Among the main macroeconomic accounts, the monetary accounts play a special role, for a number of reasons. First, in a market economy based on money, the financial system provides intermediation for the resources flowing among the economic sectors. Because the monetary sector serves as a clearinghouse for all financial flows, the monetary accounts provide unique insight into the behavior of these flows, which mirror the flows of real resources among the sectors.

Among the main macroeconomic accounts, the monetary accounts play a special role, for a number of reasons. First, in a market economy based on money, the financial system provides intermediation for the resources flowing among the economic sectors. Because the monetary sector serves as a clearinghouse for all financial flows, the monetary accounts provide unique insight into the behavior of these flows, which mirror the flows of real resources among the sectors.

Second, monetary accounts focus on variables (such as money, credit, and foreign assets and liabilities) that play a central role in the macroeconomic analysis of an open economy. Various classical and modern theories have been developed to explain how income, prices, and the balance of payments are determined using these variables. This chapter presents monetary accounting concepts that lie at the heart of the monetary approach to the balance of payments.1 But the monetary accounting framework is broad and flexible enough to be useful for analyses based on many alternative theories of money, prices, and the balance of payments.

Third, the adjustment programs supported by the IMF use a variety of different instruments and approaches adapted to the situations of individual countries. A central element of the theoretical foundations of these programs is the link between monetary aggregates and fiscal operations (as well, of course, as balance of payments outcomes). A clear understanding of the monetary accounts is therefore indispensable for conducting the kind of monetary analysis underlying IMF-supported adjustment programs.

Finally, the monetary accounts are generally available with little delay. Even in developing and transition economies, where reliable economic data can be scarce, they are among the most reliable of the macroeconomic statistics and are therefore useful to policymakers who need to monitor economic developments. For the same reason, financial aggregates are often used as benchmarks and performance criteria in IMF-supported adjustment programs.

The next sections of this chapter outline the structure of the financial system and review the accounting principles underlying the compilation and presentation of monetary statistics in the IMF’s International Financial Statistics (IFS). Also, following sections analyze the balance sheets of the monetary authorities and the deposit money banks.2 In particular, the distinction between the initial creation of base money, which is reflected in the balance sheet of the monetary authorities, and secondary money creation by deposit money banks (in the form of deposits) is discussed. The last part of the chapter discusses the consolidated balance sheet of the banking system (the monetary survey), outlines the rationale for analyzing it, and illustrates the monetary survey’s usefulness in assessing the impact of monetary and credit developments on the economy.

Monetary Accounting

The Structure of the Financial System

Financial institutions specialize in channeling financial savings to firms planning to undertake real investment, although they can also provide funds for government institutions. This process, called financial intermediation, is accompanied by a transformation of the maturity structure of financial assets. Borrowers gain access to the surplus funds of savers deposited with the banking system through a variety of credit instruments, including stocks, bonds, commercial bills, mortgages, and mutual funds.

The financial system consists of the banking system and nonbank financial institutions such as insurance companies, mutual funds, pension funds, and money market funds. In many countries, there is a third sector, the unorganized financial sector, which can often be an important part of the financial system. The banking system, which consists of the monetary authorities (MAs) and deposit money banks (DMBs), creates an economy’s means of payment, including currency and demand deposits. In the IFS, the widely accepted framework for classifying financial statistics, monetary, and financial data is presented on three levels (see Fig. 5.1). The first level contains the separate balance sheets for the monetary authorities and the DMBs.3 The second level consolidates the data for the monetary authorities and the DMBs into the monetary survey, which provides a statistical measure of money and credit. Finally, the third level consolidates the monetary survey and the balance sheets of other financial institutions (OFIs) into the financial survey.

Figure 5.1.
Figure 5.1.

Scope of the Financial System

This chapter focuses on the banking system rather than the entire financial system for three reasons. First, empirical evidence shows that the monetary liabilities of the banking sector strongly influence aggregate nominal spending in an economy and thereby affect the final objectives of economic policy—growth, inflation, and the balance of payments. Second, data on the banking sector are usually readily available, even for developing and transition economies, making them invaluable for timely economic analysis and monitoring of financial policies. And, third, in countries where financial markets are not well developed, the banking system typically accounts for the bulk of an economy’s financial assets and liabilities, although, as noted above, the unorganized financial sector often plays a major role in financial intermediation in these economies.

Accounting Principles Underlying Monetary Statistics

Stocks versus flows. Monetary statistics are based on balance sheets and therefore are compiled in the form of stock data—that is, in terms of outstanding stocks of assets and liabilities at a particular point in time rather than as flow data, which record transactions carried out over a period of time. However, the statistics are analyzed in terms of changes in stocks from one period to the next, or in terms of flows. Since changes in stocks need to be assessed in relation to the amount of liabilities outstanding at the beginning of the period, both stocks and flows are important.

Cash versus accrual. The IFS records transactions on a cash basis (when an obligation is settled rather than when it is incurred). In many countries, banking sector data tend to be recorded on an accrual basis (when a liability is incurred), because the balance sheets of the banking system from which the statistics are derived are constructed in accordance with the rules of business accounting. However, since most transactions of banks are typically carried out immediately in cash, this distinction is of little practical importance.

Currency denomination. Monetary accounts are expressed in local currency. All items denominated in foreign currency are converted into domestic currency at the exchange rate prevailing on the date the balance sheet is compiled (i.e., end-period exchange rate) because the balance sheet aggregates are stocks. This is in sharp contrast to the conversion of flow aggregates (e.g., imports or exports), which are converted at an average exchange rate for a period.

Consolidation. Unlike aggregation, consolidation involves netting out the transactions between the entities being consolidated. For example, in consolidating the accounts of different deposit money banks, interbank entries (items due from and to other banks) are netted out. Two levels of consolidation are carried out for the monetary survey. First, the balance sheets of all DMBs are consolidated. Second, the balance sheet of the monetary authorities is then consolidated with those of the DMBs to obtain the monetary survey.

Monetary Authorities

The Definition and Role of Monetary Authorities

The term “monetary authorities” is a functional rather than an institutional concept. In most countries, the monetary authorities are represented by the central bank, but the concept can include agencies of the government, such as the treasury, that perform some of the functions of a central bank. The monetary authorities issue currency, hold the country’s foreign exchange reserves, borrow for balance of payments purposes, act as banker to the government, oversee the monetary system, and serve as the lender of last resort to the banking system. In many countries, the treasury issues coins and holds the official reserves. In some countries, a treasury-controlled exchange stabilization fund instead holds the country’s official reserves. Under IMF accounting procedures, the monetary functions of the government are grouped with the accounts of the central bank, so that all of the functions of the monetary authorities are presented under one accounting unit.

As noted above, an important function of the monetary authorities is to act as a lender of last resort to the banking system. When financial panic threatens the banking system, the monetary authorities need to take swift action to restore investors’ confidence and avoid a systemwide run on the banks. The rationale for using the central bank as a lender of last resort is based on the essentially illiquid nature of the credit system. While debtors can, given time, repay their loans, they cannot do so on demand. But many liabilities, such as bank deposits, have very short maturities, so that if all creditors ask for their assets, some banks may be pushed into default. If one deposit money bank has payment difficulties, the entire system can become illiquid, and because of the many layers of credit and intermediation in the system, the source of the actual default may not be clear. The result of this uncertainty is a systemwide crisis of confidence that leads to a credit “freeze.” To prevent financial collapse, the central bank can isolate the problem bank and guarantee payment to its depositors, preventing spillover effects in the credit market. As lender of last resort, the central bank comes into its own when it steps in to prevent illiquidity, either on the part of an individual bank or throughout the banking system.4

Because of its unique nature, the balance sheet of monetary authorities has a central place in monetary analysis. The creation of high-powered money (also known as reserve money or the monetary base) is a prerogative of the monetary authorities. The control they exercise over the amount of high-powered money in the economy is the main route through which the monetary authorities control the money supply and obtain seigniorage. Since the central bank creates reserve money whenever it acquires assets and pays for them by creating liabilities, an analysis of its balance sheet is key to understanding the process of money creation. The monetary authorities’ operations, such as open market purchases or sales of government securities, their lending to government as well as to the deposit money banks, and their purchases and sales of foreign exchange—known as foreign exchange intervention—all affect the amount of reserve money. By virtue of being the monopoly supplier of reserve money, the monetary authorities are the undisputed arbiter of monetary policy and monetary conditions in the economy.

