Monetary policy concepts and applications

Monetary Policy

Discuss some of the major determinants of the demand for money by sector and in total. Discuss some differences in the demand for money which might exist for countries other than the U.S.

An effective formulation of the Monetary Policy depends on the determining factors of the demand for money. Money Demand acts as a channel on transmission mechanism for monetary policy. Therefore the consistency of the money demand function is crucial for the monetary policy for attaining predictable effects on inflation and real output. The classical economists regard money as a numeraire, i.e. A commodity, the unit of which is used to represent the prices and values; keeping its own value unaffected by such a role. Money is assumed to be neutral having no tangible economic consequences. This is done by limiting the role of money as a store of value having the assumption of perfect information and negligible transaction costs. The concept of money demand under the classical theorem is based on the quantity theory. This is developed against the background of the classical equilibrium framework. (Katafono, 2001)

Fisher during 1911 put forth his famous theorem of the equation of exchange. He propounded that money is held simply to facilitate transaction and does not have intrinsic value. Alternatively the Cambridge group of economist advanced their own approach emphasizing that the demand for money was in terms of public demand for money holdings. This was with regard to the demand for real balances and it was an important factor in determining the equilibrium price level. This was being considered as consistent with a given quantity of money. Further John Maynard Keynes during 1930s refined the Cambridge approach and concentrated on the motives of holding of money to devise the theorem of demand for money. He depicted the demand for money in terms of transaction, precautionary and speculative motives. The interest rate as another explanatory variable in influencing the demand for real balances was introduced in his theorem. The Keynesian theorem put forth that the aggregate demand for money becomes perfectly elastic with respect to the interest rate. This is because the economic agents, expecting a future increase in interest rates at the time when interest rates are low, prefer to hold whatever amount of money is supplied. The post Keynesian models in this respect were formulated in terms of transactions, asset and consumer demand theories of money.

Under the approach of transaction theory, the inventory-theoretic approach and the precautionary demand for money models were introduced. This was being derived from the medium-of-exchange function of money. The asset function of money gives rise to the asset or portfolio approach. Here the major stress is placed on risk and the expected returns of assets. The consumer demand theory framework regarded the demand for money as a direct extension of the traditional theory of demand for any durable good. As a whole all these models implied that the optimal stock of real money balances is positively related to the real income. This is inversely related to the nominal rate of return and the differences of the approach depend upon the selection of variables while formulating the approach. Money stock is a crucial determinant of the demand for money. Money stock may be narrow money consisting of assets which are readily available for transactions and broad money encompasses a wider range of assets. The scale variable which is used as a unit of transactions in the sphere of economic activity is regarded as another determinant of money demand. The common variables in this regard are gross national product -- GNP and associated variables like gross domestic product -- GDP and net national product -- NNP. In some limited countries like the United Kingdom and United States, wealth has also been used as a scale variable. (Katafono, 2001)

The opportunity cost of holding money is also taken into account as a determinant of the demand for money. This is associated with the rate of return of money and the rate of return on alternative assets. The studies in different developed countries indicate that there is variation in the results and the difference is due to the co-integration tests selected and the combination of money and interest rates. Analysis of money demand in Australia normally focuses on money in real terms. Orden and Fisher found no co-integrating relationship for the full sample in New Zealand. Similarly, the Canadian evidence reveals that money, output, prices and interest rates are only fractionally co-integrated. Drake and Chrystal in United Kingdom found that a co-integrating relationship prevails for all the monetary aggregates analyzed and the ECM depicts a fast rate of adjustment.

The results for money demand in developing countries vary to a great extent. This is because the financial markets are not very developed and are subject to control. The money demand function in ten developing countries including India, Mexico and Nigeria reveal that the co-integration was only established in minority cases. However, a stable relationship for narrow money was revealed for the West African Economic and Monetary Union even during the period of financial liberalization. Alternatively, Dekle and Pradhan are of the opinion that in the Association of South East Asian Nations -- ASEAN continuing instability in the Demand for money occurred as financial liberalization intensified. These empirical studies reveal the financial liberalization is the most significant determinant of the stability of money demand. (Katafono, 2001)

