Download Demand for money and its role in money targeting

JEM027
Monetary Economics
Demand for money
and its role in money targeting
Tomáš Holub
[email protected]
October 6, 2014
Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague
Basic questions
▪ Why people hold money?
▪ What factors influence the demand?
▪ Is the demand stable and/or predictable?
▪ How can it be used in monetary policy?
▪ Seminar topic: ECB’s two pillars – (how) does it
work?
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Textbook money targeting
OMO
Monetary base
Money supply
(target)
We start with looking at
the stability of the last
link (we will discuss the
determination of money
supply next time)
Inflation (+output?)
(goal)
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Recall: 3 basic roles of money
1
Medium of account
2
Medium of exchange (payments)
3
Store of value
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Motives to hold money
A
Transaction motive (~medium of exchange)
B
Precautionary motive (~medium of exchange)
C
Speculative motive (~store of value)
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Transaction motive (1/2)
▪ Quantity theory of money: e.g. Irving Fisher (1911)
▪ Restated by M. Friedman (1956)
▪ T (transactions) assumed to be proportionate to output (but it
could be also other things, such as wealth or gross turnover
in the economy)
▪ V (velocity) assumed to be constant or to have a broadly
stable trend reflecting advances in transaction
▪ No interest rate sensitivity
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Transaction motive (2/2)
▪ Liquidity preference: J.M. Keynes (1930), J. Hicks (1935)
▪ Explored in W. Baumol (1952), J. Tobin (1956)
Y
Y/n
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Precautionary motive
▪ Introduces uncertainty: M.H. Miller, D. Orr (1966)
H
z
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Speculative motive
▪ Money as a risk-free asset in the portfolio of investors: e.g. Tobin
E(R)
i
Risk
▪ E.g. higher risk aversion can lead to more demand for money
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Comparison of elasticities
Y
i
Friedman
1
0
Yes
No
Baumol Tobin
1/2
-1/2
1/2
No
Miller-Orr
(1/3, 2/3)
-1/3
1/3
Yes
Yes
Yes
No
Yes
Model
Tobin
Uncertainty
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Going to macro: IS-LM (1/5)
i
MS
▪ With stable money
M’S
Money
expansion
MD
M/P
demand, control of the
money supply leads to
desired changes in
interest rates, which
influence the aggregate
demand (unless there is
a liquidity trap – which
used to be considered
not very relevant for
normal times, but now we
are in a zero-lower bound
situation!)
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Going to macro: IS-LM (2/5)
▪ If aggregate demand for
i
YFE
money remains stable and
there are IS shocks,
monetary policy based on
stable money supply leads
to better results than
keeping the nominal
interest rate stable
LM1
LM2
▪ Note that an even better
IS1
IS2
Y
policy here is to expand
money supply, as this full
offsets the adverse IS
shock by bringing i even
lower.
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Going to macro: IS-LM (3/5)
i
MS
An increase in
the demand
for money can
increase i
▪ If money demand is
unstable, money supply
may become
a bad policy instrument
/operational criterion.
MD
MD
M/P
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Going to macro: IS-LM (4/5)
i
YFE LM2
LM1
▪ Under money targeting,
shocks to the demand for
money lead to instability
in the real economy.
IS1
Y
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Going to macro: IS-LM (5/5)
i
MS
▪ A policy of stabilising
M’S
the nominal interest rate
would do a much better
job in this case.
▪ A money expansion
MD
MD
M/P
pushes the LM curve
back, thus insulating the
economy from the
money demand shock.
▪ W. Poole (1970): ratio of
IS and LM variability
matters for the choice of
proper instrument
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W. Poole (1970)
… IS
… LM
… under this condition, it is
better to fix i (it implies lower
yt variability)
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Empirical estimates (1/2)
▪ Goldfeld: US data on M1, 1952-73
▪ Lagged term needed to get a good empirical fit (explanation:
buffer-stock approach, adjustment costs, learning)
▪ Otherwise, the estimated parameters were in line with the
theory, and the overall fit was good ⇒ it looked nice and easy
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Empirical estimates (2/2)
▪ “Missing money”: after 1974, the stability of estimates in the US collapsed
(estimates over-predicted reality)
▪ Dotsey (1985): added a proxy for financial innovations – repaired stability
of money demand
▪ “Great velocity decline”: another break during the 1980s (estimates underpredicted the reality)
▪ Baba, Hendy, Starr (1992): add proxies for financial innovation, gradual
learning and uncertainty – repaired stability again
▪ Hess, Jones, Porter (1996): showed that the B-H-S estimates failed to
predict out of the sample
▪ “Goodhart law” (or Lucas critique)
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A famous quote
Gerald Bouey,
former Governor of the Bank of Canada
"We didn't abandon monetary aggregates,
they abandoned us.“
See https://www0.gsb.columbia.edu/faculty/fmishkin/PDFpapers/00BOMEX.pdf
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Velocity of money in the Czech Republic
y/y changes in %
▪ Relying on stable money velocity would lead to very wrong results in the
▪
Czech Republic.
It has a long-term declining trend, a clear cyclical component, and is
subject to significant shocks.
Source: IMF; Batini, et al. (2006)
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MP regimes in the world
Evolution of monetary policy regimes, 1985-2005
Industrial countries
▪
▪
Non-industrial countries
Money targeting not used in industrial countries (but: ECB – see seminar topic)
Monetary (and multiple) targets not dead yet in non-industrial countries (e.g. IMF
programs)
Source: IMF; Batini, et al. (2006)
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Money targeting countries
Congo, Tajikistan, Ukraine, Yemen, Argentina,
China, Rwanda, Uzbekistan, Bangladesh,
Burundi, Guinea, Kyrgyz Rep., Malawi, Nigeria,
Afghanistan, The Gambia, Kenya, Madagascar,
Mozambique, Papua New Guinea, Seychelles,
Sierra Leone, Sri Lanka, Tanzania, Uganda,
Zambia
Source: IMF classification
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Conclusions
1
Money demand functions proved unstable many times
2
The relationship was often repaired by adding new
variables, but only temporarily
3
Money targeting thus became unattractive for most
CBs in advanced countries
4
Money can still have a signalling role for monetary
policy (but cautious analyses and use needed)
5
6
ECB‘s two pillars to be discussed at the seminar
Beware: money targeting is not dead, after all, but
survives mostly in less developed countries
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