Transcript Recommending a Strategy

Economics 216:
The Macroeconomics of Development
Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)
Kwoh-Ting Li Professor of Economic Development
Department of Economics
Stanford University
Stanford, CA 94305-6072, U.S.A.
Spring 2000-2001
Email: [email protected]; WebPages: http://www.stanford.edu/~ljlau
Lecture 9
The Role of Money and Finance
Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)
Kwoh-Ting Li Professor of Economic Development
Department of Economics
Stanford University
Stanford, CA 94305-6072, U.S.A.
Spring 2000-2001
Email: [email protected]; WebPages: http://www.stanford.edu/~ljlau
Why is Money Desirable?
Money as a Facilitator of Transactions

It lowers transactions cost (and hence makes possible productive
transactions that otherwise may not have taken place in the absence
of an accepted medium of exchange)
A common unit of account--a common numeraire
 Non-coincidence (lack of synchronization) of supply and demand—barters,
and successive barters, can only take place at a single time and place (e.g.
Samuelson’s “exact consumption loan” model)
 The effect of credit-worthiness and risk--lack of mutual trust requires cash on
delivery (a future delivery on barter is risky)
 The benefits and costs of anonymity (non-discrimination; illegal activities, the
cash-in-advance constraint)


Private versus public issuance of money
Currency substitution and the network externality--the more a form
of money is accepted, the more it is acceptable
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The Different Definitions of Money




M0 = currency and coins in circulation
M1 = M0 + demand deposits
M2 = M1 + savings deposits
The distinction between demand deposits and savings deposits has
become blurred in the United States (interest and non-interest
bearing, withdrawal notice and penalty, money market funds at nonbanking institutions)
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The Demand for Money

Three traditional sources of demand for money (M1)



Transactions Demand
Precautionary Demand
Speculative Demand
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Transactions Demand (1)
 The types of market transactions requiring money balances
 The monetization of previously non-market transactions (barter, home
consumption, home services, in kind payments of rents and wages)
 Inter-firm transactions (market) versus intra-firm transactions (non-market)-the organization of the economy (the degree of vertical integration; the degree
of concentration (conglomerates), the degree of specialization and division of
labor, the degree of self-sufficiency)
 Transactions involving goods and services currently produced (thus generating
current-value added) and transactions involving existing physical assets and
inventories (which do not generate current value-added)
 Real transactions versus financial transactions--purchases and sales of business
assets versus purchases and sales of shares of common stock (securitization
facilitates the trading of assets and hence increases the volume of transactions
(reduces lumpiness and enhances liquidity)
 The multiplier effect of financial transactions (financial deepening)--mutual
funds, derivatives, holding companies
 The volume of trade in existing assets, real or financial, depends on the level of
wealth rather than the level
of J.real
orUniversity
GDP
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Lau,GNP
Stanford
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Transactions Demand (2)

The role of institutions, customs and practices


(e.g., the frequency of settlement (a higher frequency requires more money,
other things being equal), the use of credit and debit cards (increases the
GDP/Money Supply ratio), the use of sweep accounts (increases the
GDP/Money Supply ratio), the demand for money under central planning)
The cost of holding money for transactions purposes is the time
value of money (the real rate of interest)
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The Quantity Theory of Money (Friedman):
MV = PT






For the four variables, only M and P can be directly observed
V cannot be directly observed, but is measured as PT/V
T actually stands for the total real volume of transactions in the
economy but in general cannot be directly observed either
T is frequently identified with real GDP (value added), Y and is
typically assumed to be proportional to Y (real GDP), T=Y, where t
is a constant
The velocity of money, defined as V=PT/M, is in general assumed to
be an increasing function of the real rate of interest (the velocity is
so-to-speak “the number of times money needs to change hands in
order to support the given volume of transactions”)
V is in general not constant, even with the rate of real interest
constant—V tends to rise with innovations in finance and
transactions technology; e.g., a shift from the use of cash or checks
to credit cards and debit
cards reduces the money balances required8
Lawrence J. Lau, Stanford University
to support a given volume of transactions and hence increases V
The Measurement of the Velocity of Money




