EXCHANGE RATE, COMPETITIVENESS AND BALANCE OF PAYMENT PERFORMANCE

Exchange Rate, Competitiveness and Balance of Payment Performance
U P Alawattage
Abstract
This paper examines the effectiveness of exchange rate policy of Sri Lanka in achieving external competitiveness since liberalization of the economy in 1977. The conventional two-country trade model that explains the traditional approach to Balance of Payment (BOP) was applied using quarterly data covering the period of 1978:1 to 2000:4. Results reveal that the Real Effective Exchange Rate(REER) does not have significant impact on improving the Trade Balance (TB) particularly in the short run implying a blurred J-Curve phenomenon. Even though the cointegration tests reveal that there is a long run relationship between TB and the REER it shows very marginal impact in improving TB in long run. (JEL F40, O24)

I. Introduction The exchange rate is the price of national currency in terms of foreign currency. The close linkage of the exchange rate to the general price levels of the economies produce an economy wide importance of policy making since it affects the real income and wealth of those economies. One of the major objectives of the exchange rate based stabilizations is to improve the Balance of Payment (BOP) performance through international competitiveness. Countries have been using this strategy for a considerable period of time producing varying results. The empirical observations reveal that some countries were successful in following the particular strategy while some countries producing disastrous results. Under these circumstances the obvious question that has to be answered is “ What are the reasons for producing such varying results?” The objective of this study is to analyze Sri Lanka’s exchange rate behavior, competitiveness and BOP performance. As per the framework given in Figure 1.1, the main policy objective is to improve the BOP performances through external competitiveness allowing the nominal exchange rate to depreciate. External competitiveness is generally measured using the behavior of the Real Exchange Rate (RER) in terms of bi-lateral trade and Real Effective Exchange Rate (REER) in multi-lateral trade. Although there are number of other criterion used to measure the external competitiveness, the real exchange rate is extensively used in literature. In calculating RER or REER different methodologies are adopted depending on the nature of the study. The oldest and commonly used criteria is Purchasing Power Parity (PPP) based real exchange rate formula, R = EP*/P where, E is nominal exchange rate, P* is foreign price level and P is
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Figure 1.1 - Conceptual Framework For Relationship Between Exchange Rate, Price level and BOP Performance
Exchange Rate Behavior Devaluation/Revaluation Appreciation/Depreciation Improvement/Deterioration of Competitiveness Balance of Payment Performance

