Controlling Inflation Is Simple We Simply Control The Money Supply

Word Count: 1986 |

“Controlling inflation is simple, we simply control the money supply”. What do you think of this opinion?

This opinion expresses the monetarist’s stance, emphasizing the power of the Central Bank policy to control the economy by preserving the stability of the financial markets. This, in effect means maintaining an equilibrium between the supply and demand for money. Money, when used as a technical economic term is defined as: the stock of assets readily available to make transactions. Currency held by people is the asset with the greatest ease of transaction, and it constitutes one measure of money (C). However, there are also a multitude of deposits and bonds that have varying degrees of liquidity. Therefore, there are three further measures of money M1, M2 and M3 which include deposits and bonds depending on what counts as ‘readily available’, for that context. The measure referred to in this discussion will be M1, which is currency plus demandable deposits.

This essay starts by explaining the model which forms the basis of the the monetarist’s opinion, which gives it some justification. However, empirical evidence showing disparity between inflation and money supply, hence reducing this view’s credibility. The essay identifies its two major flaws. Firstly, the failure to recognise variation in other factors which influence the supply of money and are beyond the Central Bank’s control, namely, the banks’ and consumers’ behaviour. Secondly, and perhaps more crucially, the assumption that demand for money remains constant is simply too great to be justified. Significant fluctuations in the demand for money do occur, and inflation is affected by both supply and demand of money. Hence, monetary policy does not have full power over inflation.

The monetarist’s point of view is the outcome of the quantity theory of money, a model showing the relationship between quantity of money, price of goods and income level. It starts off assuming a simple money demand function, where money demand is dependent upon level of income. The reasoning behind this assumption is that as people have more income, they will be consuming more. In this case, they will desire to hold more money to ease the high number of transactions they carry out.

(M/D)d = kY
Supply of money= M/P

Where M= quantity of money, and P= price level. For stability in the financial markets,

M/P= (M/D)d = kY

k is then substituted for 1/V. V is the velocity with with money is exchanged. Therefore if k was high (ie there was a high real income balance for every dollar of income) then a lower velocity is required for the same net spending in the economy. Therefore,

M/k=PY
MV=PY

Y can be defined in terms of a production function. Therefore, the quantity theory assumes that V remains constant, and there is no growth in the factors of production and technology. When V and Y are not changing, then it follows that a 1% change in M (supply of money) will result in a 1% change in P (and a change in prices is by definition, inflation). It further assumes that the Central Bank has full control over the quantity of money (M), and hence we arrive at the statement posited in the title of the essay. An increase in the supply of money above the demand would result in a decrease in the value of the currency. An increase in the price, therefore, results in inflation.

Control of money supply does lie in the hands of the Central Bank to some extent, as it has the sole authority to print off currency. Theoretically, if it could always match money supply with money demand, then inflation could be controlled. This is true to some extent, as shown by three mechanisms of control of money supply used by the Central Bank. Firstly, it can purchase and sell bonds to the government, in what are known as open market operations, hence increasing or decreasing the quantity of money in the circulation. Secondly, it can place a requirement on banks to have a minimum reserve deposit rate. In other words, it places a limit on the amount of its deposits that a bank can loan out. Since the system of fractional reserve banking results in the multiplication of the quantity of money in the economy, placing a limit on the amount that governments can loan out would also limit the money multiplier. Finally, it can alter the discount rate at which it offers loans to banks. These loans enable the bank to loan out a greater part of its deposits while still fulfilling minimum reserve deposit rates. By making these loan rates more expensive, the Central Bank can encourage banks so keep a greater proportion of their deposits in reserves, again, reducing the multiplier effect.

If one looks at some empirical data, for example, the comparison of M2 growth, and inflation in the United States from 1970 to 2000 , it appears as though the relationship between inflation and money supply does hold in the long term. However, in the short term, there no longer remains a close correlation between the two variables. If the model of the quantity theory of money was true then there should be no reason for this discrepancy to exist. There are assumptions that have been made in coming to such a conclusion that distort the reality of the models’ outcomes. One such assumption is the complete control of the Central bank over money supply. A closer look at a model of money supply shows that it is affected by the behaviour of consumers and the banks, in addition the policies of the Central Bank.

To build the model, some definitions must firstly be clarified:
The monetary base, (B) is the total number of pounds held in reserves (R) and as currency by individuals (C).
The money supply (M) is the sum of (C) and demand deposits (D).
Reserve –deposit ratio (rr) is the fraction of deposits that banks hold in reserve.
Currency- deposit ratio (cr) is the fraction of demand deposits that people hold as currency.

