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?

JEM027 – Monetary Economics 1

Textbook money targeting

OMO Monetary base Money supply (target) Inflation (+output?) (goal) We start with looking at the stability of the last link (we will discuss the determination of money supply next time) JEM027 – Monetary Economics 2

Recall: 3 basic roles of money 1

Medium of account

2

Medium of exchange (payments)

3

Store of value JEM027 – Monetary Economics 3

Motives to hold money A

Transaction motive (~medium of exchange)

B

Precautionary motive (~medium of exchange)

C

Speculative motive (~store of value) JEM027 – Monetary Economics 4

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 JEM027 – Monetary Economics 5

Transaction motive (2/2)

▪ ▪ Liquidity preference: J.M. Keynes (1930), J. Hicks (1935) Explored in W. Baumol (1952), J. Tobin (1956) Y Y/n JEM027 – Monetary Economics 6

Precautionary motive

▪ Introduces uncertainty: M.H. Miller, D. Orr (1966) H z JEM027 – Monetary Economics 7

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 JEM027 – Monetary Economics 8

Comparison of elasticities

Model Friedman Y 1 0 i Baumol Tobin 1/2 -1/2 Miller-Orr (1/3, 2/3) -1/3 Tobin Yes Yes Yes Uncertainty No 1/2 1/3 No Yes No Yes JEM027 – Monetary Economics 9

i

Going to macro: IS-LM (1/5)

M S M’ S Money expansion M D M/P ▪ With stable money 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!) JEM027 – Monetary Economics 10

Going to macro: IS-LM (2/5)

i Y FE LM 1 LM 2 IS 2 IS 1 Y ▪ If aggregate demand for 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 ▪ Note that an even better policy here is to expand money supply, as this full offsets the adverse IS shock by bringing i even lower. JEM027 – Monetary Economics 11

i

Going to macro: IS-LM (3/5)

M S 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.

M D M D M/P JEM027 – Monetary Economics 12

Going to macro: IS-LM (4/5)

i Y FE LM 2 LM 1 ▪ Under money targeting, shocks to the demand for money lead to instability in the real economy.

IS 1 Y JEM027 – Monetary Economics 13

i

Going to macro: IS-LM (5/5)

M S M’ S M D M D M/P ▪ A policy of stabilising the nominal interest rate would do a much better job in this case.

▪ A money expansion 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 JEM027 – Monetary Economics 14

W. Poole (1970)

… IS … LM … under this condition, it is better to fix i (it implies lower y t variability) JEM027 – Monetary Economics 15

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 JEM027 – Monetary Economics 16

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 under predicted 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) JEM027 – Monetary Economics 17

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.

JEM027 – Monetary Economics 19 Source: IMF; Batini, et al. (2006)

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) JEM027 – Monetary Economics 20

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 JEM027 – Monetary Economics 21 Source: IMF classification

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 JEM027 – Monetary Economics 22