11 MONEY AND THE OPEN

ECONOMY

Section 11 deals with two crucial and interrelated aspects of an economy such
as Britain's. First of all it is an open economy since its residents engage in
foreign trade and borrow and lend abroad. Second, it is a monetaryeconomy.
The vast majority of transactions between domestic residents and between
residents and foreigners involve the exchange of money for goods, services and
financial assets. These two aspects are closely related because the balance of
payments is a monetary phenomenon. As will be explained, a balance-of-
payments deficit (surplus) implies an outflow (inflow) of foreign currency
reserves and this has efTects on the domestic money supply. Alternatively,
looking at it from the monetary angle, disequilibrium between the demand for
and supply of money results in portfolio adjustment which afTects the demand
for domestic goods, services and financial assets as weil as their foreign
equivalents. Thus the balance of payments cannot be in equilibrium unless the
demand and supply of money is also in equilibrium.
Chapter 7 outlines the relationship between the balance of payments and the
exchange rate and then discusses the Keynesian analysis of the current account
of the balance of payments. Chapters 8 and 9 examine the demand for and the
supply of money and show how the determination of the money supply is
afTected by the openness of the economy. Chapters 10 and 11 are concerned
with open-economy models with international capital flows. Chapter 10 pre-
sents the Keynesian Mundell-Fleming model from which the modern
monetary approach to the balance of payments, examined in Chapter 11, took
ofT.