For those who follow monetary theory, which is the most complete measure of the money supply?

The Monetary System

Initially, we assume that there is a single closed economy using a single currency. We also assume that money is strictly a veil, and that inflation is and will always be a monetary phenomenon, too much money chasing too few goods. The demand for money is assumed to be the traditional transaction demand for money. As such, the demand for real balances is directly proportional to the economy’s production level. The proportionality factor is nothing more than the inverse of the velocity of money or turnover rate. The demand for money is described by the following equation:

(23.1)Md/P=Y/v

where Md denotes the demand for nominal balances, P price level, Y real GDP, and υ the velocity of money.

In log linear form, the percent changes in the variables can be written as:

(23.2) Ψd−π=η−υ

where Ψd denotes the logarithm of the demand for money, π the inflation rate, η the income elasticity of the demand for money, and υ the elasticity of the demand for money with respect to changes in the velocity of money. The latter is interpreted by us as a demand shifter.

We assume that the velocity of money is a function of the opportunity cost of holding that money. Hence there are two sources for money demand shifts: one is the real GDP changes, and the other is changes in the velocity of money. Thus according to this view, once the real GDP has been accounted for, all other shifts in the real demand for money are attributable to shifts in the velocity of money. Notice that the demand for real balances is nothing more than the quantity of money divided by the price level, that is, the real purchasing power of the quantity of money. Hence holding the velocity of money constant, the nominal demand for money will be proportional to the price level. That is, the quantity of money needs to keep pace with the price level if it is to maintain its purchasing power.

We also assume that in this economy the printing of notes and or bills is under complete control of the monetary authorities, that is, the central bank. This leads to a narrow definition of money, monetary base, B. The latter consists of the greenbacks printed by the Fed. It has two alternative uses, one is as currency in circulation, C, and the other is as bank reserves, R. That is:

(23.3)B=C+R

However that is not the only monetary aggregate. Much broader aggregates are used to denote the quantity of money in circulation in an economy. As already mentioned, under a fractional reserve banking system, high-powered money is strictly controlled by the Fed. The high-powered money consists of the circulating currency and all private bank deposits at the Fed. The broader monetary supply Ms (money stock) is nothing more than the product of the monetary base and the money multiplier, m.

Under a fractional reserve banking system, the money stock is larger than the monetary base because banks need only keep a fraction, say 10%, of the money deposited by a customer in his/her bank account as a reserve backing the deposit and this way insure that the bank is able to meet the customer’s normal withdrawals. The bank then proceeds to lend out the remaining money not used as reserves. The money loaned is successively redeposited and reloaned by the same and or different banks. The net effects of these transactions is an expansion of the loan portfolios as well as the total deposits of the banking system. The maximum or potential net deposit creation is nothing more than the inverse of the reserve requirement. For example, a 10% reserve can support $10 worth of deposits for every dollar worth of reserves. This means that every dollar worth of reserves can now support $9 worth of loans. The latter two make up the bank’s assets, which by the magic of double entry bookkeeping must also match the liabilities, the bank deposits in this case. The overall expansion determines the multiplier, or the amount by which the monetary base must be multiplied to produce the actual quantity of money circulating the economy. The previous discussion suggests that the money multiplier is not fully under the control of the Fed, something to keep in mind.

The economy’s money supply is easily characterized by the following equation:

(23.4)Ms=B*m

where B denotes the monetary base circulating in the economy and m is the money multiplier.

Again in log linear form, the percentage changes in the monetary aggregates and its components can be written as:

(23.5)Ψs=ω+μ

where ψs denotes the percentage change in money supply, ω the percent change of the monetary base, and μ the percent change of the money multiplier. We interpret the latter as a money supply shifter.

Monetary equilibrium requires the intersection of the demand for and supply of money that is:

(23.6)Md=Ms

Substituting Eqs. (23.1) and (23.4) into the previous equation yields a more detailed version of the market-clearing conditions in the money market.

(23.7)(B*m)*v=P*Y

Again, the dynamic version being

(23.8)ω+μ=π+η−υ

The information in the previous equations can be rearranged to solve for equilibrium price level as well as the underlying inflation rate.

(23.8’)P=((B*m )*v)/Y

and

(23.9)π=ω+μ−η+υ

The equations are fairly general and can accommodate different points of views and versions:

For example, Eq. (23.8) shows that the product of the monetary base, B, times the money multiplier, m, denotes the quantity of money circulating in the economy, MZM.

All else the same, increases in the quantity of money lead to a higher price level. Increases in real GDP, Y, lead to a decline in the price level.

Also, as already mentioned, we do not necessarily assume that the velocity of money is constant, we have to allow for shifts in the demand for money or alternatively stated changes in the velocity of money.

Nor do we assume that the money multiplier is under the strict control of the monetary authorities, but more on these two issues later on.

The dynamic version, Eq. (23.9), is fairly intuitive. The inflation rate is positively related to the growth rate of the monetary base and supply shifter. In turn the inflation rate is negatively related to the growth of real GDP and positively to changes in the velocity of money. The equation accommodates the view that inflation is a monetary phenomenon, too much money chasing too few goods. It also allows for shifts in the demand for and supply of money to affect the overall equilibrium inflation rate.