2. Discuss some aspects of the money supply process which you find interesting and of some importance

Money refers to anything applied for purchasing goods and services and comprises of anything that is used for trading. The variation to the total money supply in an economy occurs for many of the reasons which include: the variations in behavior, the variations in expectations, and the variations in monetary policy. (The Money Supply Process and Interest Rate Determination) The supply of money normally is indicated to mean the supply of M1. This is the value of coins and currency held by the public outside of the banks including the value of our account balances. The below chart shows the year-to-year variations in U.S. M-1 which is the narrowest measure of money. (Schmidt, 2004)

The money supply is understood to start with the printing of money by the mint and sending of the same to Federal Reserve. However, it is the Fed that puts the money into the system and the currency that it provides is known as high-powered money. The Fed in this way regulates but it does not regulate the money supply. Actually the high powered money goes to the banks as reserves and a fraction goes to the people's pockets and for business purposes. Taking into consideration the nature of banking system, it is the banks that really generate money. The cash reserve maintained by banks constitutes the base of the banks for the expansion of checking accounts. The total money supply includes such deposit accounts along with the currency held by the public with the deposit accounts. (Money Supply: The Fed and the Creation and Control of Money)

Thus the money is created with the interaction of functions of the two institutions, namely the Fed and the banks. The high powered money is held by the public in terms of currencies and a portion as the reserves by the banks. The Fed regulates the reserves to be maintained by the Banks. The ability of the banks to create money from the cash has an inverse relationship with the amount of reserve. A small amount of reserves mean a bigger amount of demand deposits. The creation of demand deposits by banks is guided by basic principles such as bank profitability and bank discretion over money supply. Bank profitability means that the banks are guided by the profit motive and its activities are not in the interest of the nation. Bank discretion over money supply means that the decision of bankers to enhance the value of demand deposits will enhance the money supply. This would conversely influence their decision to hold excess reserves and would decline the money supply. It would lead to prospective conflict between the profits and safety. This would mean that the banks earn profits by enhancing demand deposits. But they cannot utilize all their cash reserves for creating demand deposits since they should be ready to meet the situation when all the depositors wanted their cash. (Money Supply: The Fed and the Creation and Control of Money)

Actually when a bank advances a loan, the borrower normally issues a claim against himself by way of a promissory note. In turn the bank issues a claim against itself in the form of an addition to the borrower's checkable deposit account. The promissory note that the borrower issues in not regarded as money. It is the addition to the account balance issued by bank. That contributes towards the money supply. Next what is done is that in order to purchase the goods and services, the borrower on getting his account credited by the loan amount issues checks against the newly created money. The lending bank then faces difficulties from the adverse clearings. This is tantamount to loss of excess reserves that provided for the extension of the loan initially. Irrespective of the fact that the net effect of the process appears to be lending excess reserves by the banks, the bank in reality do not lend excess reserves. It has only lent the newly generated money and lost reserves in the check clearing process. Thus the bank has the capability of issuing loans and thereby is able to create new money in any amount. (The Money Supply Process)

However, it is limited legally in terms of reserve requirements. It could also be due to the necessity to maintain the confidence of the depositors in the ability of the banks. This is with regard to the bank's ability to meet withdrawal requests upon demand to issue loans which are no greater in total than the excess of its required reserves. It is not common for a multi-branch bank to find itself in a deficit reserve position even when its management is not exactly risk oriented. A deficit in reserve of the bank has no legal implications. However, it may endanger the ability of the banks to meet the demand of withdrawal by the depositors. To overcome the deficit of reserves the bank may depend upon loan attrition taking into account the large numbers associated with its loan business. When the banks do not have sufficient time to depend upon the loan attrition process, then the bank resorts to borrowing from excess reserves for short periods. Even though the bank may buy some time by borrowing Federal Funds, a long-term solution may entail it to dispose some of the market asset normally. This would also include the treasury obligations so as to enhance the holding of reserves. (The Money Supply Process)