V as defined cannot be measured because T is not directly observed
Instead, one can define an alternative velocity variable V*=PY/M in terms of
observable variables, which is referred to as velocity*
V*= PT/M x Y/T = V x Y/T = V/
The variable  =T/Y the ratio of the total real volume of all transactions T to real
GDP Y is not a constant but changes over time






The volume of transactions relative to real GDP (T/Y) tends to rise in the process of
economic development
T/Y also rises with financial deepening
T/Y rises with rising volume of trade with the same trade surplus/deficit
For most developing economies, especially in the early stages of their economic
development, T is likely to rise much faster than Y, and hence  is increasing over
time; for developed economies,  is likely to be more stable .
Since both V and  tend to rise over time and with economic development and
growth—what is likely to happen to V*?
At the beginning phase of economic development, V, which depends on financial
and technological innovation, is likely to increase very slowly, whereas  is likely
to increase quite rapidly, leading to a fall in V*; as an economy matures, Increases
in V become much more important,
 becomes
relatively more stable, and V*
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Lau, Stanford
University
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is likely to rise
The Velocity of Money:
China and the United States of America
The Velocity of Money, China and U.S.A.
(International Monetary Fund Data)
8.5
7.5
GDP/M1 China
6.5
GDP/M2 China
GDP/M1 US
GDP/M2 US
GDP/Money
5.5
4.5
3.5
2.5
1.5
0.5
-0.5
1959
1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
Year
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The Implications of the Quantity Equation of
Money: MV* = PY
Differentiating the quantity equation with respect to t, we obtain:
dM
dV*
dP
dT
V*
M
T
 P
. Dividing both sides by MV, we obtain:
dt
dt
dt
dt
dM
dV*
dP
dT
dY
dT
/M 
/V* 
/P 
/T. Substituting
/Y for
/T, and
dt
dt
dt
dt
dt
dt
rearranging, we obtain:
dP
dM
dV*
dY
/P 
/M 
/V*/Y. In other words, the rate of inflation
dt
dt
dt
dt
may be written as difference of the rate of growth of the money supply
and the rate of growth of real output, assuming that the velocity* of money
remains constant.
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The Rate of Change of Velocity*
V* = V/τ;
dV*
dV
dτ
dV
dτ
Thus,
/V* 
/V /τ. Both
/V and
/τ are likely to be
dt
dt
dt
dt
dt
positive so that the rate of change of velocity* is likely to be indeterminate
in sign. However, the presumption is that for developed economies,
dV*
/V*
dt
dV*
/V* is likely to be
dt
negative. Thus, in developed economies, if the rate of growth of the money
is likely to be positive and for developing economies,
supply exceeds the rate of growth of real GDP, there is likely to be inflation,
whereas in developing economies, the rate of growth of money supply can
exceed the rate of growth of real GDP significantly without necessarily
causing inflation.
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The Usefulness of the Quantity Equation of
Money: MV* = PY



The usefulness of the quantity equation of money is greatly
diminished if the velocity* of circulation of money is variable
For most developing countries, especially those without a history of
high or hyper-inflation, the rate of growth of money supply can be
significantly higher than the rate of growth of real GDP without
necessarily causing additional inflation
This is because the velocity* of money, defined as PY/M, has, on the
whole, been declining (a given level of real GDP requires more
money balances to support over time)
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The Velocity of Money and
Real GDP per Capita
Velocity of Money and Quasi-Money
14.0
GDP/Money Supply
12.0
10.0
8.0
6.0
4.0
2.0
0.0
10.0
100.0
1000.0
10000.0
100000.0
Real GDP per capita
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The Rate of Growth of Money Supply and
Real GDP per Capita
Average Annual Rate of Growth of Money Supply, 1985-1995
1,000.0
Percent per annum
100.0
10.0
1.0
100.0
1000.0
10000.0
100000.0
0.1
Real GDP per Capita
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The Rate of Inflation and
Real GDP per Capita
Average Annual Rate of Inflation, 1985-1995
1000.0
Percent per annum
100.0
10.0
1.0
100.0
1000.0
10000.0
100000.0
0.1
Real GDP per Capita
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Precautionary Demand



