Before 1987 the banking system was essentially of the monobank variety, characteristic of centrally planned economies. The dominant financial institution, the National Bank of Hungary (NBH), was both the central bank and the prime commercial bank for the enterprise sector. Banking services to households were provided separately by the National Savings Bank and a network of saving cooperatives. In addition, the financial system included several small joint venture banks and a limited number of specialized financial institutions, such as the Foreign Trade Bank—which was mainly involved in the financing of external trade—and the State Development Bank—which largely operated with budgetary funds to finance state initiated investments.

Institutional and Recent Monetary Developments in Hungary

1. Institutional developments

a. Establishment of a two-tier banking system

Before 1987 the banking system was essentially of the monobank variety, characteristic of centrally planned economies. The dominant financial institution, the National Bank of Hungary (NBH), was both the central bank and the prime commercial bank for the enterprise sector. Banking services to households were provided separately by the National Savings Bank and a network of saving cooperatives. In addition, the financial system included several small joint venture banks and a limited number of specialized financial institutions, such as the Foreign Trade Bank—which was mainly involved in the financing of external trade—and the State Development Bank—which largely operated with budgetary funds to finance state initiated investments.

This system was substantially changed on January 1, 1987. A two-tier banking system was established with the separation of the central and commercial banking functions of the NBH. Commercial bank operations of the NBH and the State Development Bank were taken over by three newly created commercial banks. Two previously existing specialized banking institutions, including the Foreign Trade Bank, also received commercial bank charters. These five banks formed the core of the banking system dealing with enterprises. In the course of 1987, the requirement for enterprises to keep their current accounts with a particular commercial bank was lifted and administrative regulations on interest rates on enterprise deposits and loans were abolished.

The segmentation between banking services for enterprises and the traditional network of savings institutions for households was, however, preserved. This left financial institutions for households practically untouched in this first phase of banking reform.

b. Integration of household and enterprise banking

A first step in integrating enterprise and household banking was taken in 1988. Commercial banks were allowed to issue certificates of deposit to households at competitive interest rates but continued to be prevented from accepting other forms of deposit. By end 1989, the stock of certificates of deposits, although still small in absolute terms, had reached about 4 percent of household’s deposits.

The necessary steps for fuller integration, however, were not taken until 1989. Until then, household deposit rates had been administratively set at very low levels to finance the subsidization of housing loans. These loans were the main type of credit extended to households by the National Savings Bank and were supplied at extremely low interest rates (0–3 percent). Under this system there was thus considerable cross-subsidization from household depositors to household borrowers. These arrangements needed to be changed before the household banking system could be put on a competitive basis. In 1989, interest rates on housing loans were raised and the remaining subsidy on new housing loans was assumed by the budget. Moreover, the existing stock of low interest housing loans was transferred to a newly established housing fund in exchange for bonds with market-related yields. While interest rate ceilings on household deposits remained, they were increasingly adjusted in line with movements in market rates (Table 1).

Table 1.

Hungary: Selected Interest Rates

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Source: IMF Institute data base.

In 1989 the distribution of deposits was: 6 percent sight and current accounts; 79 percent time deposits; 7 percent housing deposits; and 8 percent foreign currency deposits.

In 1989, a 20 percent withholding tax was introducted on interest payments to households.

Data for 1988–89 are averages; for 1987, they are in terms of ranges.

The bulk of loans to households are for housing.

c. Toward a more competitive banking system

The number of financial institutions grew rapidly in response to the initiatives described above. For example, by end 1989 the number of commercial banks had reached 20, 13 of which were Hungarian owned. 1/ Despite the expansion in the number of financial institutions, activity remained very concentrated and the process of integrating household and enterprise business was slow. The three new commercial banks that inherited the portfolio of the NBH, together with the National Savings Bank, accounted for over 85 percent of the deposit base and a similar share of total assets. 2/ As discussed below and in the following sections, a number of other factors slowed the pace of change. These included the inherited fragile credit portfolios of the major commercial banks, the strong dependence of commercial banks on central bank refinancing, a thin capital market, and some features of the regulatory environment.

Despite the measures taken to integrate enterprise and household banking, the National Savings Bank and savings cooperatives continued to account for the bulk of household operations. While rapid transformation was not to be expected, the regulatory environment may also have had an effect. Notably, high reserve requirements were imposed on deposits of households at commercial banks in order to protect the savings cooperatives from a rapid drain of funds.

Although the newly incorporated commercial banks were profitable in their first three years of operation, the quality of their asset portfolios remained poor. Credits continued to be largely extended to the enterprises that accounted for the largest share of the pre-reform portfolio. This in part reflected the lack of incentives and regulatory requirements for banks to recognize losses resulting from bad loans in their portfolios. In addition, the Bankruptcy Law, enacted in 1986, while used to liquidate small enterprises on a modest scale, had little or no effect on large state enterprises. Unchanged, if not worsening, portfolio composition probably also reflected the small number of both large borrowers and banks, which inevitably resulted in strong links between them.

