(a) Explain the concept of "sterilization" in the context of monetary approach to balance of payments. (20 marks) (b) Tax burden…

(a) Sterilisation in the monetary approach to the balance of payments

In the monetary approach, the balance of payments is a monetary phenomenon. The money supply is M = m(NDA + NFA), where NDA is domestic credit of the central bank and NFA its net foreign assets. Under a fixed exchange rate, the change in reserves equals the excess of money demand over domestic credit expansion: ΔR = ΔMᵈ − ΔDC. A deficit is thus a symptom of excess money supply, and a surplus of excess demand for money, and the automatic adjustment works through reserve flows.

Sterilisation is the central bank's offsetting of the effect of reserve changes on the domestic monetary base. Suppose capital inflows lead the RBI to buy foreign currency to hold the rupee. Reserves (NFA) rise by ΔR and so does base money. To neutralise it, the RBI cuts domestic credit (NDA) by the same amount, for example by selling government securities (open market sales), issuing Market Stabilisation Scheme bonds, raising the cash reserve ratio or absorbing liquidity through reverse repo. Then NFA rises by ΔR, NDA falls by ΔR and the money supply is unchanged. The offset coefficient measures how much of the reserve change is offset by domestic credit; complete sterilisation means −1.

Implications: sterilisation blocks the automatic adjustment, since money stays constant, and so it can postpone but not remove a disequilibrium. With high capital mobility and a fixed rate, sterilised purchases attract more inflows at the higher domestic rate, which makes them self-defeating, and the impossible trinity implies that monetary autonomy is limited. Costs include the quasi-fiscal cost of paying interest on sterilisation securities above that earned on reserves, and upward pressure on interest rates. India used the MSS and open market sales from 2004 to absorb large inflows.

(b) Distribution of a tax burden between buyers and sellers

A specific tax t puts a wedge between the price paid by buyers, P_b, and received by sellers, P_s: P_b = P_s + t. Starting from price P₀, let the buyer's price rise by ΔP_b and the seller's price fall by ΔP_s, so that ΔP_b + ΔP_s = t.

The new quantity must be the same on the demand and supply side, so the fall in quantity demanded, Eᵈ·ΔP_b/P₀, equals the fall in quantity supplied, Eˢ·ΔP_s/P₀. Hence Eᵈ·ΔP_b = Eˢ·ΔP_s, and ΔP_b/ΔP_s = Eˢ/Eᵈ.

So the burden is shared in inverse proportion to the elasticities: buyers bear Eˢ/(Eᵈ + Eˢ) of the tax and sellers Eᵈ/(Eᵈ + Eˢ). The less elastic side bears the larger share. (So the statement holds as an inverse ratio: buyers' share to sellers' share is Eˢ : Eᵈ.)

Cases: if demand is perfectly inelastic or supply perfectly elastic, buyers bear the whole tax. If supply is perfectly inelastic or demand perfectly elastic, sellers bear it. Necessities, with inelastic demand, pass most of the tax to consumers. Incidence is the same whoever formally pays the tax, which is the difference between statutory and economic incidence.

(c) Friedman's restatement of the quantity theory and its reduction to the classical form

Friedman (1956) restated the quantity theory as a theory of the demand for money, not of the price level. Money is an asset held in a portfolio with bonds, equities, goods and human wealth. Real money demand is M/P = f(Yp, w, rᵦ − rₘ, rₑ − rₘ, (1/P)(dP/dt) − rₘ; u), where Yp is permanent income (a proxy for wealth), w is the ratio of human to non-human wealth, the next terms are the returns on bonds, equities and goods (expected inflation) relative to money, and u stands for tastes. Because permanent income is stable, money demand and velocity are stable functions of a few variables, so changes in the money supply mainly determine nominal income.

It reduces to the classical quantity theory when: (i) the demand for money is interest-inelastic, since money is not a close substitute for other assets and the return terms have no effect; (ii) the income elasticity of money demand is unity, giving M/P = kYp, or M = kPY, which is the Cambridge form; (iii) velocity (1/k) is constant, and so MV = PT; and (iv) output is at the full employment level. Then a change in M changes P proportionately.

Friedman differs in treating the interest rate and expectations as relevant, in permitting short-run changes in velocity and output, and in emphasising empirical stability over a rigid identity.