The Monetary System

Next we make the assumption that inflation is a monetary phenomenon, in which case monetary equilibrium can be described as:

(9.2)B*m*v=P*Y

where B denotes the monetary base in the economy, m is the money multiplier, v is the velocity of circulation of money, P the price level in local currency, and Y is real GDP in the economy in question. The information in the equation can be rearranged to solve for the price level:

(9.2′)P=B*m*v/Y

The equation is fairly general and can accommodate different monetary views and variations. For example, the product of the monetary base, B, times the money multiplier, m, denotes the quantity of money circulating in the economy, money zero maturity (MZM). All else the same, increases in the quantity of money lead to a higher price level. Also, increases in the real GDP, Y, lead to a decline in the price level. We do not necessarily assume that the velocity of money is constant; we have to allow for shifts in the demand for money or changes in the velocity of money, but more on this later on.

The dynamic version of the previous equation can be written as:

(9.2″)π=β+μ−η

where π denotes the rate of change of the price level or inflation rate, β denotes the growth of the monetary base, η the real GDP growth rate, and μ is a term capturing the changes in the money multiplier and the velocity of money, that is, shifts net shifts in money demand.

3.3.2 Financial Inclusion Has Improved the Environment for Monetary Policy in Kenya

The role of the Central Bank is to conduct monetary policy which works more efficiently when financial markets are fairly developed. In Kenya, perhaps the starting point is participation in the bank-dominated financial sector. Most of the population were financially excluded and over time with declining economic opportunities, most commercial banks had withdrawn their branch networks from the rural areas and poor peri-urban centers. Secondly, most transactions were taking place in cash and a large proportion of currency outside the banking system. The introduction of M-Pesa platform changed the traditional holding of currency outside of banks and the preference of cash. These developments affected the velocity of money and the money multiplier, the basic pillars of monetary policy framework at the time.

As soon as M-Pesa hit the ground, currency outside the banking system started to decline and the velocity of money started to decline. Since 2009, velocity of money and proportion of currency outside banks have declined significantly reflecting financial deepening and increased financial innovation. The declining currency outside banks and the significant velocity decline reflect changes in behavior of holding cash – people are keeping less and less money outside of banks and prefer less cash in their daily transactions. The monetary policy framework at the time relied on the assumption that velocity of money was constant and the relationship between base money and broad money, the multiplier, was stable and predictable. From 2007, the picture changed as Figs. 3.4–3.6 show and the monetary policy framework had to be revised to incorporate these changing dynamics.

In addition, due to innovations taking place in the banking sector through the M-Pesa technological platform, the money multiplier has been rising, see Fig. 3.6.

Declining velocity and rising money multiplier reflects the fact that money demand function has shifted and thus became unstable. This provided a chance to revise the monetary policy framework to a forward-looking framework. This has created an environment for monetary policy signals to work through the market effectively and efficiently. Monetary policy works through signals in the market: these signals cannot be processed by market agents if they are not included in the financial system. In this case, financial inclusion allows access and participation in the financial system and this has provided a better environment for monetary policy to influence the market.

The Financial Crisis

The previous paragraphs have outlined a simple framework that can be used to analyze and interpret monetary policy. In the process, we outlined the differences between our framework and traditional textbook representations of the monetarist, Keynesian, and Phillips Curve. While we showed that each of these frameworks produces a partial explanation of the 2007 financial crisis, we believe that our framework provides a much better and more complete explanation.

One common criticism of the Fed’s behavior leading to the financial meltdown is that the Fed was too easy as it expanded its balance sheet which lead to an explosion in the growth of the monetary base, see Fig. 25.6. Recall that some of the Fed’s critics used to argue that inflation would be coming down the pike. Our view then and now is that the critics focused solely on the expansion of the monetary base. Given this information, the critics inferred that there was too much money in the system. While we agree that inflation is a monetary phenomenon, we are not willing to concede that the money growth was excessive. Here is why. If the Fed was, in effect, following a price rule, the money growth would simply reflect increases in money demand. If that is the case, the inflation rate should remain within the Fed’s target range. In fact, as shown in Figs. 25.7 and 25.8, that was the case. MZM growth accelerated prior to the recession, yet its growth rate did not explode as the monetary base and neither did the PCE inflation rate. The latter dipped briefly and quickly rebounded to remain within the price rule range.

Other important relationships can be found in the different figures. For example, the relationship identified in Fig. 25.9 shows that. The money multiplier declined, yet the velocity of money does not show an abrupt change. It merely continued its downward trend. Fig. 25.10 shows that the expansion of the monetary base eliminated the negative impact of the decline in the money multiplier, leaving the MZM essentially unchanged. The Fed did a great job in providing liquidity, that is, transaction money to the economy. In fact, we can say more than that the fact that the inflation rate did not creep up with the expansion of the base, if anything it did decline, see Fig. 25.9, this means that if anything the Fed was a bit cautious or tight.

More often than not the expansion of the money multiplier is associated with declines in velocity or increases in the demand for money. This suggests that the money and credit supply and their prices do adjust to bring about a new equilibrium in response to the changing market conditions. The fact that the Fed was able to offset the negative impact of the decline in the money multiplier on MZM does not mean that the Fed took care of everything in the financial markets. Yet, it did provide transaction money, but what about the credit markets. The decline in the money multiplier would significantly reduce the credit creation by the banking system and that would have a negative impact on the credit markets. Fig. 25.5 shows how, as expected, the yield on the lower quality credit increased and perhaps in a flight to quality the yield on the higher quaintly corporate declined. As a result, the spread between the Baa and the Aaa bonds widened during the crisis.