One consequence of these circumstances was that the burden of a tightening of monetary policy was born disproportionately by viable enterprises which tended to be crowded out of the credit market because of continuing credit expansion to nonperforming enterprises.

d. Policy instruments

The general direction of change was to increase reliance on indirect instruments of monetary control. The principal instrument of monetary control, however, was central bank refinancing quotas, including rediscounting of commercial bills. By varying the volume of credit extended to commercial banks, the NBH was able to exert considerable influence over the amount of resources available to banks for their lending operations.

In 1989 central bank refinancing credits accounted for nearly one third of banking system credit to enterprises and households; nearly three-quarters of long-term bank lending was covered by refinancing credits. These were a cheaper form of financing than deposits because they were subject only to a liquid asset requirement, and not a reserve requirement as were deposits. Bank specific refinancing credit ceilings were linked to a bank’s equity and capital. On this basis, they were adjusted whenever the overall quota for central bank refinancing credits was revised.

The introduction of an auction market in Treasury bills in December 1988 facilitated use of a more flexible interest rate policy. These bills were well received due to their liquidity and competitive rates (26.5–27 percent at end 1989). However, with only a small amount of bills issued, the scope for open market operations remained limited. Reflecting the methods of credit allocation by the NBH, the authorities’ main instrument for influencing interest rates continued to be the terms on which, through various “windows”, they provided refinancing to the commercial banks. While changes in rates on refinancing credits from the NBH had been small in 1987–88, there were larger increases in 1989 (see Table 1). At the end of 1989 the basic refinancing rate used for longer-term credits stood at 17 percent while the more widely used liquidity rate for working capital needs was 21 percent (compared to an inflation rate of 17 percent).

A system of reserve requirements, introduced in early 1987, served largely prudential purposes. A uniform rate was introduced for reserve requirements in 1989 (which was raised from 15 percent to 18 percent in September 1989), 1/ although these requirements did not apply to all liabilities, with external liabilities and refinancing credits excluded. Interest payments on reserve deposits were discontinued in 1989.

Interbank lending continued to be intermediated by NBH and turnover remained low.

e. Foreign exchange transactions

An important step in expanding the scope of banking operations was the relaxation of restrictions on foreign exchange transactions. In 1988, commercial banks were authorized to provide foreign exchange-related services, including the provision of special travel accounts in foreign exchange. 1/ From September 1989, banks were effectively free to collect all forms of deposits in foreign exchange of households. They were also permitted to extend foreign currency loans to Hungarian enterprises and households, at their own risk. Trade related foreign exchange operations remained prohibited.

f. Other financial assets

The bond and securities markets were too small to create strong competition for commercial banks. The thinness of these markets also forestalled significant financial flows between households and enterprises that could otherwise have mitigated the effects of the separation of household and enterprise banks. The relative attractiveness of bonds waned after the authorities ceased issuing government guarantees for bonds issued to households in early 1987; bonds also became less attractive as the main underwriters refrained from adjusting bond prices, despite the rapid rise in interest rates and increasing competition from treasury bills and certificates of deposits. The most notable development in the capital markets was the increase in the volume of shares sold by enterprises, from FT 48 billion in 1988 to FT 150 billion in 1989.

2. Monetary developments in 1989

Monetary developments in 1989 were dominated by the weakness of the fiscal position and the large unplanned external payments surplus in nonconvertible currencies. Both these factors contributed to high bank liquidity, which downward adjustments to the NBH refinancing limits were insufficient to offset. As a result, credit to the state enterprise sector grew by 21.5 percent, compared with a slight decline in 1988. Household credits grew by considerably less (5.5 percent) reflecting the increased costs of housing loans. These developments, together with the financing needs of the fiscal sector, resulted in total domestic credit of the banking system increasing by about 22 percent, or over twice the rate of 1988.

The easing of credit conditions was accompanied by a much larger than planned increase of private consumption. Enterprises, which enjoyed greater freedom over wage determination following a liberalization of the wage system in January 1989, granted large wage increases and social benefits continued to grow rapidly. The wage bill of socialized enterprises is estimated to have risen by 19 percent, compared to a planned increase of 6–7 percent. Another important factor contributing to the growth of private consumption was the accelerated spending abroad, reflecting the liberalization of regulations on personal imports and travel abroad in 1988. This increase in spending underlay a further small rise in inflation and a sharp deterioration of the external current balance in convertible currencies.

The strong growth in credit was partly reflected in a faster rate of growth of broad money (12 percent in 1989 compared with 2 percent in 1988). This increase in liquidity was held by enterprises whose deposits grew by 26 percent, which was more than the growth of GDP. By contrast, household deposits actually declined in nominal terms, reflecting the noted drawdown of travel allowances (whether for travel, private imports, or holdings of foreign currency) as well as a significant prepayment of housing loans to avoid an anticipated new tax on the interest payments of these loans (this tax was later deemed unconstitutional). Note, however, that currency in circulation, most of which was held by households, increased substantially (10 percent). The increased relative importance of currency in household’s financial portfolios is consistent with their observed increase in real spending.

