Understanding Monetary Policies & Globalization Analysis

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

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. Analysis Quantity Theory of Money • Oldest macroeconomic theory • MV = PY • V = PY/M (velocity) • P = (V/Y)M P The price level is approximately proportional to the money supply over long periods Long-run relationship M

5. Analysis Quantity Theory of Money • To keep the price level under control, it is essential to control the money supply P This is why money and monetary policy must play a key role in financial programming Long-run relationship M

6. Analysis The Role of Money • Generally, it is necessary to control money to manage aggregate demand • Money affects aggregate demand directly and indirectly P Direct effect Through interest rates and investment Indirect effect • Through interaction with fiscal policy Aggregate supply Aggregate demand Y

7. Analysis 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 r Supply of loanable funds Hence, monetary expansion increases the price level and also output, as long as the aggregate supply schedule slopes up Demand for loanable funds S, I

8. Analysis 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 ... P ... 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 Aggregate supply Aggregate demand Y

9. Empirical evidence 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

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

11. Empirical evidence Inflation and financial depth Add these two correlations, and an inverse correlation between inflation and growth follows r = -0.45 Switzerland Japan Austria Nicaragua Argentina Brazil 87 countries  /(1+ )

12. Accounting 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 • M1, M2, etc.

13. Accounting Overview of Banking System

14. Accounting 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

15. Accounting 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

16. Accounting Adding Up the Two Balance Sheets R D DG + DP+DB +RB+RC + B = C + T + B + DB M Hence, M = D + R

17. Monetary Survey Balance Sheet of Banking System D = DG + DB = net domestic credit from banking system (net domestic assets) R = RC + RB = 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 (M2), which equals narrow money (M1) + 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. Accounting 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 • You’ll be surprised!

20. Accounting 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

21. Accounting 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

22. Accounting 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 Hence, M = D + R so that M = D + R • So, adding them up, we get 0 = D - M + R because DG + DP = D

23. Analysis 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

24. Analysis 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

25. Analysis 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

26. Analysis 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

27. Analysis 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

28. Analysis Forecasting Money Demand: An Example M/P = Ya eb 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

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

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

31. Analysis Effects of an Increase in Inflation Rate M Money demand A Money supply B An increase in inflation reduces money holdings relative to income PY

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

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

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

35. Conclusion to Part I • 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 M = D + R

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 • Monetary institutions • The main instruments of monetary policy • The role of money and credit in financial programming • Exchange rate regimes

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

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. 2 Instruments of monetary policy • Methods used by central banks to change the amount of money in circulation • Open-market operations • Reserve requirements • Discount rates • Printing money • Direct instruments • Persuasion

47. 1. Open-market operations • Central banks conduct open-market operationswhen 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 requirementis 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 rateis 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