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