Availability of social (or even private) insurance (e.g., retirement,
survivor, health care, unemployment, inflation)--degree of
completeness of markets
Availability of credit (households and firms)
The time value of money (the rate of interest)
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Speculative Demand


Money balances maintained for the exploitation of unexpected
opportunities
The time value of money (the rate of interest)
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The Degree of Monetization and
Growth of Real GDP



The degree of monetization increases with economic development
Measured GDP may grow faster than true GDP especially at the
early stage of economic development
Examples



Marketization of barter transactions
Marketization of household work
Growth of financial transactions--financial deepening
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Seigniorage and Inflation Tax


The central bank (or private banks) issuing the currency in
circulation has seigniorage to the extent that money balances are held
solely for the purpose of transactions or as a store of value
In developing economies, inflation is sometimes deliberately used as
an instrument of taxation
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The Role of Finance (Credit) as a Facilitator of
Transactions


The “Cash-in-Advance” Constraint
There are transactions that would not have taken place in the absence
of finance or credit, formal or informal



Asymmetric information between savers and entrepreneurs/investors
Transfer of risks from savers and producers to financiers (e.g. letter of credit)
Economies of scale
Maturity transformation
 Pooling of resources (lumpiness of investments)
 Pooling of risks across borrowers
 Transaction costs
 Specialization in information acquisition and monitoring
 Amelioration of exchange rate risk


Lack of alternative investment instruments for savers
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Explicit or Implicit Deposit Insurance







Enhances confidence in and hence stability of the financial system
Reduces the probability of bank failure due to illiquidity as opposed
to insolvency
Reduces the spillover (contagion) effect of bank failure
Levels the playing field between large and small banks (a large
number of small banks is not as efficient as a small number of large
banks because of the intrinsic economies of scale in banking;
however, the political economy may favor a large number of small
banks)
Encourages moral hazard on the part of both depositors and owners
of financial institutions
Prudential regulation and supervision are therefore required
A high reserve ratio as a substitute for ineffective prudential
regulation and supervision
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Moral Hazard and Financial Institutions




The capital requirements (e.g., the Bank for International Settlement
(BIS) standard of 8%) are generally too low to discourage moral
hazard on the part of the owners of the financial institutions
Government-directed credit and the doctrine of “too big to fail”
encourage moral hazard on the part of the borrowers (as well as
lenders)
Explicit or implicit deposit insurance encourage moral hazard on the
part of savers and depositors in their choices of depository
institutions for their deposits
Informal credit markets (the lack of anonymity which limits moral
hazard)


Mutual credit associations
Grameen banks
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The Rate of Interest on Savings Deposits and
Real GDP per Capita
The Deposit Rate and Real GDP per Capita
1000.0
Percent per annum
100.0
10.0
1.0
100.0
1000.0
10000.0
100000.0
0.1
Real GDP per Capita
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The Rate of Interest on Loans and Real GDP
per Capita
The Lending Rate and Real GDP per Capita
1000.0
Percent per annum
100.0
10.0
1.0
100.0
1000.0
10000.0
100000.0
0.1
Real GDP per Capita
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The Interest Rate Spread and
Real GDP per Capita
The Interest Rate Spread, 1995
1000.0
Percent per annum
100.0
10.0
1.0
100.0
1000.0
10000.0
100000.0
0.1
Real GDP per Capita
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The Interest Rate Spread and
Real GDP per Capita
The Interest Rate Spread, 1995
250.0
Percent per annum
200.0
150.0
100.0
50.0
0.0
100.0
1000.0
10000.0
100000.0
-50.0
Real GDP per Capita
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The Interest Rate Spread and
Real GDP per Capita
The Interest Rate Spread, 1995
90.0
Percent per annum
70.0
50.0
30.0
10.0
-10.0100.0
1000.0
10000.0
100000.0
Real GDP per Capita
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The Rate of Interest on Savings Deposits and
the Lagged Rate of Inflation
The Deposit Rate (1998) and
the Lagged Rate of Inflation (1997)
45
40
35
The Deposit Rate %
30
25
20
15
10
5
0
-10
0
10
20
40
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J. Lau, 30
Stanford University
The Lagged Rate of Inflation %
50
60
70 29
The Rate of Interest on Loans and the Lagged
Rate of Inflation
The Lending Rate (1998) and
the Lagged Rate of Inflation (1997)
80
70
The Lending Rate %
60
50
40
30
20
10
0
-10
10
30
50
70
Lawrence J. Lau,
Stanford University
The Lagged Rate of Inflation %
90
110
30
The Rate of Inflation and the Rate of Economic
Growth (1970-1998)
The Rate of Economic Growth and the Rate of Inflation
(1970-1998)
Average Annual Rate of Growth of GDP (%)
10
8
6
4
2
0
0
-2
20
40
60
80
100
Lawrence J. Lau, Stanford University
Average Annual Rate of
Inflation (%)
120
140
160
31
The Effectiveness of Monetary Policy





