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Monetary Accounts: An Overview. 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 - PowerPoint PPT Presentation
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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
AssetsAssets LiabilitiesLiabilities
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
AssetsAssets LiabilitiesLiabilities
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
PrivatePrivate sector sector I – S = I – S = DDPP - - M - M - BB
ExternalExternal sector sector X – Z = X – Z = R - R - DDFF
An Alternative An Alternative Derivation of Derivation of Monetary SurveyMonetary Survey
PublicPublic sector sector G – T = G – T = BB + + DDGG + + DDFF
PrivatePrivate sector sector I – S = I – S = DDPP - - M - M - BB
ExternalExternal sector sector X – Z = X – Z = R - R - DDFF
An Alternative An Alternative Derivation of Derivation of Monetary SurveyMonetary Survey
PublicPublic sector sector G – T = G – T = BB + + DDGG + + DDFF
PrivatePrivate sector sector I – S = I – S = DDPP - - M - M - BB
ExternalExternal sector sector X – Z = X – Z = R - R - 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