monetary accounts: an overview

Monetary Accounts: Monetary Accounts: An OverviewAn Overview

Why stress money?Why stress money?

Money affects output, Money affects output, inflation, and the balance of inflation, and the balance of payments payments

Money is a medium of Money is a medium of exchange that greases the exchange that greases the wheels of production and wheels of production and tradetrade

Thorvaldur Gylfason

OutlineOutline

1.1. Role of money Role of money

2.2. Money and bankingMoney and banking

3.3. Money and the balance of Money and the balance of paymentspayments

4.4. Forecasting money Forecasting money

5.5. Money, prices, and incomeMoney, prices, and income

Quantity Theory of Quantity Theory of MoneyMoney

Oldest macroeconomic Oldest macroeconomic theorytheory

MV = PY MV = PY

V = PY/M (V = PY/M (velocityvelocity))

P = (V/Y)MP = (V/Y)M

M

P

Long-run relationship

The price level is approximately proportional to the money supply over long periods

Quantity Theory of Quantity Theory of MoneyMoney

To keep the price level under To keep the price level under control, it is essential to control, it is essential to control the control the money supplymoney supply

M

P

Long-run relationship

This is why money and monetary policy must play a key role in financial programming

The Role of MoneyThe Role of Money

Generally, we need to control money Generally, we need to control money to manage to manage aggregate demandaggregate demand

Money affects aggregate demand Money affects aggregate demand directly and indirectlydirectly and indirectly

Y

P

Aggregate supply

Aggregate demand

Direct effectthrough interest rates and investment

Indirect effectthrough interaction with fiscal policy

Direct Effects of MoneyDirect Effects of MoneyAn increase in An increase in money supplymoney supply

increases supply of loanable funds,increases supply of loanable funds,thus driving down interest ratesthus driving down interest rates

As interest rates fall, As interest rates fall, investmentinvestment rises,rises,thus increasing aggregate demandthus increasing aggregate demand

S, I

r

Supply of loanable funds

Demand for loanable funds

Hence, monetary expansion increases the price level and also output, as long as the aggregate supply schedule slopes up

Indirect Effects of Indirect Effects of MoneyMoneyAn increase in government An increase in government budget budget

deficitdeficit needs to be financed needs to be financedIf it is financed by If it is financed by credit from the credit from the

banking systembanking system, i.e., by increasing , i.e., by increasing the money supply, then ...the money supply, then ...

Y

P

Aggregate supply

Aggregate demand

... aggregate demand will rise (a) because of the expansionary effect of the increased government budget deficit and (b) because of the effect of the monetary expansion used to finance it

Money is UsefulMoney is UsefulM/PY M/PY (in %)(in %) 19701970 19919988

MalawiMalawi 1818 1414

BotswanaBotswana …… 2244

NamibiaNamibia ...... 4400

ZimbabweZimbabwe ...... 2233

ZambiaZambia 2525 1616

UgandaUganda 1717 1133

TanzaniaTanzania ...... 1717

United StatesUnited States 6363 5588

FranceFrance 4141 6969**

The ratio of The ratio of money supply to money supply to nominal income nominal income reflects the reflects the degree of degree of monetizationmonetization Mature Mature economies economies generally have generally have higher ratios of higher ratios of money to income money to income than developing than developing economieseconomies

* 1997

But What is Money?But What is Money?Liabilities of Liabilities of banking systembanking system to the public to the public

that is, the private sector and public that is, the private sector and public enterprises enterprises

M = C + T M = C + T C = currency, T = deposits C = currency, T = deposits

The broader the definition of deposits ...The broader the definition of deposits ...demand deposits, time and savings deposits, demand deposits, time and savings deposits,

etc.,etc.,

... the broader the corresponding ... the broader the corresponding definition of moneydefinition of moneyMM11, M, M22, etc. , etc.

Overview of Banking Overview of Banking SystemSystem

C entral Bank C om m ercia l Banks

Banking System(M onetary Survey)

O ther F inancia l Institutions

F inancial System

Balance Sheet of Balance Sheet of Central BankCentral Bank

AssetsAssets LiabilitiesLiabilities

DDGG CC

DDBB BB

RRCC

DDGG = domestic = domestic credit to credit to governmentgovernment

DDBB = domestic = domestic credit to credit to commercial commercial banksbanks

RRCC = foreign = foreign reserves in reserves in Central BankCentral Bank

C = currencyC = currency

B = commercial B = commercial bank deposits bank deposits in Central Bankin Central Bank

