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Introduction to Financial ProgrammingPowerPoint Presentation

Introduction to Financial Programming

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An alternative derivation of monetary survey

Outline

- Monetary approach to balance of payments
- Accounting relationships
- Trace linkages among
- Balance of payments accounts
- National income accounts
- Fiscal accounts
- Monetary accounts

- Proceed from linkages to financial programming

- Trace linkages among
- Financial programming in action

What is money?

1

- Liabilities of banking system to the public
- That is, the private sector and public enterprises

- M = C + T
- C = currency, T = deposits

- The broader the definition of deposits ...
- Demand deposits, time and savings deposits, etc.,

- ... the broader the corresponding definition of money
- M1, M2, M3, etc.

Balance sheet of Central Bank

DG = domestic credit to government

DB = domestic credit to commercial banks

RC = foreign reserves in Central Bank

C = currency

B = commercial bank deposits in Central Bank

Balance sheet of Commercial Banks

DP = domestic credit to private sector

RB = foreign reserves in commercial banks

B = commercial bank deposits in Central Bank

DB = domestic credit from Central Bank to commercial banks

T = time deposits

Balance sheet of banking system

Monetary Survey

D = DG + DP = net domestic credit from banking system (net domestic assets)

R = RC + RB = foreign reserves (net foreign assets)

M = money supply

A fresh view of money

The monetary survey implies the following new definition of money:

M = D + R

where M is broad money (M2), which equals narrow money (M1) + quasi-money

- One of the most useful equations in economics
- Money is, by definition, equal to the sum of domestic credit from the banking system (net domestic assets) and foreign exchange reserves in the banking system (net foreign assets)

An alternative derivation of monetary survey

- Public sector
- G – T = B + DG + DF

- Private sector
- I – S = DP - M - B

- External sector
- X – Z = R - DF

Now, add them up

An alternative derivation of monetary survey

- Public sector
- G – T = B + DG + DF

- Private sector
- I – S = DP - M - B

- External sector
- X – Z = R - DF

G – T + I – S + X – Z = 0, so left-hand sides sum to zero

An alternative derivation of monetary survey

- Publicsector
- G – T = B + DG + DF

- Privatesector
- I – S = DP - M - B

- Externalsector
- X – Z = R - DF

An alternative derivation of monetary survey

- Publicsector
- G – T = B + DG + DF

- Privatesector
- I – S = DP - M - B

- Externalsector
- X – Z = R - DF

An alternative derivation of monetary survey

- Publicsector
- G – T = B + DG + DF

- Privatesector
- I – S = DP - M - B

- Externalsector
- X – Z = R - DF

- Publicsector
- G – T = B + DG + DF

- Privatesector
- I – S = DP - M - B

- Externalsector
- X – Z = R - DF

An alternative derivation of monetary survey

Hence,

M = D + R

- Publicsector
- G – T = B + DG + DF

- Privatesector
- I – S = DP - M - B

- External sector
- X – Z = R - DF

So, adding them up, we get: 0 = D - M + R

because DG + DP = D

Monetary approach to balance of payments

The monetary survey (M = D + R) has three key implications:

- Money is endogenous
- If R increases, then M increases
- Important in open economies

- Domestic credit affects money
- If R increases, may want to reduce D to contain M

- R = M - D
- Here R = X – Z + F
- Monetary approach to balance of payments

Monetary approach to balance of payments

The monetary approach to the balance of payments (R = M - D) has the following implications:

Need to

- Forecast M
- And then

- Determine D
- In order to

- Meet target for R
- D is determined as a residual given both M and R*
- R* = reserve target, e.g., 3 months of imports

Essence of financial programming

Monetary approach to balance of payments

- Domestic credit is a policy variable that involves both monetaryand fiscal policy
- Can reduce* domestic credit(D)
- To private sector
- To public sector
- By reducing government spending
- By increasing taxes

- Monetary and fiscal policy are closely related through domestic credit

*Or rather slow down

Linkages

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Fiscal accounts

G – T = DB + DDG + DDF

Linkages

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages: Reserves

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages: Current account

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages: Foreign credit

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages: Credit to government

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages

Private sector accounts

I – S = DDP – DM – DB

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages: Bonds

Private sector accounts

I – S = DDP – DM – DB

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages: Money

Private sector accounts

I – S = DDP – DM – DB

National accounts

Y = E + X–Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Linkages: Private credit

Private sector accounts

I – S = DDP – DM – DB

National accounts

Y = E + X – Z

Balance of payments

DR = X – Z + F

= X – Z + DDF

Monetary accounts

DM = DD + DR

= DDG + DDP + DR

Fiscal accounts

G – T = DB + DDG + DDF

Model

3

- Express accounting linkages in terms of simple algebra
- Use model to describe how nominal income and reserves depend on domestic credit
- Demonstrate how BOP target translates into prescription for fiscal and monetary policy
- Financial programming in action

D = domestic credit

R = foreign reserves

DR = R-R-1 = balance of payments

P = price level

Y = real income

v = velocity

X = real exports

Px = price of exports

Z = real imports

Pz = price of imports

F = capital inflow

m = propensity to import

List of variablesTwo behavioral parameters: m and v

List of relationships

M = D + R (monetary survey)

M = (1/v)PY (money demand)

R = (1/v)PY – D (M schedule)

DR = PxX – PzZ + F (balance of payments)

PzZ = mPY (import demand)

R = PxX – mPY + F + R-1 (B schedule)

