Transcript Monetary Accounts and Analysis

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
Tunis, February 2006
Outline
Role of money
Money and banking
Money and the balance of
payments
Forecasting money
Money, prices, and income
Quantity Theory of
Money
P
 Oldest macroeconomic theory
 MV = PY
 V = PY/M (velocity)
 P = (V/Y)M
Long-run
relationship
M
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
P
Long-run
relationship
M
This is why money and
monetary policy must
play a key role in
financial programming
The Role of Money
P
 Generally, it is necessary to
control money to manage
aggregate demand
 Money affects aggregate demand
directly and indirectly
Direct effect
Aggregate
supply
Through interest rates
and investment
Indirect effect
Aggregate
demand
Y
Through interaction
with fiscal policy
Direct Effects of Money
 An increase in money supply
increases supply of loanable funds
 Thus driving down interest rates
r
 As interest rates fall, investment
rises
 Thus increasing aggregate demand
Supply of
loanable funds
Demand for
loanable funds
S, I
Hence, monetary expansion
increases the price level and also
output, as long as the aggregate
supply schedule slopes up
Indirect Effects of Money
P
 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 ...
Aggregate
supply
Aggregate
demand
Y
... 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
South Africa
Zimbabwe
Zambia
Uganda
Tanzania
Swaziland
Namibia
Malawi
Lesotho
2002
Botswana
Beginning
Angola
0
20
40
60
80
Financial depth and
economic growth
Growth of GNP per capita 1965-98, adjusted
for initial income (% per year)
6
r = 0.66
Botswana
4
Austria
2
Indonesia
Japan
Switzerland
0
0
20
40
60
80
100
120
-2
Jordan
-4
-6
-8
Money and quasi-m oney 1965-98 (% of GDP)
Money and quasi-money 1965-98 (% of GDP)
Inflation and financial
depth
120
Switzerland
100
80
r = -0.45
Japan
Austria
60
40
Nicaragua
Argentina
Brazil
20
0
0,00
0,20
0,40
0,60
0,80
Inflation distortion 1965-98
1,00
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
Financial System
Banking System
(Monetary Survey)
Central Bank
Other Financial Institutions
Commercial Banks
DG = domestic
credit to
government
DB = domestic
credit to
commercial banks
RC
= foreign
reserves in
Central Bank
Balance Sheet of
Central Bank
Assets
Liabilities
DG
C
DB
B
C = currency
B = commercial
bank deposits in
Central Bank
RC
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
Balance Sheet of
Commercial Banks
Assets
Liabilities
DP
DB
RB
T
B
Adding Up the Two
Balance Sheets
D
R
D G + DP + D B + RB + R C + B
= C + T + B + DB
M
Hence, M = D + R
Balance Sheet of
Banking System
D = DG + DB =
net domestic
credit from
banking system
(net domestic
assets)
R = RC + RB =
foreign reserves
(net foreign
assets)
M = money supply
Assets
Liabilities
D
M
R
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
Hence,
F
X
–
Z
=
R
D
M = D + R
so that
 So, adding them up, we get
M=D+R
0 = D - M + R
because DG + DP = D
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 Payments
The 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 Example
M/P = Ya eb
log(M/P) = a log(Y) + b
a = income elasticity
Income effect means that a  0
 Typically, a is around 1
b = inflation semi-elasticity
Inflation effect means that b < 0
 For example, b can be around -5
Equilibrium of Supply
and Demand For Money
M
Money
demand
Nominal income
depends on the
money supply
Money
supply
PY
Effects of an Increase in
Money Supply
M
B
A
An increase in
money supply
increases nominal
income
Money
demand
Money
supply
PY
Effects of an Increase in
Inflation Rate
M
Money
demand
A
B
An increase in
inflation reduces
money holdings
relative to income
Money
supply
PY
Effects of Increases in
Money Supply and Inflation
Monetary
expansion, by
increasing
inflation, reduces
money holdings
relative to income,
thereby impeding
efficiency and
economic growth,
even if nominal
income rises in the
short run
M
Money
demand
B
A
Money
supply
PY
Effects of Increases in
Money Supply and Inflation
Monetization is a
good thing, but
printing money is
not the way to
achieve it
On the contrary,
monetary
expansion reduces
the amount of
money available to
finance economic
transactions
M
Money
demand
B
A
Money
supply
PY
Money and quasi-money 1965-98 (% of GDP)
Inflation and financial
depth, again
120
Switzerland
100
80
r = -0.45
Japan
Austria
60
40
Nicaragua
Argentina
Brazil
20
0
0,00
0,20
0,40
0,60
0,80
Inflation distortion 1965-98
1,00
These slides will be posted on my website:
www.hi.is/~gylfason
Conclusion


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