M.

Aslam Chaudhary and Ghulam Shabbir

Macroeconomic Impacts of Monetary
Variables on
Pakistans Foreign Sector
M. Aslam Chaudhary and hulam Shabbir
!
Abstract
This study examines the impact of monetary
variables on the balance of payments of Pakistan. Besides
exo!oneity of monetary variables is also tested. The
empirical "ndin!s of the study sho# that balance of
payments is a monetary phenomenon and monetary
policy could be useful in improvin! the forei!n sector. The
studies so far have not con"rmed this e$ect. The study
also sho#s that an increase in price level and real income
lead forei!n reserves to in%o#. &o#ever an increase in
the interest rate money multiplier and domestic credit
lead international reserves to out%o#. Partial sterilisation
#as evident in the short run. But in the lon! run it tends
to be e'ual to minus one indicatin! no sterili(ation e$ect
on the forei!n reserve movements. The central implication
derived from the study is that an increasin! !overnment
bud!et de"cit leads to excessive expansion in domestic
credit creation and as a result a loss of forei!n reserves.
The null hypothesis for exo!oneity of price level real
income interest rate and in%ation rate to forei!n reserves
is accepted. &o#ever the null hypothesis for the
exo!oneity of domestic credit is re)ected for the !eneral
model but accepted for the linear model. *t appears that
monetary policy is e$ective in Pakistan
I. Introduction
*
The authors are Professor at the University of the Punjab, Lahore and Lecturer at
Government College, Bhera, respectively The authors are than!ful to "r G # $rif for
valuable comments %hich helped to improve the study The vie%s e&pressed are entirely
those of the authors
+
,
The -ahore .ournal of /conomics 0ol.1 2o.3
Most underdeveloped economies face several
economic problems such as budget defcit, chronic balance
of payments defcit, debt servicing, low productivity and
domestic resource mobilisation (Chaudhary and Abe, 1999,
Navi, 19!" and #han, $iluees and #emal 19%&, #han
199' and #han 19!()* Moreover, they also face the
problem of slow growth of e+ports and increasing demand
for imports to accelerate their economic growth which
creates a balance of payments problem, that has several
impacts* ,hus, balances of payments defcit deserves
special attention (Mundell,19!")* ,here is hardly any
country in the world that does not rely to some degree for
its national well being on international trade and
payments* ,his veracity is mostly seen in the case of
developing countries, whose trade and payments
magnitudes are particularly large in relation to domestic
economic activity (#illic-, 19%1)* ,he management of
balance of payments is, thus, of great importance to the
economic growth of such countries and .a-istan in
particular* .a-istan/s balance of trade remains in defcit
since its birth
1
*
Conventionally, the theory of balance of payments
ad0ustment mechanism is viewed as a succession of
approaches1 the 2ume/s price specie 3ow mechanism, the
elasticity approach, the #eynesian Multiplier or income
approach, the absorption approach and the policy
approach that stresses internal and e+ternal balance*
2owever a new approach is developed, which centers on
the idea that the balance of payments is essentially a
monetary phenomenon* 4t is -nown as the monetary
approach to the balance of payments ad0ustment
mechanism* ,he essence of the approach is its consistent
insistence that the balance of payments is a monetary and
not a real phenomenon as postulated by the conventional
theories* ,he ma0or point of departure of this theory from
other theories is the recognition of the fact that
diseuilibria in the balance of payments of a country
involve the in3ow and out3ow of foreign e+change, caused
by money mar-et diseuilibrium*
'
(t is true for more than fifty years, out of fifty four
+
4
M. Aslam Chaudhary and Ghulam Shabbir
,he balance of payments is closely related with
di5erent aspects of the economic system because it
describes the transaction of all the residents of the country
with the rest of the world* ,hese connections are the basic
