In discussing monetary measures for demand management, two interrelated questions are usually raised: first, how to evaluate the impact of changes in monetary variables on aggregate demand and, second, which monetary variable is appropriate from the viewpoint of policy.1 In examining these questions, but mainly the second, the paper concentrates on the choice between money and credit as the policy-controlled variable—that is, whether the authorities should act (place a ceiling) on credit or on money when they intend to regulate pressures on demand, and particularly pressures on the balance of payments.2
Monetary theory has generally concentrated on an analysis based on the assumption of a closed economy;3 the policy conclusions derived have ignored the existence of international transactions and yet have found their way into the analysis of an open economy. This procedure may be valid when an open economy operates under a system of freely fluctuating exchange rates, which precludes any change in the net foreign assets of the banking system. In this case, the consolidated balance sheet of the banking system is isolated from external disturbances. From the standpoint of policy, it may also be permissible in economies that are nearly self-sufficient and whose balance of payments does not impose any serious constraint on the implementation of their monetary policies. However, economic policy designed for open economies operating under fixed exchange rates and seeking to achieve the internal objective of price stability at full employment, and the external objective of a viable balance of payments, has to be based on a theoretical analysis that explicitly takes into account the role of international transactions. Recently, monetary theory has begun moving in that direction.4 The paper concentrates on the choice between money and domestic credit as an appropriate policy-controlled variable.
Section I compares an analytical framework based on the assumptions of a closed and an open economy with a flexible exchange rate. Section II discusses the rationale of credit as the policy-controlled variable in an open economy with a fixed exchange rate. Section III presents some conclusions. The model underlying the analysis is described in the Appendix.
I. The Money Approach
In this paper, we consider a two-sector closed economy—the banking system and the rest of the economy 5—with two markets—goods and services and money (total liquid assets). The latter is supplied by the banking system through increases in credit. Opening the economy to international trade introduces a potentially additional source of money, that is, money can be supplied by the banking system through credit expansion and/or purchases of international reserves. It also adds a constraint to the policy alternatives of the authorities, that is, the balance of payments. The results from the model under the assumption of both a closed and an open economy will be compared with a view to determining the appropriate monetary variable that can be controlled consistently with the balance of payments constraint.
Temporary quasi-equilibrium is defined as the absence of excess flow demands in the economy.6 The nature of this quasi-equilibrium is that the community is able both to spend on goods and services and to change its money holdings at the desired rates. This is a necessary, although not sufficient, condition for long-term equilibrium. The latter requires, in addition, equilibrium in the stock of money and of international reserves, that is, the actual and the desired stock of money and of international reserves are equal.
In the presence of stock disequilibrium, the flows will be affected as the community alters its spending patterns to adjust its actual to the desired stocks. These flow adjustments are subject to the sectoral budget constraints, which imply that the sum of all excess flow demands in the economy must be equal to zero. In turn, this implies that the excess flow demands are not independent. If all but one are equal to zero, so must be the remaining one. In the simple economy under analysis, the nonbanking sector can spend on goods and services, or add to its money holdings, or both. An excess demand for the former must be exactly offset by an excess (flow) supply of the latter. It follows then that equilibrium in the goods and services market means equilibrium in the market for additional money, and vice versa. Concentration on achieving equilibrium in the money market is based on a number of empirical statements made at this high level of aggregation. The most important of these statements is that there is a consistent relationship between the rate of growth of money and the rate of growth of nominal income.7 This relationship is interpreted to reflect the existence of a stable, well-defined demand for the stock of money.8
Most of the analyses made along these lines start from an initial position of full equilibrium (both in stocks and in flows) and inquire about the consequences of changes in the quantity (or in the rate of growth) of money.9 This point of departure can be upheld because of the difficulty of empirical identification of an equilibrium stock of money and because the achievement of a flow equilibrium will ensure the achievement of stock equilibrium over time. This leads to concentrating, for policy purposes, on the flow demand for and supply of money, which can be identified separately. Identification of the flow demand follows from the stable demand function for money,10 while the flow supply is considered to be under the control of the banking system. This assumption is crucial to the choice of a policy-controlled variable; it is valid in some but not in all cases.
