Monetary Accounts:
An Overview
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
Thorvaldur Gylfason
Outline
1. Role of money
2. Money and banking
3. Money and the balance of
payments
4. Forecasting money
5. Money, prices, and income
Quantity Theory of Money
P
Oldest macroeconomic theory
MV = PY
V = PY/M (velocity)
P = (V/Y)M
Long-run
relationship
M
The price level is
approximately
proportional to the
money supply over
long periods
Quantity Theory of Money
To keep the price level under control,
it is essential to control the money
supply
P
Long-run
relationship
M
This is why money and
monetary policy must
play a key role in
financial programming
The Role of Money
P
Generally, we need to control money
to manage aggregate demand
Money affects aggregate demand
directly and indirectly
Direct effect
Aggregate
supply
through interest rates
and investment
Indirect effect
Aggregate
demand
Y
through interaction
with fiscal policy
Direct Effects of Money
An increase in money supply increases
supply of loanable funds,
thus driving down interest rates
r
As interest rates fall, investment rises,
thus increasing aggregate demand
Supply of
loanable funds
Demand for
loanable funds
S, I
Hence, monetary expansion
increases the price level and also
output, as long as the aggregate
supply schedule slopes up
Indirect Effects of
Money
P
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 ...
Aggregate
supply
Aggregate
demand
Y
... 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
Money is Useful
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
M/PY (in %)
Malawi
Botswana
Namibia
Zimbabwe
Zambia
Uganda
Tanzania
United States
France
1970
18
…
...
...
25
17
...
63
41
1998
14
24
40
23
16
13
17
58
69*
* 1997
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.
Overview of Banking System
Financial System
Banking System
(Monetary Survey)
Central Bank
Other Financial Institutions
Commercial Banks
DG = domestic
credit to
government
Balance Sheet of Central
Bank
DB = domestic
credit to
commercial banks
RC = foreign
reserves in
Central Bank
Assets
Liabilities
DG
C
DB
B
C = currency
B = commercial
bank deposits in
Central Bank
RC
DP = domestic
credit to private
sector
Balance Sheet of
Commercial Banks
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
Assets
Liabilities
DP
DB
RB
T
B
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
Assets
Liabilities
D
M
R
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)
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
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
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
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

So, adding them up, we get
0 = D - M + R
because DG + DP = D
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
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
1) Forecast M and then
2) Determine D in order to
3) 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
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 and fees
Monetary and fiscal policy are closely
related through domestic credit
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
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
Forecasting Money Demand:
An Example
M/P = Ya e- b
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
Equilibrium of Supply and
Demand For Money
M
Money
demand
Nominal income
depends on the
money supply
Money
supply
PY
Effects of an Increase in
Money Supply
M
B
A
An increase in
money supply
increases nominal
income
Money
demand
Money
supply
PY
Effects of an Increase in
Inflation Rate
M
Money
demand
A
B
An increase in
inflation reduces
money holdings
relative to income
Money
supply
PY
Financial Depth and
Economic Growth
Growth of GNP per capita 1965-1998, adjusted for initial
income (% per year)
6
4
2
Indonesia
Japan
Switzerland
0
0
20
40
60
80
100
120
-2
Jordan
-4
-6
r = 0.66
-8
Money and quasi-money 1965-1998 (% of GDP)
85 countries
Financial Depth and
Inflation
Money and quasi-money 1961-99 (% of GDP)
200
180
r = -0.51
Hong
Kong
Switzerland
160
140
120
100
80
60
40
Nicaragua
Jordan
Angola
20
Congo,
Dem. Rep.
0
0
200
400
600
800
1000
Average inflation 1961-99 (% per year)
1200
160 countries
Financial Depth and
Inflation, Again
Money and quasi-money 1961-99 (% of GDP)
200
180
r = -0.51
160
140
Indonesia
Japan
120
Switzerland
100
80
60
Jordan
40
20
0
0
0.2
0.4
0.6
0.8
Average inflation tax 1961-99 (% per year)
1
160 countries
Effects of Increases in
Money Supply and Inflation
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
M
Money
demand
B
A
Money
supply
PY
Effects of Increases in
Money Supply and Inflation
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
M
Money
demand
B
A
Money
supply
PY
Conclusion


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
These slides – and more! – can be viewed
on my website: www.hi.is/~gylfason
Bottom line


Need to control credit
expansion – and hence apply
fiscal restraint – to achieve
the rate of monetary
expansion that is consistent
with our international reserve
target
Key to financial programming