grounds for the emergence of various approaches to the
balance of payments analysis* ,he classical theory began
with 6avid 2ume/s price7specie73ow mechanism, of the
mercantilist belief that a country could achieve a
persistent balance of trade surplus by import7substituting
and e+port7promoting policies* According to price7specie7
3ow mechanism, a temporary rise or fall of the general
price level in the country is due to e+cessive or defcient
supply of money relative to demand* ,his relative price
level movement leading to a balance of trade defcit or
surplus alters the stoc- of money in the direction of
euilibrium*
,he 8lasticity approach associated with 9obinson,
(19"!) and chronologically the frst of :Non classical/ or
:#eynesian/ approaches to the balance of payments theory
and analysis involves the application of Marshallian partial
euilibrium analysis to the separate mar-ets for e+ports
and imports on the assumption that capital movements
are e+cluded so that an e+cess or defciency of the value
of e+ports in relation to the value of imports gives rise to a
balance of payments surplus or defcit as one aspect of
euilibrium* 4n the #eynesian multiplier approach,
2arberger (19;&) and <aursen and Met=ler (19;&)
simplifed the approach by assuming a two7good
international economy (e+portable and importable goods
only) and production of e+port goods at constant domestic
money cost* According to this an e+tra demand for
domestic output created by a successful devaluation will
be satisfed by re7employing some of the unemployed and
that, because part of it will be saved, the e+tra income
generated by increased employment will not increase
demand adeuately to wipe out the initial improvement in
the balance of payments*
4n the :Absorption Approach/ Ale+ander (19;>)
argues that devaluation will produce an in3ationary price
+
5
The -ahore .ournal of /conomics 0ol.1 2o.3
rise that will cancel out the initial relative price e5ect,
unless in3ation itself de3ates the aggregate demand for
goods through an income redistribution e5ect or through a
reduction in the real value of e+isting money balances* 4n
the :economic policy approach/ ,inbergen (19;>) and
Meade (19;1) analyse devaluation, not only as an
arbitrary policy change but also as one of the two
independent policy instruments (wage price 3e+ibility and
devaluation) reuired to achieve the two policy ob0ectives
of full employment (internal balance) and a balanced
balance of payments (e+ternal balance)* ,he implicit
assumption underlying these approaches is that balance of
payments diseuilibria are permanent*
A new approach, which describes that balance of
payments, is essentially a monetary phenomenon has
developed* 4t originated in the 19;&s, by .ola- (19;!) and
his associates at the 4M?, and developed in the 19'&s and
19!&s by Mundell (19'%) and @ohnson (19!>)* ,he ma0or
point of departure of the new approach is the recognition
of the fact that a country/s imbalance of payments defcit
(surplus) would ceteris paribus, e+perience a change in its
money stoc-* ,he main distinguishing feature of the new
approach to the payments problem is its focus upon the
monetary implications of balance of payments
diseuilibria* ,he balance of payments problems are
monetary problems in a monetary world economy is
basically the assertion of the proponents of the approach
(Musa, 19!')* ,he monetary approach assumes that the
demand for real money balances is a conventional function
for real income and interest rate and it is always stable*
,he goods and fnancial assets mar-ets are perfectly
mobile at the international level* ,he country for which the
balance of payments is to be analysed is small relative to
the world in the sense that it cannot a5ect world prices or
the interest rate* 9eal forces, independent of the monetary
factors determine real output* ,hese assumptions imply
that the domestic price level and interest rates are
determined e+ogenously* ,he demand for real money
balances is a conventional function of real income and the
interest rate and it is stable*

