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
H CR
M CD
M
CD

H
CR
 C


1
M

D

C

H
R
D
D

M  mH
 C
1 


D
m
C

R
D
D

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
 

 

M  f ( P, Y , Rb )
d
M  f ( P, Y , Rb  Rd )
d
Implications for monetary
policy
Rb
LM post-FI
LM pre-FI
Y
Implication of decreasing
interest rate sensitiveness of
the demand for money
y  y 0  R  u
M
d
 y  R
M  M v
E (u )  E (v )  0
s
*
E (u )   ; E (v )  
2
2
u
2
2
v
Continued
 
  

   
v  
  y0 
M *   
y  

    
  
    
  
Y
0


M *     


 2Y



 (   ) 2
M *

 
  
  
let  u2  0
2
Y
2

  0

 

  v2  
  

2

  u2

  

 Y2

 2
2

     (   )

  0


u

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

 
Rt     t    yt  y
*
t
1
2
*
t
1
2
*
t

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
Rt  yt  E Pt 1  E Pt   t
(1)
IS
M t  pt  y t  Rt   t
(2)
Md
yt  y *   ( M t  E M t )  vt
(3)
Aggregate Supply
ht  M t  Rt  ut
(4)
Money supply
t 1
t 1
t 1
To examine the instrument choice problem - let the policy instrument be R, set to satisfy
some target M*.
Therefore
Rt  R  E Rt
t 1
from (2) taking expectations
M *  E p t  E y t   E Rt
t 1
t 1
t 1
(5)
subtract (5) from (2)
( M t  M * )  ( p  E pt )  ( y t  E y t )   t
t 1
t 1
(5’)
Taking expectations of (3)
E yt  y *
t 1
Then
yt  E yt   ( M t  E M t )  vt
t 1
t 1
(6)
Assume that prices are pre-set in the short period, so that there are no one period
*
surprises. Thus pt  tE1 pt  0 and note tE1 M t  M
Thus
M t  M *   ( M t  M * )  vt   t
 2v   2
 
(1   ) 2
2
m
(7)
Let base money be the policy instrument to hit a target M*.
Therefore
ht  M *   E Rt
(8)
t 1
subtract (8) from (4)
0   ( M t  M * )   ( Rt  E Rt )  ut
t 1
but from (2), taking expectations and subtracting
M t  M *  ( pt  E pt )  ( y t  E y t )   ( Rt  E Rt )   t
t 1
t 1
t 1
substitute for Rt  tE1 Rt from (9) and for y t  tE1 y t from (6)
(9)
*


(
M

M
) ut 
*
*
t
M t  M   ( M t  M )  vt   
 t



  
u
( M t  M * ) 1      (v t   t  t )

 

2
  2m 
2
2 
 v        2u

  
1    
 

2
(10)
Comparing (10) and (7) it is not clear which is the superior instrument
Allow for lagged reserve accounting
ht  M t 1  Rt  ut
(11)
*
Taking expectations of (2) and setting tE1 M t  M
M *  E p t  E y t   E Rt
t 1
t 1
t 1
(12)
Take expectations of (11) and note that tE1 ht  ht
 ht  M t 1   E Rt
t 1
substituting for tE1 Rt in (11) into (12)
ht  M t 1 



E y t  M *  E pt
 t 1

 t 1
(11’)
substituting for ht from (11) and thereby eliminating Mt-1
Rt  ut  



E yt 
M* 
E p
 t 1

 t 1 t
substituting for R from (2) and re-arranging
M t  pt  ( y t  E y t )  M *  E pt 
t 1
since
t 1
p t  E p t  0 and y t  E y t   ( M t  M * )  v t
t 1
t 1
vt   t 
then

u t
 t
Mt  M * 

u
 t
(1   )
2
 2v
  2m 

  2     2u

(1   ) 2
(13)
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