Typical Balance Sheet of the Monetary Authorities

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The Balance Sheet of Monetary Authorities

A typical balance sheet of the monetary authorities is shown in Box 5.1, and an analytical summary table presented in Box 5.2. While most of the items in the monetary authorities’ balance sheet are self-explanatory, it is important to highlight the key features of some of the main items as those features appear in the analytical version.

Net foreign assets include the domestic currency value of (i) the net official international reserves (on the asset side, including gold, foreign exchange, the country’s reserve position in the IMF, and holdings of SDRs; on the liability side, including shortterm liabilities to foreign monetary authorities—that is, deposits of foreign central banks, swap facilities, overdrafts, and some medium- and longterm foreign debt, such as a country’s use of IMF credit); and (ii) any other foreign assets and liabilities of the monetary authorities not included in the definition of official reserves (for the treatment of IMF transactions, see Box 5.4). While in many countries the net foreign assets of the monetary authorities are equated with the net official international reserves, the definition of net foreign assets is broader than the definition of net official international reserves. For example, in some transition economies, net foreign assets include monetary authorities’ holdings of foreign assets that are not regarded as available if a balance of payments problem develops (i.e., should not be included as net official international reserves). Such holdings include foreign currency that cannot be converted and claims arising from bilateral payments agreements. By definition, these assets can be used only for official settlements with specific countries.

Analytical Balance Sheet of the Monetary Authorities

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Claims on the government5 (net) are direct loans and government securities held by the monetary authorities. They are shown net of government deposits, because the government has easier access to credit than do other sectors (including overdraft facilities at the central bank), so that its expenditures are not usually constrained by its deposits or cash balances. Moreover, it is the monetary authorities’ net credit to government that corresponds to the creation of high-powered money. Claims on deposit money banks include all direct credits to DMBs, as well as bills of exchange for discount from the DMBs accepted by the central bank. The central bank interest rate on loans to banks is called the discount rate. Both the amount of central bank lending to deposit money banks and the discount rate can be important instruments of monetary policy. These claims are gross claims, since DMBs’ deposits in the monetary authorities’ accounts are not netted out. These deposits play a key role in monetary policy.

Claims on the private sector are in general likely to be insignificant; typically it is the business of the deposit money banks, not the central bank, to make loans to households and enterprises. Note, however, that this category also includes the monetary authorities’ claims on other financial institutions and public enterprises.

Other items (net) is a residual category that is usually shown on a net basis. In Box 5.2, it is shown on the asset side. Other items (net) include the physical assets of the central bank (on the asset side); capital and reserves (as a liability); profits or losses of the central bank; valuation adjustments to the net foreign asset position resulting from developments such as changes in the exchange rate and including any unrealized profits or losses resulting from these changes; and any other items that have not been classified elsewhere.

Reserve money is the main liability of the monetary authorities, and it plays a central role in monetary analysis and policy. Reserve money includes mainly currency that has been issued and is held both in banks (cash in vault) and outside banks (currency in circulation), plus bank and nonbank deposits with the monetary authorities. It excludes the deposits of the government and nonresidents with the monetary authorities; these are netted against claims on the government and foreign assets, respectively. Deposits of other domestic sectors (such as private individuals or firms) with the monetary authorities are included, as well as foreign currency deposits by residents. This treatment is based on the fact that the central bank, in essence, has the power to create money simply by writing a check against itself. When it makes payments to domestic residents (for instance, for a government bond it purchases from them) by writing checks against itself, the resident can deposit the checks in a deposit money bank, which in turn deposits them at the central bank. The resulting increase in bank deposits with the central bank adds to reserve money. No other entity in the economy has this ability.

Given the balance sheet constraint that assets must be equal to liabilities, from Box 5.2 it can be seen that changes in reserve money (RM) reflect changes in the asset side of the balance sheet of the monetary authorities (Box 5.3). For example, an overall surplus (deficit) in the balance of payments adds to (subtracts from) the net international reserves of the monetary authorities which, in the absence of offsetting changes in domestic credit or other net assets, increases (decreases) reserve money. Similarly, if the monetary authorities bring about a net increase (decrease) in their domestic assets by buying (selling) government securities or making (calling in) loans to (from) deposit money banks, the increase (decrease) in these assets, unless offset by a fall in net foreign assets or in other items (net), results in an increase (decrease) in reserve money.6

The balance sheet constraint of the monetary authorities is summarized by the identity
In terms of flows (changes in stocks), this identity can be rewritten as
Dividing both sides of equation 5.2 by the lagged value of reserve money (RMt−1) the growth rate of reserve money ΔRMt/RMt−1 can be expressed in terms of the contributions of the various asset items, or as

In other words

Growth rate of reserve money = Sum of weighted growth rates of asset items

where the weights are the relative shares of lagged asset items in lagged money stock.

The monetary authorities’ control over reserve money tends to be 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 fully policy-controlled variable. Also, variations in claims on the government are, in many countries, adjusted passively to the government’s budgetary position, especially in countries without an independent central bank. Although the central bank could, to some extent, counteract exogenous shocks from the balance of payments and/or resist the monetization of the fiscal deficit, in practice the most controllable factor remains claims on commercial banks.

Interpretation of Balance Sheet Changes

The monetary authorities can influence monetary conditions through their influence on reserve money. There are five main direct instruments available to the monetary authorities to influence reserves money: foreign exchange intervention; open market operations; financing of the budget deficit; rediscount policy; and reserve requirements.7

  • Foreign exchange intervention. Monetary authorities intervene in the foreign exchange market, inter alia, to defend the exchange rate and achieve a desired amount of international reserves. Their interventions directly affect reserve money and hence have a direct impact on overall liquidity in the economy and the stance of monetary policy. For example, when the central bank purchases foreign exchange from a domestic resident and pays for it by writing a check against itself (or equivalently by printing money), it increases reserve money. Its balance sheet shows an increase in foreign assets and a corresponding rise in reserve money. Conversely, when the central bank sells foreign exchange, foreign assets are reduced, and there is a corresponding reduction in reserve money.

  • Open market operations. This is one of the preferred methods of changing the stock of the monetary base. It consists of buying and selling government papers, often securities in the secondary market. For example, when the central bank purchases government securities from the public, the central bank’s holding of government securities increases (an increase in its assets), with a counterpart increase in liabilities (i.e., reserve money) in the form of an increase in currency in circulation (if newly printed currency is used to pay for the government security) or an increase in banks’ deposits in the central bank (if the central bank writes a check against itself to pay for the purchase). Conversely, a sale of government securities to the public will reduce the central bank’s holding of government securities and thus reduces reserve money.

  • Financing of government deficit. When the government finances its deficit by borrowing from the central bank (or, equivalently, sells a government security to the central bank), the central bank’s holdings of securities increase. When the government borrows from the central bank, central bank claims on the government as well as government deposits with the central bank rise; hence, there is no change in net claims on government. But when the government uses the borrowed money to make a payment to the private sector, the stock of reserve money rises, because the government’s deposits with the central bank are reduced, thus increasing the central bank’s net credit to government. A fiscal deficit financed by borrowing from the central bank thus results in a one-for-one increase in reserve money. For this reason, financing a deficit by borrowing is equivalent to financing a deficit by issuing currency (frequently referred to as deficit financing by printing money, or simply as the monetization of the deficit). The central bank’s ability to control the reserve money it creates by refusing to lend to the government is therefore one hallmark of an independent central bank.

  • Discount window. The discount mechanism is an instrument of monetary control encompassing a variety of arrangements designed to influence the level of central bank credit to the banking system. The most important of the arrangements is the rate of interest charged.8 The central bank can influence reserve money through the quantity and terms of its lending. The central bank’s credit to deposit money banks is in practice the source of reserve money most directly under its control.9 An increase in the interest rate the central bank charges (i.e., the discount rate) signals its intention to tighten monetary conditions. By making such borrowing more costly, it tends to reduce bank borrowing from the central bank, while at the same time inducing banks to increase their holding of excess reserves. Thus, it tends to reduce central bank assets and hence reserve money. Conversely, a reduction in the discount rate tends to increase banks’ borrowing from the central bank and hence reserve money.