Estimate m and v by regression analysis

The M schedule

Reserves (R)

M schedule

R = (1/v)PY – D

PY = v(R + D)

1

An increase in reserves increases demand for money, and hence also income

v

D up

PY is nominal income

GNP (PY)

The B schedule

Reserves (R)

R = PxX – mPY + F + R-1

An increase in income encourages imports, so that reserves decline

m

1

F up, e down

B schedule

GNP (PY)

Solution to model

Two equations in two unknowns

- R = (1/v)PY – D
- R = PxX – mPY + F + R-1
Solution for R and PY

Multipliers: Numbers

Suppose m = ¼ and v = 4

Credit multiplier

Half of credit expansion leaks abroad through balance of payments

Economic models

Exogenous

variables

Model

Endogenous

variables

Change in domestic credit or the exchange rate

Financial programming model

Foreign reserves and nominal income

Export boom

Reserves (R)

M

C

An increase in exports increases both reserves and nominal income

A

B’

B

GNP (PY)

Exogenous

variables

Model

Endogenous

variables

Export boom or

capital inflow

Financial programming model

Foreign reserves and nominal income increase

Another experiment: Domestic credit expansion

Reserves (R)

An increase in D increases PY, but reduces R.

M

M’

D up

D up M up

PY up

PzZ up R down

A

C

B

GNP

Reserves (R)

When D falls, M also falls, so that PY goes down and PzZ also decreases. Therefore, R increases.

Here, an improvement in the reserve position is accompanied by a decrease in income.

M’

M

C

D down

R*

Too low reserves

A

B

GNP (PY)

Domestic credit contraction accompanied by devaluation

Reserves (R)

When D falls, M also falls, so that PY goes down and PzZ also decreases. Therefore, R increases.

Further, a devaluation strengthens the reserve position and helps reverse the decline in income.

M

M’

C

R*

F up, e down

B’

A

D down

B

GNP (PY)

Comparative statics: An overview

P = inflation

Experiment: Inflation goes up

Reserves (R)

An increase in inflation (p) increases v, so the M schedule becomes flatter.

Hence, R goes down and PY increases in the short run.

M

p up

M’

A

C

B schedule

GNP (PY)

Experiment: Inflation goes up

p up

X down

B shifts left

eP/P* up

Reserves (R)

An increase in inflation (p) makes domestic currency appreciate in real terms, so the B schedule shifts left.

Hence, R goes farther down and PY can rise or fall in the short run.

M

M’

p up

A

C

B schedule

B’

GNP (PY)

Numerical examples

- History and targets
- Record history, establish targets

- Forecasting
- Make forecasts for balance of payments, output and inflation, money

- Policy decisions
- Set domestic credit at a level that is consistent with forecasts as well as foreign reserve target

Financial programming step by step

- Make forecasts, set reserve target R*
- E.g., reserves at 3 months of imports

- Compute permissible imports from BOP
- More imports will jeopardize reserve target

- Infer permissible increase in nominal income from import equation
- Infer monetary expansion consistent with increase in nominal income
- Derive domestic credit as a residual: D = M – R*

- Known at beginning of program period:
- M-1 = 70, D-1 = 60, R-1 = 10
Recall: M = D + R

- X-1 = 30, Z-1 = 50, F-1 = 15 (all nominal)
Recall: DR = X – Z + F

- So, DR-1 = 30 – 50 + 15 = -5, so R-2 = 15
- Current account deficit, overall deficit

- R-1/Z-1 = 10/50 = 0.2
- Equivalent to 2.4 (= 0.2•12) months of imports
- Weak reserve position

- M-1 = 70, D-1 = 60, R-1 = 10

Forecast for balance of payments

- X grows by a third, so X = 40
- F grows by two thirds, so F = 25
- Suppose R* is set at 15 (DR* = 5)
- Z = X + F + R-1 – R*
- = 40 + 25 + 10 – 15 = 60

- Level of imports is consistent with R*
R*/Z = 15/60 = 0.25

- Equivalent to 3 (= 0.25•12) months of imports

BOP fore-casts

- Increase in Z from 50 to 60, i.e., by 20%, is consistent with R* equivalent to 3 months of imports
- Now, recall that Z depends on PY
- where P is price level and Y is output

- Hence, if income elasticity of import demand is 1, PY can increase by 20%
- E.g., 5% growth and 15% inflation

Recall M = D + R

- If PY can increase by 20%, then, if income elasticity of money demand is 2/3, M can increase by 14%
- Hence, M can expand from 70 to 80
- Alternatively, by quantity theory of money
- MV = PY
- Constant velocity means that
- %DM = %DPY = %DP + %DY
- If so, income elasticity of money demand is 1

˜

- Having set reserve target at R* = 15 and forecast M at 80, we can now compute level of credit that is consistent with our reserve target, based on M = D + R
- So, D = 80 – 15 = 65, up from 60
- DD/D-1 = 5/60 = 8%
- Quite restrictive, given that PY rises by 20%
- Implies substantial reduction in domestic credit in real terms

Financial programming step by step: Recap

Sequence of steps

R*ZYMD

Z = X + F + R-1 – R*

MV = PY

Z = mPY

D = M – R*

Conclusion

These slides will be posted on my website: www.hi.is/~gylfason

- The four mains sets of macroeconomic accounts are closely intertwined
- These interrelations form the analytical basis of financial programming
- Fund economists understand that countries differ, and they seek to help tailor financial programs to the needs of individual countries
- Even so, certain fundamental principles and relationships apply everywhere

The End

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