1. Monetary Policy in an Era of Globalization Thorvaldur Gylfason Pretoria, South Africa, June 2005 Two parts Monetary accounts and analysis Monetary policy in open economies

2. Monetary Policy in an Era of Globalization 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

3. Monetary Accounts and Analysis: Outline Role of money Money and banking Money and the balance of payments Forecasting money Money, prices, and income

4. 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 Analysis

5. 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 Analysis

6. 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 Analysis

7. 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 Analysis

8. 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 Analysis

9. 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 Empirical evidence

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

11. 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 = -0.45  /(1+  ) Empirical evidence

12. 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. Accounting

13. Overview of Banking System Accounting

14. 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 Accounting

15. 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 Accounting

16. 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 Accounting

17. 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

18. 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)

19. 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! Accounting

20. 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 Accounting

21. 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 Accounting

22. 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 Accounting

23. 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 Analysis

24. 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 Analysis

25. 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 Analysis

26. 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 Analysis

27. 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 Analysis

28. 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 Analysis

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

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

31. 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 Analysis

32. 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 Analysis

33. 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 Analysis

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

35. Conclusion to Part I 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

36. Monetary Policy Money matters, so monetary policy is important Monetary policy is closely related to fiscal policy and to exchange rate policy Monetary institutions also matter

37. Monetary Policy: Outline Presentation in four parts 1.Monetary institutions 2.The main instruments of monetary policy 3.The role of money and credit in financial programming 4.Exchange rate regimes

38. Monetary institutions Central banks Commercial banks Other financial institutions  Central banks’ clients Government Commercial banks  Commercial banks’ clients Households and firms 1

39. Central banks: Independent or not? Most central banks, but not all, are owned and operated by the government Central bank officials are public officials Inflation in 1970s and 1980s raised concerns: were central banks being too willing to print money for short-sighted political purposes?

40. Central banks: Independent or not? Governments may be tempted to instruct central banks to print money rather than raise tax revenue  Major source of inflation, especially in some developing countries Several central banks have been made independent of politicians in order to immunize monetary policy from political pressures (US Fed, ECB, BoE, etc.)

41. Central banks: Independent or not? Division of labor  Government sets inflation target Political task  Central bank uses its instruments to achieve that target Technical task “Instrument independence” Central banks do not make political judgments, not their business

42. Central banks: Independent or not? Independence does not mean lack of accountability  Courts and judges are supposed to be independent, yet accountable  Central banks: Same story  Free press: Same story Accountability can be upheld through legally stipulated checks and balances

43. Commercial banks: Private or public? Some countries have mainly private banks, others have a mixture of private and public banks, a few have only public ones Private banks are usually better run  Commercial vs. political motives  Hence, privatization in banking sector  Not obvious why governments should own and operate commercial banks

44. Commercial banks: Foreign or domestic? Most countries have home-grown banks  Domestic banks know best the needs of their domestic customers Yet, foreign banks are becoming more common – e.g., in Eastern Europe  To increase competition so as to be able to offer more loans at lower interest  To harness foreign expertise Foreign central bank governors: may not be such a bad idea!! (Israel, New Zealand, etc.)

45. Other financial institutions: Large or small? Other financial institutions – financial intermediaries – play an important role They create additional outlets for national saving, by households and firms  They buy and sell bonds, facilitating non- inflationary financing of fiscal operations  They buy and sell stocks, facilitating the buildup of a strong private sector Africa needs both

46. Instruments of monetary policy  Methods used by central banks to change the amount of money in circulation 1.Open-market operations 2.Reserve requirements 3.Discount rates 4.Printing money 5.Direct instruments 6.Persuasion 2

47. 1. Open-market operations Central banks conduct open-market operations when they buy government bonds from or sell government bonds to the public  When they buy government bonds, the money supply increases  When they sell government bonds, the money supply decreases Foreign exchange market intervention also affects the money supply

48. 2. Changing the Reserve Requirement The reserve requirement is the amount (in %) of a bank’s total reserves that may not be loaned out to its customers  Increasing the reserve requirement decreases the money supply  Decreasing the reserve requirement increases the money supply

49. 3. Changing the Discount Rate The discount rate is the interest rate the Central Bank charges commercial banks and the government for loans  Increasing the discount rate decreases the money supply  Decreasing the discount rate increases the money supply

50. 4. Printing money The Central Bank can create money by extending loans to the government  How? By buying bonds from the government that issues them  Inflationary finance Open-market operations are less inflationary than printing money  Hence the need for efficient financial markets that facilitate trade in bonds

51. 5. Direct instruments Ceilings on interest rates  Create excess demand for credit  Prone to abuse  Inefficient and unfair Quotas on credit  Essentially the same effects as ceilings on interest rates

