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 P The price level is approximately proportional to the money supply over long periods. Long-run relationship M

Quantity Theory of Money To keep the price level under control, it is essential to control the money supply P This is why money and monetary policy must play a key role in financial programming. Long-run relationship M

The Role of Money Generally, it is necessary to control money to manage aggregate demand. Money affects aggregate demand directly and indirectly. P Direct effect Through interest rates and investment Indirect effect Through interaction with fiscal policy Aggregate supply Aggregate demand Y

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. r Supply of loanable funds Hence, monetary expansion increases the price level and also output, as long as the aggregate supply schedule slopes up. Demand for loanable funds S, I

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 ... P ... 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. Aggregate supply Aggregate demand Y

Money is Useful 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. M/PY (in %) 1970 2001 Botswana … 28 Ethiopia 43 Kenya 27 39 Nigeria 9 26 Rwanda 11 16 Uganda 17 Tanzania 18 France 41 69 United States 62 65

Financial depth and economic growth r = Spearman rank correlation r = 0.66 Botswana Austria Indonesia Japan Switzerland Jordan 87 countries

Inflation and financial depth Add these two correlations, and an inverse correlation between inflation and growth follows Switzerland r = -0.45 Japan Austria Nicaragua Argentina Brazil 87 countries  /(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

Balance Sheet of Central Bank 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 Assets Liabilities DG C DB B RC

Balance Sheet of Commercial Banks 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 Assets Liabilities DP DB RB T B

Adding Up the Two Balance Sheets R DG + DP + DB + RB + RC + B = C + T + B + DB M Hence, M = D + R

Balance Sheet of Banking System Monetary Survey Balance Sheet of Banking System 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 M = D + R 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

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 Hence, M = D + R So, adding them up, we get 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 e- b 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 Money demand Money supply Nominal income depends on the money supply. PY

Effects of an Increase in Money Supply Money demand B Money supply A An increase in money supply increases nominal income. PY

Effects of an Increase in Inflation Rate M Money demand A Money supply B An increase in inflation reduces money holdings relative to income. 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. 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. Money demand B A Money supply PY

Inflation and financial depth, again Switzerland r = -0.45 Japan Austria Nicaragua Argentina Brazil 87 countries

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 M = D + R