Exchange Rate PassThrough on domestic Prices

domestic price level. The price ratio of tradable to non-tradable is another method, which generally measures the internal competitiveness (Hinkle and Montiel, 1999). In both methods domestic price level has substantial influence on RER. Increasing of domestic price level at a higher rate relative to foreign price levels directly affects the RER in terms of appreciation of domestic currency in real terms eroding the external competitiveness. Nominal devaluation in turn leads to increase in the domestic price level. As stated earlier, the main objective of the devaluation or depreciation is to gain external competitiveness and BOP improvement in an economy. Under this scenario the policy makers should face certain dilemma in terms of increasing price level and eroding competitiveness under a single policy variable if the pass-through of exchange rate is substantial. It is also apparent that the policy makers have to face certain trade-off between external competitiveness and increasing price level in formulating their policies. This scenario is more or less applicable to both developed and developing economies in policy making. II. Literature Review Mercantilism and balance of trade doctrine, which was in existence during the period between 1500-1800, is considered to be the oldest approach to the BOP. In a broader sense, Mercantilists believed that the wealth of merchants and power of nations could be increased by accumulation of species (precious metals such as gold and silver that one used as money in international transactions). As a result, they strictly advocated maintaining the surplus on Balance of Trade and commodity imports were considered to be undesirable due to resulting outflow of accumulated species. Hence, foreign trade was regulated by way of subsidizing exports and taxing imports. In this approach, financial flows between countries were not given a great prominence and trade flows were the main determinant of the analysis. (Pitchford, 1995) Through the price specie- flow and gold standard mechanism David Hume (1752) established an opposing view of mercantilists, elaborating the fact that any attempt to sustain the trade surplus would not be persistent in the absence of capital flows due to changes of money supply as a result of accumulation of species. In Hume’s exposition, general price levels in domestic economy and abroad is determined by quantity theory of money under the classical assumptions. (Ibid) If a country which is initially in equilibrium, experience an
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increase in supply of species (Gold) due to continuous trade surpluses, then the price level of that country tend to be driven up encouraging imports and discouraging exports worsening trade balance. As a result, corresponding outflow of species would continue until the price level return to its original level and thereby returning of trade balance back to zero. (Caves et al, 1999) In this sense, Hume’s explanation of BOP is a self-adjusting process, which demonstrate how the price mechanism can equilibrate the trade balance, current account and balance of payment under the classical assumptions. A fundamental pre-requisite for the self-adjustment mechanism is the flexibility of prices and it is in turn a close function of the flexibility of cost of production, notably of labor costs. The flexibility of production costs particularly labor costs had been rather high until the middle of the 19th century and as a result BOP adjustment process was automatic and occurred without major frictions when Hume postulated his mechanism. (Riechel, 1978) The Elasticity Approach is one of the traditional approaches that acquired substantial attention of the economic theorists and researchers who focused on the balance of payment literature during the past few decades. Even though a number of new BOP approaches has come to light subsequently, traditional elasticity approach still possesses the substantial popularity in the current empirical research especially in analyzing the trade performances in developing countries. The elasticity approach is considered to be a sub theory of the Keynesian approach to the balance of payment and focuses mainly on trade balance while capital movements are being considered as exogenous and play a minimum role in the BOP analysis. (Arize et al, 2000) The development of elasticity approach was accredited to Charles Bickerdike, John Robinson and Lloyd Metzler and subsequently the model has come to be known as Bickerdike, Robinson and metzler model even though this theory somewhat explains the absorption approach which would be dealt in a subsequent section. The particular model developed in terms of independent markets for exports and imports is considered to be a partial equilibrium in nature. (Dornbusch, 1988) The exchange rate is an important policy variable in the elasticity approach and deficits in a BOP require a devaluation of domestic currency against foreign currencies to eliminate the deficit. This approach stresses the relative price induced substitution of domestic demand away from foreign imported goods to the domestic goods and foreign demand towards the domestic exports through devaluation. Hence, the elasticity notion was typically set in a fixed exchange rate environment and also subsequently applied to the managed floating regimes by policy makers. The key question of the elasticity approach was whether exchange rate devaluation or depreciation would raise net exports and current account balance and thereby restore the BOP equilibrium? The answer generally rests on the elasticities of demand for both exports and imports. If both export and import elasticities are together greater than unity (Ex+EM>1), it was considered to be the sufficient and necessary condition for devaluation or depreciation to improve the trade balance. This notion is called Marshall-Lerner condition, (M/L Condition) which was named after Alfred Marshall and Abba Lerner who presented this view. (Krugman and Obstfeld, 1997) If the demand elasticities of both export and imports do not satisfy M/L condition, devaluation would increase current account deficit or reduce surplus. (Pitchford, 1995)

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However, the empirical results had shown mixed results with regards to holding of M/L condition and in 1940s a view known as Elasticity Pessimism arose suggesting that in most of the cases the actual trade elasticities were insufficient to hold M/L condition. It is generally observed that when the elasticities were measured in the short run, the M/L condition is unlikely to hold. However, there is abundant evidence that elasticities are higher in long- run and M/L condition is more likely to hold. (Caves, Frankel and Jones, 1999) See Krugman (1991:10) with respect to US Current account and Krugman and Obsfield(1997:485) with respect to the OECD countries. In recent studies, Bahmani-oskooee and Brooks (1999) found that M/L condition holds for a long run with respect to US bilateral trade elasticities with some of the major trading partners. In another study by Bahmani-oskoee (1998) with respect to less Developed Countries (LDCs) reveals that in most LDCs considered in his paper, the M/L condition was satisfied indicating that devaluation could improve their trade balances. Arize (1994) studied whether there is a long run relationship between REER and Trade Balance (TB) using data of nine Asian countries including Sri Lanka. The study revealed that except Sri Lanka and India there is a long run positive relationship between REER and TB confirming the ML condition of other seven countries. The data covered the period of 1973:1 to 1991:1. However, after 1977 there is a structural break in economic policies and therefore the results are not reliable in the Sri Lankan context.1/ The particular long run relationship between exchange rate devaluation/depreciation and trade/current account balance postulated in the Marshall-lerner condition was further analyzed in the popular J-Curve Hypothesis. The tendency of the elasticities to rise over time and its impact on the trade balance as a result of devaluations or depreciations of domestic currencies is observed by this phenomenon. The theoretical discussion of J-Curve hypothesis can be better discussed by the following equation. BOT = PX · QX – PM ·QM (2.1)

