THE PURPOSE of this paper is to examine some of the assumptions that are frequently implicit in monetary models of the economic system and to consider some of the lines along which further investigation of the operation of the banking system might be pursued.
Most analyses of the monetary mechanism proceed from an assumption that there is a relation, or a series of relations, between money and other assets available to the community. They examine the influence of these relations and of changes in the prime aggregate, money, on the rest of the economy. In general, they assume that the amount of money available to the community can be determined by the monetary authorities.1 This view is based on the traditional postulates regarding the operation of the banking system under a system of fractional reserve banking, which lead to the conclusion that the central bank has absolute control over its monetary liabilities.2 Deliberate changes in central bank monetary liabilities are assumed to result in proportionate changes in bank reserves. These changes in bank reserves, in turn, induce a secondary expansion or contraction by the banking system of an amount indicated by the ratio of currency in circulation to money and the ratio of customary or required reserves against deposits. These two ratios are considered to be reasonably stable, i.e., subject to only insignificant changes in the short run (in the absence of changes in legal reserve requirements). Hence it is assumed that the effect of given changes in central bank monetary liabilities on the total money supply is reasonably certain and predictable. It follows, from these assumptions, that a central bank can control the money supply in a fairly automatic and reliable fashion by producing changes in its monetary liabilities or, of course, by changing legal reserve requirements. Accordingly, limitations to central bank control of the money supply are attributed mainly to inability to manipulate monetary liabilities or to impose, vary, or enforce reserve requirements for banks. This inability may be the result of political or technical difficulties in offsetting changes in monetary liabilities arising from changes in foreign assets, or from credit given to the government as a result of fiscal policies. Limitations such as these are usually emphasized in discussions of monetary policy in less developed countries. For advanced countries, they are often considered insignificant.3 For such countries, discussions of monetary control are primarily concerned with the choice of instruments, the timing of measures, and their impact on effective demand for goods and services and on international capital movements.
Inasmuch as a large part of banking theory has been developed in the United Kingdom and the United States, its assumptions are naturally related to the institutional setting in those countries. It might, therefore, be useful to examine the validity of the assumptions for a wider range of countries, in order to explore avenues along which the work being done toward integration of the banking mechanism into macro-economic analysis could be carried forward.4
It is assumed in this paper that central banks have absolute control over changes in their monetary liabilities. Attention is focused on their ability to control and predict the effect of these changes on the total money supply, i.e., on an examination of the stability of the ratio relating changes in money to changes in central bank monetary liabilities (the money multiplier). This ratio is determined by the ratios of currency to money and of required reserves plus working reserves to deposits.5 It is also influenced by changes in the nonmonetary liabilities of the banking system, excluding the central bank (e.g., time deposits and bank capital). If changes of this kind are ignored for the moment, the stability of the currency/money and reserve ratios will assure a fairly high reliability for predictions of the magnitude of secondary credit creation on the basis of a given change in central bank monetary liabilities. The validity of the assumption that these ratios are reasonably constant in the short run is a question of fact and can therefore be tested.
The behavior of the two ratios and of the multiplier derived from them is reviewed here for selected countries6 and periods. First, the percentage changes in money that are attributable to changes in central bank monetary liabilities and to changes in the money multiplier are calculated for these countries. Then, the percentage changes in money attributable to variations in the three components of the multiplier (the ratio of currency to money, of required reserves to demand deposits, and of excess reserves to demand deposits) are estimated. Finally, the percentage changes in money which arise from (1) direct central bank action, i.e., through changes in its monetary liabilities and its required reserve ratio and (2) changes in behavior variables, i.e., the ratio of currency to money and the excess reserve ratio of banks, are separately identified. In conclusion, some implications of the estimated monetary impact of changes in the behavior variables are considered, and suggestions for further study are made.
The conclusion of these investigations is that the assumption of short-run stability in currency and excess reserves, and therefore in the money multiplier, is not warranted. Although in most years observed the monetary effects of changes in central bank monetary liabilities and in legal reserve requirements exceeded those of changes in behavior variables, in certain years the opposite was true for most of the countries reviewed. The conclusion is that continued observation of the currency and excess reserve ratios and their explicit inclusion in the analytical framework would improve monetary analysis and focus attention on the feasibility of introducing further refinements.
I. Methodological Notes
II. Sources and Explanatory Notes
Mr. Ahrensdorf, economist in the Finance Division, was educated at the Universities of Berlin, Heidelberg, and Michigan. Before joining the Fund staff, he was professor of economics at the University of the East, Manila, and lecturer at the University of the Philippines. He has contributed several papers to economic journals.
Mr. Kanesathasan, a graduate of the University of Ceylon, is economist with the Central Bank of Ceylon. He was formerly economist in the Finance Division, Research and Statistics Department, of the International Monetary Fund.
For example, see J. J. Polak, “Monetary Analysis of Income Formation and Payments Problems,” Staff Papers, Vol. VI (1957-58), pp. 1-50; Robert Triffin, “Un Esquema Simplificado para la Integration del Análisis Monetario y de Ingreso,” Memoria, V Reunion de Técnicos de los Bancos Centrales del Continente Americano (Bogotá, 1957), and Europe and the Money Muddle (New Haven and London, 1957), especially pp. 48-53.