In a closed economy, an excess (flow) supply of money—say, through credit being expanded at a higher rate than that at which the economy is willing to increase its money holdings—reflects an excess demand for goods and services. Prices and output (if there are unemployed resources) will increase until the disequilibrium in the money market disappears; the increase in prices and output will raise the demand for money to a level equivalent to the rise in the money supply. This process will also eliminate the excess demand for goods and services. Under these conditions, the public must hold any nominal quantity of money created by the banking system through credit expansion. The excess demand for or excess supply of money will reflect itself only through its effect on prices and output. In this way, the public can determine the real quantity of money while the banking system determines the nominal quantity of money. The public adjusts its nominal demand for money to any given nominal supply. The latter is under the control of the banking system, and the issue of whether to control money or credit does not arise.
If the same situation of excess supply of money prevails in an open economy operating under a freely fluctuating exchange rate, the excess supply of money reflects an excess demand for goods and services, as in the closed economy. This excess demand for goods and services will push domestic prices (and output) upward, but, additionally, it will create an incipient excess demand for foreign exchange that, in turn, will induce a depreciation in the exchange rate. As before, the domestic price increase, the increase in output (if any), and the depreciation in the exchange rate will raise the desired money holdings. This process will continue until general equilibrium in the economy is achieved. The freely fluctuating exchange rate policy implies balance in the country’s external transactions in the sense that there is no change in the net foreign assets of the banking system.11 As a consequence, the public has not been able to change the nominal amount of money, which, as before, is determined by the monetary authorities.
II. The Credit Approach
In Section I it was argued that in a closed economy or in an open economy facing no balance of payments constraint as a result of the implementation of a freely fluctuating exchange rate policy, a choice between money and credit does not arise.
As soon as we change the basic framework to analyze an open economy facing a balance of payments constraint, there is a link between the balance of payments and the money supply. Then the distinction between money and domestic credit becomes crucial. The analysis underlying the credit approach is similar to that used in Section I and can be considered as an extension of monetary analysis to include balance of payments problems.12 In open economies maintaining fixed exchange rates or implementing a policy of limited exchange rate flexibility that allows for endogenous changes in the net international reserves of the banking system, the balance of payments becomes an additional source of supply of money.13 The rest of the economy, in these circumstances, can adjust the nominal supply of money to what it demands by exporting or importing money through deficits or surpluses in the balance of payments.14 Therefore, the banking system has no direct control over the nominal supply of money, which becomes an endogenous variable of the system. What the banking system can do is to determine domestic credit, that is, one of the sources of supply of money. This is in strong contrast to the closed economy or the flexible exchange rate cases, where the rest of the economy could not change the nominal supply of money.
The credit approach, like the monetary approach, stresses the interdependence between the markets for goods and services and for additions to the stock of money. However, in a closed economy or its equivalent, equilibrium in one market implies equilibrium in the other market and, thus, general equilibrium in the system. In an open economy we are concerned with achieving equilibrium in the money market and in the balance of payments,15 defined as a given desired rate of change in international reserves. Given a rate of growth in the quantity of money demanded, an equivalent rate of growth in the quantity of money supplied, in principle, can be derived from any combination of changes in domestic credit and in net foreign assets of the banking system.16 In other words, an increase in the quantity of money demanded is compatible with different balance of payments outcomes. It follows therefore that equilibrium in money flows need not coincide with equilibrium in the balance of payments. Specification of the latter as a desired change in net international reserves (a reserve target) determines the appropriate change in domestic assets needed to satisfy the desired change in money holdings.
Recognizing the balance of payments as a source of supply of money ensures that the supply of money adjusts to the demand for it, and not the inverse; this is so because the public can dispose of or acquire money through the balance of payments. The implication of this is that the authorities, and therefore the banking system, can only determine the division of the supply of money between foreign and domestic assets through controls over domestic credit.