Where, BOT is the trade balance in the local currency, PX is the unit price of exports, QX is the volume of exports, PM is unit price of imports and QM is volume of imports. (Zhang, 1996) The J-Curve analysis considers two effects of changing in exchange rate on trade balance-“price effect” and “volume effect”. The price effect implies that devaluation or depreciation would cause imports to be more expensive and domestic exports to be cheaper for foreigners at least in short-run. Here the assumption is that the economy’s export and import contracts are mainly written in local currency and foreign currencies respectively. Since the volume of goods imported and exported might not be changed in short-run due to various reasons2/ and as a result, the trade balance may initially deteriorate. However, in a long –run, import and export volume would respond to the changes in the exchange rate dominating the volume effect eliminating the perverse effect generated through the price effect. In other words, the price effect is generally believed to dominate volume effect in the
1/ It is generally considered that the cointegration property is equivalent to stability of long run behavior and therefore, if there is a structural break there cannot be cointegration. 2/ Import and supply contracts, strng consumer habits, Lags in prductin and delivering of import orders and payments, inability of switching immediately from the intermediate imported goods in domestic manufacturing and supply rigidities of domestic export in short run are sum of the reasons for short run pervasive effect on trade balance after devaluation.

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short-run deteriorating the trade balance (Declining part of the J-Curve) while the volume effect takes over and reverses the perverse effect generated in the short run and trade balance improves (Rising Part of the J-Curve) if the M/L condition holds. This can be observed when the total effect is plotted on two-dimensional space with trade balance in Y-axis and time variable in the X-axis which together yield the J-curve. However, the empirical studies reveal mixed results with regards to validity of the Jcurve hypothesis. Gupta-Kapoor and Ramakrishnan (1999) conducted a study using a Vector Error Correction (VEC) model for the period of 1975:1 to 1996:4 with respect to Japanese data and concluded that the J-curve phenomenon holds for Japan and there is a long run equilibrium relationship between exchange rate and trade balance. Rosensweig and Koch (1988), Mahdavi and Sohrabian (1993) and Mead (1988) find evidence of delayed J-curve pattern in relation with US data. In contrast, Rose and Yellen (1989) with respect to G-7 countries and Rose (1990) for the sample of developing countries observed that J-curve phenomena do not hold for both the situations. When the elasticity approach and its extensions had reached a stalemate in the economic discussions, Sidney S. Alexander (1952) introduced a new approach to devaluation analysis. The particular approach to BOP analysis is called as Absorption Approach, the name introduced by Alexander himself when he presented this proposition. Here the term, absorption refers to the total domestic expenditure and BOP is considered to be the difference between the flow of aggregate income and expenditure of an economy. In his original article Alexander concentrates on trade balance as same as the elasticity approach neglecting the adjustments in the capital flows. (Reichel, 1978) The identity of absorption approach could be depicted using the equations below. Following Keynesian national income identity, Y = C + I + G + (X – M) A=C+I+G Substituting (2.3) in 2.2 and re-arranging them yields, Y–A=X–M (2.4) Where, A= total absorption, X= Exports, M= Imports, Y= total income, I= Private domestic investments and G=Govt. expenditure. The equation 2.2 can be calculated in both nominal and real terms since the identity holds both ways. (Arize et al, 2000) This set of equations says that if absorption is greater than income, the economy will experience trade deficit. This is obvious since the income is derived from production, so if absorption is greater than production the difference must be made up by net imports which in turn leads to trade deficit. To reduce the deficit, the expenditure–output gap must be reduced or eliminated through reduction of absorption, increase in output (income) or combination of both. Therefore, devaluation to be a success, adjustments are required in either or both of these two variables, increase in income (Output) and reduction in expenditure. One of the main criticisms is that the absorption approach does not contain the automaticity in the adjustment process and domestic policy measures would generally be required along with the exchange rate policy in order to achieve the desired changes of BOP. Hence, the devaluation should be accompanied with contractionary fiscal and monetary policies to improve the trade balance.
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One of the main criticisms against the conventional approaches was that most of those approaches were partial equilibrium in nature. In order to overcome this problem and other inherent weaknesses ie. as ignorance of the role of the capital account etc., a modern approach called Monetary Approach to the Balance of Payment (MABP) was presented, alternative to the traditional theories of BOP in 1960s and early 1970s. The traditional approaches exclusively concentrated on real variables and ignored the influence of the monetary variables on BOP adjustment mechanism. In order to address the above problems MABP possesses following fundamental principals. (Riechel, 1978) 1. The BOP has been considered essentially as monetary phenomenon and imbalances of BOP are rooted in the relationship between the demand and supply of money. 2. It considered the importance of both stable money supply process and money demand function. 