Compounding the problems of excess liquidity in the economy was a loosening of financial discipline in the enterprise sector, as reflected by a significant increase in the stock of forced inter-enterprise credits, i.e., a build-up of inter-enterprise arrears. These arrears are estimated to have reached FT 127 billion, equivalent to 7.5 percent of GDP or about half of the short-term credit extended by banks to enterprises (certain estimates put the total as high as FT 200 billion). 1/ This debt was believed to stem from a relatively small number of enterprises (30–40) whose insolvency placed about 400 other enterprises in financial difficulty. These arrears, which were in effect a substitute for bank credit, complicated the task of managing the liquidity of the economy.

Forecasting the Monetary Survey

1. Introduction

The liabilities of the banking system to the private sector and state enterprises (currency, demand deposits, time and savings deposits) are called monetary aggregates. These aggregates have been found to play an important role in the determination of real output, prices, and the balance of payments, which indicate some of the final objectives of economic policy. The forecasting of monetary aggregates is thus a crucial step in the design of monetary policy.

In formulating monetary policy, the authorities must ultimately have in mind the relationship between the monetary instruments under their control and their final objectives. However, these relationships are typically indirect and can be thought of as having two components: (1) the link between monetary aggregates that represent intermediate targets and final objectives; and (2) that between policy instruments and intermediate targets.

The monetary survey provides a framework for analyzing the desired values for the variables for which the authorities can set intermediate targets, i.e., monetary aggregates. It reflects the consolidation of the balance sheets of the different components of the banking system, i.e., the sum of transactions of the NBH and commercial banks, netting out all inter-bank transactions. Monetary aggregates represent the counterpart of, and by definition must be equal to, the sum of net foreign assets (valued in local currency) and net domestic credit (including other items, net) (Box 1).

Stylized Monetary Survey

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The link between policy instruments and intermediate targets is discussed below in the context of the balance sheet of the monetary authorities.

2. Determinants of monetary aggregates and forecasting tecniques

a. Demand for and supply of monetary aggregates

For analytical and forecasting purposes, a key distinction must be drawn between monetary aggregates defined in real terms (at constant prices) and in nominal terms (at current prices).

Money is voluntarily held to finance a flow of transactions and as a savings asset. The amount of money willingly held by the general public will be assessed in terms of its real value, i.e., the purchasing power of money over a representative basket of goods. For instance, if prices all doubled and then stayed at their new level, the public would need to hold exactly twice as much money on average as it would otherwise to conduct any given amount of real transactions. While the demand for money should, thus, be thought of in real terms, the monetary authorities can only affect the nominal money stock (see section below for a discussion of the money supply process).

The impact of changes in the nominal money stock depends crucially on how movements in actual money balances, defined in real terms, compare with the demand for these real balances by the public. If the monetary authorities supply more (less) than the public wishes to hold, the public will reduce (increase) the value of this supply.

How does the public affect real money balances? There are two principal mechanisms:

  1. (1)The public may buy (sell) foreign currency in exchange for local currency in conjunction with balance of payments transactions, i.e., imports (exports) of goods and services or capital transactions. The stock of net local currency would be reduced (increased) by the transaction, as would be the stock of foreign assets held by the monetary authorities.
  2. (2)The public may buy (sell) domestic goods in exchange for local currency. If the public feels it has too much money as compared with real goods, purchases will increase. This increase in the demand for goods will raise domestic prices. The public will have, in effect, reduced its stock of real money balances via inflation, although the nominal stock may remain the same.

Both mechanisms may operate at the same time. If the monetary authorities supply too much (little) money, prices of local goods may increase (decrease) and the balance of payments may worsen (improve). The impact on the balance of payments will be larger the more open are the goods and capital markets and the less flexible is the exchange rate system.

For instance, in an economy with a fixed exchange rate and no exchange and trade controls, the authorities would have little control over the nominal money stock. Any imbalance between the supply of and demand for money would result in a monetary expansion or contraction through the balance of payments, with limited impact on prices. By contrast, in an economy with a fully flexible exchange rate and no controls, the exchange rate would equilibrate the supply of and demand for foreign exchange so that net foreign assets would remain unchanged. In this case, a monetary expansion would permanently increase the nominal level of monetary aggregates, the counterpart of which is likely to be an increase in prices, including the price of foreign currency (the exchange rate).

