The Role Of Exchange Rate And Monetary Policy In The Monetary Approach To The Balance Of Payments: Evidence From Malawi

This study tests the reserve flow equation (RFE) of the monetary approach to the balance of payments using Malawi as a case study. Within the RFE the study investigates the roles of relative prices, defined as the ratio of the product of the nominal exchange rate (NER) and the foreign currency prices to the price of nontraded goods, and domestic credit control. The nontradables price is found to be negatively related to the balance of payments implying the dominance of relative price effects over money demand effects. The NER is found to exert perverse effects in the initial year prior to positively influencing the balance of payments in the following year. This means that a devaluation first leads to a loss of reserves before they can rebuilt. This is also the case with the real exchange rate (RER) on a quarterly basis although it is well-behaved on an annual basis. Domestic credit is revealed to have the expected negative impact followed by a positive coefficient which suggests the effective use of selective credit policy stance which favoured the export-oriented plantation sector. The potential for sterilization operations is rejected on an annual basis but weakly supported on a quarterly basis. Although causality is observed to be from credit to reservesand not from reserves to credit on an annual basis, it is found to be in both directions on a quarterly basis.