Based on the framework outlined here and the previous chapter, we can make inferences regarding the possible impact of different shocks to the economy on the supply of credit and MZM as well as on the opportunity cost of holding MZM. More importantly, we can also show that the inference process is reversible. From the changes in the opportunity costs and the total amount of credit and money, we can clearly identify the nature of the shock. A few comments illustrate these points and put the monetary situation in perspective.

Let’s say that for some reason the banks stopped lending. In that case, the credit creation will collapse to zero. The credit contraction will have an unintended effect; it will lead to a decline in the money and credit multiplier and, as a result the quantity of money will decline too (Figs. 25.7 and 25.10). That is exactly what happened during the financial crisis. If left to the market clearing mechanism, prices change to bring about a new equilibrium. The excess demand for money leads to a decline in the inflation rate (Fig. 25.8). That is exactly what happened in 2008. The question is whether the Fed overdid it? Our answer is simple. Some people would look at MZM growth. We would look at the inflation rate. Looking at Fig. 25.8, we can see that in the aftermath of the crisis MZM grew in the mid-teens on a year over year basis while the inflation rate declined. All of this suggests that the expansion of the monetary base barely offset the collapse in the money multiplier.

The credit market is another story. While the increase in the base added the needed transaction balances, it did not address the credit issue. A shortage of credit will lead to an increase in the price of credit and the spread between corporate and government bonds. That is exactly what happened in 2008 (Fig. 25.11).

An attempt by the government to fill in the credit void was not as successful. However, this was not for lack of trying. The Fed intervened at the long and short end of the yield curve. The Fed went back to its low Feds funds rate and even though the flight to quality led to lower bond yields, the slope of the yield curve increased.

The point we want to make is that the money and credit markets interact with each other. If the Fed is to control the left side of the equation of exchange, it has to simultaneously manage the credit markets and the demand for money. These two objectives require at least two policy instruments on the part of the policy makers. The monetary base and the credit restraints (i.e., reserve requirements, etc.) should suffice. The velocity of money is also affected by inflation expectations and the opportunity cost of holding money. As long as we assume that the demand for money is stable, we can describe a systematic relationship between the multiplier, velocity, and the inflation rate. If inflation is to flare up, we expect to see an increase in the velocity of money and the money and credit multipliers. Those are the markers that we need to watch.

Helicopter Ben’s Crisis Response

Armed with this framework, we can begin to evaluate the Fed’s actions, and we can surmise the impact that possible Fed actions will have on the economy’s future inflation rate. Let’s start with the supply of credit. Fig. 36.5 shows the decline in the money and credit multiplier around 2007. Holding the monetary base constant, the amount of MZM and bank credit would decline in the same proportion that the multipliers were declining. This was a true deflationary pressure combined with a tremendous downdraft in the bank credit creation. Fig. 36.6 illustrates the Fed’s response to the liquidity events that began in late 2007 and exploded in September, 2008. Fig. 36.6 shows the vertical ascent of the monetary base at the time the money multiplier was declining.

In the aftermath of the Lehman failure, and the “breaking of the buck” of the Reserve Fund leading to its inability to honor withdrawals, the financial system experienced a run on nonbank banks and money market funds. The nonbank banks could not obtain funding as overnight or deposit funding stopped. They had to deliver. Money market funds were overwhelmed with withdrawals and became net sellers of commercial paper, the key source of funding for many businesses. In addition, financial institutions recognized large losses, resulting in a lack of capital and a loss of confidence in the system. The panic that ensued led to the demand for money going through the roof while credit collapsed. Fig. 36.6 shows the explosion of the US monetary base and the collapse of the MZM money multiplier (Fig. 36.5). This collapse in credit was especially severe in the nonbank bank sector—asset backed securities, investment banks, REITs, and mutual funds. These events led to a stunningly large fall in nonbank lending (Table 36.1) in the fourth quarter of 2008. Our estimate shows that nonbank bank lending fell at an annualized rate of $1.6 trillion, or 11.2% of GDP. The credit collapse shock was too big for the real economy to absorb and growth stopped around the world.

Table 36.1. Lending Flows ($ Billions)

The Fed responded rapidly to the financial shock. It expanded its balance sheet to replace this lending by initiating a wide range of lending facilities. The key facilities are the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Term Asset Backed Securities Lending Facility (TALF), and the Term Auction Facility (TAF). These new facilities expanded the collateral the Fed would lend against, from T-bills and conforming Fannie and Freddie mortgage standard, to a wide range of assets and maturities. This is referred to as “quantitative easing.” The result was the Fed expanded its balance sheet in an attempt to offset the sudden collapse of nonbank bank credit. This can be seen clearly in Table 36.2. The Fed’s actions prevented a wave of bankruptcies and panic by allowing nonbank banks to fund and money market funds to honor withdrawals. The Fed did this by using its open market operations described above to be the lender of last resort to a wide range of financial intermediaries. This is also quite visible in Fig. 36.6. In fact, the Y2K response pales in comparison to the expansion of the monetary base during the financial crisis. But this is logical given that the size of the drop in non-bank bank lending was greater than 11% of GDP.