6omestic output level is
+
+
M. Aslam Chaudhary and Ghulam Shabbir
assumed to be determined e+ogenously*

6omestic
component of money supply is also e+ogenous* ,he goods
and fnancial mar-ets are perfectly mobile* ,he approach
is applicable to a small country* $esides, real forces
determine real output* Af course, most of these
assumptions may not be applicable to developing
countries* $ut with the liberalisation programmes and
introduction of B,A reforms, .a-istan/s economy is
liberalised and interference of the public sector has been
signifcantly minimised (Chaudhary >&&" and Chaudhary
and Ahmed >&&()*
Any diseuilibrium in the money mar-et is e+pected
to be ad0usted through changes in the international
reserve 3ows under the f+ed e+change rate system and
changes in e+change rate when the economy is operating
under the 3e+ible e+change rate regime*
>
,his proposition
was tested by the :reserve73ow euation/ (#reinin and
ACcer, 19!')* A reserve73ow euation is an euation in
which the dependent variable is either the level of the
country/s international reserves, the change in reserves or
the rate of change in reserves (Connolly and ,aylor 19!')*
,he e+planatory variables were interest rate, government
e+penditure, money multiplier, money stoc-, price inde+,
e+change rate, and demand for nominal and real money
balances and so on* Bithin this range, the e+planatory
variables may however vary from study to study* Dsing
this euation, Courchene (19!")E 6e Franwe (19!')E
$iluees (19%9) and Nwaobi (>&&") got negative results,
and Courchene and Gingh (19!')E 6onna (19!')E Cos and
Bilford (19!!)E Bildford and Hecher (19!9)E $hattia
(19%>)E Adedo-um (199!) and 2owaed and Mamingi
(>&&>) got positive results* Bhereas $ean (19!')E Connolly
and ,aylor (19!')E Fenberg (19!')E Aghevli and #han
(19!!)E Fuitan (19!')E Gohrab7ud7din (19%;) and Hecher
(19!') got mi+ed results*
)
*ee +ossain ,'-../, pp 00
+
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The -ahore .ournal of /conomics 0ol.1 2o.3
4n the case of .a-istan, studies carried out by
Gohrab7ud76in (19%;) and $iluees (19%9) showed that the
monetary approach to balance of payments is not valid for
.a-istan* ,he problem of these studies is that both studies
have not tested the basic assumption of the monetary
approach i*e* the e+ogoneity of money demand
determinants and domestic credit with respect to foreign
reserves* 4f the monetary approach to the balance of
payments assumptions regarding e+ogoneity are not
verifed, then the estimation procedure would be
inconsistent*
"
Moreover, $iluees/s study also su5ers from
uality of data* Ghe generated her own series of
representative data for present .a-istan for some
variables* 6ata for some variables may not e+ist before
19!1* ,hus, it was not actual data for the variable used for
estimation* $esides her period of study and its results are
hardly useful for the formulation of current polices* ,he
very reason that the present economic structure is more
liberal than that of the early periodE when the public sector
controlled over 9& percent of ban- deposits and f+ed
e+change rate was the rule for foreign sector and trade
(Chaudhary >&&")* .resently .a-istan/s economy is
liberalised to the e+tent that there is no f+ed e+change
rate, tari5 barriers have been reduced, trade is much
liberalised, the fnancial mar-et is moving towards the free
mar-et and the central ban- has much autonomy* 4n the
light of the above, there is a need for a fresh study, which
must be up to date, and not su5ering from the above cited
drawbac-s, so that it is useful for current policy
formulation*
II. Methodology
,he monetary approach to the balance of payments
relates the balance of payments directly to the demand for
and supply of money* 4n the closed economy analysis, the
main interest is focused on the a5ects of variations in the
nominal stoc- of money (monetary base), on interest rate,
output and domestic price level* 2owever, in a small open
economy, the money supply can no longer be considered
1
2or detail see3 4ame, # 4ohannes ,'-.'/
+
7
M. Aslam Chaudhary and Ghulam Shabbir
an e+ogenous instrument because it can be made to
change through surpluses and defcits in the balance of
payments* ,herefore, it can be said that the monetary
approach to the balance of payments is concerned with
the relationship between the domestic component of
money stoc-, prices, output, interest rate and the balance
of payments*
4n general, an e+cess demand for goods, services
and fnancial assets creates diseuilibrium in the balance
of payments* Dnder the f+ed e+change rate system the
uantity of money is a -ey mechanism for attaining and
maintaining monetary euilibrium* ?or instance, with the
e+cess supply of money over demand, the residents must
ad0ust their portfolios by purchasing foreign goods and
assets in order to achieve monetary euilibrium* ?or this
purpose, residents can purchase reserves from the central
ban- to ma-e payments to foreigners, which decreases the
domestic money supply until euilibrium is achieved* 4n
this sense, the balance of payments is a monetary
phenomenon* ,he formal monetary model of the balance
of payments consists of the money demand function, a
money supply euation and an euilibrium condition*
,here will be a change in money demand and supply
due to variations in economic activities* Go it is necessary
to watch these changes for meaningful analysis* ,he money
demand shows the economy/s capacity to absorb the
increased money supply* ,he intertemporal stability of the
money demand function is crucial for monetary policy to
have predictable e5ects on the economic variables* ,hree
basic issues in specifying the money demand function are1
the defnition of money, the variables to be used in the
money demand function, the stability of money demand
function*
(
,he specifc features of underdeveloped
economies such as .a-istan may a5ect these variables
di5erently from the case of developed countries* 4n less
developed economies, the interest rate is included in the
money demand function, as an opportunity cost of holding
the money variable, which is one of the most controversial
5
*ee, $hmed, ,)666/
+
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The -ahore .ournal of /conomics 0ol.1 2o.3
issues* $ecause in such economies mar-et forces, due to
the e+istence of dual money, do not determine mar-et
interest rate (organised and unorganised)*

4n <6Cs where
the range of alternative assets is limited, substitution may
ta-e place between goods and money* ,herefore, it is more
appropriate to represent the opportunity cost by the
interest rate and the implicit return on goods, the rate of
in3ation*
;


