Discussion

Abstract

The monetary theory of the balance of payments (MTBOP) has two obvious virtues. It is simple and it is based on assumptions that economists of nearly every persuasion would accept, namely that there exists a stable demand function for real money balances and that purchasing power parity holds in the long run. One question regarding the theory remains unanswered, how well does it explain actual balance of payments and exchange rate behavior over the short and long run? If, as theorists such as Dornbusch (1976) and Kouri (1976) suspect, the theory is only applicable in the long run, how must it be amended to explain short-run fluctuations? The Sargen and Brittain papers attempt to shed empirical light on this problem. The Sargen paper begins by using quarterly data to estimate the reserveexchange rate equation developed by Girion and Roper (1976) for Germany, Canada and the U.K. Sargen's regressions leave two issues unresolved. At the outset he states that the money multiplier is assumed to be constant for expositional purposes. After deriving his model, Sargen never again returns to the issue of the multiplier. It is possible, therefore, that variation in the multiplier could bias his regression results, particularly if his data on the monetary base have not been adjusted for reserve requirement changes. Purchasing power parity can only be expected to hold net of tariffs and other taxes or controls which add to the cost of international transactions. More precisely, the purchasing power parity condition may be written as P = P* T/ e where the variable T is added to summarize the effects of taxes and controls. As long as the regulatory environment does not change, the addition of T will not affect Sargen's regressions, because it drops out when logarithmic derivatives are taken. If, however, T is variable, its omission from the regression equations may lead to biased results. In the case of Mexico, for instance, the government was able to pursue a monetary policy greatly more expansive than that of the U.S. while simultaneously holding the peso-dollar exchange rate fixed by imposing increasingly stringent controls on international transactions.As Sargen notes, his regressions show that the MTBOP does not perform as well under floating exchange rates as when rates are fixed. In particular, the model fails to adequately explain the rapid fluctuation in the exchange rates under the floating regime. This problem is obvious from a cursory glance at the exchange rate history of the DM. From June of 1973 to September of 1976 the mark has bounced between $.35 and $.44 several times without substantial changes in U.S. or German monetary policy. Such behavior is in sharp contrast to the slow appreciation of the mark which the MTBOP predicts.To explain this phenomenon Sargen turns to the interest rate parity model of the exchange rate in the short run lucidly analyzed by Dornbusch (1976). The key assumption behind this approach is that prices are rigid in the short run so that the exchange rate is determined by equilibrium in...