Balance Sheet of Balance Sheet of Commercial BanksCommercial Banks


DDPP DDBB

RRBB TT

BB

DDPP = domestic = domestic credit to private credit to private sectorsector

RRBB = foreign = foreign reserves in reserves in commercial commercial banksbanks

B = commercial B = commercial bank deposits in bank deposits in Central BankCentral Bank

DDBB = domestic = domestic credit from credit from Central Bank to Central Bank to commercial commercial banksbanks

T = time depositsT = time deposits

Balance Sheet of Balance Sheet of Banking SystemBanking System


DD MM

RR

D = DD = DGG + D + DBB = = net domestic net domestic credit from credit from banking system banking system (net domestic (net domestic assets)assets)

R = RR = RCC + R + RBB = = foreign reserves foreign reserves (net foreign (net foreign assets)assets)

M = money M = money supplysupply

Monetary Survey

A Fresh View of A Fresh View of MoneyMoneyThe monetary survey implies the The monetary survey implies the

following new definition of money:following new definition of money:

M = D + RM = D + Rwhere M is broad money (Mwhere M is broad money (M22), which ), which

equals narrow money (Mequals narrow money (M11) + quasi-) + quasi-moneymoney

This is one of the most useful This is one of the most useful equations in all of economicsequations in all of economics

Money is, by definition, equal to the sum of domestic Money is, by definition, equal to the sum of domestic credit from the banking system (credit from the banking system (net domestic net domestic assetsassets) and foreign exchange reserves in the ) and foreign exchange reserves in the banking system (banking system (net foreign assetsnet foreign assets))

An Alternative An Alternative Derivation of Derivation of Monetary SurveyMonetary SurveyPublicPublic sector sector

G – T = G – T = B + B + DDGG + + DDFF

PrivatePrivate sector sector I – S = I – S = DDPP - - M - M - BB

ExternalExternal sector sector X – Z = X – Z = R - R - DDFF

Now, add them upNow, add them up

An Alternative An Alternative Derivation of Derivation of Monetary SurveyMonetary Survey

PublicPublic sector sector G – T = G – T = BB + + DDGG + + DDFF



An Alternative An Alternative Derivation of Derivation of Monetary SurveyMonetary Survey

PublicPublic sector sector G – T = G – T = BB + + DDGG + + DDFF



So, adding them up, we get 0 = D - M + R

because DG + DP = D

Hence,

M = D + R

A Fresh View of A Fresh View of MoneyMoneyThe monetary survey (The monetary survey (M = D + RM = D + R) has ) has

three key implications:three key implications:Money is Money is endogenousendogenous

If If RR increases, then increases, then MM increases increasesImportant in open economiesImportant in open economies

Domestic creditDomestic credit affects money affects moneyIf If RR increases, may want to reduce increases, may want to reduce DD to to

contain contain MM

R = R = M - M - DDwhere where R = X – Z + FR = X – Z + FMonetary approach to balance of paymentsMonetary approach to balance of payments

Monetary Approach to Monetary Approach to Balance of PaymentsBalance of PaymentsThe monetary approach to the balance of The monetary approach to the balance of

payments (payments (R = R = M - M - DD) has the ) has the following important implication, in three following important implication, in three parts parts

Need toNeed to1)1) Forecast Forecast M M and thenand then2)2) DetermineDetermine DD in order toin order to3)3) Meet target for Meet target for RR

Hence, D is determined as a residual given Hence, D is determined as a residual given both M and R*both M and R*

R* = reserve target, e.g., 3 months of importsR* = reserve target, e.g., 3 months of imports

Monetary Approach to Monetary Approach to Balance of PaymentsBalance of PaymentsDomestic credit is a policy variable Domestic credit is a policy variable

that involves both that involves both monetary monetary and and fiscal policyfiscal policy

Can reduce domestic creditCan reduce domestic credit ((DD)) To private sectorTo private sectorTo public sectorTo public sector

By reducing By reducing government government spendingspending

By increasing By increasing taxes and feestaxes and fees

Monetary and fiscal policy are Monetary and fiscal policy are closely related through domestic closely related through domestic creditcredit

Forecasting MoneyForecasting MoneyMoney is determined by equilibrium Money is determined by equilibrium

between between money demandmoney demand and and money supplymoney supply

Money demand, like the demand for Money demand, like the demand for goods and services, depends ongoods and services, depends on

Income, i.e., GNPIncome, i.e., GNPPrice, i.e., the opportunity cost of Price, i.e., the opportunity cost of

holding moneyholding moneyInflation rate in developing Inflation rate in developing

countriescountriesInterest rate in industrial Interest rate in industrial

countriescountries

Forecasting Money Forecasting Money DemandDemand

Theory and empirical evidenceTheory and empirical evidenceWhen GNP goes up, so does the demand When GNP goes up, so does the demand

for moneyfor moneyTransactions demandTransactions demand

When inflation goes up, money demand When inflation goes up, money demand goes down ...goes down ...

