Controlling any monetary aggregate involves an ongoing process compared with discretionary policy decisions, such as changes in the exchange rate or in the trade and payments system. At the same time, the effects of a monetary disturbance on other variables are not instantaneous; the salient problem therefore in determining the appropriate rate of monetary expansion for the future is to take account of the lagged effects on these aggregates. However, the precise structure and length of the lags involved are in general not known, nor are they easy to determine. Moreover, although governments can control domestic credit of the banking system, experience in countries that resort to indirect controls—for example, discount rate policy, reserve and liquidity ratios, and open market operations—shows that credit objectives cannot be met with precision at every moment in time.1 Furthermore, depending on the individual country, external and internal credit markets outside the banking system may play a major role and influence aggregate demand and the balance of trade and payments.
The paper addresses itself to the following questions:
(1) What is the appropriate monetary variable to be controlled?
(2) How can targets or limits for monetary variables be formulated to take account of the lagged effects on expenditures and the trade balance?
(3) What are the implications of short-run deviations of credit from the predetermined limits?
The choice of which monetary aggregate to control—that is, money or credit—depends on the policy objective and on the presence or absence of nonprice credit rationing. The appropriate variable for the control of expenditures, and hence for the balance of trade, is total (domestic and foreign) credit, while the overall balance of payments objective requires emphasis on domestic credit.
The paper shows that, owing to lags, the actual level of credit outstanding at each moment in time is of limited importance for changes in expenditures and trade as it provides only an indirect measure of monetary disequilibrium; the duration of the disequilibrium is of utmost importance. This is particularly true in countries with a wide range of financial assets, and hence a complex money supply process, and where developments of credit outside the institutional banking system, for example, the actions of other financial intermediaries, are important.
From the difference in the financial systems among countries, it follows that short-run fluctuations in domestic credit are of varied importance for the balance of trade; they are of utmost importance for the overall balance of payments if capital is highly mobile. As lag structures differ between countries, a credit disturbance lasting for, say, two months may be of minor consequence in one country and spell disaster in another. Some aspects of the determinants of the lag structure are discussed, and the importance of “credit rationing” (i.e., nonclearing markets) for the lag structure is analyzed.
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Mr. Keller, economist in the Stabilization Policies Division of the Exchange and Trade Relations Department when this paper was prepared, is currently in the External Finance Division. He is a graduate of the University of Würzburg and the University of Rochester. For helpful comments, he is indebted to colleagues in the Fund, as well as to Prof. Rudiger Dornbusch of the Massachusetts Institute of Technology.
The best-known proponents are probably Milton Friedman, Anna Schwartz, Karl Brunner, and Allan Meltzer; and with respect to the aspects of trade and payments, Harry Johnson, Rudiger Dornbusch, and Michael Mussa. There is, however, dissent, for example, from Nicholas Kaldor and Joan Robinson.
Abstracting from Friedman’s “helicopter” method of increasing the money supply.
Moreover, as reserve movements affect the monetary base, they will, in the absence of offsetting action by the monetary authorities, lead (under a fractional reserve banking system) to multiple credit expansion or contraction.
See, for example, Johnson (1972).
The relative adjustment speed on the import and export side depends, inter alia, on whether the export commodity is also consumed domestically and on the time required to reallocate resources from the export sector to the domestic goods sector, and vice versa.
As an individual has the choice between spending (consuming) and saving out of current income, the marginal utility of consumption that he forgoes increases with an increase in the rate of savings, and vice versa for dissaving.
This compares with the findings of Dornbusch (1973); since he considered only one asset, money, the current account surplus in his model equals the flow demand for money.
If this is not the case, the absolute level of wealth must be included in the equation. It is also assumed that people are indifferent between holding foreign and domestic bonds.
The assumptions of perfect immobility and perfect mobility are imposed for expository reasons; the more realistic case of limited mobility is treated later on.
Private sector income will remain unchanged, as the interest earned on foreign bonds acquired must equal the interest forgone on bonds sold to the banking system.
It is assumed that changes in earnings by the banking system will not be reflected in expenditures or wealth of the private sector.
This characterizes the situation in the majority of countries.
Moreover, the sectoral distribution of credit is also of importance. This aspect will, however, be set aside.
Brunner and Meltzer (1972 a) stress the importance of the relative price process covering all assets and yields for the transmission of monetary impulses. Although this author agrees with the usefulness of such an approach, it is not possible to incorporate such a transmission process fully into the present simple model.
To actually determine the value of the elasticities of substitution between various real and financial assets and to gain a complete picture of the effects of nonprice credit rationing would necessitate an approach similar to that of Brunner and Meltzer (1968) and (1972 a), which includes a model of bank behavior. The estimations of demand for money functions generally yield low and often insignificant values for the interest rate, which is interpreted by some monetarists as indicating a low elasticity of substitution between money and other financial assets.
It is certainly true that even in countries with well-developed capital markets small businesses have to depend on bank credit, as their size would prevent access to the private capital markets. See White (1976).
See also Polak and Argy (1971), who suggested that the availability of credit should enter into the expenditure function.
This could be interpreted as a Keynesian liquidity trap, that is, an “unstable” demand for money function.
And, by implication, domestic income and employment.
That is, changes in the money supply or in total (foreign and domestic) credit.
The actual adjustment speed will depend on the structural characteristics of the individual country, and especially on the role money and credit play in the economy, that is, on the development of the financial markets.
Empirical money demand studies indicate that the adjustment speed with which the desired level of balances is achieved is roughly 50 per cent in the first year, that is, g = 0.055 on a monthly basis; g2 is therefore negligibly small relative to g.
The rough proportionality, with respect to time, comes about as a deficit or surplus, which persists for only a short period, does not affect the initial conditions of the system—that is, the prevailing monetary disequilibrium—in a significant way.
All capital flows are assumed to take place during the first quarter.
In the absence of offsetting capital flows, an expansion of credit must initially bring about an equal increase in liquidity.
This is probably the effect of widespread credit rationing.
A caveat is, however, appropriate regarding the generalization of the findings. The strong immediate response of imports to changes in Q (zero lag) implied by the equation for Korea may reflect not only the short time lag between monetary expansion and aggregate demand but also circumstances specific to Korea, such as the tying of imports to exports through the import control system and the fact that foreign direct investment often took the form of imports of capital equipment. Moreover, high import content and short assembly time for certain export commodities may also have contributed to the high degree of correlation observed between imports and Q in the same quarter.
Even Milton Friedman, who is a strong proponent of the idea of letting the money supply expand at constant rates, indicates that “… it would have been absurd to append a constant growth path to the 1933 money stock, for example, … it was desirable to start the long-run growth path from a position of rough monetary equilibrium, not from a position of significant disequilibrium.” Friedman (1972, p. 913, footnote 4).