Setting the basic or reference rate of interest (e.g., the federal funds
rate, the rediscount rate)
Setting the capital requirement (BIS standard)
Setting the reserve ratio
Inflation targeting
Open market operations (the lack of a deep and liquid bond market)
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Financial Repression


Is there financial repression in developing economies?
Is financial repression desirable or undesirable?
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The Benefits and Costs of a Currency Board
System (Dollarization)

True dollarization (Panama) and quasi-dollarization (Hong Kong,
Argentina)



True dollarization implies that the U.S. dollar will be legal tender for all
obligations and contracts can be denominated in U.S. dollars
Hong Kong and Argentina with a fixed U.S.$ peg are not quite truly dollarized
but is very close to being so
Indonesia considered adopting a currency-board system in the midst
of the East Asian currency crisis
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The Benefits and Costs of a Currency Board
System (Dollarization)

Benefits:







Insulation of economy from exchange rate volatility
Credible pre-commitment to non-interventionist monetary policy, in particular,
non-inflationary financing of government expenditures
Implicit commitment to a low rate of inflation (a rate of inflation similar to that
of the United States)—lowers inflationary expectations if credible
The rate of interest and the rate of inflation will be at U.S. levels if credible
Promotes long-term FDI as well as foreign portfolio investment
Facilitates foreign trade
Costs:



No more monetary policy (neither money supply nor interest rate can be
independently controlled)
Fiscal policy constrained by the ability to issue local currency or US$
denominated government notes and bonds
Loss of seigniorage from currency issuance under true dollarization
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The Currency Board System

Adequate foreign exchange reserves, in excess of M0, will still be
required



Even a completely cashless society, which implies M0 = 0, will still require
foreign exchange for the smooth and orderly conduct of business
Flexibility (especially downward) of prices and wage rates is
essential for prompt and successful adjustment to external shocks
Low stock of external (especially short-term) debt denominated in
foreign currency relative to foreign exchange reserves
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Outstanding Issues of Dollarization

Outstanding issues




Is there a lender of last resort (to domestic financial institutions)?
Can the seigniorage be shared (true dollarization)?
Coordination, if any, of monetary policy with the U.S. (e.g., monetary union)?
The U.S. benefits from seigniorage, both direct and indirect
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Voluntary Virtual Dollarization



In economies with a high rate of inflation and a continuously
depreciating currency, it is quite common for transactions (e.g., loans
and interest) to be denominated in U.S. dollars but settled in terms of
the local currency in accordance with the exchange rate (either the
official market rate or the black market rate, as specified by prior
agreement)
Example 1: A firm may place an order in terms of U.S. dollars and
upon delivery will settle in local currency in accordance with the
market exchange rate on the date of delivery
Example 2: A firm may borrow money in terms of U.S. dollars. It
will be given the proceeds in terms of the local currency in
accordance with the market exchange rate on the date of the loan
draw down. Upon maturity, it will repay in terms of the local
currency in accordance
with the exchange rate on the date of
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maturity.