A Note on Monetary and Non-Monetary Analyses of LDCs Balance of Payments Problems

Although balance of payments problems have been pervasive in the developing economies, there is little agreement amongst economists as to the causes and the cures for these problems. This paper focuses upon two models of the balance of payments: the two-gap model and the monetary approach to the balance of payments (MAEP). The two-gap model describes the chronic excess demand for foreign exchange in the developing economies as structural in origin, and implies that monetary cures for it do not seem to be relevant. MAEP, on the other hand, describes balance of payments deficits as reflecting disequilibrium in the money market and hence must be treated as a monetary phenomenon, requiring the use of tools and concepts of monetary theory. Balance of payments disequilibrium involves an inflow or outflow of international money, and the behaviour of monetary authorities is regarded as crucial to any sensible study of the balance of payments. The analysis of these two models presented in this paper tries to reveal their underlying structures and emphasizes the differences in their approach to the balance of payments problems. After providing brief expositions of the two models in the following two sections, we discuss the importance of the assumptions in each of the model. Next, we present a synthesis by relating to the two-gap model some aspects of the monetary approach. This has not been done before in the literature. This attempt at a synthesis raises certain issues, some of which are answered in this paper. For instance, we are able to provide a reasonable explanation of why the LDC governments engage in excessive credit creation, leading to balance of payments deficits and then devaluation.