Literature Review

Previous researchers have examined several variables that influence balance of payment in which they have different results. Duasa (2004) investigated the Malaysian balance of payment uses Keynesian and Monetary approaches from the 1^st quarter of 1974 to the 4^th quarter of 1995. She used the dynamic model of time series regression to analyse the influence of exchange rate, GDP, price level, money supply, and interest rate. Her finding showed that Keynesian approach is more appropriate in the Malaysian case.

Fleermuys (2005) employed Monetary approach to balance of payment in examining the case of Namibia during the period of 1993 to 2003 using Error Correction Model (ECM). He used some independent variables such as GDP, inflation, interest rate, and domestic credit. His research showed that monetary variables are not playing an overwhelming role to determine the balance of payment in Namibia. He also

concluded that the balance of payment phenomenon in Namibia is not a monetary phenomenon.

Adamu (2007) conducted a study to test the influence of GDP, inflation, interest rate, and domestic credit to balance of payment using Panel Generalised Method of Moments (GMM) estimation in the West African Monetary Zone (WAMZ) using Monetary approach during the period of 1974 to 2008. The research showed that according to both the within-country and cross-country effects suggests that the monetary approach is applicable in the West African Monetary Zone (WAMZ).

Ali, et.al (2008) analyzed the influence of political stability on balance of payment and the relative importance of political stability and economic freedom in balance of payment and exchange rate stability. His study focused on ten selected Asian countries of various income levels and tested the factor of political stability and economic freedom in the stability of balance of payment using a simple econometric model with various techniques. His findings showed that stable political stabilitywith visionary leadership leads to improve balance of payment.

Umer, et.al (2010) used Error Correction Model (ECM) to investigate the influence of GDP, inflation, interest rate and domestic credit to balance of payment in Pakistan during the period of 1980 to 2008 through Monetary approach. He found that Pakistan’s balance of Payment is not really a Monetary phenomenon.

Tijani (2014) conducted a study of empirical analysis of balance of payment adjustment mechanism in Nigeria through monetary approach during the period of 1970 to 2010. He used linear regression estimation to analyse the influence of exchange rate, inflation, balance of trade, domestic credit, and GDP to balance of payment. His findings showed that Monetary approach is more appropriate in the case of Nigeria.

Ismalia (2015) also examined the monetary phenomenon to balance of payment in Nigeria during the period of 1986 to 2013. He used Error Correction Model (ECM) estimation to analyse the influence of bank credit to private sector, exchange rate, inflation rate, interest rate, money supply and transparency of the economy to balance of payment. His result also showed that monetary approach is applicable in the case of Nigeria.

Brown and Bidemi (2015) investigated fiscal policy measures and balance of payment in Nigeria during the period of 1980 to 2012. He used some independent variables such as government expenditure, government tax revenue, and government debt. The data was analysed using Error Correction Model (ECM). The major findings

showed that in Nigeria, the success of fiscal policy in order to promote balance of payment depended over the level of public revenue available, the direction of public expenditure and its implementation.

This research focuses on six variables which are exchange rate, GDP, domestic credit, interest rate, and price which can be categorised as economic variables, and political stability and government’s consumption expenditure as control variables.

Previous researches have suggested that those variables have the ability to contribute in influencing balance of payment. Table 1 shows a summary of the findings.

Table 1.1. Summary of previous researchers’ findings.

Significant GDP Inflation Interest rate Domestic Credit Political Stability Fleermuys (2005) in

Significant Exchange Rate Trade Balance Transparency Money Supply Bank Credit to Private Sector

Significant Government Expenditure

Government Tax

Revenue Government Debt Price Level

Duasa (2004) Insignificant

Tijani (2014) Ismalia (2015) Duasa (2004) Tijani (2014)

Ismalia (2005) in short and long term

1.3. Organisation of Thesis

This thesis is structured as follows. Chapter 2 is the theoretical framework of both Keynesian approach and Monetary approach, including the relationship of each independent variable to dependent variable. Chapter 3 describes the methodology, including data analysis and model specification. Chapter 4 explores the background of research variables. Chapter 5 explains the research of estimation and the result of theoretical examination. Finally, Chapter 6 is conclusion and policy implication.

