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

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*

0

)(;)(

0)()(

vu

s

d

vEuE

vEuE

vMM

RyM

uRyy

Continued

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2

0

0)(

0

2

2

2

2

2

2

2

2

2*

2

*

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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

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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