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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
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D
C
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m
mH M
D
R
D
C
D
C
H
M
R C
D C
H
M
D C M
R C H
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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d b
d
b
d
R R Y P f M
R Y P f M
÷ =
=
÷ + +
÷ + +
Implications for monetary
policy
R
b

Y
LM pre-FI
LM post-FI
Implication of decreasing
interest rate sensitiveness of
the demand for money

2 2 2 2
*
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0 ) ( ) (
v u
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d
v E u E
v E u E
v M M
R y M
u R y y
o o
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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=AH + AB
• 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 AH and
substituting in the financing constraint
• AM = (G-T) + AL - AB - AE
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

( ) ( )
*
2
1
*
2
1
*
t t t t t t
y y R ÷ + ÷ = ÷ t t 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
R y E P E P
t t
t
t
t
t t
= ÷ + ÷ +
÷
+
÷
¸ q
1
1
1
(1) IS

M p y R
t t t t t
÷ = ÷ + o c (2) M
d


y y M E M v
t t
t
t t
= + ÷ +
÷
*
( ) |
1
(3) Aggregate Supply

h M R u
t t t t
= ÷ + o | (4) Money supply
To examine the instrument choice problem - let the policy instrument be R, set to satisfy
some target M*.
Therefore
R R E R
t
t
t
= =
÷1
from (2) taking expectations
M E p E y E R
t
t
t
t
t
t
*
÷ = ÷
÷ ÷ ÷ 1 1 1
o
(5)
subtract (5) from (2)
( ) ( ) ( )
*
M M p E p y E y
t
t
t t
t
t t
÷ ÷ ÷ = ÷ +
÷ ÷ 1 1
c
(5’)
Taking expectations of (3)
E y y
t
t
÷
=
1
*
Then
y E y M E M v
t
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 period
surprises. Thus
p E p
t
t
t
÷ =
÷1
0
and note
E M M
t
t
÷
=
1
*
Thus
M M M M v
t t t t
÷ = ÷ + +
* *
( ) | c
o
o o
|
c
m
v 2
2 2
2
1
=
+
÷ ( )
(7)
Let base money be the policy instrument to hit a target M*.
Therefore
h M E R
t
t
t
= ÷
÷
o |
*
1
(8)
subtract (8) from (4)
0
1
= ÷ ÷ ÷ +
÷
o | ( ) ( )
*
M M R E R u
t t
t
t t
(9)
but from (2), taking expectations and subtracting
M M p E p y E y R E R
t t
t
t t
t
t t
t
t t
÷ = ÷ + ÷ ÷ ÷ +
÷ ÷ ÷
*
( ) ( ) ( )
1 1 1
o c
substitute for
R E R
t
t
t
÷
÷1
from (9) and for
y E y
t
t
t
÷
÷1
from (6)
M M M M v
M M u
t t t
t t
t
÷ = ÷ + ÷
÷
+
¦
´
¹
¹
`
)
+
* *
*
( )
( )
| o
o
| |
c
( ) ( )
*
M M v
u
t t t
t
÷ + ÷
¦
´
¹
¹
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)
= + ÷ 1
oo
|
| c
o
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=
+ +
|
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+ ÷
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o
o o
o
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oo
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c
m
v u
2
2 2
2
2
2
1
(10)
Comparing (10) and (7) it is not clear which is the superior instrument
Allow for lagged reserve accounting
h M R u
t t t t
= ÷ +
÷
o |
1
(11)
Taking expectations of (2) and setting
E M M
t
t
÷
=
1
*
M E p E y E R
t
t
t
t
t
t
*
÷ = ÷
÷ ÷ ÷ 1 1 1
o
(12)
Take expectations of (11) and note that
E h h
t
t t
÷
=
1
= ÷
÷
÷
h M E R
t t
t
t
o |
1
1
substituting for
E R
t
t
÷1
in (11) into (12)
h M E y M E p
t t
t
t
t
t
= ÷ + ÷
÷
÷ ÷
o
|
o
|
o
|
o
1
1 1
*
(11’)
substituting for h
t
from (11) and thereby eliminating oM
t-1
÷ + = ÷ + ÷
÷ ÷
|
|
o
|
o
|
o
R u E y M E p
t t
t
t
t
t
1 1
*
substituting for R from (2) and re-arranging
M p y E y M E p u
t t t
t
t
t
t t t
÷ = ÷ + ÷ + +
÷ ÷
( )
*
1 1
o
|
c
since
p E p
t
t
t
÷ =
÷1
0
and
y E y M M v
t
t
t t t
÷ = ÷ +
÷1
|( )
*
then
M M
v u
t
t t t
÷ =
+ +
÷
*
( )
c
o
|
| 1
=
+ +
|
\

|
.
|
÷
o
o o
o
|
o
|
c
m
v u
2
2 2
2
2
2
1 ( )
(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