Lecture 6 Money Supply Control and Financial Innovation

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

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

Implications for monetary policy Rb LM post-FI LM pre-FI Y

Implication of decreasing interest rate sensitiveness of the demand for money

Continued

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

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 M 1 • 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

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 M 3 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