UCL ECON7003 Money and Banking Lecture 12' Preliminaries, contd' and History of the two traditions i

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UCL ECON7003 Money and BankingLecture
12.Preliminaries, contd. andHistory of the two
traditions in monetary policy.

• Preliminaries, contd
• From simple deposit multiplier to money
  multiplier.
• Determinants of Money Supply required reserve
  ratio cash ratio excess reserves ratio and
  interest rates.
• Borrowed component of monetary base.
• Monetary theory and policy before the great
  depression.
• William Petty and the velocity of circulation.
  QTM formalised Fisher equation of exchange. QTM
  as theory of money demand Cambridge version.
• Keynes and the classics.
• Circular flow bond prices and interest rates.

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?D (1/r).?R Simple deposit
multiplier Underlying assumptions (1) Banks
exhaust all ER in making loans. (2) All
transactions are carried out by cheque. Lifting
these assumptions Deposit creation process is
interrupted. To allow for lifting of these
assumptions, 2 additional ratios e ER /
D excess reserve ratio c C / D currency
ratio Model that will incorporate these
ratios. The money multiplier m m (1 c) /
(r e c)
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Deriving the money multiplier MB R C R RR
ER and RR r.D , so we can write R r.D
ER ? MB r.D ER C Note Parameter of 1 on
ER and C ? increase in MB that public decides to
hold in cash ? one-for-one increase in MB / not
multiplied through creation of additional
deposits. Similarly, increase that goes into ER.
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MB r.D ER C e ER / D ? ER e.D c C
/D ? C c.D ? MB r.D e.D c.D MB (r
e c).D D 1 / (r e c) . MB
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M M1 D C Substituting C c.D M D c.D
(1 c ).D We have D 1 / (r e c) .
MB ? M (1 c) / (r e c) .MB We thus
have m (1 c) / (r e c) the money
multiplier
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m (1 c) / (r e c) the money
multiplier i.e. The change in M ( M1) resulting
from given change in MB. In terms of calculus m
dM / dMB. Note Outside money Created by CB
(i.e. through expansion of MB). Inside money
created by the commercial banking system. i.e.
through multiple deposit creation.
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Money multiplier numerical example. We have r
0.10 C 400 bn D 800 bn ER 0.8
bn c C / D 400 / 800 0.5 e ER / D 0.8
/ 800 0.001 m (1 c) / (r e c)
(1 0.5) / (0.10 0.001 0.5) 1.5 /
0.601 2.496
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We have m (1 c) / (r e c) (1
0.5) / (0.10 0.001 0.5) 1.5 / 0.601
2.496 Note If ER 0 and no leakage into cash
transactions (i.e. e c 0), m would reduce
to (1 0) / (r 0 0) 1/r i.e. the SDM
model would hold / m would be 1 / r 1 / 0.1
10 i.e. about 4 times greater.
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Determinants of money supply (a) required reserve
ratio. Inverse relationship (ceteris paribus)
between RRR and MS r? ? supportable D? ?
Bank must contract loans and consequently
deposits. i.e. A contraction in
MS. Relationship (ceteris paribus) between RRR
and m Also inverse -- r is in denominator of m !
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Recall above example m (1 c) / (r e c)
(1 0.5) / (0.10 0.001 0.5) 1.5 /
0.601 2.496 Now suppose r ? from 0.10 to
0.15 m (1 c) / (r e c) (1 0.5) /
(0.15 0.001 0.5) 1.5 / 0.651
2.304 i.e. m has fallen from 2.496 to 2.304.
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Determinants of money supply (b) cash ratio.
Relationship (ceteris paribus) between NBPs
cash to deposits ratio and money supply money
multiplier Deposits undergo multiple expansion
currency does not. ? shift from deposits into
cash, i.e. rise in c, is switch from component of
M that undergoes multiplication into one that
does not. i.e. both m and M are negatively
related to c.
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Recall above example m (1 c) / (r e c)
(1 0.5) / (0.10 0.001 0.5) 1.5 /
0.601 2.496 Now suppose c rises from 0.5 to
0.75 (cet. par.) m m (1 c) / (r e c)
(1 0.75) / (0.10 0.001 0.75) 1.75 /
0.851 2.056 m falls from 2.496 to 2.009.
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Determinants of money supply (c) excess reserve
ratio. Recall above example m (1 c) / (r
e c) (1 0.5) / (0.10 0.001 0.5)
1.5 / 0.601 2.496 Now suppose fivefold
increase in e m (1 0.5) / (0.10 0.005
0.5) 1.5 / 0.605 2.479 i.e. The increase in r
has reduced m VERY LITTLE -- from 2.496 to 2.479.
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Note RRR ? is equivalent to ER?. Both bank
reduces amount of deposits supported by given
level of R. Bank determines e by costs and
benefits of holding ER. Two main factors Market
interest rates Expected deposit outflows.
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High r / monetarism / high opportunity cost of ER
Not fully reversed when r? Developments in
liability management, etc.
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Borrowed component of monetary base.
Non-Borrowed MB created by OMOs MBn
Borrowed Discount Loans. DL CB has control
over MBn component Effect of OMOs on MB is
certain. DL CB can influence DL by setting
discount rate, but actual decisions to borrow are
made by the commercial banks. i.e. MBn
fully controlled by CB. DL not fully controlled
by CB.
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• Monetary theory and policy before the Great
  Depression.
• Debates over Bank of England Charter 1844
• Currency school
• Bank credit to behave as if metallic money.
• Tight restrictions / rules for issue of bank
  notes.
• Took lead from Ricardo.
• Banking school
• Bank of England should have discretion / act
  according to market conditions.