  • Reserve requirements. The central bank can influence reserve money simply by changing the amount of required reserves banks must hold with it. For example, an increase in the reserve requirement will force the banking system to hold a larger level of reserves for the same level of deposits, thus increasing reserve money. At the same time, however, it will reduce the ability of the banking system to create money.

Deposit Money Banks

DMBs include all banks and similar financial institutions with appreciable liabilities in the form of deposits (payable on demand) that can be transferred by check or otherwise used to make payments. DMBs have four primary economic roles. First, and most importantly, DMBs provide financial intermediation for savers and investors, a process that transforms the maturities of financial assets. DMBs’ important role in this respect consists of using what amounts to short-maturity deposits and producing long-maturity loans. Second, DMBs are the primary creators of deposit money in the economy, a role they fulfill by extending credit. In the context of a fractional reserve system, DMBs contribute to the creation of money in the economy. Third, the behavior of DMBs—in particular their policies on deposit-taking and lending—affects the money supply and liquidity. Finally, acting within the constraints set by the monetary authorities, DMBs help to transmit monetary policy from the monetary authorities to the public. DMBs are able to fulfill this role because, unlike other financial institutions, their deposit liabilities serve as a means of payment—that is, deposits are used to settle deposit holders’ obligations.10

The definition of DMBs indicates that the line dividing those financial institutions that are regarded as deposit money banks from those that are not is somewhat arbitrary, since it is based on the size and composition of deposits rather than on the nature of the institutions themselves. Analysts need to keep the arbitrariness of this definition in mind in conducting monetary analyses, since it suggests that bank liquidity is not an unambiguous concept.

A typical balance sheet of a deposit money bank is shown in Box 5.5 and a summary analytical presentation is presented in Box 5.6. Most of the items in the box need no additional explanation. Three points, however, are worth noting.

  • DMBs typically hold foreign assets, because of their activities in financing foreign trade. Whether these foreign assets are included as part of the net official reserve position of the country is a matter of judgment and depends primarily on the extent to which the monetary authorities control their use.11

  • Unlike their assets, DMBs’ liabilities are classified by type of instrument—particularly in terms of liquidity—rather than by sector. This classification system reflects the fact that some liabilities of DMBs are included in the (narrow) money supply on the basis of liquidity, which is determined by their maturity.

  • DMBs hold only a fraction of their total assets in the form of reserves with the monetary authorities, as required by law, in an arrangement known as the fractional reserve system. The monetary authorities require DMBs to have a percentage of their deposits available as cash, in part to ensure that the money is readily available should depositors request it and in part to help control the money supply. DMBs sometimes also hold excess reserves as an additional safety margin.

    DMBs must maintain their reserve levels because they accept the obligation to convert deposit liabilities into cash. While demand deposits may be cashed immediately, time and other less liquid deposits can only be cashed after a stated period. It is unlikely that all depositors will seek to withdraw their funds at the same time, and DMBs can borrow from the monetary authorities at the central bank discount rate should reserves run low.

    Thus, demand for reserves by the DMBs is an important element in the determination of reserve money and money supply. Changes in reserves can support an expansion or contraction of DMBs’ deposit liabilities equal to a multiple of the change in their reserves. Because DMBs borrow at the central bank discount rate, their holdings will depend in part on the interest rate. Another factor that is important in explaining the DMBs’ demand for reserves is the efficiency of the payments system. In many transition economies, this is an important determinant of the demand for reserves.

Transactions with the IMF

Transactions between a member country and the IMF are recorded in the balance sheet of the monetary authorities. SDR holdings are classified as foreign assets; the counterpart of SDR allocations is a liability included in the capital account and in “other items (net)” in the analytical balance sheet of the monetary authorities. A country’s reserve position with the IMF is included in the foreign assets of the monetary authorities, while the use of IMF credit is included in foreign liabilities. Examples of transactions with the IMF include paying a quota subscription and purchasing a credit tranche, transactions that leave the net foreign asset position unchanged. In the first case, the increase in the country’s reserve position with the IMF is offset by a decline in the country’s foreign exchange position. In the second case, there is an increase in foreign exchange from the proceeds of the loan that is equal to the increase in foreign liabilities in the form of use of IMF credit. In contrast, a new allocation of SDRs increases the net foreign assets of the country, because the increase in assets is not matched by an increase in liabilities. See the Appendix to this chapter for more details.

The Monetary Survey

The monetary survey—the consolidated balance sheet for the entire banking system—consolidates the consolidated balance sheet of the DMBs and the balance sheet of the monetary authorities. The assets and liabilities of the monetary survey therefore represent the assets and liabilities of the entire banking system. One important purpose of the monetary survey is to present, in a timely fashion, data on monetary and credit developments for the entire banking system that will allow policymakers to monitor these developments and to adjust monetary policy, if necessary.

Box 5.7 shows an analytical presentation of a typical monetary survey. On the liability side, the monetary survey contains the overall liquidity generated by the banking system, or the stock of money.12 Narrowly defined, the money stock consists of currency in circulation outside banks (CY) plus demand deposits in the banking system. This narrow money is referred to as MI in the economic literature.13


A broader definition of money includes, in addition, quasi-money (QM), which consists of time and savings deposits in the banking system. The concept of broad money (M2) covers the liabilities of the banking system. In particular, it includes foreign currency deposits of residents, certificates of deposit, and security repurchase agreements.

Typical Balance Sheet of Deposit Money Banks

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The identity between assets and liabilities of the banking system implies that the stock of money (M2) is identical to the sum of its counterparts, namely net foreign assets (NFA) valued in domestic currency, and net domestic assets (NDA). In other words, for the banking system as a whole
Since NDA consists of net domestic credit (NDC) and other items net (OINb), equation 5.6 can be rewritten as
or, in terms of changes

Analytical Balance Sheet of Deposit Money Banks

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This item is the counterpart to the gross claims of the monetary authorities on the DMBs.

Algebraic manipulations similar to those involving the accounts of the monetary authorities (equations 5.15.4) can also be performed here to derive the contributions of various assets items to the growth of M2.15

The above two notions of money (M1 and M2) are among the most widely used. However, with financial liberalization, even broader definitions (M3, M4, L) of the money stock have been found useful in many countries. Although the precise definition differs from country to country, M3 is generally defined to include M2, plus a wider range of instruments and issuing institutions. It includes travelers checks, commercial papers (money market mutual funds, cash vouchers). M4 includes, in addition to M3, liquid government securities, negotiable bonds, and liabilities of other financial intermediaries. Sometimes an even broader concept of liquidity (L) is used. This concept (L) is often defined to include, in addition to M4, other less liquid financial assets such as treasury bills, government bonds, mortgage bonds, and even some corporate bonds.

Financial innovations, which have tended to blur the distinction between money and nearmoney assets, have led to a continuing debate on where to draw the line between financial assets that form part of money and those that do not. In the spectrum of financial assets, currency (which carries no interest) is at one end and assets with higher yields but less liquidity at the other. The choice of one or more of these measures of money for purposes of making monetary policy and monitoring monetary developments is also influenced by the stability and predictability of the relationship between the monetary aggregate and nominal aggregate demand in the economy, as well as the degree to which the monetary authorities control the monetary aggregate. This notion implies, however, that no one set of assets will always be included in the money supply and that present definitions of money are likely to change in the future. Reflecting this essentially empirical test of which assets constitute money, several monetary aggregates should be analyzed.

Monetary Analysis

The monetary survey, which is the balance sheet of the banking system, highlights two essential relations: the link between a country’s external position and the net foreign assets of the banking system, and the direct link between the government accounts and government financing provided by the banking system. The banking system is also clearly linked to the real sector (and the national accounts) through the demand for money and through credit provided to the private sector.