The channels through which the credit approach operates can be determined by examining the behavior of the different sectors in the economy. As the economy grows, an increase in the quantity of money demanded reflects the decision of the community to use part of its increasing income and wealth to add to its money holdings. This is a saving decision by which surplus sectors release real resources to accumulate claims on the banking system. These resources are channeled to those economic units whose expenditure exceeds their income. The deficit units borrow the savings of the surplus units through the banking system, which accepts their promise to pay in the future. Hence, the credit expansion of the banking system is tied to the availability of resources that the public is willing to save in the form of assets created by the banking system.
Thus, the existence of a well-functioning banking system contributes to the separation of the saving and investing functions as reflected in the decision of the surplus sectors to hold money and of the deficit sectors to supply domestic assets.17 The banking system, however, can extend credit in amounts different from those made available by the public. In this case, prices and the balance of payments will perform the necessary adjustments. Thus, in an open economy credit policies represent a method of managing aggregate demand and the balance of payments. Any attempt by the authorities to reduce or eliminate a deficit or to create or increase a surplus will require control of domestic credit, so that, on the one hand, resources can be released to expand exports and, on the other hand, imports can be reduced. By this process, the balance of payments outcome will be consistent with objectives of the authorities and at the same time will satisfy the demand for money. The inverse process applies to a planned balance of payments deficit or to a reduction in a balance of payments surplus.
Given a balance of payments target as an initial condition, the design of credit policy is based on the estimation of the economy’s demand for money in terms of the relevant set of independent variables. Assumptions on or projections of the time path of the latter determine, ceteris paribus, the time path of the quantity of money demanded. This time path may consist of two different elements: normal (trend) growth in money holdings in response to normal growth in the economy, and adjustment of desired to actual money balances if the two are not initially equal, that is, if there is stock disequilibrium in the money market. This estimated time path combined with the international reserve target determines the appropriate domestic credit expansion. Thus, a relationship is established between domestic credit expansion and the balance of payments. This relationship indicates that excessive (insufficient) domestic credit expansion relative to the rate of growth of the demand for money will induce a balance of payments deficit (surplus). The transmission mechanism operates through the behavioral reactions of the public to changes in the policy-controlled variable. It provides a complex link between domestic credit and the balance of payments through major variables, such as expenditure, income, domestic prices, and the demand for money. This line of reasoning implies a large degree of stability in the money market and that the brunt of the adjustment process falls on the flow of expenditure channeled through the goods and services market.
Introduction of capital movements
The analysis thus far has dealt with the current account of the balance of payments. The introduction of capital movements adds a market for domestic and foreign securities.18 There are now three stocks in the economy (money, securities, and international reserves) and four flows (goods and services, changes in the stock of money, changes in the stock of securities, and changes in international reserves). The extension of the model does not affect the conclusions. If anything, it strengthens the link between domestic credit and the balance of payments. For example, an excess (flow) demand for money reflects an excess supply of goods and services and/or of securities. The excess supply of goods and services will tend to depress prices, increase exports, and reduce imports, while the excess (flow) supply of securities will tend to increase interest rates. These factors will tend to absorb the excess demand for money. In terms of the balance of payments, the excess supply of goods and services will improve the balance on current account, while the excess supply of securities will induce both residents and foreigners to purchase more domestic (relative to foreign) securities. This tends to improve the capital account. Therefore, as previously, an excess demand for (supply of) money is associated with a balance of payments surplus (deficit).
The balance of payments thus continues to be one of the channels through which the supply of money is adjusted to its demand; the total nominal supply of money is not within the direct control of the banking system, and the distinction between money and domestic credit continues to be crucial for balance of payments purposes. In fact, capital mobility increases the effectiveness of domestic credit policy to influence the international reserves position of a country.