,hus, demand for real money balances can be
written as1
M
d
" P # a y
b$
i
b%

b&
(1)
Bhere M
d
is the demand for nominal money
balancesE . is the domestic price levelE y is the level of
domestic real incomeE i is the domestic interest rateE and
is the rate of in3ation* ,he money supply is defned as
eualing the product of money multiplier and high7
powered money*
M
s
# 'm (>)
Bhere M
s
is the supply of moneyE # is the money
multiplier and m is the monetary base (volume of high7
powered money)* $y defnition the stoc- of high7powered
money or the liabilities of the monetary authorities (m) is
eual to the stoc- of international reserves (9) and domestic
assets (net of liabilities) holdings of the monetary authorities
(6C)* ,hus we may defne it as1
m # ( ) *C (")
.utting this in euation (>)*
M
s
# ' +()*C, (()
Bith the help of monetary euilibrium, we can derive
the international reserves 3ows euation* ,he money
mar-et euilibrium will be1
M
d
# M
s
(;)
7
2or detail see, 2ai8 Bil9uees, ,'-.-/
6
8
M. Aslam Chaudhary and Ghulam Shabbir
$y combining euation (1), (() and (;), ta-ing the
variables in percentage changes, foreign reserves as
dependent variable and adding intercept, we get the
following foreign reserve 3ows euation
'
*
+("m, g ( #
-
)
$
gP )
%
g y )
&
g i )
.
g

/
g ' )
0

+*C"m, )g *C ) u
(')
8uation (') represents the -ey relationship in the
monetary theory of the balance of payments* ,he
e+pected signs and e+pected magnitudes of the
parameters of euation (') are as follows,

1
I 1,
>
J &,
"
K &,
(
K &,
;
I
'
I 71
,he e+pected sign of
1
implies that an increase in
the rate of growth in price level (gp) improves the
international reserve position because of devaluation*
6evaluation is treated as a monetary phenomenon, since
devaluation raises the domestic price level leading to
reduction in domestic e+penditures on goods and services
via reduction in residents purchasing power* ,his leads to
increase in the production of e+portable goods* As a result,
the level of income and employment improves* An
increase in income and employment leads to increase in
nominal money demand over money supply* 4f domestic
credit is constant, the increased money demand generates
capital and foreign e+change reserves in3ows*
,he coeCcient
>
is the income elasticity of demand
for nominal money balances and, therefore is positive and
in the neighborhood of unity* 4n particular, a one percent
increase in income generates
>
percent increase in the
demand for money and conseuently reserves in3ows*
!
0
2or detail derivation of e9 0 see $ppendi&
:
This result may appear to be different %ith the absorption theory in %hich rising income
increases imports and generates reserve outflo%s +o%ever, the absorption theory is
concerned %ith the balance of trade rather than balance of payments ,;echer, '-:5/, pp
)-6
6
3
The -ahore .ournal of /conomics 0ol.1 2o.3
4ncrease in interest is associated with reserves out3ow in
this hypothesis* Ather things being the same, a given
increase in the interest rate would depress the demand for
money, creating an e+cess supply of money and
conseuently would result in reserves out3ows* 2ence, the
interest rate and changes in this rate are assumed to
re3ect similar movements in interest rates all over the
world*
%
2owever, if changes in .a-istan/s interest rate are
dominated by changes relative to the rest of the world, the
estimates of
"
are such as to be positive* i*e* increase in
.a-istan/s interest rate relative to the rest of the world
would attract capital and generate reserve in3ows and
vice7versa*
,he coeCcients of growth rates of money multiplier
and domestic credit should be negative ones (
;
I
'
I 7
1)* ,he coeCcient (
'
) on domestic assets (net) called the
o5set coeCcient and e+pected to have a value of minus
unity (Gohrab7ud76in, 19%;)* ,he o5set coeCcient
indicates the degree to which changes in the domestic
component of money supply are o5set by the changes in
international reserves ($hatia, 19%>)*
III. 12ogoneity test for Monetary 3heory
,he test used in this study is based on the wor- of
Fewe-e (19!%) and is summarised in Fewe-e (19!%)*
Consider the Lcomplete dynamics simultaneous euation
model C6G8MM*
4 +5, 6
t
) +5, 7
t
# (!)
(gg) (g1) (g-) (-1) (g1)
Bhere $ (<) and (<) are matrices of polynomials in
the lag operator which purports to be a complete
.
Under the current international monetary system in %hich the financial mar!ets have
become more integrated, the domestic and foreign interest rates move together
+amburger ,'-::/ argued that the domestic and foreign interest rates generally move
together and %hen they do, it is the domestic interest rate that determines the amount of
money held by the public
6
9
( ) X F X G Y t
t s t s s t s t
s s
= + +