Table 36.2. Fed Balance Sheet Changes ($ Billions)

The information in Fig. 36.7 shows the impact of the explosion of the monetary base on MZM, a blip, insignificant in relation to the explosion of the monetary base, Fig. 36.6. More importantly the information presented in Fig. 36.8 shows that with the slight decline in the growth rate of MZM and the inflation rate, the deflation that some expected as a result of the collapse of the credit market did not materialize. The Fed’s actions averted the deflation. Now the issue is whose responsibility it was to avert the depression and reactivate the economy.

4.7 Tests of panic theories

On the basis of the stylized facts about cross-country banking history, reviewed above, it would seem straightforward to observe that banks are not fundamentally flawed institutions. In fact, it does not seem to be an exaggeration to say that most of the theoretical work on panics has been motivated by the USA experience, which has then been incorrectly generalized. Panics simply are not a feature of most economies that have banks. The world is more complicated; industrial organization seems to be at the center of the incidence of panics. Not surprisingly, therefore, almost all the empirical work on panics has been on the USA experience. Until bank “crises” around the world in the last ten years, there simply has not been much else to study. Clearly, from the point of view of public policy and the design of bank regulation and central bank lender-of-last-resort activity it is important to distinguish between the two views of banking panics outlined above, if only because policies should be in place that are workable in economies where the banking system is susceptible to panics.

With regard to testing, a major difficulty is that Diamond and Dybvig (1983) is not a testable theory, since any observed a phenomenon is consistent with “sunspots”. Instead, empirical investigations of panics have focused on the timing of panics in the USA, checking for patterns that would be consistent with the information-based theories of panics. Importantly then, there are no formal tests that have been conducted that test one hypothesis against any particular alternative. Rather, there has been a variety of empirical work studying the times series behavior of the deposit–currency ratio, interest rates, and other variables, as well as studies of individual panic episodes. Empirical investigations include Gorton (1988), Donaldson (1992a), Mishkin (1991), Park (1991), Calomiris and Gorton (1991) and Calomiris and Mason (2002a,b). Wicker (1980, 1996, 2000), Donaldson (1993), Moen and Tallman (1992, 2000), Calomiris and Schweikart (1991) and White (1984) are also relevant.

Gorton (1988) argues that demand deposits are risky, like other securities, and that depositor behavior should correspond to consumption smoothing behavior based on the aggregate information available to them at the time. The basic idea is that when depositors receive information forecasting a recession they know that they will be dissaving, drawing down their bank accounts. But, their banks are more likely to fail during recessions, so they withdraw in advance to avoid such losses. Empirically Gorton analyzes the period 1863–1914 (and also the Great Depression) and shows that the post Civil War period behavior of the deposit–currency ratio displays the hypothesized timing. In fact, on every single occasion that a leading indicator of recession crosses a threshold, there is a recession. The basic conclusion is that there is nothing special about panic dates compared to nonpanic dates in terms of the behavior of the deposit–currency ratio. While the “sunspots” theory cannot be rejected, the conclusion is that if there are “sunspots” they must be consistent with estimated reduced for description of the deposit–currency ratio.

Donaldson (1992a) revisits the issues raised by Gorton (1988) using weekly data, compared to Gorton who used data from the Call Reports, reported five times a year. Donaldson confirms that there are periods that predictably (from the point of view of an econometrician) correspond to instances when panics are more likely to occur, but that the exact starting dates during such periods are unpredictable. One interpretation of his results is that, although panics do tend to occur at business cycle peaks, there is some unknown triggering event that is not predictable, perhaps a “sunspot”, but the data are not fine enough to say anything further.

Calomiris and Gorton (1991) first examine whether pre-panic periods were unusual. That is, do measures of seasonal flows of reserves and deposits show any evidence of tightness or shocks? There is no such evidence. The onset of panics is after the money flows associated with planting and harvesting. However, measures of real economic activity, in particular, the liabilities of failed businesses do decline. Also, stock prices declines did precede panics. Calomiris and Gorton write: “if one posits that the simultaneous violations of thresholds for percentages of real stock price decline and commercial failure increase are sufficient for panic, one can predict panics perfectly” (p. 144). Second, Calomiris and Gorton analyze bank liquidations and deposits losses during and after panics. Basically, there is no evidence of banks failing due to the panic. Rather, weak banks, by pre-panic measures, fail. Finally, Calomiris and Gorton look at sufficient condition for panics to end. The basic point here is that availability of liquidity to satisfy depositor demands does not seem to end panics, with the availability of the discount window during the Great Depression being the outstanding example. Rather, panics end when information becomes available, information typically produced by clearinghouses or the government about which banks are weak.

Mishkin (1991) also studies the National Banking Era in the USA, as well as the Great Depression. He focuses on the timing of events and financial variables to distinguish between the monetarist and asymmetric information-based views of bank panics.48 For example, an observation that interest rate spreads widen and stock market prices decline just prior to the panic, rather than a disruption in the financial markets following the panic, is viewed as evidence in favor of the information theory. Mishkin analyses each panic episode in USA history starting with the Panic of 1857 and concludes that “the asymmetric information approach to financial crises explains the timing of patterns in the data and many feature of these crises which are otherwise hard to explain” (p. 104). Mishkin’s evidence is consistent with that of Gorton and Donaldson.

