1. 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

2. Outline Role of money Money and banking
Money and the balance of payments
Forecasting money
Money, prices, and income

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

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

10. 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+ )

11. 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.

12. Overview of Banking System

13. 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

14. 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

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

16. 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

17. 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).

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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.

25. 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

26. 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.

27. 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

28. Equilibrium of Supply and Demand For Money
Money demand
Money supply
Nominal income depends on the money supply. PY

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

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

31. 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

32. 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

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

34. These slides will be posted on my website:
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