Chapter 2

Theoretical Framework

2.1. Balance of Payment and Its Components

Balance of payment is a systematic recording of international economic transactions between the citizen of a country and the citizen of another country within a certain period of time. The aim of balance of payment is to provide some information to government over the position of financial debt in economic relations with other countries as well as to assist governments in the shaping of monetary, fiscal, trade and international payment policies (Nopirin, 1999).

Fleermuys (2005, p.2) notes that the most important components of balance of payment are current accounts and capital and financial accounts. Current account is one of the components in the balance of payment that records export and import of goods and services, investment income, repayments and principal of foreign debt, as well as shipment balance and money transfer from and to other countries. Surplus in current accountindicates that a nation is a net lender to the rest of the world, in contrast to a current account deficit, which indicates that it is a net borrower. Current account surplus will increase a nation’s net assets by the amount of the surplus. While, capital account is a component on the balance of payment that records the value of capital inflow and outflow of a country such as foreign direct investment especially investments made by multinational companies, portfolio investments and other short-term investments, foreign loans provided by national private banks, grants from other country governments and from multilateral donor institutions such as IMF and world bank.

Debit transaction will record any capital transaction that cause an increase in a foreign country’s wealth is called as capital outflow. Then, any transaction leading to an increase in capital inflow will be recorded in credit transaction. A surplus on the capital account means that there are more investment funds flowing into the country than out of the country, or capital inflow greater than capital outflow.

Balance of payment also can be explained through the nation’s balance sheet of the Central Bank. According to Table 2.1, the central bank’s balance sheet is divided over two parts; asset and liabilities. High-powered money are central bank’s liabilities.

High-powered money consists of currency and bank reserves, while, net foreign asset and domestic credit are central bank’s asset. Net foreign asset is the total of foreign

exchange reserves, gold, and claims on the government or central bank, whereas domestic credit consists to the central bank’s holding of claims, government debt and loans bank of private sector (Dornbush, 1995, p.614).

Table 2.1. Nation’s balance sheet of central bank

Assets Liabilities Net foreign asset (NFA) High-powered money (H)

Domestic Credit (DC)

Source: Dornbush (1995)

Then, according to Table 2.1, the equation of a change in net foreign asset can be written as:

∆ ∆ ∆ ... (2.1) Where, ∆ is a change in net foreign asset, ∆ is a change in high-power money, and ∆ is a change in domestic credit. In words, equation (2.1) can be written that a change in net foreign asset is equal to a change in high-power money and a change in domestic credit. According to equation (2.1), Dornbush (1995, p.64) noted that ∆ is equal to the balance of payment.

2.2. Keynesian Approach and Monetary Approach to Balance of Payment

The idea of Keynesian approach is based on the macroeconomics theory of John Maynard Keynes (1883-1946). Keynesian theory does not believe that market mechanism automatically can work towards equilibrium point. Keynes argues that equilibrium point can be achieved by government intervention and he also argues that wage rate and price level are rigid and state is always beset with unemployment issues.

Keynesian approach is divided into several approaches, such as: elasticity approach and absorption approach. Both elasticity and absorption approach have some weaknesses, such as: those approaches can only be viewed as balance of payment theory in a world without capital flows.

2.2.1. Elasticity approach

Elasticity approach is developed by Robinson (1937) and emphasises changes in the price of goods and services as the main determinant of nation’s balance of payment (Daniels, 2005, p.274). A currency depreciation or appreciation will lead to

change the domestic currency price paid for import and the price received for exports, then leads to change in the import demanded quantity and export supplied quantity. The amount of a change in the quantity of import demanded and the quantity of export supplied is determined by elasticity of export supply and elasticity of import demand.

Furthermore, depreciation will lead to improve trade balance if the absolute sum export supply elasticity and import demand elasticity is greater than unity.

The impact of depreciation on domestic currency to improve trade balance takes a long time. It means that the effect of depreciation on domestic currency is not instantly followed by an increase in trade balance. The effect can be seen by J curve, in which J curve shows the differences of depreciation effect on the trade balance in the short run to the long run. The depreciation effect will show worse to trade balance in the short term, but will increase and show better to trade balance in the long term.