Increased spending resulting from a monetary expansion may also raise real output, especially if there is unutilized capacity. Conversely, decreased spending may reduce output, the more so if prices are inflexible downward. Taking the first case as an example, the increase in real output, by raising the number of transactions that need to be financed, should result in an increase in the demand for money. The output effect thus serves as a third avenue for restoring equilibrium. It is generally accepted that there is normally a positive relationship between the growth of monetary aggregates and nominal output. However, considerable differences of view still remain as regards the strength of this relationship and the division of the effects of changes in the nominal money supply between prices and real output.

b. Forecasting techniques

Since households and enterprises determine the real value of the monetary aggregates, forecasting these aggregates requires consideration of the behavior of these economic agents. Two general methods are discussed. One method is based on the use of regression techniques to estimate a demand for money Junction. The other approach is less formal and concentrates on trends in the velocity of money. The choice of methods is generally dictated by data availability and the stability over time of institutional arrangements and behavioral relations in the case in question.

(1) The demand for money equation

This method assumes that the financial behavior of economic agents can be explained as a function of a small number of economic variables. It also assumes that the relationship between monetary aggregates willingly held and the explanatory variables is stable over time. As discussed below, there are various factors that could render this relationship unstable, limiting the usefulness of this approach.

Whether to use narrow or broad definitions of the money supply in estimation should be dictated by the empirical results. It is not possible to identify a priori the aggregate for which there is the most stable demand from the public. Generally, the larger the share of the banking system’s liabilities to the nongovernment sector that is included in the definition of money, the more helpful it is in forecasting the monetary survey. However, it may be more difficult for the monetary authorities to control a broadly defined monetary aggregate.

The most commonly used demand for money function includes as explanatory variables a transaction-related (“scale”) variable, most often real GDP, and a variable measuring the relative attractiveness of holding money as compared with other financial or real assets.

The choice of opportunity cost variable depends to some extent on the definition of monetary aggregate being used and on the institutional arrangements of a country. Some general representative nominal interest rate could be the most appropriate measure of opportunity cost of holding monetary assets which earn no interest. For monetary assets which earn interest, a variable measuring the interest rate differential between money and other financial assets may be more appropriate. In countries where the financial liabilities of the banking system to the private sector represent the greatest part of the latter’s total financial assets, the real rate of interest has sometimes been used as a proxy for the yield on financial assets relative to real assets (the expected effect of the real interest rate on the demand for the monetary aggregate being positive). Where interest rates remain unchanged for long periods, this effect may be captured by considering the rate of inflation alone (the expected effect of inflation on real money holdings being negative).

Many empirical estimations of the demand for monetary aggregates have found the most successful formulation to be in logarithmic form, except for the opportunity cost variable. For example:



  • M = the monetary aggregate

  • P = the price level

  • Y = GDP in nominal terms

  • π = the opportunity cost of holding money

  • a1 = income elasticity of the demand for money

  • a2 = semi-elasticity of money with respect to the opportunity cost variable (the sign depending on the definition used for π)

An important assumption underlying estimation of equation (1) is that the real demand for money balances is always equal to the actual real supply. In fact, adjustment to any disequilibrium may not be instantaneous. This could reflect factors such as costs and inconveniences of spending any excess money immediately or the time that it takes to realize that a monetary expansion has occurred and that money holdings exceed their desired levels. To take account of the lags involved in returning to equilibrium, a partial-adjustment model is often used that assumes that the adjustment in a given period corresponds to a fraction, λ, of the desired adjustment.

Then, denoting by MD and M fee desired and actual amounts of the monetary aggregate in nominal terms, respectively:


where 0 ≤ λ ≤ 1

Substituting equation (1) into equation (2) and putting ln(MP)t1 on the right hand of the equation:



  • b0 = λa0

  • b1 = λa1

  • b2 = λa2

  • b3 = 1 – λ

The values of coefficients b1, b2, and b3 can be estimated directly from fee regression. These estimated values can be used to derive fee estimated values for a1, a2 and λ of equations (1) and (2). 1/

Table 2 summarizes the results of estimating a demand for money function for broad money in Hungary using annual data for the 1982–89 period. 2/ The dependent variable is the average stock of broad money held during the period deflated by the consumer price index. The independent variables measuring the transactions motive and opportunity cost of holding money are, respectively, GDP in constant 1986 prices and the inflation rate, as measured by the consumer price index.

Table 2.

Hungary: Money Demand Estimates

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Notes: t-values are in parenthesisln(MP)t = the dependent variable, is defined as the average of end of period and beginning period stock of broad money, divided by consumer price index (1982 = 100). In log terms.ln(MP)t1 = ln(mp)t lagged one period.ln(YP) = GDP at constant 1986 prices. In log terms.Π = Percentage change in the consumer price index.F.95 = Critical value to be exceeded by the calculated F statistic of the regression for the overall fit of the equation to be statistically significant at the 95 percent confidence level.

Equation (4) assumes that the demand for money takes the form of equation (1) of the text, i.e., assuming that the desired stock of real money holdings is equal to the supply at all times. The overall fit of the equation is of borderline significance at the 95 percent confidence level. Also, while the values of the regression coefficients are of the expected sign, the estimated coefficient for real income is close to zero, a suspect result in itself.