This extension of the model allows for an analysis of the composition of the balance of payments. While the overall balance is related to the conditions prevailing in the money market, its composition will depend on the conditions prevailing in the goods and services and the securities markets. If an excess demand in the latter is exactly matched by an excess supply in the former, the overall balance of payments will remain unaffected but its composition may change; a net capital outflow may offset a current account surplus brought about by the excess supply of goods and services.19
The general argument of the paper can be stated as follows. In any economy, the public determines the real quantity of money that it desires to hold. This may be obtained by changing the price level, the nominal quantity of money, or both. In a closed economy or its equivalent, the banking system determines the nominal quantity of money that the public has to hold; the public obtains the desired real quantity of money mainly through changes in the domestic price level. In an open economy operating under a fixed exchange rate, however, it becomes possible for the public to change the nominal quantity of money through international transactions. As a consequence, the nominal supply of money adjusts to the demand for money through the balance of payments. Thus, the banking system and, in particular, the monetary authorities do not directly control the total money supply but only the part that is made available through domestic credit. Furthermore, the attainment of a quantity of money desired by the community is compatible with different movements in international reserves that may not be consistent with the balance of payments objective of the authorities. These considerations lead to emphasizing the role of domestic credit as the control variable for stabilization purposes.
E = total private nominal expenditure on goods and services
p = domestic price level
e = exchange rate (exogenous)
P = overall price level
Y = gross national product
y0 = real domestic output of goods and services (exogenous)
Md = demand for the stock of money
G = public sector deficit
R = foreign exchange reserves
M0 = outstanding stock of money
B = balance of payments
Be = balance on current account
Bk = balance on capital account
c = real private domestic expenditure on domestic goods and services
m = volume of imports of goods and services
x = volume of exports of goods and services
D = domestic credit
r = interest rate
Sd = demand for securities (expressed in terms of money)
S0 = outstanding stock of securities (expressed in terms of money)
W0 = nominal wealth
EDi = excess demand in the ith market
The market for goods and services21
subject to f1, f2, f4 > 0; f3 < 0
subject to i1, i4 > 0; i2, i3 < 0
subject to d1 > 0
Equilibrium in this market obtains when
The market for money
subject to F1, F3 > 0; F2 < 0
Equilibrium in this (stock) market obtains when
Sectoral budget constraints22
Addition of the three constraints yields
Changes in international reserves [the fourth bracket in the overall budget constraint (equation (17))] is a residual item that equals zero at all times. This is so because, under a system of fixed exchange rates, the banking system stands ready to buy (sell) whatever amount of foreign exchange the rest of the economy provides (demands). In the model, the nonbanking sector determines the incremental demand for money (ΔMd) as well as one of the sources of money supply, that is, the balance of payments (given the fixed exchange rate). The banking system can control only the other source of money, that is, domestic credit. Exercise of this control, which implies allowing for endogenous changes in the price of bank loans, makes the term for changes in domestic credit [EDΔD = (ΔD0 – ΔD)] equal to zero. Therefore, the overall budget constraint is reduced to
This implies that the two terms are not independent: if one is equal to zero, so must the other be.23
The overall budget constraint (equation (17)) is the ex post expression of equilibrium conditions (equations (9) and (20)). If equation (20) is satisfied, so must be equation (9), and vice versa. Concentration on satisfying equation (9) yields an analysis in terms of expenditure flows, while concentration on satisfying equation (20) yields a monetary or credit analysis. This underscores the interdependence of these two types of analysis. The choice between them emerges as an empirical question that depends on the relative stability of the expenditure or the money demand functions.25
Consider now the cases mentioned in the text. In a closed economy, equation (7) disappears and, consequently, also does the foreign sector budget constraint, equation (16). The domestic price level becomes the overall price level (Ṗ =p) and, furthermore, M0 = D0, ΔM = ΔD. Thus, the need for a distinction between money and domestic credit does not arise. In an open economy with freely fluctuating exchange rates, equation (7) is always equal to zero. As a consequence, AM = AD, and the same conclusion holds.
The importance of a distinction between money and domestic credit in an open economy with a fixed exchange rate is crucial and follows from equations (18), (19), and (20), where ΔMd stands for the estimated incremental demand for money and ΔR stands for the desired change in international reserves. Then, equation (20) determines the domestic credit expansion needed to satisfy ΔMd and to achieve ΔR.
