This approach is an extension of the cash balances version of the quantity theory of money. It claims that changes in demand for and supply of money balances in a country leads to corresponding changes in its demand for goods and services (including imports).
The demand for its exports is similarly influenced by monetary factors operating in its trading partners. Thus, balance of payments deficit is an outcome of monetary phenomena and can be corrected by appropriate monetary measures.
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Assumptions:
This approach makes the usual assumptions of free trade and competitive markets together with some other simplifying assumptions relating to transport costs, etc. Thus, amongst others, this approach assumes the following:
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i. On account of free trade and international competition, each product tends to have a uniform price (net of transport costs) in all trading countries.
If for some reason, the price of a commodity in some country is lower than its world price, it will be exported by that country.
Similarly, a country will import a commodity if its world price is lower than it is in its domestic market. By implication, the international flow of a commodity will ensure the uniformity of its price throughout the world.
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ii. There is full employment in each country, so that no country can meet increased demand for a product by increasing its domestic output. It can be done by either importing it or by reducing the output of some other commodity.
iii. There is a fixed exchange rate, and sterilisation of currency flows is not possible.
Demand for a currency is assumed to be a stable function of a small number of macroeconomic variables. Thus the demand for cash balances in a country increases with an increase in its national income and a fall in the rate of interest.
By extending cash-balances version of quantity theory of money, monetary approach asserts that an imbalance in the balance of payments of a country is also a monetary phenomenon and can be corrected through an appropriate monetary policy.
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Given these assumptions, a deficit balance of payment of a country is caused by and is equal to the excess of its domestic money supply over its demand.
The excess supply of money means unwanted cash balances with the market. To get rid of them, the money holders spend their excess cash balances on imports [they cannot do so by spending upon domestically produced goods because of full employment] and thus cause a deficit trade balance.
Under a fixed exchange rate, the central bank receives domestic cash balances and sells foreign exchange to importers. In the process, the situation of excess cash balances with the market is eliminated and balance of payments equilibrium is restored.
Just the opposite happens if domestic money supply is insufficient as compared with its domestic demand. The market will increase its cash balances by exporting goods and services.
Evaluation:
i. This approach has the advantage of emphasising that monetary forces play an important and crucial role in international trade of a country.
In particular, it highlights the relevance of money supply and its impact on demand and supply behaviour of the economy.
ii. However, this approach suffers from all the deficiencies of the quantity theory of money and other unrealistic assumptions.
iii. The theory wrongly assumes that demand for money is a stable function of income or some other macro variable.
iv. This approach confines itself to short run phenomenon and ignores the problems of a dynamic modern economy relating to its restructuring, income and employment stability, and so on.
v. This approach ignores the backlash effect of international adjustment, which is unavoidable because of interdependence of modern open economies.
vi. It wrongly assumes that both domestic and international markets are perfectly competitive.
vii. It suffers from the deficiencies of the cash-balances version of the quantity theory of money. The demand for cash balances is intricately connected with the demand for non-cash financial assets, including the demand for both domestic and foreign bonds. This approach fails to take this fact into account.
viii. It wrongly assumes that the central bank cannot regulate money supply and is only a passive supplier of cash balances to the market.