=

' '
.
M. Aslam Chaudhary and Ghulam Shabbir
description of the interaction between L-M e+ogenous
variables (i*e* +
t
represents observations at time t on -
putative e+ogenous variables) and endogonous variables y
t
* Fewe-e argued that a testable implication of the
hypothesis that +
t
is e+ogenous* Gince +
t
is determined
outside the C6G8M, a proper specifcation of the
determinants of +
t
will not include any value of y
t
* 4n other
words, in the regression of +
t
on past +
t
and past y
t,*
i*e*

Bhere1
+
t
I 8+ogenous variables ( g p, g y, g i, g and g
dc)*
y
t
I 8ndogenous variables (g r)*
?s I CoeCcients of lagged e+ogenous variables +
t*
Fs I CoeCcients of lagged endogenous variables y
t*

t
I error term*
,here Le+ists a C6G8M with e+ogenous +
t
and
endogenous y
t
and no other variables, if and only if Fs I
& for all s > oM*

,he main purpose of the analysis is to test
the hypothesis of e+ogoneity of price level, real income,
interest rate, rate of in3ation and domestic credit with
respect to reserve 3ows* Dsing the Bald statistics we test
the null hypothesis that Fs I & for all s > &* Dnder the null
hypothesis both tests are asymptotically distributed as a
Chi7suare with degree of freedom eual to the number of
regressions*
IV. 1mpirical (esults
,he annual data is utilised from 4nternational
?inancial Gtatistics* All the series are stationary at level*
?or this purpose, Augmented 6ic-y7?uller (A6?) and
6
,
The -ahore .ournal of /conomics 0ol.1 2o.3
.hillips7.erron (..) tests are usedE results are reported in
appendi+ ,able71* ,he foreign reserve euation (') is
estimated by Gimple A<G for the period (19';799) using
the broad (M>) defnition of money* ,he Chow $rea- point
test is carried out to investigate the validity of the model
during the sample period* ,he data was divided into two
periods (19';7%1) and (19%>799)
9
* ,he results indicate that
the model was stable for the whole period* ,his means
that there is no change or any shift in the reserve 3ow
euation between the periods of f+ed e+change rate and
managed 3oating e+change rate regimes*
,he results reported in ,able (1) show that the
positive signs of the growth rate of prices and real income
confrm the proposition of the monetary approach but do
not support the assumption of linear homogeneity in
prices* ,hese results also indicate that, if all other things
are eual then a rise in growth rate of the prices and real
income will lead to reserve in3ows* Moreover, the view
that interest rate and in3ation both should be used to
measure the opportunity cost of holding money in less
developed countries is also supported by this study/s
fnding* ,he domestic credit coeCcient (o5set coeCcient)
is statistically di5erent from N1, the value predicted by the
monetary model* ,his would imply that all increases in this
variable would not totally lea- out through reserve
out3ows* 4t means that the government sterilises the
reserves through domestic credit in less developed
countries such as .a-istan*
,he coeCcient of income shows that an increase in
income at an annual rate of 1&O will generate reserve
in3ows of 11*9 O, while the same increase in growth rates
of interest, in3ation, money multiplier and domestic credit
will lead to reserve losses of 1*;O, '*>;O >*1"O and
%*>>O, respectively* ,hus, the e5ect of domestic credit
e+pansion on international reserve out 3ows is more than
other variables in the long run* ,herefore, the movements
-
The Cho% test is carried out to investigate the validity of the model during the sample
period 2or this, the data %as divided into t%o periods
6
4
M. Aslam Chaudhary and Ghulam Shabbir
in growth rate of domestic credit re3ect the behaviour of
monetary policy* ,he results portray the true picture of
.a-istanPs economyE where the government often fails to
collect enough revenues to meet its reuirements* As
such the monetary authorities are forced to e+pand
domestic credit irrespective of its adverse e5ects on the
economy*
,he results of this study support the monetary
approach to the balance of payments, as also stated by
others, for e+ample, Courchene and Gingh (19!')E 6onna
(19!')E Hecher (19!')E A-hter, .utnam, and Bilford,
(19!!)E Bildford and Hecher (19!9)E $hattia (19%>)E and
2oward and Mamingi (>&&>) found similar results* All these
studies concluded that balance of payments is a monetary
phenomenon and monetary policy is useful in dealing with
it* $ut our results for .a-istan do not support the results
found by Gohrab7ud76in (19%;) and $iluees (19%9)*
,he reason for this deviation lies perhaps in the
defnition of in3ation
1&
and use of di5erent time period for
this study* $esides, our study has a larger sampleE
'6
Bil9uees used gro%th rate of G<P deflator and CP( as pro&y for the gro%th rate of
inflation and gro%th rate in prices in the same e9uation But %e use the gro%th rate of
