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Monetary Accounts: Analysis and Forecasting Why stress money? Money affects output, inflation,
and the balance of payments Money is a medium of
exchange that greases the wheels of production and trade
Thorvaldur Gylfason
Outline
Role of money Money and banking Money and the balance of
payments Forecasting money Money, prices, and income
Quantity Theory of Money Oldest macroeconomic theory MV = PY V = PY/M (velocity) P = (V/Y)M
M
P
Long-run relationship
The price level is approximately proportional to the money supply over long periods
Quantity Theory of Money To keep the price level under
control, it is essential to control the money supply
M
P
Long-run relationship
This is why money and monetary policy must play a key role in financial programming
The Role of Money
Generally, it is necessary to control money to manage aggregate demand
Money affects aggregate demand directly and indirectly
Y
P
Aggregate supply
Direct effectThrough interest rates and investment
Indirect effectThrough interaction with fiscal policy
Aggregate demand
Direct Effects of Money An increase in money supply
increases supply of loanable funds Thus driving down interest rates
As interest rates fall, investment rises Thus 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 Money
An increase in government budget deficit needs to be financed
If it is financed by credit from the banking system, i.e., by increasing 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
Broad Money (% of GDP)The ratio of money supply to nominal income reflects the degree of monetization Mature economies generally have higher ratios of money to income than developing economies
0 20 40 60 80
Angola
Botswana
Lesotho
Malawi
Namibia
Swaziland
Tanzania
Uganda
Zambia
Zimbabwe
South Africa
2002
Beginning
Financial depth and economic growth
-8
-6
-4
-2
0
2
4
6
0 20 40 60 80 100 120
Money and quasi-money 1965-98 (% of GDP)
Gro
wth
of
GN
P p
er
cap
ita 1
965-9
8, ad
juste
d
for
init
ial in
co
me (
% p
er
year)
r = 0.66
Japan
Switzerland
Jordan
Indonesia
Austria
87 countries
r = Spearman
rank correlation
Botswana
Inflation and financial depth
87 countries0
20
40
60
80
100
120
0,00 0,20 0,40 0,60 0,80 1,00
Inflation distortion 1965-98
Mo
ney
an
d q
uas
i-m
on
ey 1
965-
98 (
% o
f G
DP
)
Brazil
NicaraguaArgentina
Austria
Switzerland
Japan
Add these two correlations,
and an inverse correlation
between inflation and
growth follows
r = -0.45
/(1+/(1+ ) )
But What is Money? Liabilities of banking system to the public
That is, the private sector and public enterprises
M = C + T C = currency, T = deposits
The broader the definition of deposits ... Demand deposits, time and savings
deposits, etc., ... the broader the corresponding
definition of money M1, M2, etc.
Overview of Banking System
C entra l Bank C om m ercia l Banks
Banking System(M onetary Survey)
O ther F inancia l Institu tions
Financia l System
Balance Sheet of Central Bank
Assets Liabilities
DG C
DB B
RC
DG = domestic credit to government
DB = domestic credit to commercial banks
RC = foreign reserves in Central Bank
C = currency
B = commercial bank deposits in Central Bank
Balance Sheet of Commercial Banks
Assets Liabilities
DP DB
RB T
B
DP = domestic credit to private sector
RB = foreign reserves in commercial banks
B = commercial bank deposits in Central Bank
DB = domestic credit from Central Bank to commercial banks
T = time deposits
DG + DP + DB + RB + RC + B = C + T + B + DB
Adding Up the Two Balance Sheets
D R
M
Hence, M = D + R
Balance Sheet of Banking SystemMonetary Survey
Assets Liabilities
D M
R
D = DG + DB = net domestic credit from banking system (net domestic assets)
R = RC + RB = foreign reserves (net foreign assets)
M = money supply
A Fresh View of Money
The monetary survey implies the following new definition of money:
M = D + R Where M is broad money (M2), which equals
narrow money (M1) + quasi-money This is one of the most useful equations in all
of economics Money is, by definition, equal to the sum of
domestic credit from the banking system (net domestic assets) and foreign exchange reserves in the banking system (net foreign assets)
An Alternative Derivation of Monetary Survey Public sector
G – T = B + DG + DF
Private sector
I – S = DP - M - B External sector
X – Z = R - DF
Now, add them up You’ll be surprised!
