Excessive growth in the money supply leads to high rates of spending on domestic or foreign goods. Given that domestic supply is essentially inflexible in the short run, the former is likely to result in substantial inflationary pressures in the economy. To the extent that spending pressures are directed towards foreign goods (or assets) balance of payments pressures will ensue.

1. Introduction

Excessive growth in the money supply leads to high rates of spending on domestic or foreign goods. Given that domestic supply is essentially inflexible in the short run, the former is likely to result in substantial inflationary pressures in the economy. To the extent that spending pressures are directed towards foreign goods (or assets) balance of payments pressures will ensue.

Countries implementing adjustment programs usually suffer from high inflation, sluggish growth and external disequilibrium. To a substantial extent these problems are likely to reflect inappropriate developments in monetary aggregates. The task of monetary policy is to ensure that the expansion in domestic liquidity is consistent with the authorities’ objectives for growth, inflation and the balance of payments. In this context policies to control monetary aggregates play a central role in adjustment programs.

From the viewpoint of stabilization policy, the primary role of monetary policy is to prevent excessive spending. However, in a broader sense financial policy plays a key role in affecting the efficiency of resource use in the economy by influencing the mobilization and employment of financial resources. The role of financial intermediation in influencing savings and investment is discussed in Chapter VII. Importance should be attached to ensuring that the mechanisms of monetary control are consistent with efficient financial intermediation.

Section 2 of this chapter develops a framework for considering monetary policy that emphasizes the determination of the appropriate monetary stock and the money supply process. In Section 3 the effectiveness of different instruments of monetary policy are reviewed.

2. A framework for monetary control

a. Instruments and objectives

Monetary policy requires establishment of a relationship between the monetary instruments that the authorities control and objectives for growth, inflation and the balance of payments. Rather than establishing a direct relationship between instruments and objectives, an intermediate target such as money or credit is often considered. Introduction of an intermediate target allows a two–stage process that focuses on the appropriate level of the money supply and the use of policy instruments to limit monetary aggregates to that amount.

  • Demand for money. The appropriate level of the money supply depends on the amount of money the public (i.e., households and enterprises) wish to hold. This requires analysis of the public’s demand for money balances.

  • Supply of money. Control of monetary aggregates depends on the use of monetary instruments and the impact of other factors affecting the money supply. This requires consideration of the money supply process.

Money may be defined as the sum of currency outside banks and demand deposits held with the monetary institutions by the rest of the economy other than the central government. However, the choice of intermediate target should reflect the stability of its relationship with ultimate policy objectives. This may lead to consideration of a more broadly defined monetary aggregate that includes deposits (quasi–money) that are close substitutes for money more narrowly defined. The need to achieve balance of payments targets in the context of fixed exchange rate regimes may lead to an emphasis on credit variables as intermediate targets (see Section 2.d).

b. Determination of the appropriate money stock

The alternative to holding money balances is to spend them. Consideration of the appropriate money stock requires determination of desired holdings of money balances given objectives for inflation and growth. The demand for money results from the need to have money balances available to carry out routine purchases (transactions demand), and its use as a store of value. For both of these purposes it is the real purchasing power of money that is important.

  • Transactions demand. Holdings of money balances for transactions depends on the level of economic activity, which may be approximated by the GDP.

  • Store of value. The demand for money for this purpose depends on how well money keeps its purchasing power. For example, if the interest rate paid on deposits exceeds the inflation rate, there is an incentive for the public to hold money balances with the banking system. More generally, expectations of high inflation will reduce the likely purchasing power of money and its attractiveness as a store of value.

Empirical estimation of the demand for money may based on statistical relationships with GDP, inflation, interest rates and other variables, using historical data. Particularly where there is substantial structural change in the economy, including reform of the financial system, past relationships may prove of limited value in predicting future developments.

A more judgmental approach would be to assess the demand for money on the basis of the likely movement of the ratio of money to nominal GDP. Alternatively, attention may focus on the velocity of money, which is the inverse of this ratio.

c. The supply of money

Consideration of the use of policy instruments to affect monetary aggregates requires analysis of the money supply process. Such analysis is facilitated by reference to the summary accounts for the monetary sector that are presented in Box II.1.

(1) The accounting framework

Analysis of the money supply process requires review of three sets of accounts.

  • The monetary survey. The liabilities of the monetary survey show the movement of money and quasi–money. In an accounting sense these liabilities may be related to the domestic and external assets of the banking system. Consideration of the money supply process, however, requires a more disaggregated approach.

  • Monetary authorities. This account focuses on the activities of the agency responsible for monetary policy. The liabilities of the monetary authorities include currency held outside the banks and bank reserves (holdings of currency and deposits with the monetary authorities), which together are referred to as reserve money. Currency held outside the banks represents a direct component of the money supply, while the availability of bank reserves affects the ability of deposit money banks to create deposits. Analysis of the asset side of the balance sheet indicates external and domestic factors affecting the growth of reserve money.

  • Deposit money banks (DMB). The DMB’s accounts summarize the activities of the institutions whose liabilities represent the deposit component of the money supply. Assets of the DMBs include their reserves and their extensions of domestic credit.

(2) The money multiplier

From the above the money supply process can be defined in terms of two factors.

  • The initial creation of reserve money, which is achieved by increasing the liabilities of the central bank to the public and the banking system.

  • A secondary expansion of the money supply by the DMBs. This is achieved through the “multiplication” of the resources deposited with these banks, whereby part of the credit provided with these resources, when spent by the borrower, returns to the DMBs as new deposits which can be lent out again.

An understanding of this process can be facilitated by consideration of some simple identities based on the previously discussed accounts.

An Accounting Framework for Monetary Analysis

Monetary analysis and policy is greatly facilitated by an appropriate accounting framework. The following accounts are particularly important in considering the factors determining the money supply.

  • Monetary authorities. The monetary subsector responsible for currency issue, credit control, managing the country’s international reserves and maintaining general supervision of the monetary system. These duties are usually largely carried out by the central bank or a similar body.

  • Deposit money banks. Those financial institutions, other than the monetary authorities, which have significant liabilities in the form of deposits payable on demand and transferable by check or otherwise usable in making payments. Usually largely composed of commercial banks.

  • Monetary survey. A consolidation of the accounts of the monetary authorities and deposit money banks that shows the financial relationship between the monetary institutions subsector—whose liabilities include the economy’s money supply—and other sectors of the economy.

Schematic versions of each of these accounts as shown below are referred to extensively in the text to illustrate the factors affecting the growth of monetary aggregates.

Monetary Authorities

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Deposit Money Banks

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Monetary Survey

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The first equation defines money (MO) as the sum of currency outside the banking system (CY) and deposits (D). Equation ( II.2) defines reserve money (RM) as the sum of CY and bank reserves (R). Defining the money multiplier (m) as the ratio of money to reserve money,


The money multiplier can equally be defined in terms of the ratios of currency and reserves to deposits. Dividing the right hand side of equations (II.1) and (II.2) by deposits and substituting in equation ( II.3),


where c represents the ratio of currency to deposits and r indicates the ratio of reserves to deposits.

From the asset side of the monetary authorities’ accounts,


where reserve money is indicated as the sum of net foreign assets (NFA), domestic credit to the government net of government deposits (NDCG) and claims on deposit money banks (CCB).

(3) Implications

The following implications may be drawn from this analysis:

  • the money supply depends on the factors affecting the money multiplier and reserve money;

  • monetary policy instruments work through their impact on either the money multiplier or reserve money;

  • the money multiplier depends on the behavior of the banks (reserve ratio) and the nonbank public (currency ratio);

  • movements in reserve money depend not only on the policies of the monetary authorities, but also on developments in the external (NFA) and fiscal (NDCG) sectors; and

  • NFA and NDCG reflect movements in the balance of payments and government budget, respectively; therefore, a fundamental requirement for effective monetary policy is that it be coordinated with the use of fiscal and external policies.

d. Financial programming

The Monetary Survey indicates that changes in the money stock reflect movements in net foreign assets or domestic credit. Countries undertaking adjustment programs may be expected to have a target for the balance of payments and are not indifferent to the combination of external and domestic factors affecting the money stock. Further, in an open economy operating under a fixed exchange rate, the money supply is an endogenous variable influenced by surpluses and deficits in the balance of payments.

For these reasons Fund–supported adjustment programs usually adopt domestic credit as an intermediate target rather than the money supply. Linkage of monetary instruments with balance of payments, growth and inflation targets might then involve the following steps:

  • prediction of the demand for money that is consistent with growth and inflation targets;

  • establishment of a target for net foreign assets that is consistent with the balance of payments forecast;

  • determination of a ceiling for domestic credit that is consistent with the predicted demand for money and the balance of payments (NFA) objectives;

  • consideration of the appropriate allocation of credit to the government given the total credit ceiling and the requirements of the private sector; and

  • setting values for monetary instruments that are consistent with the desired level of domestic credit and the money stock.

This framework remains predicated on the ability to establish reasonably stable links between money balances and spending (demand for money) and the money stock and policy instruments (supply of money). Limitations on credit and the money stock also remain dependent on coordination of monetary, fiscal and balance of payments policies.

3. Instruments of monetary policy

a. Types of instruments

A broad distinction may be made between direct and indirect instruments of monetary control.

  • Direct instruments seek to attain the authorities’ objectives through regulations that directly set the monetary targets at desired levels.

  • Indirect instruments operate by taking advantage of the relationship between money and reserve money and of the special role of the monetary authorities in the creation of reserve money. In contrast to direct controls, indirect instruments seek to align market behavior with monetary policy objectives.

b. Direct controls

Monetary policy in developing countries has typically relied on direct instruments of control. Most important from a macroeconomic viewpoint have been credit ceilings on individual banks, and direct controls on interest rates. Controls have also encompassed sub–ceilings relating to the amount or cost of credit to be provided to individual sectors. Use of other monetary instruments has often been geared to sectoral and fiscal priorities rather than the needs of monetary control.

Direct controls may in the short run be reasonably effective in preventing excessive credit expansion. However, a trade–off needs to be recognized inasmuch as there are substantial resource allocation costs attached to such measures. Direct instruments may also have significant limitations over time from the immediate viewpoint of monetary control.

(1) Resource allocation costs

  • Reduces competition among the commercial banks and penalizes the most efficient institutions.

  • Distorts portfolios of banks with, for example, lending focused on established borrowers rather than potentially profitable new enterprises.

  • Encourages financial disintermediation (i.e., a reduction in the share of savings channeled through the financial system) and contributes to the growth of the informal sector and alternative monetary instruments.

(2) Monetary control problems

  • Disintermediation limits the effectiveness of controls inasmuch as they focus on the formal financial system whose market share is falling.

  • Excess reserves emerge if reserve money growth is not constrained. This increases incentives for disintermediation and complicates the future removal of credit ceilings.

  • Administrative allocations of credit may encourage demand–determined access to credit by government or public enterprises.

c. Indirect instruments of control

Reflecting these problems there has been a recent trend, in both industrial and developing countries, towards substituting indirect instruments for credit ceilings. This is illustrated in Box II.2 by reference to the case of Indonesia.

Reform of the Financial System: Indonesia

A key element of Indonesia’s comprehensive adjustment effort in 1983, following a sharp decline in oil revenues and a weakening of the economy’s finances, was a reform of the financial system. Before the reform, the major instruments for conducting monetary policy available to the central bank, Bank Indonesia (BI), were credit ceilings for individual banks, interest rate controls for state banks, and a selective rediscount mechanism (liquidity credits) designed to reallocate credit at subsidized interest rates.

Prior to financial reform, the expansion of liquidity credits and net foreign assets had led to a rapid growth of reserve money, which left the banking system with a large volume of surplus funds. This excess liquidity together with interest rate controls produced distortions in the pattern of domestic financial intermediation. Moreover since an increasing proportion of deposits was being placed in nonbank financial intermediaries which were not subject to either interest rate controls or credit ceilings, during this period, the effectiveness of monetary controls was weakened.

The financial reform included replacing the system of restrictions on financial institutions with a more indirect system of monetary control. Interest rate controls were eliminated, a wide range of loan categories were made ineligible for liquidity credits, credit ceilings on individual banks were eliminated, and a new mechanism of monetary control that relied principally on open market operations was introduced.

Since there were no domestic public debt instruments available for open market operations, BI began issuing its own debt instruments which could be readily marketed under the prevailing circumstances of excess liquidity. The sale and repurchase of these instruments allowed the central bank to absorb or inject bank reserves at its own initiative and to influence domestic money market conditions.

The most conspicuous success of the reform was the rapid growth of domestic currency deposits after June 1983 and the marked slowdown in the accumulation of foreign currency deposits, reflecting the increased confidence in the domestic banking system and its greater competitiveness. Moreover, the move to open market operations as the principal instrument of monetary control greatly improved the authorities’ technical ability to manage monetary and reserve aggregates. Indonesia was able to successfully put in place an indirect system of monetary and interest rate management despite the lack of a sophisticated money market at the outset of the liberalization process.

Market–oriented instruments of monetary control seek to influence the demand for and supply of reserve money to achieve values consistent with intermediate targets for monetary aggregates. Use of such instruments leaves financial institutions free to determine the allocation of credit in accordance with market forces. Despite the advantages of indirect instruments, there should be caution in eliminating aggregate credit ceilings until alternative methods of monetary control are seen to be operating effectively.

Effective utilization of indirect instruments is closely linked to the development of money markets. Indirect instruments of monetary control may both be facilitated by, and help foster, money market development. Strong interrelations also exist between government debt management policy and indirect instruments of monetary control.

Indirect instruments are based on some variant of open market operations, supported by suitable policies on reserve requirements and central bank lending.

(1) Open market operations

Open market operations involve the sale or purchase of securities by the central bank to withdraw or inject liquidity into the system. Reliance on open market operations has several advantages:

  • flexibility exists both in terms of the amount and the timing of intervention;

  • the central bank has the initiative, whereas in the case of discount policy, for example, it is the financial institutions that decide whether and how much to borrow; and

  • transactions are voluntary at market–determined yields.

The central bank may undertake open market operations in either secondary or primary markets.

  • Secondary market operations are based on purchase and sale of existing securities, or self–reversing transactions, such as repurchase agreements. In countries with well–developed secondary markets, central banks generally prefer to operate in these markets.

  • Primary market operations involve new issues and redemptions. Although not quite as flexible as those in secondary markets, such operations have the same effects and are the primary form of intervention in countries with less–developed financial markets.

Several practical problems are involved in setting up open market operations. Particularly, important issues relate to the type and maturity of securities and the choice of selling mechanism. Approaches to these issues may vary according to the particular institutional features of each country. A willingness to accept market determined interest rates and to pay such rates on government debt is, however, central to the success of open market operations.

(2) Reserve requirements

Reserve requirements (cash in vault and deposits with the central bank) help to achieve control of money and credit by affecting the demand for reserve money and thereby the money multiplier. Changes in reserve requirements are better suited to effecting secular rather than short–term changes in the money supply.

  • Frequent variations in reserve requirements complicate financial management and lead to large holdings of excess reserves that frustrate monetary control.

  • Insofar as reserve requirements carry zero, or below–market, interest rates, they involve a taxation element that adversely affects financial development and encourages disintermediation.

More broadly defined liquidity requirements are usually designed to place government securities rather than contribute to monetary control. From the viewpoint of monetary control, liquid asset ratios are of little relevance and may be determined solely by prudential requirements.

The effectiveness of open market operations does not depend on the level of reserve requirements. However, certain technical changes in the requirements can make them more compatible with indirect mechanisms of monetary control. For example, reliance on average reserve requirements can reduce excessive interest rate pressures to meet end–of–period positions.

(3) Central bank lending facilities

The cost and availability of central bank refinancing should ensure that borrowing from the refinancing window is consistent with the desired track for reserve money.

  • Importance should be attached to ensuring that the availability of central bank finance is constrained so as to avoid offsetting the impact of open market operations.

  • The discount rate should be sufficiently penal to discourage borrowing, with the rate kept under review to ensure it remains significantly above market yields.

  • Central bank refinancing should, however, be sufficiently available to maintain its short–term safety role, and provide some insurance against excessive fluctuations in interest rates.


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  • 5

    Villanueva, Delano, “Issues in Financial Sector Reform,” Finance and Development, Vol 25 (March 1988), pp. 1417.