If asymmetric information is at the root of panics, then panics should end when depositors receive credible information about individual bank shocks. Park (1991) argues that empirically the evidence suggest that panics in the USA did end when information about banks was provided to the public. He focuses on the actions of private bank clearinghouses and the government in providing credible information and concludes: “this empirical finding confirms the crucial link between bank-specific information and bank panics” (p. 285). Calomiris and Mason (1997) study the June 1932 bank panic in Chicago. They compare the attributes of banks that failed during that event to those that did not fail. They conclude that: “the failures during the panic reflected the relative weakness of failing banks in the face of a common asset value shock rather than contagion” (p. 881). “Private cooperation by the Chicago clearing house banks appears to have been instrumental in preventing the failure of at least one solvent bank during the panic” (p. 864). Other papers on the Great Depression are discussed below.

Demirgüç-Kunt and Detragiache (1998) study banking crises in a large sample of countries internationally during the period 1981–1994.49 Their basic results “reveal strong evidence that the emergence of banking crises is associated with a deteriorated macroeconomic environment. Particularly, low GDP growth, high real interest rates, and high inflation significantly increase the likelihood of systemic problems in our sample; thus crises do not appear to be solely driven by self-fulfilling expectations as in Diamond and Dybvig (1983). This is consistent with the evidence presented in Gorton (1988) on determinants of bank runs in the USA during the 18th century” (p. 3–4). While this study is the only study of an international cross section of countries, and therefore is unique, it did not include any variables that might capture cross section variation in the industrial organization of the banking system, which the studies reviewed above suggest would be important. However, the study does include a dummy variable for the presence of explicit deposit insurance and an index of the quality of law enforcement. The presence of explicit deposit insurance significantly increases the likelihood of a banking crisis, while the “law and order” index shows that more “lawful” countries are less likely to have a crisis.

It should be emphasized that none of the above work constitutes a test in a statistical sense. While the evidence is suggestive, the basic finding that panics are associated with business cycle downturns does not rule out any theory of panics. In fact, in the Goldstein and Pauzner (1999) and Morris and Shin (2001) extensions of Diamond and Dybvig, the business cycle timing is completely consistent with the self-fulfilling nature of a panic. Morris and Shin write of their extension that: “The theory suggests that depositors will indeed withdraw their money when the perceived riskiness of deposits crosses a threshold value. But, nevertheless, the banking panic is self-fulfilling in the sense that individual investors only withdraw because they expect others to do so” (pp. 14–15).

In fascinating recent research Kelley and Ó Gráda (2000) and Ó Gráda and White (2001) study the patterns of withdrawals from a single bank, the Emigrant Savings Industrial Bank, during bank runs in 1854 and 1857. Study at this level of detail can address questions concerning whether depositors respond to a signal that causes them to all crowd at once at the bank, or whether the run builds up slowly. Do rich or poor, less sophisticated or uninformed, line up first? And so on. Kelley and Ó Gráda (2000) find that in 1854 the bank panic followed ethnic patterns, particularly within the Irish community. Ó Gráda and White (2001) document time patterns in withdrawals (or account closings). There are responses to bad news, but there are elements of contagion as well. Moreover, the patterns are different in 1854 and 1857. In 1857, unlike 1854, the run was led by business leaders and apparently sophisticated agents, followed by less informed depositors.

What is more important, however, is to keep in mind that, while to date it has not been possible to discriminate between panic theories with data, it is clear that the prima facie evidence is against theories that inherently intertwine banks and panics. The previous evidence about the industrial organization of the banking system strongly suggests that, at least historically, there is no necessary link between banks and panics.

The Different Specifications

The policy implications for the monetarist framework are straightforward: Inflation is a monetary phenomenon, or too much money chasing too few goods. Therefore, according to the strict monetarist view, in order to forecast or explain the US inflation rate, we only need two pieces of information. One is the US real GDP growth, which, holding the money velocity constant, is our proxy for the demand. The other piece of information is the quantity of money, and it is the proxy for the money supply. Since according to this view, the Fed controls all the aggregates, it does not matter which one we use. In what follows, we will use two proxies: a narrow aggregate, the monetary base, and a broader aggregate, M3.

As the monetarist assumptions are relaxed, the proxies for the demand for US dollars and supply of US dollars changes. For example, the Fed controls the monetary base to the decimal point. In turn, the monetary base has two uses. The dollars can be used as either currency or reserves. In formal terms, the two are perfect substitutes in supply. This also means that the Fed does not control how the private sector allocates the base between bank reserves and currency in circulation. This also means that the Fed does not completely control the money multiplier and that, in turn, means that the multiplier can change and potentially offset undesired changes in the monetary base or amplify desired changes in the base. In principle, this makes the narrower aggregate a better proxy for money controlled by the Fed. However, that ignores the organization of the monetary system. Under a price rule, the open market operations are determined by the underlying inflation rate relative to the target rate. The point of all of this is that, if the broader aggregate is endogenous (as we are arguing here), they cannot cause inflation. In fact, the reverse is true. Another insight produced by this analysis is that the broader the aggregate the greater the explanatory power.