Link to the balance of payments. As discussed in Chapter 4 on the balance of payments, when the transactions of the entire banking system are entered below the line, the overall balance in the balance of payments is financed by the change in the banking system’s net international reserves. In principle, the change in net foreign assets is the same whether it is derived from the monetary survey or from the balance of payments accounting identity. Therefore, in the monetary survey


and in the balance of payments,

CAB + ΔFI + ΔRES = 0.

Since ΔNFA = −ΔRES, then


Analytical Balance Sheet of the Banking System: Monetary Survey

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In some transition economies, a bank float is significant. For more on this issue, see Tomas Balino, ]uhi Dhawan, and Vasudevan Sundararajan, “The Payments Systems Reforms and Monetary Policy in Emerging Market Economies in Central and Eastern Europe,” IMF Working Paper 94/13 (Washington: International Monetary Fund,1994).

where ΔFI = nonmonetary financing flows.16 These expressions can be rewritten as

The monetary survey identity indicates that any excess of domestic credit expansion over the increase in money stock (which, in equilibrium, is equal to the demand for money) is reflected in a decline in the net foreign assets of the banking system (that is, ΔNFA is negative). This relation constitutes the basis of the monetary approach to the balance of payments and provides the theoretical justification for setting ceilings on net domestic assets in IMF-supported programs.

Indeed, the distinction between money of domestic origin (domestic credit) and money of external origin (net foreign assets) and the linkages between the two are at the core of the IMF’s financial programming framework. Starting with the monetary survey identity, which expresses the money stock as the sum of changes in its foreign and domestic components, and incorporating a demand function for money that links changes in real money balances to changes in real income and inflation, the framework posits a relationship among the net foreign assets of the banking system, the money stock, and domestic assets. The change in net foreign assets is positive (and the balance of payments in surplus) if the change in the money stock exceeds the change in domestic credit. An increase in net domestic assets that exceeds the desired increase in money is offset by decreases in net foreign assets on a one-for-one basis.17 In the actual formulation of adjustment programs, targets are set for output, inflation, and other variables in a comprehensive policy package, and the implications of any changes for output, inflation, the balance of payments, and other policy objectives are carefully analyzed. The link between the monetary accounts and the balance of payments is often complicated by exchange rate changes and valuation adjustments (see Box 5.8).

Link to the government accounts. The banking system’s net claims on the government appear on the asset side of the monetary survey. The changes in these claims represent the banking system’s net lending to the government to finance any deficits. This direct link to the government sector shows how the monetization of a fiscal deficit (that is, the financing of the fiscal deficit through credit from the banking system) has a direct impact on the monetary stock.

Links to the real sector. On the asset side, the credit that the banking system provides to the private sector has a clear impact on developments and growth in that sector. On the liability side, the private sector’s desire to hold the cash balances the banking system generates constitutes the private sector’s “reaction function,” which is an important determinant of the rate of inflation in the economy.

Valuation Adjustments

In analyzing the balance sheet of the banking system, changes in stocks are often equated with transaction flows. This is not always accurate. In particular, changes between two periods in stocks reflect not only transactions flows, but also revaluation and other factors. Revaluations result from changes in the prices of financial assets and liabilities due to fluctuations in market prices or exchange rates, and other changes, including allocation or cancellation of SDRs and writing off of debts by creditors. Equating changes in stocks over time to transaction flows is particularly misleading when exchange rate changes are significant over the period of analysis. Hence, in these situations, it is important to adjust for the effects of exchange rate changes so as to isolate the transaction flows.

Specifically, changes in stocks over time of those items that are affected by exchange rate fluctuations should be decomposed into changes due to transactions and changes due to valuation.1 Formally:
LetAtR=balance sheet stock item denominated in local currencyAt$=balance sheet stock item in dollarsEt=exchange rate(local currency units per dollar),end of periodEt*=exchange rate(period average)
total change in stocks=(AtRAt1R)transaction flows2=Et*(At$At1$)total change in stocks=transaction flows+valuation
valuation change=(AtRAt1R)Et*(At$At1$).
It can be shown that the valuation adjustment (VAd) can also be expressed as

If foreign currency-denominated assets and liabilities in the monetary survey are adjusted for the effects of exchange rate changes, valuation adjustments should be, in this case, reflected in “other items (net)” to ensure that the balance sheet remains in balance.


Changes due to other factors and market price fluctuations are assumed to be negligible in the above illustration.


Transaction flows expressed in terms of local currency. Please note that the average period exchange rate is used to convert dollar-denominated transactions into local currency. This reflects the fact that these transactions are presumed to have taken place throughout the period.

Money Market Equilibrium

Functions of Money

In a market economy, money serves several functions. It can be any of the following:

  • A medium of exchange. This function corresponds to the transactions motive for holding money.

  • A store of value. Money is an asset that can be used to transfer purchasing power from the present to the future. This function corresponds to the portfolio (speculative) motive for holding money; demand for money in this role is therefore concerned with the rate of return to money, compared with yields on alternative assets (Box 5.9).

  • A unit of account. Prices of goods, services, and assets are typically expressed in terms of money (for instance, dollars, rubles, or zlotys).

Monetary policy focuses initially on the quantity of financial assets that serve as transaction balances—usually currency in circulation plus demand deposits (MI). However, as the liquidity characteristics of financial assets other than money begin to resemble those of money, broader monetary aggregates become relevant to formulation of monetary policy.

The Quantity Theory and the Demand for Money

The earliest monetary theory—and one of the most influential—is based on the link between the stock of money (M) and the market value of output that it finances (PY). The so-called quantity equation equates the stock of money in real terms with real output, with a proportionality factor, k. Thus,

If k is assumed to be constant, this expression provides the quantity theory of money. This theory postulates a direct link between the stock of money and the price level (P) whenever the economy is assumed to be at full employment (i.e., Y is fixed). Thus, so long as k remains constant, there is a proportional relation between M and P.

Equation 5.10 can also be rewritten as
where V = 1/k (the proportionality factor) is the income velocity of money,18 which is the ratio of the money income (i.e., nominal GDP) to the money stock. Put differently, it is the number of times the stock of money turns over in a given period in financing the flow of nominal income. Velocity is one of the most studied variables in monetary economics. It is a very useful concept for a policymaker. Indeed, if V can be predicted with confidence, then one can aim at a level of the money supply that is consistent with the attainment of the desired real growth and inflation rate. A closer examination of V reveals that it is not a mechanical link between nominal income and the stock of money. Rather it is a concept very much linked to the demand for money and, in fact, velocity and money demand are inversely related. They are essentially equivalent ways of describing the same phenomenon. Converting equation 5.11 into growth form and using a dot over a variable to denote its rate of change over time, we obtain

Assuming a constant velocity, V/V=0. Equation 5.12 is a simple restatement of the quantity theory equation 5.11. It states that the percentage growth in money supply is equal to the sum of the percentage growth in prices (i.e., inflation), real GDP growth, and the growth in velocity.19 Assuming constant velocity, the rate of change in money supply necessary to keep prices constant would need to be equal to the rate of growth of real GDP (a proxy for real income). Another way of looking at the implications of equation 5.12 is to note that for a constant velocity, growth in money supply beyond the growth in real incomes will lead to inflation. The higher the growth in money supply, the higher the inflation rate.

In many transition economies, inflation has been a monetary phenomenon, particularly in the early stages of the transition. Several studies have shown that inflation has been strongly correlated with the rate of monetary expansion in virtually all transition economies.20

In the above discussion, velocity has been assumed to be constant, but clearly velocity is not constant. In many countries, it has been shown to increase with increases in inflation and interest rates, and to be less sensitive to changes in income.21

Demand for Money

It is essential to clarify at the outset the distinction between real and nominal money balances. The nominal demand for money is the demand for a given number of specific currency units, such as rubles or zlotys. The real demand for money, or the demand for real money balances, is the demand for money expressed in terms of the number of units of goods that the money can buy. Therefore, the demand for real money balances is the quantity of money (M) expressed in real terms (M/P), that is, deflated by the index for the general level of prices. The demand for money is fundamentally a demand for real money balances, because people hold money for what it can buy.