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• Currency school won out ? Bank of England divided
  into
• banking department
• issue department
• In practice, considerable discretion.
• i.e. already prefigures debates over
• rules versus discretion
• hawks versus doves on the MPC, etc.

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• William Petty (1623-87)
• multiplier
• national income accounting (income and
  expenditure accounts)
• public works as a remedy for unemployment
• velocity of circulation
• simple deposit multiplier.

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William Petty, Verbum Sapienti, c.1665. How much
money is necessary to drive the Trade of the
Nation? Total expence of nation is 40m. ?
revolutions undergone by money Labourers
short circles / weekly / every Saturday ?
would need 40/52 parts of 1m, or say around
1m. Rent and taxes quarterly. ? would need
10m. Supposing a mixed circle between 1 week
and 13 ? Total needed may be around (1
10) / 2 . i.e. 5½m would be enough.
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QTM formalized The Equation of Exchange, Irving
Fisher, 1911. MV PT M
Money-in-circulation. P Price level.
T Transactions within a given time period.
V Velocity of circulation.
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MV PT Plausible assumptions at the
time, T T Self-regulating economy with
constant (i.e. full-employment) level of
activity. V V Determinants institutional /
slow to alter, e.g. Structure of banking system,
slow pace of evolution of banking system at the
time. Frequency with which people are paid
(Petty), etc.
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• Classical assumptions thus give us
• V V , T T
• ? MV PT becomes MV PT
• ? P V/T X M
• Thus prices are a constant multiple of the money
  supply, or
• P const. X M
• i.e. QTM !

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Advantages of EE M, P and Y measurable / in NI
accounts. ? V specified in quantitative
terms. Note In theory, velocity could be
measured directly, as per Pettys
formulation. But this has not been attempted in
practice. Continuing shortcomings Direction of
causation between ?M and ?P remains unspecified.
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QTM as theory of MD ( Cambridge / cash
balance version). EE reformulated to income EE
MV PY Marshall / Cambridge on MD Primarily
transactions motive (also precautionary). Assumpt
ion Cash held will be stable proportion of
income. Not only individual but holds for economy
as a whole. i.e. All cash balances are active /
not idle. MD / P k.Y Where k ( Marshallian
k) is constant / stable. Determined by habit and
experience.
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Thus QTM holds Classical assumptions Economy
is self-regulating / e equilibrium at Y YFE ?
we can write Y Y, and also k k, as per
above. ? we have M / P k.Y ? P (1 /
k.Y).M i.e. Once again we have P const.M,
i.e. QTM.
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e.g. Initial equilibrium M0/P0 k.Y MS
unexpectedly ? to M1. Public hold more money in
proportion to income than would have chosen. i.e.
Excess holding of M1/P0 M0/P0. Do not wish to
hold idle balances. ? Spend this excess on C or
I. ? Holdings eventually back to chosen optimal
proportion between M and income.
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BUT Spending this excess M on C or I AND
Supply of goods is fixed (Y YFE). ? Quantity of
goods cannot adjust. ? Equilibrium restored
solely by adjustment of prices. i.e. till they
rise to P1, where we have M1/P1 M0/P0
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Note Cambridge version is formally equivalent to
EE Cambridge M / P k.Y ?
M.(1/k) PY EE M. V PY i.e.
Just redefines V as the inverse of the
Marshallian k. But Cambridge version suggests
economic reasons why this k is constant / new
explanation why V is constant. MD kPY Agents
choose to hold constant proportion of nominal
income as money.
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• Fisher EE
• Merely a formal identity / true by definition /
  truism.
• Casts no light on direction of causation between
  ?M and ?P.
• Quantity theorists commonly assume direction is M
  ? P.
• But equation in itself equally appropriate to
  opposite direction!
• Cambridge version of QTM
• Goes beyond algebraic identities.
• Incorporate assumptions regarding economic
  behaviour.
• Reformulates the QTM as theory of money demand.
• Based on assumptions regarding cash balances
  agents will choose to hold, given nominal income.

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• Keynes versus the classics the debates take
  definitive shape.
• Keynes termed established approach
• classical
• Treasury View
• Market forces work OK.
• Says law supply creates its own demand.
• ? will ensure smooth circular flow
• Economy self-stabilising at full employment.
• i.e. Y YFE is unique point of equilibrium in
  the economy.
• IF government minimizes intervention / balances
  budget.
• Subsequent macro mostly a re-play of this debate??

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Circular flow
Keynes Government may need to intervene to
increase AD / compensate if J lt W
INJECTIONS
Export expenditure (X)
Investment expenditure (I)
Government expenditure (G)
C
Y
BANKS, etc
GOV
ABROAD
T
M
S
WITHDRAWALS
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Classical view All aspects of market economy are
self-regulating.Only government intervention /
deficit financing, etc., can imprede circular
flow.
INJECTIONS
C
Y
Therefore, for W J to ensure unimpeded circular
flow, we must have T G !
WITHDRAWALS
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Bond prices and interest rates. Perpetuity Face
value 100 Coupon 10. Market interest rate 10.
? PB 100, i.e. remains at face value
5 200
100
20 50
Fall in market interest rates to 5 ? 100
invested elsewhere would only return half as
much ? PB doubles. Rise in market interest rates
to 20 ? 100 invested elsewhere would return
twice as much ? PB is halved. i.e. Bond prices
are inversely related to market interest rates.
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15 perceived as higher than normal ? holders
of bonds expect r? ? PB? ? message to holders of
bonds is Hold onto bonds. Assumption Only two
assets, money and bonds. ? Hold onto bonds
Do not hold onto M ? MD is low.
Conversely, 5 perceived as low? expect r? ?
PB? ? message is Sell bonds Hold onto M ?
MD high.