Economics 374-01A Dr. John F. Olson

Monetary Theory and Policy Spring 2008

Study Guide for Second Test

The second test (Tuesday, April 15^th) will be on the remaining part of Unit 2 (not addressed on the first test) and on Unit 3 with the material from Handa, chapters 7, 9, and 10 plus the supplementary web-documents on estimating the demand for money function, the money supply process and the Federal Reserve documents on monetary policy tools. The bulleted points below are from the end of the chapter “Summary of Critical Conclusions” in the Handa text. See/study the appropriate chapter sections of the text for details. I have inserted my annotations (and some potential test questions) in italics.

Chapter 7 – The Estimating Function for the Demand for Money

This chapter begins addressing some practical problems in estimating the money demand function.

• The appropriate scale variable for the demand for money may be current income, expected income or permanent income.
• Rational expectations is more suitable than adaptive expectations for estimating expected income for the next period.

RE is more suitable from a theoretical perspective, but the modeling and informational requirements may not be worth the effort in estimation.

• Adaptive expectations is the more appropriate statistical method for estimating permanent income since this concept specifies the average expected income over the future.

AE is more appropriate statistically than RE – see above.

• The unanticipated component of income is usually estimated as income less the statistical estimate of expected income.
• The partial adjustment model provides one way of capturing the lagged adjustment of actual to desired money demand.

If there are costs to adjusting into or out of money balances in response changes in equilibrium holdings, then a partial adjustment model needs to be incorporated.

• There are considerable theoretical and econometric problems in the accurate estimation of the money demand function. In particular, the relevant time series must be stationary. If they are not stationary, the appropriate technique is co-integration with an error correction model.

Beside stationarity, other problems include single-equation (partial equilibrium) vs. general equilibrium estimation, imposing coefficient restrictions, the identification problem, multi-collinearity, and serial or auto-correlation of the error terms. Another issue is the selection of the functional form for estimation – usually a log-linear form is employed because the coefficients can be directly interpreted as elasticities – the choice is often determined by the relative empirical performance of different forms.

Chapter 9 – Money Demand and Empirical Findings

While empirical estimation of the money demand function yields some meaningful results, the endeavor also demonstrates the difficulties and problems described in previous chapters.

• The income elasticity of the demand for M1 is less than one. The income elasticity of M2 demand is higher than for M1 demand and is sometimes estimated to be greater than one.

What economic reasons would explain these empirical results?

• The negative interest elasticity of the demand for money, no matter how it is defined, is now beyond dispute.

What do the empirical results tell us about the economic nature of money?

• Incorporating more than one interest rate into the estimated money demand function or an interest rate and the expected inflation rate usually introduces multi-collinearity which leads to biased estimates.
• Empirical studies do not show convincing evidence of the liquidity trap, even for data covering the 1930s.
• Financial innovations during the last three decades rendered the money demand function unstable for this period. Numerous attempts and innovative variations in estimation have not established a stable demand function, with a specific form and invariant coefficients, for out-of-sample data.

Money has changed and, accordingly, so has the demand function.

• M1 has done better than broader monetary aggregates during some periods and worse in others. Several recent studies have supported the use of M1 over M2 and broader aggregates. Empirical evidence shows very limited evidence of currency substitution.
• For the 1960s and 1970s, estimates based on a partial adjustment model often indicated a low-impact income elasticity for the first quarter but a long-run elasticity close to one, indicating a slow adjustment of money demand to its long-run level.

If the partial adjustment model is capturing the effects of costs of adjusting money balances to their desired level, explain this empirical result.

• Most of the variables relevant to the money demand function have proved to be non-stationary. Therefore, most empirical studies now use co-integration analysis with an error-correction model.
• Even the co-integration techniques have not provided estimates that are robust or that consistently favor one monetary aggregate over others.
• There is evidence of buffer stock holdings of money balances. Therefore, in the short run, money demand is not independent of money supply.

Chapter 10 – Money Supply Process

The money stock is not exogenously fixed as is often assumed in basic macroeconomic models to reduce the complexity of the analytical framework. The money supply depends upon the behaviors of the public and the banking system, as well as the direct and indirect influences of the monetary authorities (primarily the Federal Reserve).

The money supply process can be expressed analytically as M ^s = m x Base. The money multiplier (m) is determined, in turn, by the currency-deposit and reserve-deposit ratios. See the course web-document on the money supply process for the derivation of the expression and further details.

What is fundamental to understanding the money supply process is its integration with the process of credit and deposit creation in the banking system. Banks accept deposits, then extend those funds as new credit (loans and/or acquired securities) which, in turn, becomes the source of new, additional deposits.

You should be able to explain how the money supply (and money multiplier) process works in terms of the economic behavior of the public, banks, and the Federal Reserve, as well as how their behaviors are determined and affected by changes in economic variables (interest rates, etc.).

• The private sector affects the money supply, so that the central bank must be able to predict its responses if it is to offset them and control the money supply in the economy.
• The non-bank public influences the money supply through its demand for currency and various forms of its deposits with the banks.

This is measured by the currency-deposit ratio in the money multiplier formula.

• The commercial banks influence the money supply through changes in their demand for reserves.

This is measured by the reserve-deposit ratio in the money multiplier formula.

• The central bank can influence the money supply through open market operations, through changes in the minimum reserve requirements, if any, imposed by it on the commercial banks, and through changes in its discount rate for loans to commercial banks. In some countries, it also does so by shifting government deposits between the commercial banks and itself.

See the Federal Reserve web-pages for each of the three policy tools linked from http://www.federalreserve.gov/policy.htm. How do changes in each of the tools subsequently affect (directly and/or indirectly) the monetary base and/or the money multiplier through the currency-deposit and/or the reserve-deposit ratio? Note that the new lending facilities are temporary methods to provide borrowed reserves through the discount window channel/tool.

• Monetary evolution, inducing changes in the currency or deposit ratios, can change the monetary base multiplier. In general, this has been increasing over time.

You can also empirically determine on your own from the course web-site accessible data sets that the currency-deposit and reserve-deposit ratios have been declining over time, which increase the value of the money multiplier.

• Empirical studies support a behavioral approach to the money supply and indicate that the money supply depends on the interest rates in the economy.

Refer to the Handa text sections 10.6 and 10.7 and the tables 10.1 and 10.2 for theory and evidence.

• The estimated money supply functions are very sensitive to the monetary policy and target regimes.

We will discuss the details of this in Unit 5.