A balance of payments deficit can only occur if the domestic monetary authority allows domestic credit to expand faster than demand for money holdings where domestic credit substitutes for international reserves in the backing of the money supply.
- Balance of payments accounting identity (X-Z)+K = ΔR = ΔM-DCC
- (X-Z) = current account, K = capital account, ΔR = change in the foreign reserves of the central bank, ΔM= new money (from abroad) and DCC= domestic credit creation
- M' = P.L(y,i) and M=R+D
- M' = money demand M= Money supply, D = domestic assets of the banking system (that contribute to money supply) R= foreign reserves of the central bank
- Arguments of money demand need to be predictable or independent of the money supply so use a series of assumptions around purchasing power parity and interest rate parity
- P=eP* and in growth rates P-dot=e-dot+P*-dot where P* is world prices
- Domestic and foreign securities are substitutes
- Perfect capital mobility ensures that i=I*+pi where pi = expected depreciation of the domestic currency)
- With exchange rates e constant (assumed = 1)
- y=y_0 (full unemployment
- In equilibrium R+D = P*.L(y_0, i*)
- Once the adjustment to world levels is complete and all the right-hand side variables are fixed it follows that if L(y_0, i*) is stable credit creation involving domestic assets (D) is offset by an equal and opposite decrease in reserves (R) until equilibrium is restored.
Two scenarios when a closed economy model is appropriate:
- Unified world economy employing a uniform currency or its close approximation fixed exchange rates pegs under the IMF from 1945 to 1971
- National currency to be linked to other currencies by a completely flexible exchange rates.