3. It concentrates on long-run consequences of policy and parametric changes for behavior of the BOP. As stated in the first principal, if the system is disturbed by the excess supply of money creating disequilibria in the money market, then actual cash balances exceed the desired balances. This would cause BOP deficit as individuals adjust their excess money balances for foreign goods, services and capital assets. (Humphrey and Keleher, 1982) In a BOP surplus, process works the other way around. However, MABP does not differentiate among the partial balances such as trade balance, long term and short capital account etc., in the BOP account as in the traditional approaches. Hence, MABP relies on a comprehensive definition of BOP namely, as the sum of the items “below the line” which relates to balance of official settlement or official reserve transaction account. (ORT Account) (Riechel, 1978) Therefore, MABP is considered as a general equilibrium analysis. Any imbalance or change in the official settlement account is identical to change in the country’s international reserves. As a result, in most empirical analysis, monetary approach considers the changes in the reserve flow as a target variable. In this sense, BOP is considered as essentially a monetary phenomenon. Another premise of BOP to be considered as monetary phenomena is that MABP treats demand function for money as a stock and not as a flow as treated in conventional approach. This is the same reason that under monetary approach BOP is considered as self-adjusting. When the desired level of stock of money is reached, the inflow or outflow of funds ceased and as a result deficit and surplus of BOP is also eliminated. Hence, monetary approach postulates a direct relationship between BOP and money supply. (Humphrey and Keleher, 1982) Due to the self-adjustment mechanism, some writers suggested that MABP is the intellectual grandchild of the specie flow mechanism of David Hume. Self-correcting external balance and monetary flows are cornerstones to both the theories. However, there is a major difference in self-correcting process and in Humes’ specie flow mechanism adjustments in the BOP occurred through relative changes in the commodity prices and where as in the monetary approach it is done through the stable demand and supply of money as a stock. Hence, surplus or deficit in the BOP reflects stock disequilibria between the demand and supply of money. (Arize et al, 2000)
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The monetary approach, unlike traditional approach clearly delineates between monetary and real variables while asserting the fundamentality and superiority of monetary variables. The term superiority is defined in terms of ability of variables to act as initiators of disturbances and transmission channels in the system and real variables are generally considered as neither initiators nor transmission channels. (Ibid) Even though the MABP was initially designed in the regime of fixed exchange rate, the analysis was subsequently extended to other exchange rate regimes as well. The Monetary Approach to the exchange rate determination was the floating exchange rate version of the monetary approach. According to monetary approach, freely floating exchange rates maintain continuous equilibrium in the BOP. Since reserve changes are held at zero, monetary authority has direct control over money supply and as a result it becomes a policy variable. In the fixed exchange rate regime money supply becomes an endogenous variable since any change in the domestic component in the monetary base is a change in the international component (external reserves) if the reserves flows are not-sterilized. The monetary approach also takes an account of the intermediate regime of managed floating. “It has to be borne in mind, however, that a policy which fixes the exchange rate above its equilibrium value or one which through a “dirty float” keeps the exchange rate of the domestic currency undervalued will induce an adjustment process in the private sector very similar to those brought about by a devaluation. Therefore, if adopted correctly and interpreted carefully, the result of the analyses presented in this study will be relevant for wide range of exchange arrangements and policies.” (Riechel, 1978) Under the fixed exchange rate regime, the govt. (monetary authority) is obliged to buy and sell foreign exchange with its own currency to maintain the exchange rate at a fixed parity and as a result the adjustment occurs through the Official Reserve Transactions (ORT) account accumulating or de-cumulating the foreign exchange reserves. The result is the BOP deficit or surplus. In the case of floating exchange rate regime, an adjustment occurs through changes in exchange rate and not through the reserve flow or BOP. Finally, under the regime of managed floating, crawling peg or crawling band, adjustment occurs both through the foreign reserves (BOP) and exchange rate changes. (Humphrey and Keleher, 1982) Under this situation, the authorities intervene time to time in the foreign exchange market to control the fluctuations in the exchange rates and to keep the rate in the equilibrium level. Also they have to decide the proportionate amount of exchange rate pressure, originated through disequilibria in the money market, should be relieved through the exchange rate movement and through the reserve flows. In this case, both the variables will change and contribute to the restoration of monetary equilibrium. Although devaluation as a policy tool plays a prominent role in the traditional approaches of BOP. MABP consider that exchange rate does not provide an effective contribution towards correcting external imbalances. According to the MABP, under fixed exchange rate regime, external imbalances are viewed as self-correcting and therefore such policies are considered unnecessary and ineffective except in short run transitory effects. (Kreinin and Officer, 1978) Even in short run, the mechanism that has certain impact on BOP though devaluation depends neither on variations in relative prices nor on elasticities as predicted in the traditional approaches. “For the monetarists, devaluation operates through a totally