2.2.2. Absorption Approach

Absorption approach is developed by Alexander (1952) that emphasises the role of a nation’s expenditures or absorption and income. This approach assumes that price is constant and, therefore, economists view the absorption approach as a short-run approach to balance of payment (Daniels, 2005, p.292).

Daniels (2005, p.282) explained that absorption is a national’s total expenditures on the finals good and services. The nation’s absorption can be written as:

≡ ... (2.2) Where, is absorption, is real consumption expenditure, is real investment expenditure, is real government expenditure, and is the real expenditures of a nation on imported goods and service. On the other hand, real income of a nation is equivalent to the real expenditures on its output of final goods and services. Therefore, real income is equal to real consumption expenditure, real investment expenditure, real government expenditure, and real export in which can be written as;

≡ ... (2.3) Where, is real income and is real export. Furthermore, in absorption approach, current account balance is only representing the difference between foreign real expenditure on export and domestic real expenditure on import, or can be called as trade balance. The formula of trade balance can be written as:

... (2.4)

Where, is trade balance. Then, according to absorption approach trade balance is determined by the difference between its income and absorption, or it can be written as:

... (2.5) Or, it can be written as:

... (2.6) According to estimation (2.6), the trade balance will surplus if the nation’s income is greater than it absorption, and the trade balance will deficit if the nation’s income is less than it absorption. Then, if the nation’s income is equal to it absorption the trade balance is balanced. Table 2.2 shows the summary of main differences between elasticity approach and absorption approach.

Table 2.2. Summary of main differences between elasticity and absorption approaches

No Balance of Payment

Elasticity Approach Absorption Approach

1

Elasticity approach emphasises changes in the price of goods and service as the main determinant of nation’s balance of payment

Absorption approach emphasises the role of a nation’s expenditures or absorption and income

2 Elasticity approach assumes that price is

not constant Absorption approach assumes that

price is constant Source: Daniel (2005)

2.2.3. Monetary Approach

Monetary approach of balance of payment defines that balance of payment is the change in international reserve of a country. Monetary approach argues that balance of payment is a monetary phenomenon. It claims that money is the most important role in determining balance of payment. This approach is not refuting that the other important non-monetary factors such as productivity changes, tariff, government spending and taxation on the balance of payment. However, these factors should be linked by money market. Monetary approach also assumes that external disequilibrium is transitory and will revert back to the equilibrium point in the long run. In the monetary approach money market disequilibrium is an important factor causing balance of payment disequilibrium. If demand of money is greater than the supply of money, it will lead to the excess money demand. This condition can be met by inflow of money from overseas.

On the other hand, if the money supply is greater than the demand, the excess supply can be eliminated by outflowing the money to the other countries. Therefore, the

volatility in money market mechanism then will lead to change the number of international reserve and then leads to change the number of balance of payment.

The equation of balance of payment according to monetary approach can be derived from money supply, money demand, and money market equilibrium. This model was developed by Johnson (1976) in Tijani (2014) with the following equation as:

··· (2.7) , , ··· (2.8) ··· (2.9) Where:

= money supply = price level = international reserves = interest rate

= domestic credit = equilibrium stock of money = money demand

= level of real domestic income

Equation (2.7) shows that money supply is determined by the ability of international reserves and domestic credit level created by monetary reserves of a country. Then, equation (2.8) shows that money demand is influenced by the level of real domestic income, price level, and interest rate. While, equation (2.9) is the equilibrium in the money market. By combining equation (2.7), (2.8) and (2.9), commuting the variables in to percentages, and replacing international reserve variable as dependent variable, we can write the equation of international reserve as:

∆ ∆ , , ∆ ··· (2.10) Equation (2.10) is the basic monetary approach to balance of payment. Tijani (2014) explains:

It postulates that the balance of payments is the outcome of the divergence between the growth of the demand for money and the growth of domestic credit, with the monetary consequences of the balance of payments bringing the money market into equilibrium. An increase in domestic credit brings about an opposite and equivalent change in international reserves, given a stable demand function for money. The coefficient of ∆ is thus known as an offset coefficient. It shows the extent to which changes in domestic credit are

offset by changes in international reserves. The monetary approach predicts a value of minus unity for this coefficient in the reserve flow equation (p.71).

