Economics 216:The Macroeconomics of Development
Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)Kwoh-Ting Li Professor of Economic Development
Department of EconomicsStanford University
Stanford, CA 94305-6072, U.S.A.
Spring 2000-2001
Email: [email protected]; WebPages: http://www.stanford.edu/~ljlau
Lecture 9The Role of Money and Finance
Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)Kwoh-Ting Li Professor of Economic Development
Department of EconomicsStanford University
Stanford, CA 94305-6072, U.S.A.
Spring 2000-2001
Email: [email protected]; WebPages: http://www.stanford.edu/~ljlau
Lawrence J. Lau, Stanford University
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Why is Money Desirable?Money as a Facilitator of Transactions It lowers transactions cost (and hence makes possible productive
transactions that otherwise may not have taken place in the absence of an accepted medium of exchange)A common unit of account--a common numeraire Non-coincidence (lack of synchronization) of supply and demand—barters,
and successive barters, can only take place at a single time and place (e.g. Samuelson’s “exact consumption loan” model)
The effect of credit-worthiness and risk--lack of mutual trust requires cash on delivery (a future delivery on barter is risky)
The benefits and costs of anonymity (non-discrimination; illegal activities, the cash-in-advance constraint)
Private versus public issuance of money Currency substitution and the network externality--the more a form
of money is accepted, the more it is acceptable
Lawrence J. Lau, Stanford University
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The Different Definitions of Money M0 = currency and coins in circulation M1 = M0 + demand deposits M2 = M1 + savings deposits The distinction between demand deposits and savings deposits has
become blurred in the United States (interest and non-interest bearing, withdrawal notice and penalty, money market funds at non-banking institutions)
Lawrence J. Lau, Stanford University
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The Demand for Money Three traditional sources of demand for money (M1)
Transactions Demand Precautionary Demand Speculative Demand
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Transactions Demand (1) The types of market transactions requiring money balances
The monetization of previously non-market transactions (barter, home consumption, home services, in kind payments of rents and wages)
Inter-firm transactions (market) versus intra-firm transactions (non-market)--the organization of the economy (the degree of vertical integration; the degree of concentration (conglomerates), the degree of specialization and division of labor, the degree of self-sufficiency)
Transactions involving goods and services currently produced (thus generating current-value added) and transactions involving existing physical assets and inventories (which do not generate current value-added)
Real transactions versus financial transactions--purchases and sales of business assets versus purchases and sales of shares of common stock (securitization facilitates the trading of assets and hence increases the volume of transactions (reduces lumpiness and enhances liquidity)
The multiplier effect of financial transactions (financial deepening)--mutual funds, derivatives, holding companies
The volume of trade in existing assets, real or financial, depends on the level of wealth rather than the level of real GNP or GDP
Lawrence J. Lau, Stanford University
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Transactions Demand (2) The role of institutions, customs and practices
(e.g., the frequency of settlement (a higher frequency requires more money, other things being equal), the use of credit and debit cards (increases the GDP/Money Supply ratio), the use of sweep accounts (increases the GDP/Money Supply ratio), the demand for money under central planning)
The cost of holding money for transactions purposes is the time value of money (the real rate of interest)
Lawrence J. Lau, Stanford University
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The Quantity Theory of Money (Friedman):MV = PT For the four variables, only M and P can be directly observed V cannot be directly observed, but is measured as PT/V T actually stands for the total real volume of transactions in the
economy but in general cannot be directly observed either T is frequently identified with real GDP (value added), Y and is
typically assumed to be proportional to Y (real GDP), T=Y, where t is a constant
The velocity of money, defined as V=PT/M, is in general assumed to be an increasing function of the real rate of interest (the velocity is so-to-speak “the number of times money needs to change hands in order to support the given volume of transactions”)
V is in general not constant, even with the rate of real interest constant—V tends to rise with innovations in finance and transactions technology; e.g., a shift from the use of cash or checks to credit cards and debit cards reduces the money balances required to support a given volume of transactions and hence increases V
Lawrence J. Lau, Stanford University
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The Measurement of the Velocity of Money V as defined cannot be measured because T is not directly observed Instead, one can define an alternative velocity variable V*=PY/M in terms of observable
variables, which is referred to as velocity* V*= PT/M x Y/T = V x Y/T = V/ The variable =T/Y the ratio of the total real volume of all transactions T to real GDP Y
is not a constant but changes over time The volume of transactions relative to real GDP (T/Y) tends to rise in the process of economic
development T/Y also rises with financial deepening T/Y rises with rising volume of trade with the same trade surplus/deficit
For most developing economies, especially in the early stages of their economic development, T is likely to rise much faster than Y, and hence is increasing over time; for developed economies, is likely to be more stable .