There is considerable support in the economic literature for the view that the demand for real cash balances, like the demand function of any other asset, is a function of its price, the price of related assets, income, wealth, taste, and expectations. In a simplified form, the demand for real cash balances is positively related to income and negatively related to the opportunity cost of holding money.

  • Real income. As real income grows, the demand for real cash balances grows, reflecting the increased level of transactions. As noted earlier, the impact of real growth on the velocity will depend on the income elasticity of demand for real cash balances.

  • Opportunity cost of holding money. The cost of holding cash balances as opposed to other forms of wealth depends on the alternative forms of holding wealth. Thus economists in financially developed countries use the nominal interest rate as the opportunity cost of holding money relative to other assets. Expected inflation is also used as a proxy of the opportunity cost of holding real cash balances. In cases of hyperinflation, the opportunity cost of holding money becomes too high and the demand for money is drastically reduced. See Box 5.10.

The Concept of the Money Multiplier

As seen in the discussion of the balance sheets of the monetary authorities, the initial increase in reserve money serves as a base for financing subsequent monetary expansion by the banking system.22 (See Figure 5.2.) Under the fractional reserve system, banks use their deposits to make loans, keeping only a fraction of their deposits as reserves.

A simple model for the money supply process starts with the supply of reserve money (RM) generated by the monetary authorities. The demand for reserve money comes from the public, which wants to use it as currency (CY), and the banks, which need it as reserves. Starting with definitions of reserve money (RM = CY + R) and money (M = CY + DD), then the multiplier mm is simply the ratio of the money stock over base money, where CY = currency, DD = deposits, and R = DMBs’ deposits with the monetary authorities, or
Then, dividing the numerator and denominator on the right side by DD, and defining c as the currency-deposit ratio, and r as the reserve-deposit ratio, we obtain
The identity shows how the money supply depends on two parameters, c and r, and the exogenously given RM. The factor of proportionality (c+l)/(c+r) is the money multiplier and shows how much money. Thus, the money supply function can be rewritten as
In terms of changes

The above equation shows that money supply can increase either because of an increase in the multiplier (mm) or an increase in reserve money. In particular, an increase in the money multiplier for the same reserve money target would loosen monetary conditions.

It can be seen from equation 5.14 that the money multiplier (mm) is larger (i) the smaller the reserve requirement ratio and (ii) the smaller the currency ratio.

A more general formulation of the money multiplier (with the reserve ratio decomposed into the required reserve ratio on demand deposits (rd), the required reserve ratio against time and savings deposits (rt), and excess reserves as a ratio of demand deposits (re)) can be obtained by redefining M and RM as follows:

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The multiplier can be defined as
Dividing the numerator and denominator by DD and defining c and b as the ratios to demand deposits of currency outside banks and time and savings deposits, respectively, the value of the multiplier can be expressed as

Equation 5.17 indicates that the value of the multiplier may not be constant over time, weakening the predictability of the relationship between reserve money and the money supply. Moreover, the equation highlights that changes in the multiplier reflect the behavior of three different types of economic agents: (i) the monetary authorities that set the reserve requirements; (ii) the commercial banks that decide how much to hold in excess reserves; and (iii) the nonbank public, which determines the composition of the money stock (the amount of currency held relative to deposits and the relative share of demand deposits in total deposits) in light of the structure of interest rates, inflation, and other variables. Figure 5.3 summarizes the factors that affect the composition of money.23 Thus the money supply function given in equation 5.15 takes into account the behavior of the public, the banking system, and the monetary authorities. In other words, the monetary authorities do not fully control the money stock, in large part because the public’s preference for cash versus deposit and DMBs’ desire to hold excess reserves24 also contribute to the determination of the money stock. However, if the multiplier is constant or at least predictable, then a possible strategy for a central bank to achieve the targeted level of money supply would be first to obtain an estimate of the multiplier, and then to set reserve money so that the targeted money supply is attained using equation 5.15.

Figure 5.3.
Figure 5.3.

Factors Affecting the Money Supply

Special Issues in Monetary Analysis

There are several issues that need to be kept in mind when analyzing monetary developments in a country. Some of the more important are (i) financial innovation and deregulation; (ii) currency substitution; (iii) the role of the exchange rate; (iv) the complications introduced by capital flows; and (v) seigniorage. These five issues are analyzed in detail below with special reference to the experience of countries in transition.

  • Financial innovation and deregulation. As noted earlier, the distinction between monetary and nonmonetary financial assets has increasingly become blurred in many countries, largely because of the innovations brought about by improved information technology and the development of new financial instruments and financial market techniques. In many countries, demand deposits earn interest comparable to the yields of other financial assets as stores of value. The ease with which money can be withdrawn from mutual funds that invest in stocks and bonds has made holding bonds and stocks much more liquid than before. These nearmoney assets make the demand for money less predictable and more unstable, thereby complicating monetary policy.

    Rapid changes in households’ holdings of money and near-money assets can make the velocity of money (either M1 or M2) unstable. Thus, the quantity of money can be an unreliable guide to changes in aggregate demand. Some countries have responded to this problem by shifting to a broader definition of money that includes some near-money assets. However, this approach is an inherently ad hoc exercise, especially since the pace of financial innovation can cause the dividing line between broader monetary aggregates and other assets to shift continuously. More importantly, the broader the monetary aggregate, the less ability the monetary authorities have to control it, since many forms of near money have no reserve requirement and are issued by institutions outside the banking system. The authorities therefore face a dilemma as they try to preserve the link between the intermediate and ultimate targets of policy. They may adopt a broader, “more relevant” monetary aggregate for targeting but will have less control over it. Relevance (the link with aggregate demand) and controllability therefore need to be finely balanced when intermediate targets of monetary policy are being chosen.

    As different measures of money begin to move in different directions because of financial innovation and deregulation, monetary policy is confronted with the problem of choosing appropriate indicators of monetary conditions. Policymakers may, of course, be tempted to use the aggregate that gives the most favorable data for a particular time. However, this approach can backfire and end up misleading policymakers and the public. Besides the monetary aggregates, other indicators of monetary policy have thus been found useful and should be taken into account: nominal and real interest rates, the structure of interest rates of different maturities (as captured by the yield curve), and the behavior of the exchange rate.25 A transition economy undergoing rapid structural and behavioral changes needs to adopt an eclectic approach toward the choice of intermediate monetary targets and monetary indicators.

  • Currency substitution.26 High and variable inflation seriously impairs a currency’s ability to function efficiently as a store of value, unit of account, and means of exchange. As a result, the domestic currency in high-inflation countries tends to be abandoned over time in favor of a stable currency (often, but not always, the U.S. dollar), a phenomenon referred to as currency substitution or “dollarization.”27 In many high-inflation countries, the domestic currency’s function as a store of value has virtually disappeared, because residents find it less risky and often more profitable to keep assets in foreign currency.

    The phenomenon of currency substitution typically occurs in countries with high and variable inflation and has been pervasive in several Latin American economies.28 These economies have remained highly dollarized even when inflation falls substantially. Although dollarization has the positive result of providing citizens with a reliable store of value, it has also posed formidable challenges to policymakers, by hindering the monetary authorities’ control over money. Chronic inflation, fueled by accommodative monetary and exchange rate policies and sustained by formal and informal indexation, has led to increasing dollarization in many transition economies. Depending on institutional constraints and macroeconomic conditions, the dollarization ratio—the ratio of foreign currency deposits to broad money—has generally varied from zero to 10 percent at the start of reform programs to a peak of between 30 percent and 60 percent (Figure 5.4).

    To the extent that currency substitution reflects a shift away from domestic money, it will exacerbate the inflationary consequences of a fiscal deficit, making fiscal discipline all the more important in highly dollarized economies. Moreover, currency substitution substantially undermines the authorities’ ability to conduct monetary policy, as the foreign currency component of the total money supply cannot be directly controlled. Despite these potential problems, the Latin American experience suggests that combating dollarization with artificial measures, such as issuing indexed domestic financial instruments or forcing the conversion of foreign assets, merely magnifies the eventual inflation “explosion.” Normally, sound financial and fiscal policies will increase holdings of assets denominated in domestic currency without government mandates. Finally, foreign currency holdings by residents is a close substitute for local currency and should hence be included in a measure of money.

