Money Supply Control, Financial Innovation and Monetary Policy, Slides of Banking and Finance

Download Money Supply Control, Financial Innovation and Monetary Policy and more Slides Banking and Finance in PDF only on Docsity!

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 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



 

 

 



=

=



 

 

 



=

= +

= +

= +

C D R D m C D

M mH

C D R D

C D H

M

C R

C D H

M

M C D

H C R

1

1

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

( , , )

( , , )

b d

d

b

d

M f P Y R R

M f P Y R

= −

=

• • −
• • −

Implication of decreasing interest rate

sensitiveness of the demand for

money

2 2 2 2

0

u v

s

d

E u E v

E u E v

M M v

M y R

y y R u

σ σ

α

β

Continued

(^2) ( ) 0

0

( )^0

0

2

2

2

2 2 2 2 2

• 2

2

0 *

∂∂ =−  +  +  <

→

= +  + + 

∂∂ ∂ =− + <

∂∂ = + >

= + ^ + + +  + + 

α β

β α β

β α

σ

σ

σ α ββ σ ααβ σ

α β

β α

α β

β

α β

α α β

β α

β α β

α

Y

u

Y v u let

M

Y

M

Y

y y M v u

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

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

Rt −π t = π t −π t + yt − y t

US experiment

• In October 1979 the Fed switched from controlling Fed funds rate to controlling non- borrowed reserves to target M
• 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