Since both V and tend to rise over time and with economic development and growth—what is likely to happen to V*?
At the beginning phase of economic development, V, which depends on financial and technological innovation, is likely to increase very slowly, whereas is likely to increase quite rapidly, leading to a fall in V*; as an economy matures, Increases in V become much more important, and becomes relatively more stable, and V* is likely to rise
Lawrence J. Lau, Stanford University
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The Velocity of Money:China and the United States of America
The Velocity of Money, China and U.S.A.(International Monetary Fund Data)
-0.5
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998
Year
GD
P/M
on
ey
GDP/M1 China
GDP/M2 China
GDP/M1 US
GDP/M2 US
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The Implications of the Quantity Equation of Money: MV* = PY
Differentiating the quantity equation with respect to t, we obtain:
dM dV* dP dTV* M T P . Dividing both sides by MV, we obtain:
dt dt dt dtdM dV* dP dT dY dT
/M /V* /P /T. Substituting /Y for /T, dt dt dt dt dt dt
and
rearranging, we obtain:
dP dM dV* dY/P /M /V*- /Y. In other words, the rate of inflation
dt dt dt dtmay be written as difference of the rate of growth of the money supply
and the rate of growth of real o
utput, assuming that the velocity* of money
remains constant.
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The Rate of Change of Velocity*
V* = V/τ;
dV* dV dτ dV dτThus, /V* /V - /τ. Both /V and /τ are likely to be
dt dt dt dt dtpositive so that the rate of change of velocity* is likely to be indeterminate
in sign. However, the presumption is tha
dV*t for developed economies, /V*
dtdV*
is likely to be positive and for developing economies, /V* is likely to bedt
negative. Thus, in developed economies, if the rate of growth of the money
supply exceeds the rate of growth of real GDP, there is likely to be inflation,
whereas in developing economies, the rate of growth of money supply can
exceed the rate of growth of real GDP significantly without necessarily
causing inflation.
Lawrence J. Lau, Stanford University
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The Usefulness of the Quantity Equation of Money: MV* = PY The usefulness of the quantity equation of money is greatly
diminished if the velocity* of circulation of money is variable For most developing countries, especially those without a history of
high or hyper-inflation, the rate of growth of money supply can be significantly higher than the rate of growth of real GDP without necessarily causing additional inflation
This is because the velocity* of money, defined as PY/M, has, on the whole, been declining (a given level of real GDP requires more money balances to support over time)
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The Velocity of Money andReal GDP per Capita
Velocity of Money and Quasi-Money
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
10.0 100.0 1000.0 10000.0 100000.0
Real GDP per capita
GD
P/M
oney
Sup
ply
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The Rate of Growth of Money Supply andReal GDP per Capita
Average Annual Rate of Growth of Money Supply, 1985-1995
0.1
1.0
10.0
100.0
1,000.0
100.0 1000.0 10000.0 100000.0
Real GDP per Capita
Per
cent
per
ann
um
Lawrence J. Lau, Stanford University
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The Rate of Inflation andReal GDP per Capita
Average Annual Rate of Inflation, 1985-1995
0.1
1.0
10.0
100.0
1000.0
100.0 1000.0 10000.0 100000.0
Real GDP per Capita
Per
cent
per
ann
um
Lawrence J. Lau, Stanford University
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Precautionary Demand Availability of social (or even private) insurance (e.g., retirement,
survivor, health care, unemployment, inflation)--degree of completeness of markets
Availability of credit (households and firms) The time value of money (the rate of interest)
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Speculative Demand Money balances maintained for the exploitation of unexpected
opportunities The time value of money (the rate of interest)
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The Degree of Monetization andGrowth of Real GDP The degree of monetization increases with economic development Measured GDP may grow faster than true GDP especially at the
early stage of economic development Examples
Marketization of barter transactions Marketization of household work Growth of financial transactions--financial deepening