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different mechanism- stock demand for and supply of money. The only condition postulated by the monetary approach is that a reduction in real balances (caused by an increase in domestic-currency prices following devaluation) would produce a reduction in real expenditures, or absorption, out of a real income.” (Ibid) In this sense the Monetary approach could be reconciled with the absorption approach, up to a certain extent, than the elasticity approach in terms of assumption of full employment, more longer run view and general equilibrium in nature. It is generally considered that the elasticity approach represents the short run, absorption approach to the medium run and monetary approach deals with long run, on the ground that the asset portfolios take a longer time to adjust following a major dislocation. III. Model Specifications A. Traditional Trade Balance Equation The particular study takes standard trade model as a point of departure and many researchers (Rose and Yellen (1989), Rose (1991) Bahmani-Oskooee (1991), Shirvani and Wilbratte (1997)) have employed this model with certain variations in their respective studies. Standard two country trade model which is also extensively used in the traditional elasticity approach assumes that the demand for imports (Dm) depend upon the domestic income (Y) and the relative price of imported goods to the domestically produced goods (Pm) and both measured in home currency terms. Hence, the basic equation following Rose and Yellen (1989) would be, Dm = Dm (Y, Pm) and Dm* = Dm*(Y*, Pm*) (3.1) Where, Dm and Dm* are the quantity of imports by home and foreign country respectively and * sign represents the foreign component of the analogous relative price of imports (Pm*) and foreign income (Y*). The model assumes the perfect substitutability between imports and domestic goods. Also, the above equations represent the Marshallian demand function which predict income and relative price elasticities to be positive and negative in signs with respect to demand for imports. Supply of exportable in each country depends positively on relative price of exports and this proposition postulates a perfect competitive situation. Sx = Sx (Px) and Sx* = Sx*(Px*) (3.2)

Where, Sx and Sx* are the home country and foreign country supply of exports respectively. Px is the home country relative price of exportable, defined as ratio of the domestic currency price of exportable to the domestic price level (P). Px* is analogously defined as the foreign component in which Px* is the foreign currency price of exportable divided by Foreign price level, P*. The domestic relative price of imports depicted in the equation (1) could be further expressed as,

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Pm = E·Px*/P = (E·P*/P)·(Px*/P*) a q ·Px*