  • Exchange rate regimes and monetary analysis. The discussion so far has not referred explicitly to the exchange rate regime. The nature of the exchange rate regime is, however, closely linked to the operation of monetary policy. Under a fixed exchange rate system, the monetary authorities stand ready to buy or sell the domestic currency for foreign currencies at a predetermined fixed price. Whenever the market exchange rate threatens to depart from this fixed rate, the monetary authorities buy or sell foreign exchange for the local currency to ensure that the rate remains at the fixed level. In terms of the monetary authorities’ balance sheet, net foreign assets adjust in line with the foreign exchange intervention, and the monetary base and money supply adjust in line with net foreign assets. Adopting a fixed exchange rate regime therefore dedicates monetary policy to the goal of ensuring that the officially fixed level of the exchange rate is also the equilibrium level. The central bank is then committed to adjusting the money supply to the level needed to ensure that the exchange market clears at the predetermined fixed exchange rate. The monetary authorities are therefore unable to control the money supply; in this sense, by agreeing to fix the exchange rate, they relinquish control over the money supply.

    Under a fixed exchange rate regime, the effects of the central bank’s efforts to expand domestic credit go beyond domestic prices and output. An increase in aggregate spending leads to a rise in the current account deficit and puts downward pressure on the exchange rate. The central bank must counter this pressure by selling foreign exchange, resulting in a drop in net foreign assets. The central bank’s attempt to increase the money supply is thereby frustrated. Typically, a sound financial program has the opposite effect, improving the net foreign asset position. Using domestic credit ceilings to improve the balance of payments within the financial programming framework is a simple corollary of this analysis. Under a fixed exchange rate regime, the money supply is rendered endogenous—that is, it is determined by the system—rather than being an instrument of policy.

    The only way automatic adjustments of the money supply can be offset under a fixed exchange rate regime is through sterilization operations by the central bank. Sterilization attempts to offset the impact of a foreign exchange intervention by the central bank with an open market operation in government securities. Thus, a sale of foreign exchange that reduces the monetary authorities’ net foreign assets is offset by an open market purchase of securities that raises the monetary authorities’ net domestic assets, diluting the impact on reserve money and the money supply. With sterilization, the direct link between an external imbalance and the equilibrating change in the money supply is broken. But sterilization can work only for a short period. Its basic weakness is its dependence on the kind of broad and well-functioning securities market that is not available in many transition economies. More fundamentally, sterilization is limited by the cost of interest payments on the government securities purchased, a cost that can escalate rapidly if the central bank sells too many securities to offset a large foreign exchange inflow. The basic analytics of the monetary impact of capital inflows under alternative exchange rate regimes are depicted in Figure 5.5.

    Despite being required to surrender their independence to control the money supply, countries sometimes choose to tie their exchange rate to the currency of a low-inflation country. In doing so, they seek to impose an automatic discipline on domestic policy and thus to benefit from the credibility of the low-inflation country’s central bank. The costs of such an arrangement are the surrender of monetary control to the central bank of the country whose currency is used as the peg and the relinquishing of the exchange rate as an instrument to adjust the balance of payments. Currency boards in transition economies (such as those adopted by Estonia and, more recently, Lithuania) essentially create a fixed exchange rate system with no option for sterilization, because reserve money can be created only if it is fully backed by holdings of foreign exchange. Since sterilization is ruled out, adjustments are automatic but not painless. Adjustment will eventually raise nominal and real interest rates and put downward pressure on prices: if prices, and especially wages, are not flexible, output and employment fall.

    The primary argument for a floating exchange rate is that a float allows for autonomy in monetary policy and therefore can be used for purposes such as stabilizing demand or prices. Under a pure float, the monetary authorities do not intervene in the foreign exchange market. In practice, however, a “pure” float is largely hypothetical, because most countries that adopt a floating rate regime do intervene when the exchange rate threatens to move too far from its underlying equilibrium level, thereby making the float “dirty.” With a floating exchange rate regime, the monetary authorities have full control over the domestic money supply and therefore can determine the domestic inflation rate. Excessive credit creation manifests itself through an additional channel (the depreciation of the exchange rate). In most small, open economies dependent on critical imports, the exchange rate therefore provides an additional channel between the money stock and inflation.

  • Role of capital flows. Capital flowing across national frontiers provides intermediation among countries similar to the financial intermediation services banks provide for savers and investors within a country. Capital flows strengthen the link between domestic economic policies and the balance of payments. As the world’s capital markets have become increasingly integrated in the past two decades, so too have domestic monetary policies and monetary developments in foreign countries. Under perfect capital mobility, the slightest difference between interest rates prevailing in domestic and foreign capital markets provokes very large capital flows. When a fixed exchange rate is added, a central bank cannot hope to influence the level of domestic interest rates. Any attempt by the central bank to tighten monetary policy will induce a huge capital inflow into the country, forcing the central bank to intervene in the exchange market in order to keep the domestic currency from appreciating. The increase in net foreign assets offsets the initial money contraction, forcing domestic interests rates down to the world level.

    Under a floating exchange rate regime, the absence of intervention by the monetary authorities implies no change in net foreign assets, and the current account deficit is equal to private and official capital inflows. The link between the money supply and the balance of payments is broken, and the central bank regains control over the money supply. Many real-world cases lie somewhere between the fixed and floating exchange rate regimes and full and zero capital mobility. Thus, even with strict controls over capital flows, traders influence the current account through capital inflows and outflows (for example, by failing to repatriate export receipts or by incorrectly invoicing transactions) and create partial substitution between domestic and foreign assets. The degree of substitution rises as the capital account is opened, and maintaining an independent monetary policy becomes increasingly difficult without some flexibility in the exchange rate. In practice, most countries have responded by undertaking a combination of actions involving (i) a partial intervention to buy some of the capital inflow, thereby allowing some nominal exchange rate appreciation; (ii) partial sterilization to offset part of the impact of the increased net foreign assets on the monetary base; and (iii) some increase in the monetary base and inflation and consequently real exchange rate appreciation.

  • Seigniorage and the inflation tax. An important factor driving money creation in high-inflation situations is the government’s attempts to collect seigniorage from money creation. This issue has been dealt with in detail in Chapter 3 on fiscal accounting and analysis.29

Figure 5.4.
Figure 5.4.
Figure 5.4.

Selected Transition Economies: Dollarization and Inflation1

Source: IMF, World Economic Outlook, October 1994.1 Dollarization is measured by the ratio of foreign currency deposits to broad money (including foreign currency deposits). Note that the inflation scales differ for Ukraine and Russia.2 Foreign currency deposits are evaluated at the auction exchange rate.
Figure 5.5.
Figure 5.5.

Basic Analytics of Capital Inflows1

1 Appropriate use of fiscal policy can help mitigate the effects of capital flows on the real exchange rate.

Interest Rates and Rates of Return

1. Financial Assets and Rates of Return

In general, people hold four types of assets: money; other interest-bear ing financial assets (credit market instruments or bonds); equities or stocks; and real (or tangible) assets. The theory of asset demand or portfolio choice suggests that demand for an asset is governed by three characteristics: (i) the expected rate of return, or yield (compared with other assets); (ii) the riskiness of the expected return; and (iii) the liquidity of the asset. The rate of return on a financial asset has two components: the interest or dividend paid on the asset on a regular basis, plus capital gain or loss (the increase or decline per period of time in the market price of the asset). As a holding, currency pays no interest. Demand or checking deposits usually pay a zero or low rate of interest compared with less liquid forms of wealth. By holding money, people sacrifice the higher rate of return they could earn from more illiquid assets such as bonds or time deposits. Since the interest paid on money balances is relatively constant, the difference in the rates of return on money balances and alternative, less liquid assets is reflected in the market rate of interest: the higher the rate of interest, the higher the sacrifice for holding money. In an inflationary environment, if alternative financial assets carrying attractive positive real rates of return are not available, people tend to shift their wealth from money to real assets such as property, gold, commodities, or foreign currencies, all of which tend to be more stable in real terms.