One point that we need to make here is that for many of the countries in the world, the financial system and the banking system are not as developed and deep as in the United States; therefore in these countries, the flexibility of the money multiplier may be limited. In simple terms, the central banks may have a better control of the domestic monetary aggregates. But this does not mean that foreign central banks have complete control of the quantity of money circulating in these economies.

The traditional models assume that under a floating exchange rate system only local residents use the local money. Implicitly, this assumption assumes that there are legal tender provisions that prevent the use of foreign monies in the local economy. This means that the currencies are not substitutes of each other in the domestic transaction. In technical terms, the monetarist assumes the elasticity of substitution across currencies to be zero. However, we know that foreign currencies circulate and are accepted in many economies of the world, and if the holding of these currencies respond to changes in the relative inflation, we can interpret that as evidence of currency substitution. Viewed from this perspective, it is clear that the case where local residents only hold the local currency is one where the elasticity of substitution is zero.

At the other end of the spectrum, we have the perfect substitutability case. This would be the case under a fixed exchange rate system. The convertibility assures that one country’s currency is a good as another. The more general case is when the currencies are imperfect substitutes for each other. In that case, the changes in the income in the rest of the world and the rest of the world’s money supply will affect the global demand for US dollars. The parallel here is that of the broader monetary aggregates, currency in circulation and demand deposits are not perfect substitutes in demand. They have slightly different characteristics and or transaction costs associated with their use.

Once the substitution effects among currencies are considered, it is obvious that the local central bank does not control the quantity of money circulating in the economy. This means that the rest of the world’s demand for dollars depends on how stable a monetary policy the local central bank runs. Changes in expectations and the actual domestic inflation rate induce the foreign economies to alter their demand for dollars to use in domestic transactions. While each individual country’s change may be insignificant relative to the US economy, collectively they may not be. Hence the rest of the world’s demand for US dollars to be used in local transactions could have an impact on the US monetary equilibrium, and thus the US inflation rate.

This line of reasoning produces alternative specifications for the estimation of the US inflation rate. They depend critically on the degree of substitutability, at one end of the spectrum if the different currencies are perfect or high substitutes. One specification is based on the world demand for dollars, as opposed to the US demand for dollars. The former assumes a high degree of substitutability among the currencies, be it demand and or supply through a fixed exchange rate system. The narrower aggregate based solely on local money assumes that there is no substitutability among the currencies. This gives rise to three possible specifications for the demand for dollars. One is to calculate the world income in US dollars, another possibility is to break down the world aggregates into their United States and rest of the world components and the third and final one is to consider only the US aggregates.

Domestic Credit Creation and Hot Capital Flows

One issue of great importance in the NRCC economies is hot capital flows. According to street lore, these money flows that travel around the world looking for higher rates of returns are quite fickle and tend to come and go abruptly. Even worse, if unchecked under the NRCC exchange rate mechanism, the capital flows result in an expansion of the monetary base, which, all else the same, leads to an increase in the domestic money supply. All of this brings us to the issue of whether these capital flows can be destabilizing and create speculative bubbles in an NRCC economy. If they do, what can the central bank do to ameliorate or temper these effects?

We do not believe the central banks are without tools to combat the credit expansion induced by capital inflows or asset bubbles. While we do not distinguish between hot or normal capital flows (we do not know how), we all can agree that both types of flows result in changes in a NRCC’s BOPs, and thus the stock of international reserves held by the central bank. We have already mentioned that the Chinese central bank was quite timid, if not tight, on the issuance of domestic high-powered money not backed up by international reserves during the fixed exchange rate period. In fact, Fig. 49.1 shows that, over time, the ratio of international reserves to the M1 base steadily increased. The increased ratio meant that a larger component is due to the action of private agents who bring their dollars to the central bank and convert them into yuan.

The inflow of international reserves allowed the banks to expand the quantity of money through its creation of domestic deposits under a fractional reserve banking system. The logic is simple. Under a 10% reserve requirement, 1 yuan would create a maximum of 10 yuans worth deposits. As the deposits denote a liability to the banking system, under a double-entry bookkeeping, the asset side must also match. The bank’s assets consist of 1 yuan worth of bank reserves and 9 yuans worth of loans. The credit creation is equivalent to the amounts of deposits less the reserves held by the banks.

The previous calculations illustrate an important point. The banking system creates the credit, but the supply of the credit is determined by the amount of reserves and the effective reserve requirement imposed on the deposits. Absent government regulations, one would expect the quantity of money and credit to grow at the same rate. One would not expect to find any changes to the money multiplier. However, to the extent that the ratio of the credit creation to the money creation changes, it reflects either a government regulation (i.e., tinkering with the reserve requirements) or differential growth in the demand for credit and money. The latter is the domain of the private sector and depends on a multitude of factors that we are not going to discuss at this time. The important point is that by paying attention to the credit to deposit ratio, we may identify any differential impact on the two markets and with a little luck, we may be able to discern the source of the differential performance.

