Monetary Economics : Policy and Its Theoretical Basis

523 Pages·2003·1.67 MB·English

Monetary Economics:
Policy and its Theoretical Basis

Monetary Economics:
Policy and its Theoretical Basis
Keith Bain
Principal Lecturer, East London Business School
University of East London
Peter Howells
Professor of Economics, East London Business School
University of East London
©Keith Bain and Peter GAHowells, 2003
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CONTENTS v
Contents
List of boxes, tables and figures ix
Preface xi
1 The Meaning of Money
1.1 Introduction 1
1.2 The various meanings of ‘money’ 3
1.3 Money in the aggregate 10
1.4 The development of money within economies 15
1.5 Summary 23
2 Definitions of Money in Economics
2.1 Introduction 27
2.2 World views and definitions of money 27
2.3 Economists’ definitions of money 33
2.4 Official measures of money 39
2.5 Summary 46
3 The Money Supply Process
3.1 Introduction 49
3.2 Bank balance sheets 52
3.3 The base-multiplier approach to money supply determination 55
3.4 The flow of funds approach 64
3.5 The two approaches compared 66
3.6 Summary 70
4 Money Supply and Control in the UK
4.1 Introduction 73
4.2 Short-term interest rates as the policy instrument 74
4.3 The rejection of monetary base control 82
4.4 Endogenous money 89
4.5 Summary 92
vi CONTENTS
5 The Theory of the Demand for Money
5.1 Introduction 95
5.2 The Quantity Theory of Money 96
5.3 The Cambridge cash balance approach 101
5.4 The General Theory and the demand for money 103
5.5 Interest rates and the transactions demand for money 113
5.6 Introducing uncertainty into transactions — models of 116
the precautionary motive
5.7 Tobin’s portfolio model of the demand for money 117
5.8 Monetarism and the demand for money 121
5.9 Microeconomic transactions models of the demand 126
for money
5.10 The theory of the demand for money: a conclusion 127
5.11 Summary 128
6 Testing the Demand for Money Function
6.1 Introduction
131
6.2 Problems in testing the demand for money
132
6.3 Early demand for money studies
143
6.4 Problems since the 1970s
148
6.5 Sceptical views of a stable demand for money function
162
6.6 Summary
167
7 The Transmission Mechanism of
Monetary Policy I — Monetary Policy and Aggregate
Demand
7.1 Introduction 171
7.2 The impact of a change in official interest rates on other
interest rates 173
7.3 The impact of interest rate changes on consumption and
investment as the policy instrument 173
7.4 The transmission mechanism with the money supply as
the policy instrument 180
7.5 The money supply with an interest rate control mechanism 195
7.6 Money supply changes in an open economy 197
7.7 Credit availability and expenditure 202
7.8 Summary 203
CONTENTS vii
8 The Transmission Mechanism of Monetary
Policy II - Aggregate Demand, Inflation and Output
8.1 Introduction 207
8.2 The simple Philips curve 209
8.3 The new classical model and policy irrelevance 216
8.4 Problems of the new classical model 219
8.5 Credibility and time inconsistency 225
8.6 The independence of central banks 231
8.7 Summary 239
9 The Theory of Monetary Policy
9.1 Introduction 243
9.2 Policy goals and instruments 244
9.3 Rules versus discretion 249
9.4 The choice of monetary instruments 255
9.5 Intermediate versus final targets 259
9.6 The selection of final targets 260
9.7 Central bank policy rules 268
9.8 Summary 271
10 The Open Economy and Monetary Policy
10.1 Introduction 275
10.2 Monetary policy with fixed exchange rates 276
10.3 Brakes on the transmission of monetary influences 279
10.4 Leadership of fixed exchange rate systems 285
10.5 Monetary policy with floating exchange rates 288
10.6 Monetary policy coordination 297
10.7 Capital mobility and the Tobin Tax 306
10.8 Summary 307
11 The Evolution of Monetary Policy in the UK
11.1 Introduction 311
11.2 UK monetary policy before 1985 312
11.3 Financial innovation and monetary policy 328
11.4 Monetary policy after monetary targets 340
11.5 Summary 348
viii CONTENTS
12 The Monetary Authorities and Financial Markets
12.1 Introduction 353
12.2 Central bank leverage 354
12.3 Market constraints 357
12.4 Markets as a source of information 363
12.5 Markets as a test of credibility 369
12.6 Summary 372
13 Monetary Policy in the European Union
13.1 Introduction 375
13.2 The membership of monetary unions 376
13.3 The UK and membership of the euro area 381
13.4 Monetary policy institutions in the euro area 388
13.5 The form of monetary policy in the euro area 396
13.6 ECB monetary policy since 1999 and the value of the euro 401
13.7 Possible reforms of the ECB strategy and procedure 411
13.8 Summary 412
14 Monetary Policy in the USA
14.1 Introduction 417
14.2 The story of central banking in the USA 417
14.3 The aims and form of monetary policy in the USA 424
14.4 The Federal Reserve - independence and accountability 431
14.5 The Federal Reserve - recent monetary policy 434
14.6 Summary
440
Appendices
I The IS/LMmodel 445
II The term structure of interest rates 459
Endnotes 464
References 474
Index 503
LISTOFBOXES, FIGURESANDTABLES ix
List of boxes, tables and figures
Box 1.1 Dictionary definitions of money 4
Table 1.1 Money transmission effects 13
Table 2.1 UKofficial definitions of money 42-3
Box 3.1 Official measures of money 50
Box 3.2 Commercial and central bank balance sheets 53
Table 3.1 An open-market sale of government bonds 54
Table 3.2 Commercial banks increase their lending 55
Table 3.3 Total transactions volumes in the UKby medium 60
Figure 3.1 The money supply curve 64
Figure 4.1 The supply of bank reserves 75
Box 4.1 Using gilt repo to raise interest rates 77
Box 4.2 The difficulties of monetary base control 84
Figure 4.2 The horizontal ‘money supply curve’ 91
Box 5.1 Velocity in the Quantity Theory of Money 99
Figure 5.1 The demand for active balances 105
Figure 5.2 The demand for idle balances 108
Box 5.2 Criticisms of Keynes’s speculative demand for money 109
Box 5.3 The principal variations on the inventory-theoretic model of
the demand for money 117
Figure 5.3 Possible combinations of portfolios 119
Figure 5.4 The effect of a fall in interest rates 120
Box 6.1 Problems in th testing of the demand for money 133
Figure 6.1 Equilibrium in the money market 135
Figure 6.2 The identification problem with endogenous money 136
Box 6.2 Explaining the instability of demand for money functions 148
Box 6.3 Financial innovation and the demand for money 156
Box 7.1 Interest rate control and the transmission mechanism 172
Figure 7.1 The transmission mechanism of monetary policy 178
Figure 7.2 Return to money market equilibrium 181
Figure 7.3 An increase in money supply 184
Figure 7.4 Unstable money demand 185
Figure 7.5 Money supply and wealth effects 187
Figure 7.6 Government spending and money supply 188
Figure 7.7 Expansionary monetary policy with flexible exchange rates 197