2. Nominal and Real Interest Rates

In an environment of low and stable rates of inflation, the behavior of nominal financial variables (such as the monetary and credit aggregates or the spectrum of interest rates) can serve as useful indicators of monetary developments and the stance of monetary policy. However, in general, and particularly in the presence of high inflation, the focus should be on the movements of real (adjusted for the expected rate of inflation) rather than the nominal magnitudes in order to properly assess monetary developments and policies. If prices are rising, borrowers pay back loans in terms of a currency that has lost value. If prices are rising by 10 percent, and one can borrow at 6 percent, the nominal cost of borrowing is 6 percent, while the real cost o{ borrowing is negative. This real interest rate (Rr) can be expressed as


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When the inflation rate is low, (RnPe) gives a good approximation of the actual real interest rate. For high inflation, the discrete form below should be used:

In many transition economies, although the nominal interest rates appear high, the real rates of interest are often negative. Since saving and investment respond to movements in the real rates of return, a negative real return on financial assets suggests a disincentive to save and an incentive to spend, aggravating inflationary pressures and hurting long-term prospects for economic growth.

Monetary Analysis in Transition Economies: Some Special Issues30

Monetary analysts working with transition economies face special difficulties stemming from the structural and institutional characteristics of these economies. Some of these difficulties are discussed below.

Rapid changes in velocity. Many transition economies have experienced high and variable rates of inflation and accompanying increases in the velocity of money. The increases, however, have generally occurred in large, discrete jumps rather than in smooth trends. In extreme cases (such as Armenia and Georgia in late 1993), velocity has risen as much as threefold in one quarter. The initial large increases in velocity have generally taken a long time to reverse, with real money balances remaining at low levels for prolonged periods. In countries with very high inflation, real money balances have tended to reach the minimum level necessary for transactions purposes and have gradually stabilized at that level. Earlier hyperinflations suggest that real balances do not return to their pre-inflation levels for some time, so that even with actual sharp reductions in inflation, the demand for real balances remains subdued (see Box 5.10). Countries that have maintained an aggressive interest rate policy to ensure a positive real rate of return on domestic monetary assets have succeeded in restoring confidence in the domestic currency relatively quickly.

Lack of competition among banks. The shift to indirect methods of monetary controls is hampered by a lack of competition among banks. Demand for bank reserves is not sensitive to interest rates, because many banks have not yet started behaving like profit-maximizing commercial entities. Many transition economies have therefore found it necessary to rely on nonprice rationing of central bank credit, often through auctions, with banks reallocating reserves among themselves in a market for cash balances. Competition in the banking system is limited for a number of reasons. Like many enterprises, many banks are state owned, and there are few branch networks. Banks continue to depend on central bank funds, large shares of preferential credits, and credit ceilings. Many banks rely heavily on central bank refinancing, reflecting the surplus of credits over deposits transferred from the “monobank” of the centrally planned era, the lack of well-developed interbank markets to recycle funds, and a large share of subsidized loans. (A monobank not only served as the central bank, but had a monopoly on commercial banking functions.)

Interenterprise arrears.31 When countries tighten credit policies without getting enterprises to harden their individual budget constraints, the result is often a sharp increase in disintermediation, or the movement of funds from the banking system to financial institutions outside the system. In transition economies, enterprises use payments arrears to each other as a substitute for bank credit. Use of these “interenterprise credits” has risen rapidly in many transition economies since 1990 (for instance, in Romania and states of the former Soviet Union, such as Russia). Romania’s experience demonstrates that providing bank credit to clear the arrears is not a lasting solution to the problem unless enterprises are convinced that a decisive hardening of the budget constraint will take place thereafter. Preventing new arrears requires positive real interest rates, improved payments systems, more managerial accountability, and effective bankruptcy legislation, and possibly enterprise restructuring and privatization.

Absence of money and financial markets. The lack of such markets in the initial stages of the transition to a free market economy precludes the use of open market operations as an instrument of monetary control. Exacerbating the problems are the absence both of an interbank clearing system and of confidence in the creditworthiness of interbank transactions.

Interest rate problems. The large stock of loans with long maturities at low and fixed interest rates (such as loans for housing) has complicated the process of liberalizing interest rates. Moreover, weak financial discipline tends to undermine the role of interest rates. For instance, there may be a systematic tendency for higher interest rates to feed into higher monetary growth (and hence into higher inflation) if enterprises are allowed to borrow from banks to pay interest obligations.

A large spread between deposit and lending rates. The spread has tended to remain large, as banks pass on a variety of costs to their clients. These costs are associated with (i) the large number of nonperforming loans; (ii) the large share of credits that continue to be extended at preferential rates; (iii) the central bank’s heavy reliance on noninterest paying reserve requirements in the initial stages of reform, which lower the banks’ rate of return on assets; and (iv) high administrative costs resulting from inefficiencies in the system. In the absence of competition, there is little pressure for banks to abandon the old “cost-plus” system of pricing.

Money and Hyperinflation1

The term “hyperinflation” is generally used to refer to a sustained increase in the general price level at an extremely high rate. A widely accepted definition is that proposed by Philip Cagan in a seminal study of hyperinflation, namely a monthly rate of price increase of 50 percent or more, sustained for several months. The historical episodes of hyperinflation—such as those in Germany after the first and second world wars, in Austria during the interwar period, in Hungary and in Latin American countries such as Bolivia—provide laboratory experiments for studying the consequences of high and variable rates of monetary growth and inflation.

Studies of these hyperinflations have found several common features in them. First, the real demand for money falls drastically. By the end of the hyperinflation in Germany in the 1920s, real money demand was only one-thirtieth of its level two years earlier. Second, relative prices become very unstable. In Germany, real wages changed (up or down) on average by a third each month. This large variation in relative prices and real wages and the inequities and distortions caused by them took a heavy toll on economic and social stability. Third, at high rates of inflation, inflation tends to be highly variable. In the case of German hyperinflation during 1921-1923, monthly rates of inflation ranged from zero to 500 percent. In such an environment, the nominal interest rate no longer is a useful measure of the alternative cost of holding money, because lending at prescribed nominal interest rates virtually disappears. The best indicator of the cost of holding money in hyperinflation is the expected rate of inflation.


Adapted from Robert Barro, Macroeconomics (New York: John Wiley & Sons, Inc., 1993), pp. 201–3.

High financing needs of the government sector. Where the formulation of monetary policy is not divorced from the political process, the monetary authorities must frequently subordinate their objectives to accommodate the government’s financing need. In countries that face high budget deficits and have limited sources of nonbank domestic financing, this situation has typically been associated with a high inflation outcome.

Background for Monetary Analysis

Institutional setup. With the enactment of the Banking Act in 1989, the National Bank of Poland (NBP) ceased to be the monobank, and its commercial functions were devolved to nine commercial banks. The NBP was granted considerable autonomy, although it was required to submit a draft of the guidelines for monetary policy to parliament each year. Since October 1991, monetary policy has been conducted in the framework of a crawling peg exchange rate arrangement. Although the commercial banks were initially fully owned by the government, considerable progress is being made in privatizing them, and by mid-1996, two had already been sold to the private sector. There are also four large specialized banks dealing with foreign trade, agroindustry, housing construction, and foreign currency deposits that remain in the public sector. In the last five years, a number of private banks have been set up, several with foreign participation.

Inflation performance. Inflation declined sharply from the very high rates of 1989–90 to about 40 percent annually in 1992–93, suggesting that the policy of using the exchange rate as a nominal anchor in the early stages of the stabilization program had some success. The progress in reducing inflation slowed somewhat in 1994 (see Figure 5.6).

Figure 5.6.
Figure 5.6.

Poland: Money and Inflation1

(Year-on-year percent change)

Sources: IMF, International Financial Statistics and Tables 2.5 and 5.1.1 Broad money is defined as zloty broad money plus foreign currency deposits. Inflation is measured by the CPI.

Credit expansion. The reduction in inflation has been brought about despite the extension of large credits to the government to finance budget deficits. Most of the credit to the government has been granted by the NBP, making such credit the primary source of expansion in the monetary base. Credit to the nongovernment sector, including the state enterprises, has been relatively sluggish, indicating some crowding out (Figure 5.7).

Figure 5.7.
Figure 5.7.