Looking at Fig. 49.3, it is evident that the ratio of credit-to-deposits steadily decreased during the fixed exchange rate period. This result is quite interesting, especially for those who worry that capital flows could result in an excessive credit creation. First, if the reduction in credit-to-deposits is part of the private sector equilibrating process, this is a reassuring outcome. The market automatically adjusts to deliver the results desired by the private sector. This makes a lot of sense. If, as we have assumed, under a fixed exchange rate system the private sector initiates open market operations, it will increase or reduce the quantity of international reserves held by the central bank and all else the same, that expands the monetary base and quantity of money. The second explanation is that the Chinese monetary authorities marginally increased the reserve requirements of the banks, thereby reducing the credit creation ability relative to the deposit creation ability of the banks.

Other interesting details are also evident in Fig. 49.4. Notice a divergence between the two series around 2008. The data suggest that during that time the credit created by the banking system increased relative to the deposits created. Hence, from 2008 going forward, the money multiplier has risen in China. Put another way, China’s domestic credit per yuan worth of reserves increased during this time. To the extent, that the ratio of international reserves to the monetary base also rose, it allows us to rule out hot capital flows as a source of the credit easing. Looking at Fig. 49.4, it is apparent that during the 2008–14 time period that the rate of increase in international reserves declined, it still remained positive even though the credit creation per yuan was declining. This means that the international reserves were growing throughout this time and thus we can rule out the hot capital outflows theory. However, this leads us to another question: if not hot capital flows, then what?

Our answer is simple and we have already hinted at it: central banks can also affect the domestic credit creation of the banks through moral suasion and reserve requirement increases. And we know that China’s authorities have a great deal of moral suasion. Increases in the credit creation have to be allowed by the Chinese monetary authorities. During the bubble years, the Chinese monetary authorities reduced the credit creation ability of the financial institutions in China. The credit multiplier declined steadily throughout the period. This does not mean that credit declined. During that time, the monetary base was expanding. All it means is that the amount of credit produced by each yuan’s worth of reserves was reduced as the central bank raised its reserve requirements.

It is evident to us that China’s monetary authority has the tools to regulate the domestic credit creation ability of the banks and it does with gusto when it deems appropriate. Viewed this way, it is not the hot capital flows that caused China to change its banks credit creation ability. The surge in the credit multiplier may be attributable to Chinese concerns about the slowdown in the global economy and their desires to keep their economy expanding at a rapid pace. However, the possibility remains that China may overdo it. If it does, its inflation rate will begin to increase, the exchange rate will depreciate, and the international reserves may decline as a result of a capital outflow. The next few years will tell us if we were correct in believing that China made a mistake in abandoning its fixed exchange rate system.

Price-to-earnings

The most popular market valuation measure is the price-to-earnings ratio, often just referred to as the P/E. The P/E is best interpreted within the context of the Earnings Model. To facilitate the interpretation, we consider the simplification of the EM in which we have a forecast of next year's earnings, E, which are expected to subsequently grow at a constant rate g. Therefore, we can rewrite Eq. (2.9) simply as:

(2.11)V0E=E01+gEkE−gE

Before proceeding, we adapt our notation to emphasize that the remainder of the analysis will be used to infer the market's forecast of the inputs into the EM. Consider variables with “hats” to be the market's forecast of the variable, so that kˆis the market-determined discount rate, gˆis the market's forecasted long-term growth rate, and P0 is the market price for the stock. We rewrite Eq. (2.10) as:

(2.12)P0=E01+gˆkˆ−gˆ

To obtain the P/E ratio, we simply divide both sides of Eq. (2.12) by the earnings per share, to get:

(2.13)P0E0=1+gˆkˆ−gˆˆ

Eq. (2.13) shows that the P/E ratio reflects the market's forecast of the growth rate of earnings and the required return on the firm's equity. In other words, the market is willing to pay more per dollar of earnings when it forecasts a higher growth rate of earnings and/or when it has a lowered required return on the firm's stock. The higher the expected growth, the higher the P/E ratio is, holding the required return on equity constant.

Eq. (2.13) illustrates that the P/E ratio can also be thought of as a time-value-of-money multiplier that is applied to a year's earnings to determine the present value of a growing stream of earnings. Simply put, the required rate of return and growth rate combine to determine the P/E. Any terminal value that is calculated in Eq. (2.10) of an Earnings Model could be considered as the last year's earnings multiplied by some future P/E ratio that represents the appropriate combination of required return and long-term growth rate in earnings. As such, analysts can check their long-term growth forecasts and required return assumptions against the average market P/E for similar stocks. An analyst should question any forecast of a terminal growth rate relative to the required return that results in too high of a P/E compared to what is typical in the market.

Eq. (2.13) is also useful when comparing the valuation of two stocks with similar characteristics. For example, stocks from the same industry or subsector might be assumed to have the same cost of equity capital. Assuming the same kˆ, the stock with the higher P/E ratio is the stock that has higher long-term growth prospects according to the market's expectation. The security analyst who evaluates these two companies might have a different view of which company has the better growth prospects, making one company appear undervalued relative to the other. In the case in which the security analysts shares the consensus of the market as to which stock has the higher growth prospects, then the issue of which stock represents the better relative value is less clear.