2.3. The Differences between Keynesian Approach and Monetary Approach to Balance of Payment

The fundamental philosophical differences between Keynesian and Monetary approaches can be explained by the equation (2.11). According to equation (2.11), money supply or money demand times with the speed of money volatility equal to price time output. The formula can be written as:

M.V=P.Y ………. (2.11) Where:

M = money supply or money demand V = the speed of money volatility P = price level

Y = output

According to equation 2.11, Keynesian approach focuses on the real sector, in which this condition is also basically referred as the aggregate demand (P times Y).

Meanwhile, monetary approach is focusing on the money supply or money demand (M).

In the monetary approach, the price and the volatility of money are fixed and hence M is corresponding with Y, which means that a change in M would be interpreted into a change in Y. Thus, in the equilibrium, the equation will be written as M=Md=Ms and Y=Yd=Ys.

Duasa (2004, p.3) wrote the major differences between Keynesian and Monetary approach as shown in Table 2.3 According to Table 2.3, the Keynesian approach analyses the balance of payment phenomenon through the trade balance.

Hence, it claims that the trade balance is the most important account on the balance of payment. Some variables such as exchange rate, GDP, domestic credit, interest rate and price will affect trade balance before it extends influence over the balance of payment.

Therefore, Keynesian approach argues that disequilibrium in the balance of payment is caused by disequilibrium of trade balance or real forces. On the other hand, Monetary approach analyses the balance of payment phenomenon through both trade balance and capital and financial account. Hence, it claims that international reserve is the most important account in the balance of payment, and therefore, disequilibrium in balance of payment is caused from disequilibrium in international reserve or money forces.

Table 2.3. The major differences between Keynesian Approach and Monetary Approach to balance of payment.

Source: Duasa (2004)

2.4. The Determinant of Balance of Payment

According to both Keynesian and Monetary approaches, there are some variables that influence balance of payments, such as; exchange rate, GDP, domestic credit, interest rate, and price level. Even though both approaches have similar variables, those variables have different influences on how they can affect balance of payment.

Table 2.4 shows the comparison of influences for each coefficient between Keynesian Approach and Monetary Approach to balance of payment.

No Differences

Keynesian Approach Monetary Approach

1

Analyze the balance of payment phenomenon only through trade balance

Analyse the balance of payment phenomenon through both trade balance and capital and

financial account

2 Trade balance is the most important account of the balance of payment

International reserve is the most important account of the balance of payment

3 Disequilibrium in the balance of payment is caused by

disequilibrium of real forces

Disequilibrium in the balance of payment is caused by

disequilibrium of money forces

Table 2.4. Relationship between Exchange Rate, GDP, Domestic Credit, Interest Rate, and Price to Balance of payment in Keynesian Approach and Monetary Approach

The Keynesian approach to balance of payment explains that depreciation in domestic currency will lead to an increase of output. An increase in output leads to an increase in import. This condition will lead to a decrease of trade balance and hence, a balance of payment decreases. Then, an increase in domestic income will lead to a negative way to balance of payment. The reason is because an increase in domestic income leads to an increase in imports and therefore the trade balance and the balance of payment decrease. As for domestic credit, an increase in domestic credit will lead to an increase in money supply. An increase in money supply leads to a decrease in interest rate, which will increase investment, then increases income. An increase in income leads to an increase in import. The impact of an increase in import leads to a decrease in trade balance. A decrease in trade balance leads to a decrease in balance of payment.

As for interest rate, an increase in domestic interest rate leads to a decrease in investment. A decrease in investment will lead to a decrease in aggregate demand. A decrease in aggregate demand leads to a decrease in domestic income, and then leads to a decrease in import. A decrease in import leads to an increase in trade balance, and hence will improve balance of payment. Price level has negative relationship to balance

Independent curency, X and demand of

Independent curency, X and demand of