When regression coefficients take on implausible values, or when the fit of the equation is poor, the behavioral relationship being estimated may be unstable. In order to check for instability, the equation was run over several subperiods, including for 1982–87 (see equation 5)).

Not unexpectedly, the values of the regression coefficients in equation (5) are considerably different from those of equation (4). While the income coefficient is somewhat closer to what could be expected, the fit is much poorer and statistically insignificant. These results do not reveal a stable demand for money during the period in question.

Equations (6) and (7) incorporate as an explanatory variable real money balances lagged one period to capture any temporary disequilibria in the money market, as described in equation (3) of the text. For the 1982–89 period such a specification improved the fit considerably (equation 6). Note that the implied value of λ is close to zero, which suggests, implausibly, virtually no adjustment to a disequilibrium situation. 1/ When the regression was rerun over the 1982–87 period (equation 7), the estimates once again became statistically insignificant at the 95 percent confidence level and the values of the regression coefficients changed considerably, further evidence of at least one break in the behavioral relationship around 1987.

(2) Possible estimation problems

Stability of money demand functions is predicated on an unchanged institutional environment. Structural reform would be expected to change the overall behavior of economic agents, thus rendering the estimation of most behavioral relationships, including the demand for money, difficult.

Take as an example the possible effects of financial reform. An improvement in the functioning and depth of financial markets could reduce the demand for money as innovations promote economies in money holdings and new, more attractive assets become available. This effect could however be partly offset if financial reform were to make savings in the form of financial assets, including money, more attractive. The responsiveness of money demand to interest rates may also appear to increase significantly because interest rates prior to liberalization did not vary sufficiently to allow for measurement of their effects on portfolio choices.

Poor regression results may also be attributable to data problems. The data may be affected by errors or changes in definitions and collection methods. Moreover, the data series may not be long enough: the number of needed data points increases with the number of explanatory variables. In order to avoid structural shifts, while at the same time having the necessary length of time series, it is often advisable to limit the estimation period to relatively short intervals using quarterly or monthly data. Unfortunately, such data are often either unavailable for all the needed time series or their quality is considerably inferior to annual data.

A third possible explanation for poor results may be the existence of a liquidity overhang. A liquidity overhang may be defined as the stock of money balances in excess of desired levels (apart from reversible short run variations). Liquidity overhangs are most often associated with countries that have significant price, trade and exchange controls, which are reflected in chronic shortages of goods. If excess liquidity were to exist over certain parts of the estimation period, the regression equation would be fitting points from both the demand and supply curves of the money market, limiting the usefulness of the results.

Determining whether an overhang exists is not an easy matter since the demand for money is unobservable. Estimation of an overhang is even more difficult and will not be dealt with here. 1/ Visible signs of frustrated spending intentions in the official market, such as queues, are neither a necessary nor sufficient condition for verifying the existence of an overhang. On the one hand, spending intentions may be so totally frustrated that queuing is not worthwhile. On the other hand, queuing may reflect relative price distortions—i.e., excess demand for certain products offset by growing inventories of other unwanted products—rather than absolute price distortions—i.e., generalized excess demand for goods.

Concerns over involuntarily held liquid balances arise because they could be activated any time, either during a period of price liberalization or by such factors as a worsening in expectations about inflation and/or the supply situation, leading to a much more rapid inflation than expected and possibly to hyperinflation. Moreover, so long as an overhang exists, the link between monetary aggregates and aggregate demand is severely weakened, limiting the effectiveness of monetary policy. Excess household liquidity is also likely to diminish incentives to work for money incomes and, more generally, to carry out transactions in the legalized monetized economy.

Methods of eliminating liquidity overhangs include currency reform, i.e., reduction of the nominal money stock; a rise in the price level, by fiat or by market forces (in principle this only needs to be a “blip” in the price level; in practice it might result in an outburst of inflation); and privatization schemes that absorb any excess balances. Avoiding a recurrence of the problem requires changes in the structure of the economy, including less controls and harder budget constraints.

While excess liquidity has not generally been considered a major problem in Hungary during the 1980s, because of a less distorted price system than in other Eastern European countries, the existence of some excess liquidity cannot be completely discounted. One indication is that black market exchange rates were 20–30 percent more depreciated than the official rate between 1982 and 1988, with the premium increasing to about 40 percent in 1988–89 (Table 3). These premiums may give some indication that excess balances of local currency were being channelled into black markets. The relative significance of this factor would depend on the size of, and access to these markets.

Table 3.

Hungary: Black Market and Official Exchange Rates

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Sources: Pick’s foreign currency report, official sources, and staff estimates.
(3) Velocity of monetary circulation

Velocity of monetary circulation, V, can be defined as the number of times the money supply, however defined, turns over in a given period to finance a certain level of economic activity. If we approximate fee level of economic activity by nominal gross domestic product, velocity can be represented by the following identity:


To interpret equation (8) behaviorally rather than simply as an identity, recall that in the absence of a liquidity overhang, real money balances, MP are determined by the demand for these balances. Changes in velocity thus critically reflect changes in real money demand.