(3.3)

Where, E is the nominal exchange rate, defined as the domestic currency value of foreign exchange following direct method and q is the real exchange rate defined as q = E·P*/P following the PPP based real exchange rate. Thus, increase in value of E and q indicates a devaluation or depreciation of the domestic currency. Foreign country relative price of imports could be defined analogously as, Pm* = (Px/q) (3.4)

The quantities of transactions and relative prices of exports in equilibrium condition could be expressed as, Dm = Sx* and Dm* = Sx. (3.5)

The value of domestic country Balance of Trade (BOT) or Trade Balance (TB) in general, could be expressed as, TB = Px ·Dm* - q · Px*·Dm (3.6)

BOT in the above equation in real terms is generally depicted as value of net exports in domestic currency divided by domestic price level (P). The equations (1)-(4) along with the equilibrium condition in (5) could be solved for the levels of domestic imports and exports (Dm and Dm*) and the relative prices (Px and Px*) as a function of real exchange rate (q), domestic income (Y) and foreign income (Y*). Substituting these in to equation (6) and rewriting it, yields the following reduced form equation. TB = TB (q, Y, Y*) (3.7)

The above model expresses the trade balances as a function of real exchange rate and the levels of domestic and foreign income. Taking logs of both sides and using log linear approximation, the following econometric model of testable form is derived. ln(Bt) = β0 + β1ln(qt) + β2ln(Yt) + β3ln(Yt* )+ ut) (3.8) here, ln represents natural logarithm,β0 is the constant term and u is the white noise process to represent the unimportant omitted factors in the model. The expected signs of each variable are, β1>1, β2 < 1, β3 >1. The real exchange rate in the model is taken as Multilateral Real exchange Rate (MREER) or Real Effective Exchange Rate (REER) in which the methodology of calculations are discussed subsequently in this paper. The foreign country in the two-country trade model is considered as the Rest of the World (ROW), in which two of the variables in this study are defined as the trade weighted aggregate of price levels and GDPs of major trading partners.

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However, the above model does not take the monetary variables in to consideration. Therefore, in accommodating the monetary approach to the balance of payments and some of its variables, an auxiliary regression would be tested including domestic and foreign money supplies as adopted by Bahmani-Oskooee(1985) and Shirvani and Wilbratte (1997). B. Exchange Rate Pass-Through Equation As depicted in the conceptual model in the introduction, the impact of the real exchange rate on trade balance could be influenced negatively or positively with changes in the exchange rate and thereby passing-through those changes to domestic price level. This phenomenon is also directly related with the changes of exchange rate and its impact on the real exchange rate through the increasing of domestic price level based on the degree of pass through. The expected depreciation of real exchange rate and thereby external competitiveness is generally considered to be eroded by the pass-through of exchange rate to domestic price level. Therefore, it is worthwhile to estimate the degree of pass-through of exchange rate to domestic prices. The conventional and simpler model specification of testing Exchange Rate Pass-through (ERPT) has been derived through the basic Purchasing Power Parity (PPP) relationship as depicted in the following equations. P = E ·P* (3.9) This PPP relationship could be converted to the following testable form using log linear transformation. ln Pt = a0 + a1 ln(et) + a2 ln(pt*) (3.10)

Under flexible exchange rate regimes (Both in managed and fully floating) either exchange rate or foreign price level can adjust the domestic price level in order to maintain the PPP. Following Goldberg and Knetter (1996) the equation (10) could be further extended as follows to include other variables that can possibly affect the domestic price level. lnPt = α0 + δlnxt + γlnet + ψlnzt +εt (3.11) Where, all the variables are in natural logarithm and p is the local currency domestic price and it may be import, producer, and wholesale or consumer price depending on the study. The particular study uses both general price level (consumer price) and the wholesale price level in order to study the impact of inflation on the real exchange rate changes. X is the primary control variable for cost of price of exporter and it may be general (consumer) foreign price level, producer price level (foreign) or wholesale price level (foreign) depending on the study. The variable Z may include the demand shifters such as level of income, competing prices of imports and money supply etc., that also depends on the study. Finally, the passthrough coefficient is depicted by the γ sign and in isolating the particular coefficient, the degree of pass through could be estimated. C. Reserve-Flow Equation This study intends to employ the reserve flow equation in order to fully accommodate the monetary approach to the balance of payment as an exercise of model comparison depend-

