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 effect Through interest rates and investment Indirect effect Through 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

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

Inflation and financial depth 87 countries Brazil Nicaragua Argentina Austria Switzerland Japan Add these two correlations, and an inverse correlation between inflation and growth follows r =  /(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 M 1, M 2, etc.

Overview of Banking System

Balance Sheet of Central Bank AssetsLiabilities DGDG C DBDB B RCRC D G = domestic credit to government D B = domestic credit to commercial banks R C = foreign reserves in Central Bank C = currency B = commercial bank deposits in Central Bank

Balance Sheet of Commercial Banks AssetsLiabilities DPDP DBDB RBRB T B D P = domestic credit to private sector R B = foreign reserves in commercial banks B = commercial bank deposits in Central Bank D B = domestic credit from Central Bank to commercial banks T = time deposits

D G + D P + D B + R B + R C + B = C + T + B + D B Adding Up the Two Balance Sheets D R M Hence, M = D + R

Balance Sheet of Banking System Monetary Survey AssetsLiabilities DM R D = D G + D B = net domestic credit from banking system (net domestic assets) R = R C + R B = 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 (M 2 ), which equals narrow money (M 1 ) + 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 +  D G +  D F Private sector I – S =  D P -  M -  B External sector X – Z =  R -  D F Now, add them up You’ll be surprised!

An Alternative Derivation of Monetary Survey Public sector G – T =  B +  D G +  D F Private sector I – S =  D P -  M -  B External sector X – Z =  R -  D F

An Alternative Derivation of Monetary Survey Public sector G – T =  B +  D G +  D F Private sector I – S =  D P -  M -  B External sector X – Z =  R -  D F

An Alternative Derivation of Monetary Survey Public sector G – T =  B +  D G +  D F Private sector I – S =  D P -  M -  B External sector X – Z =  R -  D F So, adding them up, we get 0 =  D -  M +  R because D G + D P = D Hence,  M =  D +  R so 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 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 = Y a 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 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 reduces 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 A B

Effects of Increases in Money Supply and Inflation PY M Money supply Money demand not Monetization is a good thing, but printing money is not the way to achieve it reduces On the contrary, monetary expansion reduces the amount of money available to finance economic transactions A B

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

Conclusion M M = 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: