(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.

Box II.1

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

Monetary Authorities

Assets		Liabilities
Foreign Assets		Reserve Money
Claims on Central			Currency
	Government			Outside Banks
Claims on Deposit			Banks*
	Money Banks	Reserves
		Foreign Liabilities
		Central Govt.
			Deposits
		Other Items (Net)

View Table

Monetary Authorities

Assets		Liabilities
Foreign Assets		Reserve Money
Claims on Central			Currency
	Government			Outside Banks
Claims on Deposit			Banks*
	Money Banks	Reserves
		Foreign Liabilities
		Central Govt.
			Deposits
		Other Items (Net)

Deposit Money Banks

Deposit Money Banks

Assets		Liabilities
Reserves		Demand Deposits
Foreign Assets		Time, Savings, and
Claims on Central			Foreign Currency
	Government			Deposits
Claims on Official		Foreign Liabilities
	Entities	Central Government
Claims on Private			Deposits
	Sector	Credit from Central
Claims on Non–			Bank
	monetary Fin.	Other Items (Net)
	Institutions

View Table

Deposit Money Banks

Assets		Liabilities
Reserves		Demand Deposits
Foreign Assets		Time, Savings, and
Claims on Central			Foreign Currency
	Government			Deposits
Claims on Official		Foreign Liabilities
	Entities	Central Government
Claims on Private			Deposits
	Sector	Credit from Central
Claims on Non–			Bank
	monetary Fin.	Other Items (Net)
	Institutions

Monetary Survey

Monetary Survey

Assets			Liabilities
Foreign Assets (Net)			Money
Domestic Credit			Quasi–Money
	Claims on Central		Other Items (Net)
		Government (Net)
	Claims on Official Entities
	Claims on Private Sector
	Claims on Non–monetary
		Financial Institutions

View Table

Monetary Survey

Assets			Liabilities
Foreign Assets (Net)			Money
Domestic Credit			Quasi–Money
	Claims on Central		Other Items (Net)
		Government (Net)
	Claims on Official Entities
	Claims on Private Sector
	Claims on Non–monetary
		Financial Institutions

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.

(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.

(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.