For example, if the income elasticity of demand for money balances were assumed to be one, i.e., a given percentage increase in real output raises the real demand for money by an equal percentage, real income changes would have no effect on velocity. On the other hand, if increasing inflationary pressures lead to the rate of return on real assets exceeding that on financial assets, the demand for money balances, at a given income level, would be expected to fall. This would result in an increase in velocity. If an overhang were to exist, i.e., involuntarily held money balances, observed velocity would be less than desired velocity. An observed downward trend in velocity could suggest the build-up of a liquidity overhang, particularly if there was no reason to expect desired velocity to decline.

The advantage of using judgmental velocity estimates rather than regression equations to forecast real money balances is that projections are not constrained by past behavioral relationships which may either be unstable or not expected to hold in the future.

Table 4 calculates the velocity of monetary circulation for the period 1980–89. In the most recent period, 1988–89, velocity rose significantly, whereas in previous years it was remarkably stable. Excluding 1988–89, average velocity (defined in terms of average broad money) was equal to 2.23, compared with 2.75 in 1989.

Table 4.

Hungary: Velocity of Monetary Circulation of the Economy

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Source: IMF Institute data base.

Defined as broad money.

Calculated both in relation to end of period and period average money stocks.

Defined as the sum of end of period and beginning of period money stocks, and divided by two.

A major problem in interpreting the results of Table 4 is that no distinction is made between the behavior of state enterprises and households. In contrast to market economies, private ownership of enterprises is limited, which weakens the link between corporate profits and household incomes: in a market economy, corporate profits are readily translated into household incomes though dividend payments. Similarly, controls on prices and incomes weaken the mechanisms whereby any ex ante excess liquidity in one sector gets distributed across other sectors. For instance, any excess liquidity of state enterprises may be prevented from being translated into a wage increase. The fact, noted earlier, that households and enterprises bank with quite separate institutions may further weaken the financial transmission mechanisms between the sectors. For all these reasons the calculated velocities may result from very different behavioral patterns on the part of enterprises and households and thus be a misleading series to use as a basis for forecasting velocity.

Tables 5 and 6 show separate velocity calculations for households and state enterprises.

Table 5.

Hungary: Velocity of Circulation of Household Money

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Source: IMF Institute data base.

Defined as the sum of currency in circulation and household deposits.

Calculated both in relation to end of period and period average money holdings.

Defined as the sum of end of period and beginning of period money holdings, and divided by two.
Table 6.

Hungary: Velocity of Circulation of Enterprise Money

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Source: IMF Institute data base.

All of currency in circulation is assumed to be with the household sector. Includes private enterprise deposits and deposits of financial institutions (which are small).

Calculated both in relation to end of period and period average money holdings.

Defined as the sum of end of period and beginning of period money holdings, and divided by two.

The velocity of monetary circulation of households (Table 5), defined as household’s disposable income divided by the sum of currency in circulation and household deposits, 1/ was on a slow declining trend through 1987, followed by significant increases in 1988 and, particularly, in 1989. As discussed in the section on recent economic developments, there was a sharp fall in the demand for money of households in 1989 reflecting drawdowns of travel allowances, following an easing of regulations in 1988, and significant prepayments of housing loans to avoid an anticipated new tax. The sharp rise in household velocities in 1989 underlines the importance of identifying the effects of changes in structural and institutional developments on economic agents’ behavior.

In contrast with developments in the velocity of household money, the velocity of enterprise money (Table 6), defined as gross domestic product over enterprise deposits, increased steadily after 1981. This trend could reflect a declining demand for money resulting from such factors as the increased use of inter-enterprise credits. It may also suggest an income elasticity of less than one. Alternatively, if there was excess liquidity at the beginning of the period, the observed rise in velocity may reflect a progressive reduction in excess holdings of money.

A particular problem in interpreting the behavior of monetary velocity for enterprises arises when they face a soft budget constraint, i.e., easy access to bank and inter-enterprise credit and financial relief from the government. In this context, enterprises may be less concerned with the amount of money that they happen to hold at a particular point in time than with their potential access to additional financing when they need it.

In assessing future movements in velocity, the stance of economic policies, whether based on unchanged policies or a more normative projection, needs to be defined as well as its implications for output, inflation, interest rates and other variables affecting the relative attractiveness of holding money as compared with other real or financial assets. Moreover, as underscored previously, it is important to identify the possible structural factors and institutional developments that could affect the demand for money, particularly as they may have the dominant influence on economic agents’ behavior in a time of change.

For example, how would enterprises alter their holdings of money in response to a tighter budget constraint, including an increased threat of bankruptcy? What are the implications for the transactions demand for money of splitting large enterprises into smaller ones? How would enterprises respond to tighter credit conditions? What if forced inter-enterprise credits also were reduced?