inflation as g = > log CP(,?'/ @ log CP( ,?)/A as used by $ghevli and Bhan ,'-::/,
Bhan ,'--0/
6
5
The -ahore .ournal of /conomics 0ol.1 2o.3
3able $8 1stimates of Foreign 12change
(eser9e Flo:s 1;uation for Pakistan8 +$<0/=<<,
Variables Coe>cients
+$, +%, +&,
Constant 71*>"%
(7>*"")QQ
7&*">1
(7"*"')Q
7>*&9
(7(*"()Q
.rice level &*&&1
(1*'()QQQ
&*&&&>
(&*9%)
&*&&1
(>*(1)QQ
9eal income 1*19
(;*99)Q
&*%";
(>'*1()Q
1*(%&
(%*&(!)Q
4nterest rate 7&*1;
(7>*!&)Q
7&*>"'
(7(*9>)Q
77777
77777
4n3ation rate 7&*'>;
(71*%()QQQ
77777
77777
71*1''
(7"*%&)Q
Money
Multiplier
7&*>1"
(7"*>')Q
7&*1(;
(71*9%)QQ
7&*>((
(7"*"%)Q
6omestic
credit
7&*%>>
(7";*1')Q
7&*%11
(7>9*;;)Q
7&*%>"
(7">*&%)Q
MA &*9(1
(1'*>%)Q
1*"9
(;*'9)Q
&*9%9
(1';>*&>)Q
97Guared &*9%! &*991 &*9%(
Ad0usted 97
Guared
&*9%( &*9%9 &*9%1
G*8* of
9egression
&*&1! &*&1( &*&19
6urbin7
Batson Gtat*
1*9% 1*(& >*""
?7statistic "11*;!Q ;"&*';Q "&>*%!Q
Chow $rea-point ,est1
?7statistic 1*'& &*>%1 1*"(
Q I Gignifcant at 1 O level
QQ I Gignifcant at ; O level
QQQ I Gignifcant at 1& O level
,herefore, these results are more reliable than the
earlier studies, which were based on a shorter period* Aur
6
+
M. Aslam Chaudhary and Ghulam Shabbir
fndings support the monetarist hypothesis of the balance
of payments despite all restrictive assumptions behind the
theory*
,o test the e+ogoneity of the determinants of money
demand (domestic price level ., real income y, interest
rate (i) and in3ation () and domestic credit 6C with
respect to reserves 9, two tests are carried out* 4n the frst
test, data is constructed as they appear in euation (')* 4n
the second test, frst di5erence of 9, ., y, i, and 6C are
used* ,he motivation underlying the second test is that if
the test data are defned as in (') then share weights for 9
and 6C will appear on both sides of (%), and it is possible
that a spurious simultaneity might be introduced*
,he test results for both sets of data are displayed in
appendi+ ,able (>)* ,he results of the frst test are
displayed under the heading MFeneral modelM and the
results of the second test under the heading L<inear
ModelM* ,he Bald ,est (?7statistic and Chi7suare) is used
to test the null hypothesis of e+ogoneityE i*e*, that si+
coeCcients on lagged reserves in all fve euations (one
for each putative e+ogenous variable) are 0ointly =ero
which are displayed in column (") and (() of ,able >* ,he
estimated value of ?7statistic and Chi7suare are
insignifcant, e+cept for domestic credit* 6omestic credit is
signifcant in the general model hypothesis and the
e+ogoneity of domestic credit is re0ected for the general
model but accepted for the linear model* ,he contradiction
in domestic credit results may be a result of spurious
simultaneity as suspected by Bhitman (19!;), Magee
(19!'), $orts and 2anson (19!!)*
V. Conclusion and policy implications
,he study focused on analysing whether the balance
of payments problem is a monetary phenomena* No study,
so far, confrmed this notion* ,he empirical fndings of this
study show that balance of payments is a monetary
phenomenon and monetary policy could be useful in
improving the foreign sector* ,he increase in price level
6
6
The -ahore .ournal of /conomics 0ol.1 2o.3
and real income lead to foreign reserve in3ows whereas
increase in interest rate, in3ation, money multiplier and
domestic credit lead to reserves out3ows* ,his also shows
that there is partial sterilisation in the short run but in the
long run, it tends to eual N1E indicating no sterilisation
policy adopted by the authorities to e5ect the foreign
reserve movements through domestic credit creation* ,he
results also indicate that e+cessive domestic credit
e+pansion will lead to reserve out 3ows*
,his increase in prices leads to an increase in the
money demand* 4f this rise in money demand is not met by
an eual increase in money supply by the monetary
authorities, then it puts pressure on reserves from abroad,
until the e+cess demand for money is entirely eliminated*
Another implication of monetary policy is that if the
monetary authorities do not increase the domestic
component of money supply to meet the increased money
demand, resulting from the growth of FN. over time, then
an in3ow of money will ta-e place to ma-e up the
di5erence* ,he central implication derived from this study
is that an increasing government budget defcit led to
e+cessive e+pansion in domestic credit and as a result, a
loss of foreign e+change reserves* ,hus, controlling
domestic credit, as well as other monetary variables can
stabilise foreign reserves*
6
7
M. Aslam Chaudhary and Ghulam Shabbir
APP1?*I7 $8 SP1CIFICA3I@? @F 3A1 M@*15
,he formal monetary model of the balance of
payments consists on, the money demand function, a
money supply euation and an euilibrium condition
Money demand function
,he demand for real money balances can be written
as1
M
d
R . I a y
b1
i
b>

