Introduction to Financial Programming

1. Introduction to Financial Programming ThorvaldurGylfason Seoul, Korea 17-28 May 2010

2. Outline • Monetary approach to balance of payments • Accounting relationships • Trace linkages among • Balance of payments accounts • National income accounts • Fiscal accounts • Monetary accounts • Proceed from linkages to financial programming • Financial programming in action

3. What is money? 1 • 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, M3, etc.

4. Overview of banking system

5. 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

6. 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

7. Adding up the two balance sheets R D DG + DP+DB +RB+RC + B = C + T + B + DB M Hence, M = D + R

8. Balance sheet of banking system Monetary Survey D = DG + DP = net domestic credit from banking system (net domestic assets) R = RC + RB = foreign reserves (net foreign assets) M = money supply

9. A fresh view of money 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 • One of the most useful equations in 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)

10. 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

11. 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 G – T + I – S + X – Z = 0, so left-hand sides sum to zero

12. An alternative derivation of monetary survey • Publicsector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

13. An alternative derivation of monetary survey • Publicsector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

14. An alternative derivation of monetary survey • Publicsector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

15. An alternative derivation of monetary survey • Publicsector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

16. An alternative derivation of monetary survey Hence, M = D + R • Publicsector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • External sector • X – Z = R - DF So, adding them up, we get: 0 = D - M + R because DG + DP = D

17. Monetary approach to balance of payments 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 • Here R = X – Z + F • Monetary approach to balance of payments

18. Monetary approach to balance of payments The monetary approach to the balance of payments (R = M - D) has the following implications: Need to • Forecast M • And then • Determine D • In order to • Meet target for R • D is determined as a residual given both M and R* • R* = reserve target, e.g., 3 months of imports Essence of financial programming

19. Monetary approach to balance of payments • Domestic credit is a policy variable that involves both monetaryand 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 *Or rather slow down

20. Linkages 2 Balance of payments DR = X – Z + F = X – Z + DDF

21. Linkages National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF

22. Linkages National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Fiscal accounts G – T = DB + DDG + DDF

23. Linkages National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

24. Linkages: Reserves National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

25. Linkages: Current account National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

26. Linkages: Foreign credit National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

27. Linkages: Credit to government National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

28. Linkages Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

29. Linkages: Bonds Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

30. Linkages: Money Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X–Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

31. Linkages: Private credit Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

32. Model 3 • Express accounting linkages in terms of simple algebra • Use model to describe how nominal income and reserves depend on domestic credit • Demonstrate how BOP target translates into prescription for fiscal and monetary policy • Financial programming in action

33. M = money D = domestic credit R = foreign reserves DR = R-R-1 = balance of payments P = price level Y = real income v = velocity X = real exports Px = price of exports Z = real imports Pz = price of imports F = capital inflow m = propensity to import List of variables Two behavioral parameters: m and v

34. List of relationships M = D + R (monetary survey) M = (1/v)PY (money demand) R = (1/v)PY – D (M schedule) DR = PxX – PzZ + F (balance of payments) PzZ = mPY (import demand) R = PxX – mPY + F + R-1 (B schedule) Estimate m and v by regression analysis

35. The M schedule Reserves (R) M schedule R = (1/v)PY – D PY = v(R + D) 1 An increase in reserves increases demand for money, and hence also income v D up PY is nominal income GNP (PY)

36. The B schedule Reserves (R) R = PxX – mPY + F + R-1 An increase in income encourages imports, so that reserves decline m 1 F up, e down B schedule GNP (PY)

37. Solution to model Two equations in two unknowns • R = (1/v)PY – D • R = PxX – mPY + F + R-1 Solution for R and PY

38. Multipliers: Algebra

39. Multipliers: Numbers Suppose m = ¼ and v = 4 Credit multiplier Half of credit expansion leaks abroad through balance of payments

40. Macroeconomic equilibrium Reserves (R) M schedule D up Equilibrium F up, e down B schedule GNP (PY)

41. Economic models Exogenous variables Model Endogenous variables Change in domestic credit or the exchange rate Financial programming model Foreign reserves and nominal income

42. Experiment: Export boom Reserves (R) M schedule A B schedule GNP (PY)

43. Export boom Reserves (R) M C A Exports increase B’ B GNP (PY)

44. Export boom Reserves (R) M C An increase in exports increases both reserves and nominal income A B’ B GNP (PY)

45. An interpretation Exogenous variables Model Endogenous variables Export boom or capital inflow Financial programming model Foreign reserves and nominal income increase

46. Another experiment: Domestic credit expansion Reserves (R) An increase in D increases PY, but reduces R. M M’ D up D up M up PY up PzZ up R down A C B GNP

47. Domestic credit contraction Reserves (R) When D falls, M also falls, so that PY goes down and PzZ also decreases. Therefore, R increases. Here, an improvement in the reserve position is accompanied by a decrease in income. M’ M C D down R* Too low reserves A B GNP (PY)

48. Domestic credit contraction accompanied by devaluation Reserves (R) When D falls, M also falls, so that PY goes down and PzZ also decreases. Therefore, R increases. Further, a devaluation strengthens the reserve position and helps reverse the decline in income. M M’ C R* F up, e down B’ A D down B GNP (PY)

49. Comparative statics: An overview P = inflation

50. Experiment: Inflation goes up Reserves (R) An increase in inflation (p) increases v, so the M schedule becomes flatter. Hence, R goes down and PY increases in the short run. M p up M’ A C B schedule GNP (PY)