THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS AND IMPORTATION OF INFLATION: A FURTHER ANALYSIS AND EMPIRICAL EVIDENCE

The main aims of this paper include a revision of the essentials of the monetary approach to the balance of payments by constructing a monetary model, an extension of the model to explain the importation of inflation in an open economy and an application of the formulated model to the two small open economies, the Netherlands and Singapore. The most important contribution of the monetary approach to the balance of payments is its focus on the role of money as opposed to the focus of traditional approaches on the real variables and on the current account of the balance of payments. Influenced originally by Johnson (1972), there have been several theoretical as well as empirical analyses supporting the major contentions of the monetary approach to the balance of payments. Notable among these are Mussa, Frenkel and Johnson (1975), Kemp (1975), Whitman (1975), and Kreinin and Officer (1978). On the basis of common elements enclosed in the writings of these authors, it is possible to construct such a model and then solve it, first, for foreign reserves inflow, and second, for the domestic inflation rate as a dependent variable. This formulation is similar to the ones found in Bhatia (1982) and Salvatore (1983), but is broader in its implications. A check of the validity of the relationships of the monetary model is also attempted by using the annual data of the Netherlands and Singapore.