b"
(1)
Bhere M
d
is the demand for nominal money
balancesE . is the domestic price levelE
y is the level of domestic real incomeE i is the
domestic interest rateE and is the rate of in3ation*
8uation (1) can be written as in log form1
m
d
N p I a S b
1
y S b
>
i S b
"
T
m
d
I a S p S b
1
y S b
>
i S b
"
T
,a-ing derivative with respect to time and denoting
it by (g), above euation becomes as1
g m
d
I
&
S
1
g p S
>
g y S
"
g i S
(
g T S u

Bhere1
g + I (1R+) (d+ R dt), and + I p, y, i, T and u is the
stochastic disturbance*
,he parameters
>
,
"
and
(
are the elasticity of real
income, interest rate and rate of in3ation with respect to
nominal money balances respectively, which are e+pected
to have the following signs1

>
J &,
"
K & ,
(
K &
6
1
The -ahore .ournal of /conomics 0ol.1 2o.3
Gince the demand for money is assumed to be
homogeneous of degree one in price level, so the
e+pected sign of
1
I1*
7
8
M. Aslam Chaudhary and Ghulam Shabbir
Money supply e;uation
,he money supply is defned as eualing the product
of money multiplier and the high7powered money*
M
s
I #m (>)
Bhere M
s
is the supply of moneyE # is the money
multiplier and m is the monetary base (volume of high7
powered money)
$y defnition the stoc- of high7powered money or the
liabilities of the monetary authorities (m) is eual to the
stoc- of international reserves(9) and domestic assets (net
of liabilities) holdings of the monetary authorities (6C)*
m I 9 S 6C (")
.utting it in euation (>)1
M
s
I # (9S6C)
Briting euation in logarithmic form we get1
m
s
I - S log (9 S 6C)
Bhere, m
s
is the log of money supply (M
s
) and - is
the log of money multiplier (#)*
,a-ing derivative with respect to time and denoting
it by (g) and after some manipulation we get1
g m
s
I g - S (9 R m) g 9 S (6C R m) g 6C
("a)
Bhere1
g + I (1 R +) (d+ R dt), and + I -, 9, and 6C
8uation ("a) can be written as1
g m
s
I g - S g r S g dc
Bhere1
7
3
The -ahore .ournal of /conomics 0ol.1 2o.3
g m
s
I Frowth rate of money supply* g - I
Frowth rate of money multiplier
g r I Frowth rate of international reserves
weighted by its share in monetary base *
g dc I Frowth rate of domestic credit weighted by
its share in monetary base*
Money market e;uilibrium
Bith the help of monetary euilibrium, we can derive
the international reserves 3ows euation*
g m
s
I g m
d
(()
g-SgrSgdcIaSb
&
gpSb
1
gySb
>
giSb
"
gTSu
grI
&
S
1
gpS
>
gyS
"
giS
(
gTN
;
g-N
'
gdcSu
(;)
8uation (;) represents the -ey relationship in the
monetary theory of the balance of payments* ,he
e+pected signs and e+pected magnitudes of the
parameters of euation (;) are as follows*