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ing on the performance of the traditional trade model depicted in the equation (3.8). If the monetary variables included in the auxiliary regression have considerably significant impact on trade balance, it may pave the path to compare the monetary approach with the traditional elasticity approach. Under these circumstances the derivation of the standard reserve flow equation that would be employed in this exercise is as follows. (Kreinin and Officer (1978), Arize et al (2000), Das (2000)) The nominal demand for money is generally considered to a function of income (Y), nominal interest rate (i) and general price level (P). Md = f(Y,i,P) Real demand for money could be depicted as, Md/P = f(y,r) (3.13) (3.12)

Differentiation of equation 3.13 with respect to time and rearranging it yields the following equation for real money demand function.

∆md/md = εy ∆y/y + εr ∆r/r d d

(3.14)

Where, m = M /p which represent the demand real money balances. åy and år are the elasticities of money demand in respect to real income and real interest rates respectively. Equation 3.14 in nominal terms could be written as,

∆Md/Md = ∆P/P + εy ∆y/y + εr ∆r/r

(3.15)

When the monetary authority in an open economy handle the international reserves R, by way of buying or selling at pre-determined rate from the household and firm sector it affects the money supply through changes of the reserves and the domestic credit extended by the monetary authority. Therefore, the money supply could be described by the following equation. Ms = a(R + DC) (3.16) Or, Ms = aH s (3.17)

Where, M is the money supply, a, is the money multiplier, R is international reserves (international component), DC is the domestic credit by monetary authority.(domestic component of Monetary Base) and M=R+D. Eq. 3.16 and 3.17 in growth form could be written as,

∆Ms/Ms = ∆a/a + ∆R/(R+DC) + ∆DC/(R+DC) ∆Ms/Ms = ∆a/a + ∆R/H + ∆DC/H
Equivalently, Eq.3.19 could be written as,

(3.18) (3.19) (3.20) (3.21) (3.22)

∆Ms/Ms = ∆a/a + R/H(∆R/R) + DC/H(∆DC/DC) and rearranging it would yields, R/H(∆R/R) = ∆Ms/Ms -∆a/a - DC/H(∆DC/DC) and (∆R/R)R/H = ∆Ms/Ms -∆a/a - DC/H(∆DC/DC) The eq. 3.22 could be re-written as,

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ÄR/R = H/R( ÄMs/Ms -∆a/a) - DC/H(∆DC/DC)

(3.23)

Under the assumption of money market equilibrium Md = Ms and substituting 3.15 in 3 .23 yields the following equation.

∆R/R = H/R(∆P/P+εy∆y/y+εr ∆r/r -∆a/a)-DC/H(∆DC/DC)
Rearranging Eq. 3.24 results the following equation.

(3.24)

∆R/R(R/H)=∆P/P+εy∆y/y+εr∆r/r-∆a/a-DC/H(∆DC/DC)

(3.25)

Eq. 3.25 is re-formulated with inclusion of a constant term and an error term for the purpose of econometric estimation in the reduced form equation with log linear transformation. The growth formed eq. 3.24 is analogous to the following equation.

∆Rt/Ht = β0 + β1 ∆(lnPt)+ β2 ∆(lnYt)+ β3 ∆(lnrt)+ â4 ∆(lnat) + β5 ∆DCt/Ht + Ut

(3.26)

where, R is the country’s international reserves, H is the monetary base (R+DC), P is the price level, y is the real income, r is the real interest rate, a is the money multiplier, DC is the domestic component of the monetary base i.e. domestic credit. The coefficient of the DC is generally known as “offset coefficient” and it shows the degree of changes in international reserves of a country against the changes in the domestic component of the monetary base (ÄDC). The expected signs and magnitudes of the coefficients are as follows.

β1 = 1 β2>0 β30 indicates that keeping all other thing equal, an increase in real income leads to increase in international reserves as a result of increase demand for money. β3