3. Discuss the reason given for credit rationing and some of the consequences of credit rationing.

Credit means what a person owes and it is distinguished from money in the sense that money is a stock of perfectly liquid assets. According to Baltensperger the work of extending credit is the transfer of property rights on a given asset for a claim on specified assets in the future. The most natural example in this regard constitutes the receipt by a debtor of current spending power in exchange for a group of repayments at specified future periods. The credit market in this connection refers to the market for an inter-temporal exchange. The credit contracts are traditionally distinguished in terms of the length of the contract period, the kinds of debtors or creditors and the types of security put forth by the debtor or the utilization of loan by the borrowers. The fixed or floating rates of interest associated with the credit also often distinguish the types of credit. The importance of credit in the economy at microeconomic and macroeconomic levels flows from the fact that it permits a more productive utilization of the savings of the economy and also as the principal source of current purchasing power. (Eco 223 - Finance and the Economy -6 Credit)

Thus the credit enables transfer of a future income stream to the present. It thus enables the households, firms and the government to fetch the spending power at present in exchange of the future repayments. There always prevailed a source of uncertainty in the credit markets. The markets generate varied processes for addressing such problems. There always exist a default risk as none can be sure when the debtors will meet their payment regulations. The process to come across such risks includes the legal measures that permit the enforcement of credit contracts. It also includes the ability of the financial institutions to forbid the non-payers from obtaining credit in the future. Additionally, the financial system discriminates among the potential borrowers. This is done by incorporating interest rates to be at a risk premium against the insurance of the lender for bearing the losses from borrower's default. (Eco 223 - Finance and the Economy -6 Credit)

Considerable parts of the credit market show that the rates of interest are not capable of varying adequately to meet the requirement of the market. Credit rationing is required to occur at this juncture. Some deficit units are not capable of borrowing at all. Other units are provided loan advances which are lower than the amount they actually desire to borrow and are also not able to get a higher loan by offering to pay a higher rate of interest. Credit rationing till 1960s was represented as the result of short-run disequilibrium. This was due to an outcome of the governmental regulations on interest rates or it resulted from a deficiency of the financial institutions to follow profit maximizing rules. Government exerts control over the hike in interest rates with varied social, political and economic objectives. The limitation on interest rates exerted in USA after 1933 is regarded as a common example in this regard. The behavior of UK building societies cartel of the 1970s is cited as an example regarding the failure of the financial institutions to follow profit-maximizing conditions.

Moreover, it has been argued that different loans have varied magnitude of risks. Besides, information about the magnitude of risk involved with loans is not only imperfect but is also asymmetric. Irrespective of the fact that the lenders are aware that loans are not homogeneous they treat them as if they were homogeneous. When they try to safeguard themselves by enhancing the risk premium on all loans, they might simply daunt safer borrowers and enhance the average magnitude of risk of other loans. In these cases lenders might prefer to reduce risk by rationing new loans on a non-price basis. This leads to confining the loans and advances to only a specific group of borrowers, enhancing their collateral requirements and also enhancing the initial deposits or shortening maximum repayment periods. Thus the credit rationing might be a rational response to uncertainty instead of a disequilibrium phenomenon. (Eco 223 - Finance and the Economy -6 Credit)

As a matter of policy implications the policy of macro-economic stabilization sometimes do not take into consideration the consequences of raising interest rates on default risks at times of financial crises. As a result they are regarded as ineffective or even counter productive in alluring the investors and restoring financial stability. The large concentration of subsidized credit by the public sector in terms of structural reforms aimed as alleviating poverty in the long terms generates adverse situations. The provision of cheap credit from the formal sector can enhance the outside options of borrowers in their informal credit relationship. Thus adversely affects the informal market seriously. (Ghosh; Mookherjee; Ray, 1999)

4. Discuss the aspects of money in the process of economic growth

Economics to most is the study of money. The role of money in economic policy appears paradoxical to them. The price stability has been acknowledged as the central objective of central banks and with this the real attention accorded to the central banks to money has declined. The role of money as a causal factor for inflation was eliminated during the 'Great Inflation' of the post war period. During 1970s the postulates that the money influenced the price level in the long run and not the level of output brought money to the focus of economic policy. This is quite evident from the studies made by McCandless and Weber over a large sample of 116 countries. This was done by taking into account the different time horizons and that there exist a strong relationship between the growth of the monetary base and inflation. It is seen that the countries with rapid growth rates depict higher inflation rates. The relation between money growth and inflation is quite visible in case of long run. However, during short run the correlation between monetary growth and inflation is much less visible. (No money, no inflation -- the role of money in the economy)