Lecture 6 Money Supply Control and Financial Innovation

Examine the simple money multiplier approach to money supply determination Examine the meaning of financial innovation. Examine implications for the monetary system and the transmission mechanism Implications for monetary control Examine the counterparts approach to money supply determination

The money multiplier Mechanical link between base money and broad (bank) money Treats base money as exogenous By assuming that the ratio of currency to deposits and reserves to deposits is constant, the link between base money and broad money is the multiplier.

The mechanical link Let H = base money H = C + R Let M = broad money M = C + D Divide M by H The multiplier m = M/H

Algebra of Money Multiplier

Principal causes of financial innovation High variable and unpredictable inflation leading to high variable and unpredictable rates of interest Restrictive regulations tending to discriminate against certain kinds of Financial Institutions Development of technology

Three strands of financial innovation Switch from asset to liability management development of variable rate lending cash management technology

Financial innovation and the demand for money

Implications for monetary policy RbRb Y LM pre-FI LM post-FI

Implication of decreasing interest rate sensitiveness of the demand for money

Continued

Technology EFT = Electronic Fund Transfer ATM = Automated Teller Machines POS = Point of Sale Machine Technology enables banks to reduce unit costs better able to maintain profitability in the face of declining spreads

Counterparts to broad money Government financing identity G-T= H + B Bank balance sheet L + R = D + E Broad Money M = C + D Base Money H = C + R

Deriving the counterparts From the last 3 equations M = (H-R) + D substituting for D M = (H-R) + (L+R-E) taking differences, solving for H and substituting in the financing constraint M = (G-T) + L - B - E

Demand for bank credit (loans) Complicated function of a number of variables the loan rate spread expected inflation expected demand costs of borrowing from abroad or capital market

Monetary Control Techniques Open Market Operations Infinite supply of base money at the current rate of interest. Interest rate policy. Taylor rule - reaction function.

Taylor Rule

Money Stock Control - Two Monetarist Experiments USA Base Control UK Medium Term Financial Strategy (MTFS) Two views concerning the pace of monetary control 1) Gradualist 2) Sudden death

US experiment In October 1979 the Fed switched from controlling Fed funds rate to controlling non-borrowed reserves to target M1 Bankers and professional economists argued that the shift to a form of base control would cause greater fluctuations in interest rates

Inflation expectations and long-term bond yields Bond rates did not reflect a fall in inflation expectations Financial innovation - development of NOW accounts Required reserves based on lagged accounting basis

The US Experiment - a model

Volatility Clearly (13) > (7) Monetarists argued that excessive volatility led to a risk premium being priced into bond rates. A temporary rise in monetary growth could have led to a rise in long term rates because people confuse a short term increase with a long term increase.

Further Distortions The fluctuations in short rates gave additional impetus to the development of new financial instruments NOW, Super NOW, Money Market Mutual Funds etc. Distortion of the money supply figures led to the abandonment of the target in 1982.

UK - Experiment MTFS announced targets for public sector deficit as % of GDP and M3 growth Autumn 1979 exchange controls abolished - ability to re-route intermediation offshore credit controls and controls on deposits abolished Banking sector liberalised Broad money failed to signal the recession

Conclusion Experiment with monetary targeting was not an unqualified success Financial innovation and financial sector deregulation had blurred the boundaries between money and non-money and distorted the established links between broad money and other economic variables Inflation targeting has an implicit monetary control