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Seigniorage and Inflation Tax The central bank (or private banks) issuing the currency in
circulation has seigniorage to the extent that money balances are held solely for the purpose of transactions or as a store of value
In developing economies, inflation is sometimes deliberately used as an instrument of taxation
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The Role of Finance (Credit) as a Facilitator of Transactions The “Cash-in-Advance” Constraint There are transactions that would not have taken place in the absence
of finance or credit, formal or informal Asymmetric information between savers and entrepreneurs/investors Transfer of risks from savers and producers to financiers (e.g. letter of credit) Economies of scale
Maturity transformation Pooling of resources (lumpiness of investments) Pooling of risks across borrowers Transaction costs Specialization in information acquisition and monitoring Amelioration of exchange rate risk
Lack of alternative investment instruments for savers
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Explicit or Implicit Deposit Insurance Enhances confidence in and hence stability of the financial system Reduces the probability of bank failure due to illiquidity as opposed to
insolvency Reduces the spillover (contagion) effect of bank failure Levels the playing field between large and small banks (a large number
of small banks is not as efficient as a small number of large banks because of the intrinsic economies of scale in banking; however, the political economy may favor a large number of small banks)
Encourages moral hazard on the part of both depositors and owners of financial institutions
Prudential regulation and supervision are therefore required A high reserve ratio as a substitute for ineffective prudential regulation
and supervision
Lawrence J. Lau, Stanford University
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Moral Hazard and Financial Institutions The capital requirements (e.g., the Bank for International Settlement
(BIS) standard of 8%) are generally too low to discourage moral hazard on the part of the owners of the financial institutions
Government-directed credit and the doctrine of “too big to fail” encourage moral hazard on the part of the borrowers (as well as lenders)
Explicit or implicit deposit insurance encourage moral hazard on the part of savers and depositors in their choices of depository institutions for their deposits
Informal credit markets (the lack of anonymity which limits moral hazard) Mutual credit associations Grameen banks
Lawrence J. Lau, Stanford University
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The Rate of Interest on Savings Deposits and Real GDP per Capita
The Deposit Rate and Real GDP per Capita
0.1
1.0
10.0
100.0
1000.0
100.0 1000.0 10000.0 100000.0
Real GDP per Capita
Per
cen
t p
er a
nn
um
Lawrence J. Lau, Stanford University
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The Rate of Interest on Loans and Real GDP per Capita
The Lending Rate and Real GDP per Capita
0.1
1.0
10.0
100.0
1000.0
100.0 1000.0 10000.0 100000.0
Real GDP per Capita
Per
cen
t p
er a
nn
um
Lawrence J. Lau, Stanford University
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The Interest Rate Spread andReal GDP per Capita
The Interest Rate Spread, 1995
0.1
1.0
10.0
100.0
1000.0
100.0 1000.0 10000.0 100000.0
Real GDP per Capita
Per
cent
per
ann
um
Lawrence J. Lau, Stanford University
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The Interest Rate Spread andReal GDP per Capita
The Interest Rate Spread, 1995
-50.0
0.0
50.0
100.0
150.0
200.0
250.0
100.0 1000.0 10000.0 100000.0
Real GDP per Capita
Per
cent
per
ann
um
Lawrence J. Lau, Stanford University
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The Interest Rate Spread andReal GDP per Capita
The Interest Rate Spread, 1995
-10.0
10.0
30.0
50.0
70.0
90.0
100.0 1000.0 10000.0 100000.0
Real GDP per Capita
Per
cent
per
ann
um
Lawrence J. Lau, Stanford University
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The Rate of Interest on Savings Deposits and the Lagged Rate of Inflation
The Deposit Rate (1998) and the Lagged Rate of Inflation (1997)
0
5
10
15
20
25
30
35
40
45
-10 0 10 20 30 40 50 60 70
The Lagged Rate of Inflation %
Th
e D
ep
os
it R
ate
%
Lawrence J. Lau, Stanford University
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The Rate of Interest on Loans and the Lagged Rate of Inflation
