ofpayment.

Whether excess of money supply has played a significant role in the disequilibriumof balance of payments.

Organization of study

This paper is divided into five sections, one consist of the introduction while section two

the literature review. The methodology is in section three. The conclusion and

recommendations was taken care of in section four.


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Chapter 2

Literature Review

The review of literature plays a significant role in identifying the backdrop of the study

being conducted. It also gives direction about the problem and eradicates the possibility of

needless repetition of the efforts. In addition, precious information on research skill is

obtained from the previous research description. The main purpose of this section is to

assess the related literature review.

Literature on the fundamental basis of the MABP in a country has been generated by

scholars such as Dornbusch, 1971, Frenkel, 1971, Johnson, 1972, Laffer, 1969, and

Mundell, 1968 & 1971).

Chacholidas, 1990 studied the relationship between countrys balance of payment andmoney supply as a monetary phenomenon through MABP approach. Further Stated that

disequilibrium in the money market is due to the deficit in the balance of payment. If

money supply exceeds money demand, then there will be deficit in the balance of

payment, if money demand exceeds money supply than surplus in the balance of payment.

Howard and Mamingi, 2002 emphasized that deficit in the balance of payment due to

fluctuation in general price level, as the real value of nominal assets. Further, they argued

that MABP specifies money supply identity, money demand identity and an equilibrium

condition. They showed positive relationship of money demand with prices and income,

while negative relationship of money demand and interest rate.

Dhliwayo, 1996 concluded that increase in the domestic credit will have an equal and

opposite change in the international reserve the co-efficient of change in domestic credit

has known as offset co-efficient, because it has inverse effect on international reserve.

Further, added that basic equation of MABP, the deficit in balance of payment mainlycomes due to the divergence of growth of domestic credit and money demand.


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However, Watson, 1990 investigated the model of Trinidad and Tobagos balance of

payments for the period 19651985 and examined that all other variables show reliable

results except dependent variable the change in international reserves that is against

MABP.

The monetary approach to the balance of payments IMF 1977, Johnson 1972 & Polak,

1957, which is a modern approach, considers the balance of payments from a broad

perspectives rather than taking it as the current account balance.

According to Salvatore, 1998 & Fleermuys, 2005 the monetary approach to the balance of

payments balance of payments is a monetary phenomenon. They further argued that the

monetary approach focuses. According to Salvatore, 1998 & Fleermuys, 2005, the

monetary approach to the balance of payments balance of payments is a monetary

phenomenon. They further argued that the monetary approach focuses on how the

demand and supply of money affect the balance of payments and the exchange rate. Their

argument is based on the view that since the exchange rate is the price of currency,

movement in this rate is basically a monetary phenomenon, and can be explained by

concentrating on the market for money.on how the demand and supply of money affect the

balance of payments and the exchange rate. Their argument is based on the view that since

the exchange rate is the price of currency, movement in this rate is basically a monetary

phenomenon, and can be explained by concentrating on the market for money.

Umer, 2010, in their paper which examines the money tarry approach to Pakistans

balance of payments for the period 1980-2008. Through the reserve flow equation, it tests

whether excess money supply played a significant role as a disturbance by using Co-

integration test and error correction modeling. The empirical results showed that monetary

variable does not play an overwhelming role in determining Pakistans balance of

payments. The results evidently showed that, although some variables suggested by the

monetary approach play significant roles, the balance of payments is not a purely

monetary phenomenon. Balance of payments disequilibrium can, therefore, not be

corrected only through monetary actions by the authorities.


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Chapter 3

Methodology

Model Specification

According to Koutsoyiannis, 1977 the first and most important step the econometrician

has to take in attempting the study of any relationship between variables is to express this

relationship in mathematical form that is to specify the model with which the economic

phenomenon will be explored empirically. The model aims to illustrate whether monetaryvariables are fundamental in determining the balance of payments of Pakistan. In order to

test this role, the study employs the standard model of the MABP. The equation and

expected signs of the coefficients are as follows:

L NFA t = 0 + 1L GDP t-1 + 2INF L t-1 - 3INT t-1 - 4LC t-1 + t

Where:

LNFA = log of Net foreign asset

LGDP = log of GDP

INF = rate of inflation

INT = interest rate

LDC = log of domestic credit

t = stochastic or error term

Estimation procedure

The ordinary least squares single equation technique is the estimation procedure chosen

for this study. It will be used for estimating the equations already specified. As a


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justification for this method, Maddala, 1977 identified that ordinary lest squares is more

robust against specification errors that many of simultaneous equation methods and also

that predictions from equation estimated by ordinary least squares often compare

favorably with those obtained from equations estimated by the simultaneous equation

method. Among other reasons is the simplicity of its computational procedure in

conjunction with optimal properties of the estimates obtained and these properties are

linearity, unbiased and minimum variance among a class of unbiased estimators.