The security analyst who has a good forecast of the required return on equity can rearrange Eq. (2.13) to determine the market's implied long-term growth forecast of a stock, as given by:

(2.14)gˆ=P0E0kˆ−11+P0E0

By comparing the growth estimate from Eq. (2.14) with her own long-term growth estimate, the analyst can judge whether the market is too optimistic or pessimistic about a firm's future long-term growth. That is, rather than arriving at a price estimate for the firm, the analyst need only forecast the growth rate for the firm's earnings and compare it to the implied growth rate from the market price. Any stock for which the market's implied growth rate is too low is undervalued, while stocks with too high an implied growth rate are overvalued by the market. Together, Eqs. (2.13) and (2.14) illustrate that security analysis and valuation depend critically on future long-term growth prospects. This is akin to calculating an implied volatility from an option premium and using that implied volatility rather than a calculated premium.

Money Demand and Supply Shocks

The easiest money demand shock to consider is to assume that suddenly people decide to carry more cash in their pockets. Given the monetary base, an increase in currency holding leads to a one-for-one reduction in the reserves available to the banking system, resulting in a decline in bank loans. Double entry bookkeeping and the assumption of no excess reserves tell us that as loans decline, so will deposits. Under a fractional reserve system, the decline in the deposits will be larger than the increase in currency holding by the private sector, which means that the quantity of transaction money MZM will decline, and so will the money multiplier (MZM divided by the monetary base).

To clear the credit and money markets in response to the aforementioned disturbance, the prices of credit and money have to change. First, we know that in equilibrium the price of money has to increase. The opportunity cost of holding money, for noninterest bearing liquid assets, will increase. The price of money in terms of goods must increase too. This means that the price level and/or inflation rate will decline. In turn, higher interest payments on deposits will entice people to switch back to demand deposits. Under a competitive environment, the higher interest rates paid on deposits are the result of the higher interest rates charged on loans, and the increase will be greater the lower the quality of the borrower. In other words, the credit spread will also widen.

The changes in interest rates or market-clearing prices will result in a partial offset of the initial disturbance. To the extent that the initial disturbance is not completely offset, the new equilibrium will consist of a higher price of money or lower inflation rate, a higher price of credit, and a larger spread. These changes in turn will result in the new equilibrium quantities: a higher currency holding, a lower MZM and lower deposits and bank credit. This is the one-to-one mapping that we have in mind, linking the new equilibrium quantities of money and credit to the new market-clearing prices.

A shift in the demand for currency leads to a market-clearing equilibrium process that results in a negative relationship between the equilibrium quantity of currency and the inflation rate, as well as a negative relationship between the currency holding and the opportunity costs of holding noninterest bearing money. An increase in the supply of currency would result in the opposite correlation. This analysis suggests a simple way to determine the nature of the disturbances in the money and credit markets, examine the correlation between these aggregates and determine the relevant prices.

Data presented in Fig. 37.6 shows that MZM and its currency and credit components tend to move together most of the time. The data also shows some deviations from the trend where the correlation among the different variables also deviates from the long-term trend. These are the episodes that may be used to identify disturbances in the money and credit markets as well as these markets adjustments to a new equilibrium. Fig. 37.7 presents information on the fluctuations in the currency–bank credit ratio over time. Visually the information presented in Fig. 37.7 provides a much better way to identify the different Currency–Bank Credit cycles that we have defined as our financial/monetary market disturbances. This in turn allows to infer the market-clearing prices that a new equilibrium would require.

Our earlier analysis argued that when a disturbance occurred, the prices in the money and credit market would change to eliminate any excess demand and/or supply in any of the markets. We also showed that the correlation between the market-clearing prices and the equilibrium quantities would depend on the nature of the shock, that is, a demand shock or a supply shock. Fig. 37.8A–C illustrates the correlation between the currency–bank credit ratio and different asset prices.

The information presented in Fig. 37.8A shows that prior to approximately 1990, there was a close correlation between the two variables and little or no correlation afterwards. One possible explanation for this is the organization of the monetary system. If as we believe, the Fed was pursuing a successful domestic price rule, then one would expect the inflation rate to oscillate around the price rule target, which means there will be little or no correlation between the currency–bank credit ratio and the underlying inflation rate. In effect, the Fed was fixing the price of money in terms of goods. Hence, we need to look at the other price variables as possible explanations for the market-clearing mechanisms. The information presented in Fig. 37.8A also shows that prior to the adoption of the price rule, the inflation rate leads the currency–bank credit ratio suggesting that it was the excess money creation that was “causing” the changes in the currency–bank credit ratio.

The positive correlation between the currency–bank credit ratio and the T-bill yields, the opportunity cost of holding interest bearing money, can be seen in Fig. 37.8B. The data shows a close fit during the nonprice rule period. Although the correlation appears to weaken during the price rule period, it is as expected. The T-bill mirrors the currency–bank credit cycles up to the financial crisis. Even there as the Fed kept rates near zero, the currency–bank credit ratios increased and peaked around the time that the Fed began increasing short-term rates. The final correlation between the currency–bank credit ratio is shown in Fig. 37.8C. Notice the negative correlation between the spread of the Baa corporate bond yields and the 10-year T-bond yields. The fit tightens after financial crisis.

Taken together the three graphs suggest that at different points in time, the money and credit market are subjected to different disturbances. Thus comparing the new equilibrium quantities or the new market-clearing prices to the preshock equilibrium quantities and market-clearing prices, one can infer the impact of the different shocks and the effectiveness of the measures taken by the authorities to offset these shocks.