As regards households, has the pent up demand for foreign consumer goods released by travel and partial import liberalization run its course? What impact would the September 1989 liberalization of regulations governing foreign currency deposits have on recorded levels of bank deposits (the issue being how much “under the mattress” money would flow into domestic banks)? How will households respond to the introduction of new payment and credit instruments or when faced with increased uncertainty as a result of prospective structural changes?

While quantification of these effects is no doubt difficult, it is at least important to assess the direction of change. In forecasting velocity, it should be noted that an underestimation of desired velocity, i.e., overpredicting real money demand, is likely to result in a higher inflation rate and/or a worse balance of payments outcome than programmed. On the other hand, an overestimation of desired velocity could have opposite effects. In this case the risk is that if there is some downward rigidity in prices the excess demand for money would translate into lower output growth and higher unemployment. The choice of velocity assumption in a financial program, thus, also depends on the relative importance that is attached to the inflation target as compared to the output and employment targets.

3. Forecasting the other monetary accounts

a. Net foreign assets

Projections of net foreign assets are directly linked to the prospects for the balance of payments and the availability of external financing. In a more normative scenario, the net foreign assets are targeted rather than being a passive outcome of existing policies. Abstracting from data and valuation problems, the change in net foreign assets of the banking system should be equal to the change in net international reserves (recorded, by convention, below the line in the balance of payments) and other foreign assets held by the banking system and not included in the definition of reserves (recorded above the line in the capital account of the balance of payments) minus the change in the banking system’s external indebtedness (also recorded in the capital account).

In projecting the net foreign asset position for the consolidated banking system for Hungary (which is negative), it is noteworthy that in 1986–89 about 90 percent of the net foreign indebtedness of the banking system was with the NBH. This share is likely to decrease as the financial system in Hungary becomes more decentralized.

Gross foreign assets of the NBH were some 10–20 percent higher than the stock of gross international reserves in 1986–89, reflecting the exclusion of certain less liquid foreign assets from the definition of reserves. On the liability side, the NBH is the largest external debtor in Hungary. Between 1986 and 1989 its share of Hungary’s total external debt remained unchanged at 86 percent.

b. Net domestic credit

Once projections for real GDP, prices, and net foreign assets have been determined, and the estimates of the monetary aggregates have been made based on the expected behavior of the public, the amount of net domestic credit may be calculated as a residual (given some reasonable assumption with respect to the change in other items). This follows from the monetary survey identity (see Box 1). The calculated amount of net domestic credit should, nevertheless, be consistent with developments in the other sectors of the economy in the sense that the behavioral relationships among key economic variables should hold, e.g., the derived growth in credit should be consistent with projected output developments. Otherwise, a further iteration of the economic forecast across sectors will be required.

The distribution of credit among the government, state enterprises, and households is a function of policy priorities. For example, in a scenario where the policies of the government are taken as given, the amount of net credit extended to the government sector is usually dictated by the existing budgetary position of the government in relation to the cost and availability of external and nonbank financing. The credit requirements of households and enterprises could of course be accommodated more fully if the budgetary position were adjusted through revenue raising and expenditure reducing measures.

c. Other items (net)

Other items (net), by its nature, is a difficult variable to forecast. Factors that heavily influence the movements of this variable include augmentation of the share capital of banks, e.g., to meet capital adequacy requirements, valuation changes of the net foreign asset position, and the profits/losses of the banking system.

For example, a depreciation of the forint will raise the level of net external indebtedness of the banking system, measured in local currency. Assuming no new net flows of foreign exchange, there should be no effect on the level of monetary aggregates, simply an offsetting valuation adjustment entry included in other items (the sign being positive if the foreign asset position is negative).

Losses of the banking system are recorded in other items (net) as if the banking system were extending a credit to itself, i.e., with a positive sign, the counterpart entry being a rise in monetary aggregates. In the case of profits that are not distributed but held as part of the banks’ capital and reserves, it is recorded as a repayment of a credit to itself, i.e., a reduction in other items (net).

The data for Hungary show that in 1986–89, other items (net) for commercial banks remained relatively stable at minus FT 40–50 billion. This must have reflected, among other things, the transfer of most of the banks’ profits to the budget. For the NBH, over the same period other items (net) was positive and increased significantly, from FT 42.6 billion in 1986 to FT 352.5 billion in 1989. The largest part of this increase was associated with valuation changes in the stock of net indebtedness.

Forecasting the Accounts of the Monetary Authorities

A typical balance sheet of the monetary authorities is shown in Box 2. The liabilities of the monetary authorities are referred to as reserve money (alternatively called the monetary base or high powered money). Reserve money is defined as the sum of currency outside banks plus banks’ cash and deposits at the Central Bank. Variations in reserve money (R) reflect changes in the asset side of the balance sheet of the monetary authorities, which are composed of net foreign assets, (NFA), claims on the government (NDCG), claims on commercial banks (DCB), and other items net (OIN). For example, an overall surplus (deficit) in the balance of payments adds to (subtracts from) net foreign assets of the monetary authorities and, given domestic credit and other items net, increases (decreases) reserve money. Similarly, when the central bank brings about a net increase (decrease) in its assets by buying (selling) government securities or making (calling in) loans to (from) commercial banks, the increase (decrease) in these assets is typically accompanied by an increase (decrease) in reserve money.