If the monetary base, and money supply are divided by each other, and the formula are rearranged, you end up with the formula:
M= (cr+1/ cr+rr) B

Therefore, it is in fact B, the monetary based that the Central Bank has full control on. But cr and rr are not fully in the Bank’s control. Although the Central Bank places a minimum rr, and can encourage or discourage banks to take loans at discounted rates, it is powerless to stop banks from deciding to hold extra reserves, or refrain from taking loans. Beyond placing a limit, the Central Bank cannot control the business policies of banks. This in turn affects the money multiplier (cr+1/ cr+rr) and hence the quantity M. Furthermore, the cr could be highly variable and unpredictable, in contrast to what the original quantity theory of money assumes. For example, financial innovations and new facilities making it easier for people to withdraw and access their money will result in a lower ratio. A simple example is the use of the credit card, where people prefer to keep that money in a bank instead of as currency, but don’t lost ease of transaction. Given constant developments, it is difficult to predict the aggregate effect of many individual cr changes on M. Hence, it is possible that money supply can fluctuate outside the central bank’s control and therefore it is not a ‘simple’ matter to control it, and therefore control inflation.

Even if we grant however, that the Central Bank has considerable, if not complete control on money supply, it still does not allow it to control inflation. The key reason is that inflation depends on the relationship between the supply and demand of money. According to Blanchard, the unpredictable fluctuations in the demand for money in the short run are the key reason for the lack of correlation between money supply and inflation. The simple model of money demand as a function of interest and income, does not explain these fluctuations. However, Baumol Tobin model, which emphasizes money as a medium of exchange is more realistic, because it also takes into the account the cost incurred from extracting currency from the bank. The less currency one holds, the more often this cost will be incurred. Therefore, the optimum amount of money that an individual keeps is when the costs of going to extract the money from their account is equal to the benefits of keeping that sum in the bank to gain interest.

By keeping the money in the bank one gains: iY/2N
where N represents the number of times one goes to the bank.
(in words, one gains the interest on the proportion of the income that you would have withdrawn from the bank)
So if the costs from going to the bank are F, and this is equated to the benefit, it results in the following formula:

N = (iY/2F)1/2
Instead of defining N simply as demand for currency, this model can be extended to the demand for monetary assets over non monetary assets, where i is the difference in gain between the two assets, and F is the cost of transferring money from the non monetary to monetary asset.

The reason why this model is helpful is that it is immediately clear that in the short term F is higher variable. For example, a rise in real wages will increase F, because a person’s wage represents the opportunity cost of the time that an individual spends on getting money from the bank, or organising the transfer between the two types of assets. Alternately, the rise of internet banking makes transfers between monetary and non monetary funds much easier, reducing F. So, for a particular individual, their demand for money might change due to them installing broadband, because they their access to their accounts was suddenly improved! When an individuals’ demand for money is modelled on such microeconomic terms, then it is immediately clear why it can fluctuate unpredictably.

Furthermore, and most importantly, the whole concept and measurement of money demand depends on the traditional macroeconomic assumption on a clear distinction between non monetary and monetary assets. The former consist of assets which are both a store of value and a medium of exchange (eg, a checkable deposit), whereas the second category are assets that are simply stores of values (eg, a fixed term bond). However, recent financial innovations have resulted in a vast variety of deposits that have the benefits of long term deposits, but can also be accessed on short notice, blurring the distinction between these two categories. Non monetary assets that have acquired some of the liquidity of money, making them attractive substitutes for money. The ease of switching from one to the other has drastically reduced F, the costs of transferring, and therefore the distinctions between the various measures of money supply have been distorted. It poses difficulties for matching the supply of money to demand when in fact it is not clear at what level it would be optimal to measure demand!

In conclusion, the quantity theory of the money is indeed valuable in describing a direct relationship between the quantity of money in the economy and inflation. However, it is also obvious that inflation depends on both supply and demand of money. It would indeed by easy to control inflation by controlling the supply of money to match its demand, and this is seen generally in the long run. However, it is not possible to match the supply of money to short term fluctuations in demand which arise from the increasing liquidity of non-monetary assets, and changing transferring costs of non monetary to monetary assets. Moreover, the Central Bank does not have complete control over money supply, because it can only influence the decisions of banks and individuals to a certain extent. How much banks decide to keep in reserves and how much of their incomes individuals decide to keep as currency are other highly variable factors which result in the short term discrepancy between inflation and money supply.

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