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

HM

RCDC

HM

DCMRCH

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

vEuEvMM

RyM

uRyy

Continued

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2

0

0)(

0

2

2

2

22

22

2

2*

2

*

*0

Y

u

uvY

let

MY

MY

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 constraintM = (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

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21*

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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 t t t t t t

1 1 1

(1) IS

M p y Rt t t t t (2) Md y y M E M vt t t t 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 Rt t 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 t t t t 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 yt t t t t t t 1 1

( 5 ’ )

Taking expectations of (3)

E y yt t

1

*

Then y E y M E M vt t t t t 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 t t

10 and note E M M

t t

1

*

Thus M M M M vt t t t * *( )

mv22 2

21

( )

(7)

Let base money be the po licy instrument to hit a target M * .

Therefore h M E Rt t t

*

1(8)

subtract (8) from (4)

01

( ) ( )*M M R E R ut t t t t (9)

but from (2), taking expectations and subtracting

M M p E p y E y R E Rt t t t t t t t t t t

* ( ) ( ) ( )1 1 1

substitute fo r R E Rt t t 1

from (9) and for y E yt t 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 22

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 t t t t 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 t t 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 t t t t 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 t t t t 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 t t t t t t t

( ) *

1 1

s i n c e p E pt t t 1

0 a n d y E y M M vt t t t t 1

( )*

t h e n M Mv u

t

t t t

*

( )

1

m

v u2

2 22

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