Stylized Balance Sheet of the Monetary Authorities

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The central bank’s control over reserve money is incomplete. For example, changes in net foreign assets, which are a reflection of the balance of payments outcome, cannot generally be considered to be a policy-controlled variable. Variations in net claims on the government are, in many countries, adjusted passively to the government’s budgetary position. Typically, the most controllable factor is claims on commercial banks.

The behavior of the monetary aggregates of the consolidated banking system, as reflected in the monetary survey, can be linked to that of reserve money of the central bank by the following equation:



  • M = monetary aggregate, however defined, of the consolidated balance sheet

  • k = money multiplier

If the monetary aggregate of interest in the consolidated banking system were to be broad money, then the multiplier would be derived as follows:

  • CY = currency outside banks

  • DD = demand deposits

  • TD = time and savings deposits

  • rd = required reserve ratio against demand deposits

  • rt = required reserve ratio against time and savings deposits

  • re = excess reserve as a ratio of demand deposits

Dividing the numerator and denominator by DD and defining c and b as the ratios between currency outside banks and time and savings deposits, respectively, to demand deposits:


Equation (11) indicates that the value of the money multiplier reflects the behavior of three different types of economic agents: (1) the monetary authorities who set the reserve requirements; (2) the general public who, given the structure of interest rates and other variables, determines the composition of the money stock, e.g., the amount of currency held relative to deposits; and (3) the commercial banks who decide on how much excess reserves to hold. Table 7 suggests that after the formal establishment of a two-tier banking system, the multiplier for broad money in Hungary was relatively stable at about 1.9.

Table 7

Hungary: Reserve Money and Money Multipliers

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Source: IMF Institute data base.

To summarize, the money supply process, as captured by equation (9), is influenced both by central bank actions, such as changes in claims on commercial banks and reserve requirements. However, it also reflects developments in the balance of payments (NFA), the behavior of government (NDCG), commercial banks (re) and nonbank public (c). These developments need to be explicitly considered when forecasting and seeking to control the money supply.

Exercises and Issues for Discussion

1. Exercises

a. Complete the monetary survey and the accounts of the NBH for 1990 as shown in Tables 8 and 9. Specifically,

  • Projections of the net foreign asset position and net credit extended to the general government should be consistent with forecasts made in the other workshops on the balance of payments and the fiscal accounts

  • Factors affecting the demand for money (including interest rate policy) and the share of currency in broad money should be explicitly assessed.

  • Consideration should be given to the expected value of the money multiplier and the implied changes in the central bank’s balance sheet relative to past trends.

  • Given the size of other items (net), estimates of valuation changes of the net foreign liability position should be undertaken. For simplicity, it can be assumed that the currency composition of the net foreign liability position is the same as the SDR basket.

  • While credit to the nongovernment sector may be calculated as a residual, it should, nevertheless, be consistent with expected developments in prices and output. Some iteration with other workshops may be needed to achieve this.

Table 8.

Hungary: Monetary Survey

(In billions of forint, end of period)

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Source: IMF Institute data base.

Mainly State Development Bank.

Table 9.

Hungary: Accounts of the National Bank of Hungary

(In billions of forint, end of period)

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Source: IMF Institute data base.

Note that this line closely approximates the sum of credits extended to the general government and to financial institutions in the monetary survey.

Refinancing credits.

2. Issues for discussion

a. Review the main factors that were taken into account in estimating the demand for money. What importance was attached to structural factors?

b. Discuss the instruments of monetary control underlying your scenario. What would be the implications of the money multiplier being larger than projected? How could this come about?

c. Relative to your scenario, what are the implications for monetary policy of an improvement in the balance of payments? What might be an appropriate policy response to this situation?

d. Discuss the main weaknesses of the financial system at end 1989. What measures could be taken to strengthen it?

e. What would be the implications of a liquidity overhang for the conduct of monetary policy?

f. What are the implications of currency substitution, i.e., switching money holdings out of local currency into foreign currency, for the conduct of economic policies? Is this a problem that you would foresee for Hungary?

Table 10.

Hungary: International Reserves and Other Foreign Assets

(In billions of forint, end of period)

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Source: IMF Institute data base.

Actual holdings of gold, at national valuation of US$4275 per fine troy oune from 1982 to 1985, and US$4320 per troy ounce from 1986.

Valued at the official exchange rates.

Mainly trade credit extended by Hungarian enterprises.

Table 11.

Hungary: Outstanding External Debt

(In millions of U.S. dollars, at end of period)

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Source: IMF Institute data base

End of period convertible currency external debt divided by GDP for the year as a whole in local currency units and converted into U.S. Dollars at the period average forint/U.S. Dollar exchange rate.