The rationale of credit policies
External imbalances can be expressed as phases of stock adjustment in the money market:
In a growing economy, the demand for money rises over time with the growth of output. This may give rise to balance of payments surpluses or deficits.26
Credit policy is based on a positive relationship between an excess demand for (supply of) money and a balance of payments surplus (deficit); it is used to influence the international reserves position of the economy and at the same time to achieve equilibrium in the money market. Define the demand for money as follows:
where X =[x1, x2 …] is a vector of the relevant variables. Then
where ηi is the elasticity of the F function with respect to the ith variable and
On the supply side, we have
The market for securities:
subject to H1 < 0, 28H2, H3 > 0
where the superscript D(F) stands for domestic (foreign)29 and
The system’s sectoral budget constraints now become30
which, combined, yield
Given this identity, ensuring that [ΔMd – ΔM] = 0 will make
The implication is that in the absence of an excess (flow) demand for money, an implicit excess demand for (supply of) goods must be matched exactly by an incipient excess (flow) supply of (demand for) securities. The overall balance of payments need not be affected, as the current account deficit (surplus) would be offset by a net capital inflow (outflow).
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Mr. Guitian, an economist in the Stabilization Policies Division of the Exchange and Trade Relations Department when this paper was prepared and presently in the External Finance Division, has degrees from the Universities of Santiago (Spain), Madrid, and Chicago.
An earlier draft of this paper was presented at the Conference on Policy Formation in an Open Economy held at the University of Waterloo, Canada, on November 11–14, 1972.
It is assumed throughout the paper that the authorities have the institutional arrangements to control the total domestic assets of the banking system.
Concentration on those two monetary variables does not imply that changes in other monetary variables, especially interest rates, do not affect demand. They were chosen merely because they appear more susceptible to direct control than do other monetary variables that, even if introduced, would not affect the conclusions reached in the paper.
For an alternative sectoral breakdown, see Christ (1968).
See Mundell (1971 a) and Friedman and Meiselman (1963) for a similar concept. In terms of the model, the flows are goods and services and the rates of change of the stock variables, which are money and international reserves.
This demand is usually expressed as a function of wealth or income, the relative rate of return on money and alternative assets.
If the initial postulate had been the stability of the expenditure function, we would be led into a Keynesian income/expenditure analysis. See Friedman and Meiselman (1963) and the ensuing controversy; also see Chand (1972).
Thus, the existing stock of international reserves is kept constant. Furthermore, the impact of changes in the exchange rate on the domestic currency value of this stock is not allowed to affect the quantity of money.
This argument can be extended to the particular case of a reserve currency country. The essence of this case stems from the existence of a foreign demand for reserve currency, which adds an extra dimension to the reserve country’s balance of payments. The authorities still do not control the quantity of reserve currency that is held domestically, but they can control the global (domestic and foreign) amount of the reserve currency. Such control, however, has to be directed to satisfying the global (world) demand for reserve money. Disregard of the foreign component will eventually impose a convertibility constraint on the reserve country, and its balance of payments will lose the extra dimension.
These two conditions imply equilibrium in the market for goods and services; however, they do not imply equilibrium for stocks.
The number of combinations is limited by the international reserve management policies of the authorities, that is, by how much they are going to allow them to increase or decrease.
For simplicity, we assume in what follows that both types of securities are perfect substitutes.
Number subscripts represent the arguments concerning which the respective functions are differentiated.
Foreign prices are assumed to be constant. Thus, the exchange rate, by appropriate choice of units, represents a foreign price index.
The constraints are expressed as flows over a period of time and discrete changes in stocks over the same period of time. They have no time dimension, although they depend on the length of the period, that is, E = ʃ
We have the following system:
subject to the overall budget constraint, that is,
This condition does not tell us whether equation (13) is satisfied. All it says is that the rest of the economy can adjust its cash balances at the desired rate.
If the economy was initially in stock equilibrium, that is, EDM = 0. Otherwise, all that equation (25) ensures is the absence of excess (flow) demands.
This condition is imposed by the wealth constraint (W0 = M0 + S0 = Md + Sd), given that F1 > 0; see equation (10).
For simplicity, we will assume that foreign and domestic securities are perfect substitutes.
Net borrowing by the rest of the economy is represented by ASd;Δ is the banking system’s net purchases or sales of securities, for simplicity identified with increases or decreases in domestic credit. See Mundell (1968) for an analogous approach.