TUTORIAL 4

THE MONETARY AND PORFOLIO BALANCE APPROACHES TO EXTERNAL BALANCE

1) In the monetary approach to the balance of payments and the exchange rate, if there is an
excess demand for money, the result is a balance-of-payments __________
deficit in a fixed
exchange rate situation and __________
depreciation of the country’s currency in a flexible exchange
rate situation.

2) In the monetary approach to the balance of payments, under flexible exchange rates, an
increase in the proportion of income that people in country A wish to hold as money would,
other things equal, lead to an __________
improvement in country A’s balance of payments and therefore
to __________
appreciation of A’s currency in the foreign exchange markets.

3) Suppose that, for a country, its money supply (Ms) is at the moment equal to its demand for
money (Md). Now suppose that the country’s central bank pumps new money into the
economy. The result of this central bank action, other things equal, is that there will be
__________
an excess supply of money under flexible exchange rates and a consequent __________
depreciation of the country’s
currency.

4) In the portfolio balance approach, which one of the following, other things equal, will cause
an increase in the demand for domestic bonds by home country citizens?

5) In the Dornbusch "overshooting" model, asset markets adjust __________

more rapidly to
disturbances than do goods markets, and therefore the exchange rate and the price level
__________
move proportionately to each other in the short run.

6) In the portfolio balance model, other things equal, an increase in home country wealth
because of a current account surplus __________________.
leads to an appreciation of the home currency.

4) In the portfolio balance approach, an increase in the domestic interest rate, other
things equal, will cause an increase in the demand for domestic bonds by home country
citizens. Higher interest rates on domestic bonds make them more attractive to investor,
leading to an increase in demand for those bonds.