52. Problems in Controlling the Money Supply Central Bank control of the money supply is not precise  Central banks do not control the amount of money that households and firms choose to hold as deposits in banks  Central Banks do not control the amount of money that commercial bankers choose to lend  Money is endogenous: M = D + R Fiscal policy Exchange rate policy

53. Rules versus discretion BenefitsCosts Rules Discretion

54. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances

55. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power

56. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle

57. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency

58. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency Lack of credibility

59. Rules versus discretion BenefitsCosts Rules Tying one’s hands as a disciplinary device Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency Lack of credibility

60. Rules versus discretion BenefitsCosts Rules Tying one’s hands as a disciplinary device Inflexibility that comes from locking the steering wheel Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency Lack of credibility

61. Money and credit in financial programming History and targets  Record history, establish targets Forecasting  Make forecasts for balance of payments, output and inflation, money Policy decisions  Set domestic credit at a level that is consistent with forecasts as well as foreign reserve target 3

62. 1)Make forecasts, set reserve target R* –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual: D = M – R* Financial programming step by step Do this in the right order

63. 1)Make forecasts, set reserve target R* –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual: D = M – R* Financial programming step by step Let’s do the arithmetic

64. Known at beginning of program period:  M -1 = 70, D -1 = 60, R -1 = 10 Recall: M = D + R  X -1 = 30, Z -1 = 50, F -1 = 15 Recall:  R = X – Z + F So,  R -1 = 30 – 50 + 15 = -5, so R -2 = 15 Current account = -20, overall balance = -5  R -1 /Z -1 = 10/50 = 0.2 Equivalent to 2.4 (= 0.212) months of imports Weak reserve position (less than 3 months) History Hypothetical example

65. X grows by 33%, so X = 40 F grows by 40%, so F = 25 R* is set at 15, up from 10 (  R* = 5) Z = X + F + R -1 – R* = 40 + 25 + 10 – 15 = 60 Level of imports is consistent with R* because R * /Z = 15/60 = 0.25 Equivalent to 3 (= 0.2512) months of imports Forecast for balance of payments BOP forecasts (in nominal terms)

66. Increase in Z from 50 to 60, i.e., by 20%, is consistent with R * equivalent to 3 months of imports Now, recall that Z depends on PY where the increase in nominal income PY consists of a price increase and an increase in output Hence, if income elasticity of import demand is 1, PY can increase by 20% E.g., 5% real growth and 15% inflation Depends on slope of aggregate supply schedule Forecast for real sector

67. If PY can increase by 20%, then, if income elasticity of money demand is 2/3, M can increase by 14% Recall quantity theory of money MV = PY Constant velocity means that %  M = %  PY = %  P + %  Y (approx.) Hence, M can expand from 70 to 80 Forecast for money ˜ M = D + R Recall M = D + R

68. Having set reserve target at R* = 15 and forecast M at 80, we can now compute level of credit that is consistent with our reserve target, based on M = D + R So, D = 80 – 15 = 65, up from 60  D/D -1 = 5/60 = 8% Quite restrictive, given that PY rises by 20% Implies substantial reduction in domestic credit in real terms Determination of credit

69. Financial programming step by step: Recap Sequence of steps R* Z Y M D Z = X + F + R -1 – R * Z = mPY MV = PY D = M – R * Forecasts of X and F play a key role: Lower forecasts mean lower D for given R *

70. Exchange rate regimes  The real exchange rate always floats Through nominal exchange rate adjustment or price change  Even so, it makes a difference how countries set their nominal exchange rates because floating takes time  There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates 4

71. Exchange rate regimes There is a range of options  Monetary union or dollarization Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC)  Currency board Legal commitment to exchange domestic for foreign currency at a fixed rate  Fixed exchange rate (peg)  Crawling peg  Managed floating  Pure floating

72. Benefits and costs BenefitsCosts Fixed exchange rates Floating exchange rates

73. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

74. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates

75. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium

76. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Instability of trade and investment Inflation

77. Exchange rate regimes  In view of benefits and costs, no single exchange rate regime is right for all countries at all times  The regime of choice depends on time and circumstance If inefficiency and slow growth are the main problem, floating rates can help If high inflation is the main problem, fixed exchange rates can help

78. What countries actually do (2001) No national currency39 Currency board 8 Adjustable pegs50 Crawling pegs 9 Managed floating33 Pure floating47 186 25% 50% There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

79. Part II: Conclusion The End  Money and credit play a key role in financial programming  Not to be taken literally as a one-size-fits-all approach Countries differ, so need to tailor financial programs to the needs of individual countries Even so, certain fundamental principles and relationships apply everywhere These slides will be posted on my website: www.hi.is/~gylfason