The Keynesian-Monetarist Controversy in International Economics: Discriminatory Power of Short-Run Empirical Tests

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ABSTRACT

Two major theories in the area of balance of payments are the Keynesian and monetarist theories. There have been many short-run tests of the monetary approach to the balance of payments and the evidence has been used to support the monetary approach. This paper argues that most of the existing empirical work does not have any discriminatory power because it assumes equilibrium in the money market. This paper recommends that Keynesian and monetarist views about the transmission mechanism and the homeostatic mechanism are fundamentally different and provide bases for discriminatory tests.

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INTRODUCTION

Keynesian and monetarist theories dominate macro-economics in general and balance of payments theories in particular. There have been many short-run tests of the monetary approach to the balance of payments and the evidence has been used to support the monetary approach. This paper argues that most of the existing empirical work does not have any discriminatory power.

/\rdalan (2003, 2005a, 2005b) has reviewed three alternative theories of balance of payments adjustments. They are the elasticity and absorption approaches (associated with Keynesian theory), and the monetary approach. In the elasticities and absorption approaches the focus of attention is on the trade balance with unemployed resources. The elasticities approach emphasizes the role of the relative prices (or exchange rate) in balance of payments adjustments by considering imports and exports as being dependent on relative prices (through the exchange rate). The absorption approach emphasizes the role of income (or expenditure) in balance of payments adjustments by considering the change in expenditure relative to income resulting from a change in exports and/or imports. In the monetary approach, on the other hand, the focus of attention is on the balance of payments (or the money account) with full employment. The monetary approach emphasizes the role of the demand for and supply of money in the economy.

/\rdalan (2003, 2005a) has comprehensively reviewed the relevant empirical work dealing with the monetary approach. Empirical work on the monetary approach to the balance of payments can be divided into two different approaches; one tests the theory in long-run equilibrium, the other considers the adjustment mechanism and the channels through which equilibrium is reached. The first approach is based on the reserve flow equation developed by Johnson (1972). Testing was undertaken by Zecher (1976) and others (See Ardalan, 2005a). The second approach is based on theoretical work of Prais (1977), with corresponding empirical work undertaken by Rhomberg (1977) and others (See Ardalan, 2003).

This paper is based on Ardalan (2003, 2005a, 2005b) and it argues that most of the existing empirical work in the short-run framework has no discriminatory power (Ardalan, 2007, has made the same argument with respect to the long-run models). Theoretical models explicitly differentiate between the two types of adjustment mechanisms, but most short-run empirical models have no discriminatory power because they assume equilibrium in the money market.

The next section explores the existing empirical work on the short-run monetary approach to the balance of payments to see if it can discriminate between the differing views of Keynesian and monetarist economists.

QUESTION OF DISCRIMINATORY POWER

The main goal of this section is to show that existing empirical work on the short-run monetary approach to balance of payments does not discriminate between Keynesian and monetarist theories of the balance of payments. This is because the evidence is consistent with both Keynesian and monetarist models, as specified.

Ardalan (2003) noted that Prais (1977) proposed a test of the short-run monetary approach to the balance of payments. Ardalan (2003) also reviewed examples (They are: Khan, 1977, 1976; Rhomberg, 1977; and Schotta, 1966) of the numerous applications (See the list of references in Appendix 1) ofthat idea to various countries. …

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