1. Monetary Accounts: An Overview 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 1.Role of money 2.Money and banking 3.Money and the balance of payments 4.Forecasting money 5.Money, prices, and income

3. 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

4. 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

5. The Role of Money Generally, we need to control money to manage aggregate demand Money affects aggregate demand directly and indirectly Y P Aggregate supply Aggregate demand Direct effect through interest rates and investment Indirect effect through interaction with fiscal policy

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 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

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... 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

8. Money is Useful M/PY (in %) 1970 1998 Malawi1814 Botswana… 24242424 Namibia... 40404040 Zimbabwe... 23232323 Zambia2516 Uganda17 13131313 Tanzania...17 United States 63 58585858 France41 69* 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 * 1997

9. 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.

10. Overview of Banking System

11. Balance Sheet of Central Bank AssetsLiabilities DGDGDGDGC DBDBDBDBB RCRCRCRC 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

12. Balance Sheet of Commercial Banks AssetsLiabilities DPDPDPDP DBDBDBDB RBRBRBRBT 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

13. Balance Sheet of Banking System 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 Monetary Survey

14. 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)

15. An Alternative Derivation of Monetary Survey Public sector G – T =  B +  D G +  D F G – T =  B +  D G +  D F Private sector I – S =  D P -  M -  B I – S =  D P -  M -  B External sector X – Z =  R -  D F X – Z =  R -  D F Now, add them up

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

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

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

19. 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

20. 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 1)Forecast M and then 2)Determine D in order to 3)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

21. 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 and fees Monetary and fiscal policy are closely related through domestic credit

22. 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

23. 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

24. 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

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

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

27. 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

28. Financial Depth and Economic Growth 85 countries r = 0.66 Jordan Switzerland Japan Indonesia

29. Financial Depth and Inflation 160 countries Jordan Switzerland Nicaragua Hong Kong Angola Congo, Dem. Rep. r = -0.51

30. Financial Depth and Inflation, Again 160 countries Jordan Switzerland Japan Indonesia r = -0.51

31. Effects of Increases in Money Supply and Inflation PY M Money supply Money demand 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

32. Effects of Increases in Money Supply and Inflation PY M Money supply Money demand 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 A B

33. Conclusion 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 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 Base forecast of monetary expansion on forecast of income growth and inflation

34. Bottom line M = D + R Need to control credit expansion – and hence apply fiscal restraint – to achieve the rate of monetary expansion that is consistent with our international reserve target Need to control credit expansion – and hence apply fiscal restraint – to achieve the rate of monetary expansion that is consistent with our international reserve target Key to financial programming Key to financial programming These slides – and more! – can be viewed on my website: www.hi.is/~gylfason