An Alternative Derivation of Monetary Survey Public sector
G – T = B + DG + DF
Private sector
I – S = DP - M - B External sector
X – Z = R - DF
An Alternative Derivation of Monetary Survey Public sector
G – T = B + DG + DF
Private sector
I – S = DP - M - B External sector
X – Z = R - DF
An Alternative Derivation of Monetary Survey Public sector
G – T = B + DG + DF
Private sector
I – S = DP - M - B External sector
X – Z = R - DF
So, adding them up, we get 0 = D - M + R
because DG + DP = D
Hence, M = D + Rso that
M = D + R
A Fresh View of Money
The monetary survey (M = D + R) has three key implications:
Money is endogenous If R increases, then M increases Important in open economies
Domestic credit affects money If R increases, may want to reduce D to
contain M R = M - D
Where R = X – Z + F Monetary approach to balance of payments
Monetary Approach to Balance of PaymentsThe monetary approach to the balance of
payments (R = M - D) has the following important implication, in three parts
Need to Forecast M
And then Determine D
In order to Meet target for R
Hence, D is determined as a residual given both M and R*
R* = reserve target, e.g., 3 months of imports
Monetary Approach to Balance of Payments Domestic credit is a policy variable
that involves both monetary and fiscal policy
Can reduce domestic credit (D) To private sector To public sector
By reducing government spending By increasing taxes
Monetary and fiscal policy are closely related through domestic credit
Forecasting Money
Money is determined by equilibrium between money demand and money supply
Money demand, like the demand for goods and services, depends on
Income, i.e., GNP Price, i.e., the opportunity cost of
holding money Inflation rate in developing countries Interest rate in industrial countries
Forecasting Money Demand
Theory and empirical evidence When GNP goes up, so does the demand
for money Transactions demand
When inflation goes up, money demand goes down ...
... because the opportunity cost of holding money goes up with inflation
Speculative demand So, to forecast money, need first to
forecast income, price level, and inflation
Forecasting Money Demand: An ExampleM/P = Ya eb
log(M/P) = a log(Y) + ba = income elasticityIncome effect means that a 0
Typically, a is around 1
b = inflation semi-elasticityInflation effect means that b < 0
For example, b can be around -5
Can show that
inflation elasticity is –1
if = 0.20
Equilibrium of Supply and Demand For Money
PY
M
Money supply
Money demand
Nominal income depends on the money supply
Effects of an Increase in Money Supply
PY
M
Money supply
Money demand
An increase in money supply increases nominal income
A
B
Effects of an Increase in Inflation Rate
PY
M
Money supply
Money demand
An increase in inflation reduces money holdings relative to income
A
B
Effects of Increases in Money Supply and Inflation
PY
M
Money supply
Money demand
Monetary expansion, by increasing inflation, reducesreduces money holdings relative to income,thereby impeding efficiency and economic growth,even if nominal income rises in the short run
A
B
Effects of Increases in Money Supply and Inflation
PY
M
Money supply
Money demand
Monetization is a good thing, but printing money is notnot the way to achieve itOn the contrary, monetary expansion reducesreduces the amount of money available to finance economic transactions
A
B
Inflation and financial depth, again
87 countries0
20
40
60
80
100
120
0,00 0,20 0,40 0,60 0,80 1,00
Inflation distortion 1965-98
Mo
ney
an
d q
uas
i-m
on
ey 1
965-
98 (
% o
f G
DP
)
Brazil
NicaraguaArgentina
Austria
Switzerland
Japan
r = -0.45
Conclusion
MM = D + R Need to forecast monetary
expansion to be able to determine the rate of credit expansion that is consistent with our reserve target
Base forecast of monetary expansion on forecast of income growth and inflation
These slides will be posted on my website: www.hi.is/~gylfason