See, for instance, John Maynard Keynes, General Theory of Employment, Interest, and Money (New York, 1953), p. 230, and A Treatise on Money, Vol. I (London, 1930), pp. 29-30.
For a somewhat different conclusion, see Committee on the Working of the Monetary System, Report (Cmnd. 827, London, 1957), p. 224.
For a recent attempt to integrate certain elements of banking theory and the Keynesian system, see Leif Johansen, “The Role of the Banking System in a Macro-Economic Model,” International Economic Papers, No. 8 (London and New York, 1958), pp. 91-110. This model adds to the four Keynesian coefficients two more functions relating the demand of households for bank deposits to income and the interest rate and shows the ratio of currency to money as depending on all six coefficients. See also the following: (1) J. E. Meade, “The Amount of Money and the Banking System,” The Economic Journal, Vol. XLIV (London, 1934), pp. 77-83 (reprinted in Readings in Monetary Theory, York, Penna., 1951, pp. 54-63); (2) Banca Nazionale del Lavoro, Quarterly Review, Vol. VII (September 1954), Amedeo Gambino, “Money Supply and Interest Rate in Recent Macro-Economic Conceptions,” Vol. VIII (September 1955), Erich Schneider, “The Determinants of the Commercial Banks’ Credit Potential in a Mixed Money System,” Vol. VIII (December 1955), R. S. Sayers, “The Determination of the Volume of Bank Deposits: England 1955-56” (reprinted in R. S. Sayers, Central Banking After Bagehot, London, 1957), Vol. IX (January-June 1956), Amedeo Gambino, “Further Considerations on the Determinants of the Volume of Bank Deposits,” and Vol. XI (September 1958), Frank Brechling, “The Public’s Preference for Cash”; (3) G. S. Dorrance, “The Bank of Canada,” Banking in the British Commonwealth (R. S. Sayers, ed., London, 1952), pp. 121-24; (4) A. H. Metzler, “The Behavior of the French Money Supply: 1938-54,” The Journal of Political Economy (Chicago, 111., June 1959), pp. 275-96; and (5) Hans-Joachim Lierow, Der Geldschöp-fungskoeffizient der Kreditbanken in der Bundesrepublik, Volkswirtschaftliche Schriften, Heft 30 (Berlin, 1957).
For a detailed exposition of the respective relationships, see p. 132, below, and also Richard Goode and Richard S. Thorn, “Variable Reserve Requirements Against Commercial Rank Deposits,” Staff Papers, Vol. VII (1959-60), pp. 9-45, and Procter Thompson, “Variations on a Theme by Phillips,” The American Economic Review, Vol. XLVI, No. 5 (December 1956), pp. 965-70.
The selection of a sample covering about 12 countries was designed to include economies in different stages of development and with different structures and a fairly wide geographical distribution.
The U.K. experience in regard to the stability of r was unique. The same percentage deviation in r (5 per cent) in Brazil must be related to three changes in legal reserve requirements during the period observed.
Inasmuch as in the United States the decline in r, especially since 1952, was associated with reductions in legal reserve requirements, the fall in r and therefore the rise in k cannot, of course, be attributed entirely to the behavior variables, c and the excess bank reserve ratio. Also, it might be argued that the fairly consistent decline in c and r since the end of the war offers some basis for projecting further declines, and thus narrowing the margin of error in the prediction of changes in money.
See Goode and Thorn, op. cit., p.43.
The multiplier in terms of the ratio of total reserves to total deposits can be proven to be equal to the ratio of money plus time deposits to central bank monetary liabilities, i.e. (M + T) /L, in the same manner.
The two ratios could also be expressed in terms of marginal rather than average values. Throughout this paper, however, equality of average and marginal ratios is assumed. Empirical comparison of average and marginal ratios and the establishment of hypotheses regarding their relationship might warrant further refinement of the analysis.
International Financial Statistics currently records as “Cash” the monetary liabilities of the monetary authorities to the deposit-money banks. In some cases, assets other than monetary deposits with the central bank are included in reserves (e.g., government securities). It has not been possible, as yet, to include in International Financial Statistics the significant reserves data for all countries; hence, in several cases, as indicated in Appendix II, country sources have been used for data on required reserves, or required reserve ratios. To some extent, the discrepancies in the data are also accounted for by the fact that the annual averages of M, L, c, and r often could not be obtained from fully consistent separate sources.
Inasmuch as Japan did not impose legal reserve requirements prior to 1959 and in Canada reserves in excess of the customary ratio were always negligible, Table 3 shows for those two countries only the effect of changes in the ratio of total reserves to demand deposits.
That is, the establishment of an informal code “by means of which the animal becomes aware of what is expected from it and behaves accordingly.” See Sir Dennis H. Robertson, “The Role of Persuasion in Economic Affairs,” Economic Commentaries (London, 1956), p. 155.
For an attempt to explain long-run changes in this ratio for the United States, see Phillip Cagan, “The Demand for Currency Relative to the Total Money Supply,” The Journal of Political Economy, Vol. LXVI, No. 4 (Chicago, August 1958), pp. 303-28.
Frank Brechling, op. cit., has found some evidence that there is a positive correlation between the currency/money ratio and income velocity. This suggestion also appears compatible with the hypothesis of Leif Johansen, op. cit. In countries where such a correlation can be found and can be shown to be fairly reliable, it would provide a highly convenient indicator of income-velocity changes in the very short run.
See Section 2.