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
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dbd
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RRYPfM
RYPfM
Implications for monetary policy
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Y
LM pre-FI
LM post-FI
Implication of decreasing interest rate sensitiveness of
the demand for money
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d
vEuE
vEuEvMM
RyM
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Continued
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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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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
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