The Lending Rate (1998) and the Lagged Rate of Inflation (1997)
0
10
20
30
40
50
60
70
80
-10 10 30 50 70 90 110
The Lagged Rate of Inflation %
Th
e L
en
din
g R
ate
%
Lawrence J. Lau, Stanford University
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The Rate of Inflation and the Rate of Economic Growth (1970-1998)
The Rate of Economic Growth and the Rate of Inflation(1970-1998)
-2
0
2
4
6
8
10
0 20 40 60 80 100 120 140 160
Average Annual Rate of Growth of GDP (%)
Average Annual Rate of Inflation (%)
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The Effectiveness of Monetary Policy Setting the basic or reference rate of interest (e.g., the federal funds
rate, the rediscount rate) Setting the capital requirement (BIS standard) Setting the reserve ratio Inflation targeting Open market operations (the lack of a deep and liquid bond market)
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Financial Repression Is there financial repression in developing economies? Is financial repression desirable or undesirable?
Lawrence J. Lau, Stanford University
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The Benefits and Costs of a Currency Board System (Dollarization) True dollarization (Panama) and quasi-dollarization (Hong Kong,
Argentina) True dollarization implies that the U.S. dollar will be legal tender for all
obligations and contracts can be denominated in U.S. dollars Hong Kong and Argentina with a fixed U.S.$ peg are not quite truly dollarized
but is very close to being so Indonesia considered adopting a currency-board system in the midst
of the East Asian currency crisis
Lawrence J. Lau, Stanford University
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The Benefits and Costs of a Currency Board System (Dollarization) Benefits:
Insulation of economy from exchange rate volatility Credible pre-commitment to non-interventionist monetary policy, in particular,
non-inflationary financing of government expenditures Implicit commitment to a low rate of inflation (a rate of inflation similar to
that of the United States)—lowers inflationary expectations if credible The rate of interest and the rate of inflation will be at U.S. levels if credible Promotes long-term FDI as well as foreign portfolio investment Facilitates foreign trade
Costs: No more monetary policy (neither money supply nor interest rate can be
independently controlled) Fiscal policy constrained by the ability to issue local currency or US$
denominated government notes and bonds Loss of seigniorage from currency issuance under true dollarization
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The Currency Board System Adequate foreign exchange reserves, in excess of M0, will still be
required Even a completely cashless society, which implies M0 = 0, will still require
foreign exchange for the smooth and orderly conduct of business Flexibility (especially downward) of prices and wage rates is
essential for prompt and successful adjustment to external shocks Low stock of external (especially short-term) debt denominated in
foreign currency relative to foreign exchange reserves
Lawrence J. Lau, Stanford University
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Outstanding Issues of Dollarization Outstanding issues
Is there a lender of last resort (to domestic financial institutions)? Can the seigniorage be shared (true dollarization)? Coordination, if any, of monetary policy with the U.S. (e.g., monetary union)?
The U.S. benefits from seigniorage, both direct and indirect
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Voluntary Virtual Dollarization In economies with a high rate of inflation and a continuously
depreciating currency, it is quite common for transactions (e.g., loans and interest) to be denominated in U.S. dollars but settled in terms of the local currency in accordance with the exchange rate (either the official market rate or the black market rate, as specified by prior agreement)
Example 1: A firm may place an order in terms of U.S. dollars and upon delivery will settle in local currency in accordance with the market exchange rate on the date of delivery
Example 2: A firm may borrow money in terms of U.S. dollars. It will be given the proceeds in terms of the local currency in accordance with the market exchange rate on the date of the loan draw down. Upon maturity, it will repay in terms of the local currency in accordance with the exchange rate on the date of maturity.