$
# $B
%
C -B
&
D -B
.
D -B
/
#
0
# =$
7
9
M. Aslam Chaudhary and Ghulam Shabbir
Appendi28 3able=$8 3he Enit (oot 3est of
Stationarity
Variabl
es
3est
3yp
e
3est for Enit (oot in 5e9el
Intercept 3est
1;uation
include in
3rend
?one
9eserve
s
A6? 7;*'1">%&
(7"*'(9')Q
7;*;91(((
(7(*>!1>)Q
7;*'%9';>
(7>*'"'9)Q
.. 7'*"'1(1;
(7"*'(>>)Q
7'*>9&9&"
(7(*>'&;)Q
7'*('%!1(
(7>*'"(()Q
.rice
<evel
A6? 7"*%>&&;!
(7"*'(9')Q
7"*!9!&'>
(7"*;;'>)QQ
7"*%'9'%'
(7>*'"'9)Q
.. 7'*1&!(%>
(7"*'(>>)Q
7'*1!&;;>
(7(*>'&;)Q
7'*1>;'1!
(7>*'"(()Q
9eal
4ncome
A6? 7"*"1;"&1
(7
>*9;;%)QQ
7"*>";!%'
(7"*>1&9)QQQ
7&*%>%'11
(71*9;1!)
.. 7>*1'"("1
(7>*'1(%)
7>*&;1;';
(7"*>&%1)
7&*;(1&&;
(71*'>11)
4nterest
9ate
A6? 7(*';'>('
(7"*'(9')Q
7(*;!(%("
(7"*;;'>)QQ
7(*!;!';(
(7>*'"'9)Q
.. 7;*'1('1!
(7"*'(>>)Q
7;*;'"%""
(7(*>'&;)Q
7;*';'%99
(7>*'"(()Q
4n3ation
9ate
A6? 7(*'(;;(%
(7"*';!')Q
7(*;;1&9&
(7(*>%>')Q
7(*!1>;9;
(7>*'"9;)Q
.. 7;*%%>('%
(7"*'(9')Q
7;*!%11;(
(7(*>!1>)Q
7;*991&%'
(7>*'"'9)Q
Money
Multiplie
r
A6? 7"*>(>(!'
(7
>*9;;%)QQ
7"*'""&;;
(7"*;;'>)QQ
7"*>9%%>'
(7>*'"'9)Q
.. 7;*>>;;>>
(7"*'(>>)Q
7;*'!"%'1
(7(*>'&;)Q
7;*"1"'!&
(7>*'"(()Q
6omesti
c Credit
A6? 7;*;>(1((
(7"*'(9')Q
7;*(%"1>'
(7(*>!1>)Q
7(*;'%9''
(7>*'"'9)Q
.. 7'*&;'99&
(7"*'(>>)Q
7;*9!>9((
(7(*>'&;)Q
7;*"1;;;1
(7>*'"(()Q
A6?1 Augmented 6ic-ey ?uller ,est, ..1 .hillips7.erron ,est*
7
,
The -ahore .ournal of /conomics 0ol.1 2o.3
( ) values show the critical (tau) statistics computed by
Mac#innon*
Q Gtationary at 1O level
QQ Gtationary at ;O level
QQQGtationary at 1&O level
7
4
M. Aslam Chaudhary and Ghulam Shabbir
Appendi28 3able %8 (egression (esults for 3esting
12ogeneity of the Monetary Model
3est Statistic for ?ull Aypothesis
s # -B for all s > -
Fald Statistic
(egress
ion
Model F=
statisti
c
Chi=
s;uare
(
%
*.F.st
at
g p Feneral
Model
<inear
Model
&*(;9
(&*;11)
&*>((
(&*'"1)
&*(;9
(&*(9!)
&*>((
(&*'>&)
&*9
9
&*%
;
>*&'
1*'!
g y
Feneral
Model
<inear
Model
&*9>9
(&*";;)
&*&!%
(&*!%;)
&*9>9
(&*"";)
&*&!%
(&*!!9)
&*9
9
&*!
!
1*%>
>*1;
g i Feneral
Model
<inear
Model
*'"(
(&*>>!)
&*;&&
(&*(9;)
1*'"(
(&*>&1)
&*;&&
(&*(!9)
&*!
'
&*'
1
>*&;
>*1(
g
Feneral
Model
<inear
Model
&*"91
(&*;(()
&*1;(
(&*!&>)
&*"91
(&*;"1)
&*1;(
(&*'9()
&*9
9
&*!
"
>*(>
1*'9
gdc Feneral
Model
<inear
Model
%*;;%QQ
(&*&")
1*&"!
(&*"';)
%*;;%QQ(
&*&")
1*&"!
(&*"&%)
&*9
%
&*!
'
>*&;
1*'1
g p I Frowth rate of domestic price level
g y I Frowth rate of real income
g i I Frowth rate of domestic interest rate
g I Frowth rate of in3ation
7
5
The -ahore .ournal of /conomics 0ol.1 2o.3
g dc I Frowth rate of domestic credit
QQ I Gignifcant at ; O level*
( ) value shows the probability*
7
+
M. Aslam Chaudhary and Ghulam Shabbir
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