Poland: Credit to Government and Nongovernment

(In constant January 1992 prices)

Sources: IMF Institute database and Table 5.1

Velocity of money. The reduction in inflation has been achieved despite significant deficit financing, because the demand for broad money has risen sharply. The fall in inflation has restored the role of money as a store of value to a significant extent, and the private sector has, therefore, channeled its savings into bank deposits. In fact, the velocity of money fell throughout 1991–93 (Figure 5.8).

Figure 5.8.
Figure 5.8.

Poland: Velocity of Money1

Sources: IMF Institute database and Table 5.1.1 Velocity is measured as nominal GDP divided by average of broad money or zloty money.2 Zloty money comprises of currency and all zloty deposits.3 Broad money comprises of currency, zloty deposits (demand, savings, and time), and foreign currency deposits.

Interest rates. The deregulation of interest rates has been an important factor in the shift of savings into bank deposits. Lending rates by banks have been influenced mainly by the central bank’s refinance rate. Real interest rates on deposits have generally remained negative for short-term deposits, but lending rates have been significantly positive (Figure 5.9). As noted, the spread between the lending and deposit rates of banks has remained wide.

Figure 5.9.
Figure 5.9.

Poland: Nominal Interest Rates

(In percent)

Sources: IMF Institute database and Table 5.3.

Currency substitution. The earlier period of high inflation and negative real interest rates had resuited in a rapid increase in dollarization, with the ratio of foreign currency deposits to broad money rising to 80 percent in 1989. Since then, the ratio has fallen sharply, although it did rise somewhat in 1993 (Figure 5.10).

Figure 5.10.
Figure 5.10.

Poland: Foreign Currency Deposits

(In billions of U.S. dollars)

Sources: IMF Institute database and Table 5.1.

Exercises and Issues for Discussion


Table 5.1.

Monetary Survey1

(In trillions of zlotys; end of period)

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Sources: Juha Kahkonen and others, Poland—Statistical Tables, IMF Staff Country Report No. 96/20 (Washington: International Monetary Fund, 1996); and Liam P. Ebrill and others, Poland: The Path to a Market Economy, Occasional Paper No. 113 (Washington: International Monetary Fund, 1994).

The figures for reserves and net credit to general government in 1994 include the impact of the net financing cost of the debt reduction operation with external commercial creditors.

Beginning in 1994, the accounting of treasury bills newly purchased by the National Bank of Poland to finance the budget deficit was changed from face value basis to a cash value basis. Accordingly, to compare net credit to government across years, the net credit to general government has been adjusted in all years to show the cash value of securities.

The change in the stock of net credit to general government can be reconciled with the flow change in financing in the fiscal table after adjustments are made for valuation effects on the dollar-denominated debt of the government and capitalized interest on the bonds issued to recapitalize the state-owned banks.

Table 5.2.

Accounts of the National Bank of Poland

(In trillions of zlotys; end of period)

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Sources: Juha Kahkonen and others, Poland-Statistical Tables, IMF Staff Country Report No. 96/20 (Washington: International Monetary Fund, 1996); and Liam P. Ebrill and others, Poland: The Path to a Market Economy, Occasional Paper No. 113 (Washington: International Monetary Fund, 1994).

To simplify the analysis, all credits to the government are assumed to be denominated in zlotys.

Including cash in vault.

Table 5.3.

Interest Rates1

(In percent)

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Sources: Juha Kahkonen and others, Poland—Statistical Tables, IMF Staff Country Report No. 96/20 (Washington: International Monetary Fund, 1996); and Liam P. Ebrill and others, Poland: The Path to a Market Economy, Occasional Paper No. 113 (Washington: International Monetary Fund, 1994).

The NBP refinance rate and the deposit and lending rates are end-period values, while all the other rates are monthly averages.

One-day reverse repo rate.

Midpoint of the range of rates offered by principal commercial banks.

Warsaw interbank offered rate.

Table 5.4.

Consolidated Balance Sheet of the DMBs

(In millions of Transitia dollars)

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Table 5.5.

Balance Sheet of Monetary Authorities

(In millions of Transitia dollars)

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Table 5.6.

Balance Sheet of the Banking System

(In millions of Transitia dollars)

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Source: Based on data provided m Tables 5.4 and 5.5.
Table 5.7.

Balance Sheet of the Banking System (Analytical Presentation of the Monetary Survey)

(In millions of Transitia dollars)

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Source: Based on data in Table 5.6.

Issues for Discussion

  1. Using Figure 5.8, discuss the implications of the changing role of foreign currency substitution in Poland for monetary developments and the conduct of monetary policy. How is the inflationary impact of a given fiscal deficit affected by changes in dollarization? Explain.

  2. Explain the importance of the concept of monetary base in monetary analysis and discuss how various actions by the central bank affect the growth of the monetary base. Would you agree or disagree with the statement that the control over its monetary base is the most effective means of conducting monetary policy by a central bank?

  3. What are the principal obstacles to the conduct of an effective market-oriented monetary policy in a transition economy? What can be done to remove these obstacles? Discuss this question on the basis of your own country’s experience.

  4. Discuss how volatile capital flows complicate the conduct of monetary policy in an open economy. Can monetary policy still retain its ability to influence the rate of inflation in the face of volatile capital inflows? Explain highlighting the role of the exchange rate.

  5. Explain why under a fixed exchange rate regime policymakers target the net domestic assets rather than broad money directly. Would this also be true in the case of a crawling peg or an exchange rate band?


Accounting for Some Transactions with the IMF

Concepts and Definitions

Quota: Upon joining the Fund, a country is assigned a quota.1 This is paid in national currency (not less than 75 percent) and in a reserve asset such as a convertible currency (up to 25 percent).

The IMF maintains three accounts with the designated depository of the member (often the central bank). They are the IMF No. 1 Account, No. 2 Account, and the IMF Securities Account.2

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  • The reserve tranche equals the Fund’s holdings of a member’s currency (excluding holdings which reflect the member’s use of Fund credit) that are less than the member’s quota. It is a part of the member’s external reserves, and a member may purchase its entire reserve tranche at any time. Purchases in the reserve tranche are not regarded as a use of Fund credit, and are not subject to charges, nor are they required to be repurchased.

  • Credit tranches are available in four tranches, each equal to 25 percent of a member’s quota. A first credit tranche purchase is defined as one that raises the Fund’s holdings of a member’s currency in the credit tranche by 25 percent of quota. The three subsequent tranches, each equal to 25 percent of quota, are known as upper credit tranches. The distinction between first and upper credit tranches also reflects the higher conditionality that accompanies the use of Fund credit in the upper tranches. In addition to purchases under the Fund’s credit tranche policies, members may use the Fund’s resources under decisions on compensatory and contingency financing, buffer stock financing, and the extended Fund facility.

  • The Fund’s holdings of a member’s currency reflect, among other things, the transactions and operation of the Fund in that currency.

  • A member’s reserve position in the Fund (RPF) comprises the reserve position and creditor positions under the various borrowing arrangements. A member’s reserve position in the Fund has the characteristics of a reserve asset. A reserve position in the Fund arises from (1) the payment of part of a member’s subscription in reserve assets and (2) the Fund’s net use of the member’s currency.

Illustrative Examples

1. Payment of quota. Assuming a quota of 100 SDRs paid in convertible currencies (25 percent) and national currency (75 percent). This is reflected in changes in the balance sheet of the country’s monetary authorities as follows:

Monetary Authorities

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or simply

Monetary Authorities

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where RPF, as defined above. In this case:

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Note that exclusions refer to holdings that reflect the member’s use of Fund credit. In this case, it is also equal to the reserve tranche.

2. Drawdown of the reserve tranche

Monetary Authorities

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In terms of RPF:

Monetary Authorities

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3. Credit tranche purchase of SDR 40

Monetary Authorities

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In terms of the reserve position in the Fund:

Monetary Authorities

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where RPF = 100 − (140 − 40) = 0.

Note the following accounting relationships:


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Appendix chart. IFS Money and Banking Sections for a Prototype Economy

(IFS line numbers in parentheses; hypothetical values as of a given date to right of time series descriptor)