For the results and estimation procedure, advanced statistical software E-Views are used.

The null hypothesis states that monetary variables put significant effect on the balance of

payment of Pakistan. The significance of results obtained from regression analysis is

checked from t-statistics at 5% confidence level. If t-ratios are equal to or greater than

two(2) in absolute than the estimator will be significant, if it is less than two (2) in

absolute than estimator will be in significant and null hypothesis will be rejected.

Sources of data

This study used Secondary data. The macroeconomic variables of interest (inflation and

interest rate, GDP Growth) were obtained from the World Bank development indicator,

and Bank of Ghana database.

Data Analysis Technique

Annual time-series data on the variables under study covering thirty year period (1980-

2010) are used in this study for estimation of functions. The study employs ordinary leastsquares in the estimation of the coefficients of the parameters. The strength of the

coefficients derived from ordinary least squares model was used to establish the

relationships between the dependent variable and the independent variables. Various tools

such as Durbin Watson were used to test for autocorrelations. Data obtained was analyzed

using statistical and econometric software such as E-views and Excel application software.


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Chapter 4

Conclusion

This study is conducted to examine the balance of payment of Pakistan through monetary

approach and tested whether this approach applies to Pakistans balance of payment

situation. The main objective is to find out that excess money supply can play an

important role in the disturbance of the balance of payments in Pakistan. The study also

identifies the role of excess money supply and its role on balance of payment interruption.

Moreover, the study also helped to analyze the relationship of monetary variables and

balance of payment. One of the main finding of this study is that Central bank requires

policies for sustainable balance of payments with stable exchange rate.

The study finds that monetary variables are not the only cause of deficit in the balance of

payment of Pakistan, but some other factors are also responsible for it like export which

mainly consists of raw materials, agriculture products, cotton and rice etc. The second

factor is that, the growth of industrial sector in Pakistan are very slow, which hardly fulfill

the domestic requirements. Third the domestic and foreign investments are also very low.

The study reveals that disequilibrium in the money market, emanating from monetary

variables such as domestic credit, interest rate, exchange rate and the price level translates

into balance of payments disequilibrium. Specifically, increased domestic credit and

interest rate deteriorates the balance of payments while nominal exchange rate

depreciation improves the balance of payments, all being in the contemporaneous sense.

Increase in the price level deteriorates the balance of payments not in the same period

however but with lags. Moreover, the negative effect of interest rate on the balance of

payments is reversed over time.


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Recommendations

The monetary authorities should also pay special attention to domestic credit creation

when controlling the countrys balance of payments. It is important that the country

achieves sufficient economic growth through money demand to correct the balance ofpayments deficit.

Further the study suggests that Pakistan should take steps of anti-inflation (control

inflation) increase the net foreign assets, improve the quality of their products which

should compete with the international market products, increase the local

production,(agriculture as well that of industrial sector), like textile, machinery, plants,

garments, and construction sectors etc. Fluctuation in the exchange rate needs to be

removed and a sustained exchange rate is required for minimizing the deficit in balance of

payment in economy.


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References

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25.

Bickerdike, J.F.O (1920), The Instability of Foreign Exchanges. The Economic Journal

Vol 30. PP118-122

Dhliwayo, R (1996), "The Balance of Payments as a Monetary Phenomenon: An

Econometric Study of Zimbabwe's Experience",African Economic ResearchConsortium,

Research Paper 46.

Engle, R.F and C.W.F Granger (1987). Co-integration and Error Correction:

Representation and Testing.Econometrical 55:251-76.

International Monetary Fund (1977). The Monetary Approach to the Balance of Payments.

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Johansen, S (1988), Statistical Analysis of Counteraction Vectors.Journal of Economic

Dynamics and Control. Vol 12. pp 231-254.

Johnson, H.G (1972). TheMonetary Approach to the Balance of Payments theory, in H.

Johnson (Ed), Further Essays in Monetary Economics, London: Allen and Unwin.


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Kallon, K.M (1994). An Econometric Analysis of Inflation in Sierra Leone. Journal of

African Economies, Vol.3, Issue 2, PP199-230.

Laursen, S. & L.A Metzler,(1950). Flexible Exchange Rates and the Theory of

Employment.Review of Economics and Statistics, Vol 32. PP 281-299.

Lerner, A.P (1944). The Economics of Control. New York. Macmillan.

Marshall, A (1923), Money, Credit and Commerce. London, Macmillan.

Metzler, L (1948). A Survey of Contemporary Economics, Vol I, Richard D. Irwin, INC,

Homewood, IL.

Mussa, M (1974), " Monetary Approach to Balance of Payments". Journal of Money,

Credit and Banking, Vol. 6 pp 333-352.

Polak, J.J (1957), "Monetary Analysis of Income Formation and Payments Problems",

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Robinson, J (1947). Essays in the Theory of Employment. Oxford, Basil Blackwell.

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