... because the opportunity cost of ... because the opportunity cost of holding money goes up with holding money goes up with inflationinflation

Speculative demandSpeculative demand

So, to forecast money, need first to So, to forecast money, need first to forecast income, price level, and inflationforecast income, price level, and inflation

Forecasting Money Forecasting Money Demand: An ExampleDemand: An Example

M/P = YM/P = Ya a ee- b- b

log(M/P) = a log(Y) – blog(M/P) = a log(Y) – ba =a = income elasticity income elasticity

Income effect means that a Income effect means that a 00

Typically, Typically, aa is around 1 is around 1

b =b = inflation semi-elasticity inflation semi-elasticity

Inflation effect means that b Inflation effect means that b >> 0 0

For example, For example, bb can be can be around 5around 5

Equilibrium of Supply Equilibrium of Supply and Demand For Moneyand Demand For Money

PY

M

Money supply

Money demand

Nominal income depends on the money supply

Effects of an Increase in Effects of an Increase in Money SupplyMoney Supply

PY

M

Money supply

Money demand

An increase in money supply increases nominal income

A

B

Effects of an Increase in Effects of an Increase in Inflation RateInflation Rate

PY

M

Money supply

Money demand

An increase in inflation reduces money holdings relative to income

A

B

Financial Depth and Economic Growth

85 countries85 countries-8

-6

-4

-2

0

2

4

6

0 20 40 60 80 100 120

Money and quasi-money 1965-1998 (% of GDP)

Gro

wth

of

GN

P p

er

ca

pit

a 1

96

5-1

99

8, a

dju

ste

d f

or

init

ial

inc

om

e (

% p

er

ye

ar)

r = 0.66

Jordan

Switzerland

JapanIndonesia

Financial Depth and Inflation

160 countries160 countries

Jordan

Switzerland

0

20

40

60

80

100

120

140

160

180

200

0 200 400 600 800 1000 1200

Average inflation 1961-99 (% per year)

Mo

ne

y a

nd

qu

as

i-m

on

ey

19

61

-99

(%

of

GD

P)

Nicaragua

Hong Kong

Angola

Congo, Dem. Rep.

r = -0.51

Financial Depth and Inflation, Again

160 countries160 countries

Jordan

Switzerland

JapanIndonesia

0

20

40

60

80

100

120

140

160

180

200

0 0.2 0.4 0.6 0.8 1

Average inflation tax 1961-99 (% per year)

Mo

ne

y a

nd

qu

as

i-m

on

ey

19

61

-99

(%

of

GD

P)

r = -0.51

Effects of Increases in Effects of Increases in Money Supply Money Supply andand InflationInflation

PY

M

Money supply

Money demand

Monetary Monetary expansion, by expansion, by increasing increasing inflation, inflation, reducesreduces money holdings money holdings relative to income,relative to income,thereby impeding thereby impeding efficiency and efficiency and economic growth,economic growth,even if nominal even if nominal income rises in the income rises in the short runshort run

A

B

Effects of Increases in Effects of Increases in Money Supply Money Supply andand InflationInflation

PY

M

Money supply

Money demand

Monetization is a Monetization is a good thing, but good thing, but printing money is printing money is notnot the way to the way to achieve it achieve it On the contrary, On the contrary, monetary monetary expansion expansion reducesreduces the amount of the amount of money available to money available to finance economic finance economic transactions transactions

A

B

ConclusionConclusion

M =

D +

R Need to forecast Need to forecast monetary monetary expansionexpansion to be able to to be able to determine the rate of determine the rate of credit credit expansionexpansion that is consistent that is consistent with our with our reserve targetreserve target

Base forecast of monetary Base forecast of monetary expansion on forecast of expansion on forecast of income growth and inflationincome growth and inflation

Bottom lineBottom line

M =

D +

R Need to control Need to control credit credit expansionexpansion – and hence apply – and hence apply fiscal restraint – to achieve fiscal restraint – to achieve the rate of the rate of monetary monetary expansionexpansion that is consistent that is consistent with our international with our international reserve reserve targettarget

Key toKey to financial programming financial programming

These slides – and more! – can be viewed on my website: www.hi.is/~gylfason

monetary accounts: an overview

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