View
219
Download
3
Category
Tags:
Preview:
Citation preview
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
DR
DC
DC
m
mHMD
RD
CD
C
H
M
RC
DC
H
M
DCM
RCH
1
1
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
),,(
),,(
dbd
bd
RRYPfM
RYPfM
Implications for monetary policy
Rb
Y
LM pre-FI
LM post-FI
Implication of decreasing interest rate sensitiveness of
the demand for money
2222
*
0
)(;)(
0)()(
vu
s
d
vEuE
vEuE
vMM
RyM
uRyy
Continued
0)(
2
0
0)(
0
2
2
2
2
2
2
2
2
2*
2
*
*0
Y
u
uvY
let
M
Y
M
Y
uvMyy
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
*21*
21*
tttttt yyR
Money Stock Control - Two Monetarist Experiments
• USA - 1979-82 Base Control
• UK 1980-85 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
R y E P E Pt tt
tt
t t
1
11
(1) IS
M p y Rt t t t t (2) Md y y M E M vt t
tt t
* ( )1
(3) Aggregate Supply
h M R ut t t t (4) Money supply
T o e x a m i n e t h e i n s t r u m e n t c h o i c e p r o b l e m - l e t t h e p o l i c y i n s t r u m e n t b e R , s e t t o s a t i s f ys o m e t a r g e t M * .
T h e r e f o r e R R E Rtt
t 1
f r o m ( 2 ) t a k i n g e x p e c t a t i o n s
M E p E y E Rt
tt
tt
t*
1 1 1 ( 5 )
s u b t r a c t ( 5 ) f r o m ( 2 )
( ) ( ) ( )*M M p E p y E ytt
t tt
t t 1 1
( 5 ’ )
Taking expectations of (3)
E y yt
t
1
*
Then y E y M E M vtt
t tt
t t 1 1
( ) (6)
Assume that prices are pre-set in the short period, so that there are no one periodsurprises. Thus p E pt
tt
10 and note E M M
tt
1
*
Thus M M M M vt t t t * *( )
mv22 2
21
( )
(7)
Let base money be the policy instrument to hit a target M * .
Therefore h M E Rtt
t
*
1(8)
subtract (8) from (4)
01
( ) ( )*M M R E R ut tt
t t (9)
but from (2), taking expectations and subtracting
M M p E p y E y R E Rt tt
t tt
t tt
t t
* ( ) ( ) ( )1 1 1
substitute for R E Rtt
t 1
from (9) and for y E ytt
t 1
from (6)
M M M M vM M u
t t tt t
t
* *
*
( )( )
( ) ( )*M M vu
t t tt
1
m
v u2
2 2
2
2
2
1
(10)
Comparing (10) and (7) it is not clear which is the superior instrument
A l l o w f o r l a g g e d r e s e r v e a c c o u n t i n g
h M R ut t t t 1 ( 1 1 )
T a k i n g e x p e c t a t i o n s o f ( 2 ) a n d s e t t i n g E M Mt
t
1
*
M E p E y E Rt
tt
tt
t*
1 1 1 ( 1 2 )
T a k e e x p e c t a t i o n s o f ( 1 1 ) a n d n o t e t h a t E h ht
t t
1
h M E Rt t
tt 1
1
s u b s t i t u t i n g f o r E Rt
t 1 i n ( 1 1 ) i n t o ( 1 2 )
h M E y M E pt tt
tt
t
1
1 1
* ( 1 1 ’ )
s u b s t i t u t i n g f o r h t f r o m ( 1 1 ) a n d t h e r e b y e l i m i n a t i n g M t - 1
R u E y M E pt tt
tt
t1 1
*
s u b s t i t u t i n g f o r R f r o m ( 2 ) a n d r e - a r r a n g i n g
M p y E y M E p ut t tt
tt
t t t
( ) *
1 1
s i n c e p E ptt
t 1
0 a n d y E y M M vtt
t t t 1
( )*
t h e n M M
v u
t
t t t
*
( )
1
m
v u2
2 2
2
2
21( )( 1 3 )
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
• 1980 - credit controls and controls on deposits abolished
• Banking sector liberalised• Broad money failed to signal the 1980-81 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
Recommended