Money, Credit and the Economy (Routledge Revivals)

Richard Coghlan

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317828914
• Edition: 1
• Topic: Economics
• Subtopic: Monetary Policy
• Index: Economics

The Theory of Money and Finance, by the same author, provided an introduction to the basic theory and concluded by introducing the idea of monetary disequilibrium, with the money supply process operating through bank credit creation. First published in 1981, this book develops that theme and provides empirical evidence in support of such an approach.

1

Introduction

The period covered by this study presents an interesting cross section of monetary policy operations. It encompasses a quite significant change in emphasis from the attempt to stabilise interest rates to trying to stabilise the quantity of money. This change has not been abrupt but has developed over time. It was encouraged by the targets for domestic credit expansion (DCE) set by the International Monetary Fund (IMF) at the end of the 1960s, but has been particularly associated with the rapid acceleration of inflation in the mid-1970s. For the majority of the period money has, in fact, been considered not to be important.

Events rather than theories have dictated the change in policy orientation, as is evident from the variety of justifications that have been put forward to explain it. However, if such policies are to be consistently applied a firm intellectual base is required. It is not suggested that this study provides all the answers but it does address itself to the question, and attempts to develop a consistent framework.

In embarking upon this book the objective was to analyse monetary policy in the United Kingdom since 1945. It became clear, however, that it was necessary first to adopt a consistent theoretical framework within which to place the analysis. The standard models available of an exogenous money supply, or an endogenous but unimportant money supply, seemed unacceptable. What was required was somehow to tie together the two sides of banks' balance sheets, and take account of both the demand for money and the demand for credit, allowing the money supply to be endogenously determined and yet still be an important determinant of aggregate demand.

Clearly this approach — relating credit flows to money supply and the rest of the economy — is concerned with a broad definition of the money supply, and for the United Kingdom this is sterling M3 (£M3), but excluding public sector bank deposits. There has so far been little agreement on how money should be defined, which reflects the uncertainty about exactly why money is important. Such indecision naturally weakens the argument that money is important. In this case the theory leaves little room for ambiguity (see Chapter 3 below). It is also argued that narrow definitions of money will generally reflect demand pressures, and therefore do not provide independent information on the future movements of other economic variables.

The problems connected with the underlying approach to be adopted came to dominate the study, so that an important aspect of the work became associated with developing this analytical framework. Moreover, given the present emphasis on empirical estimates and computer models, it seemed necessary to provide some broad test of the main elements of the theory. Because of constraints of time and space the resultant model is small by conventional standards. Although I am somewhat sceptical of the gains to be had from a high degree of disaggregation the size has not been determined by methodological considerations, and the empirical model presented here (Chapter 5) could easily be extended. Indeed, a number of further developments would be necessary before such a model could provide an adequate means of forecasting movements in the economy. Also, because any model must be judged against the alternatives available, a survey of monetary models of the United Kingdom is included (Chapter 2), and emphasis is placed on how these differ from the present approach.

Before the model estimates are given a summary of monetary policy in the United Kingdom since 1945 is included (Chapter 4), paying particular attention to the main institutional and policy changes over the period. This gives some indication of the problems facing the authorities and the responses they have made. The estimated model tries to incorporate as much of the institutional detail as possible in addition to the main policy variables, within the constraints imposed by its size.

Having estimated the model over the full data period (1954–1976) the next step was to determine whether the main characteristics were preserved if the period of rapid monetary expansion, and the floating of sterling, in the 1970s was excluded. The model was therefore also estimated up to 1971. The introduction of Competition and Credit Control (CCC) in that year provides a convenient break point; it was followed by rapid monetary expansion, accelerating inflation and the floating of sterling. However, contrary to the more popular view the introduction of CCC is not held responsible for these changes.

Certain simulations have been conducted with the model in order to see how well it performs over the period, and also in order to get some impression of the stability and size of the dynamic multipliers resulting from exogenous shocks (Chapter 6). These results give some indication of the alternative policy measures the authorities might have taken had the theoretical approach suggested here been adopted.

Although in this study the model has been applied to the United Kingdom the approach should have wider application to other countries. Moreover, the specific empirical formulation of the general theory could probably be improved upon, and there are certainly alternative ways of giving practical expression to the ideas put forward here. For these reasons the remainder of this chapter introduces the theoretical approach adopted, which is developed in Chapter 3.

Over the period since 1945 there has been considerable debate regarding the role of money in the economy. Much of this debate has been conducted at the extremes of possibility. On the one hand, if money was to have an effect on the economy it generally had to be exogenously determined by the authorities via a high-powered money multiplier. Alternatively, if the authorities did not control the monetary base — the reserves of the banking system — the conclusion reached was that money did not matter and simply accommodated the demands for money within the economy.

Although these extreme views have continued to dominate the popular debate, encouraged by the wide use of the static IS/LM framework for macroeconomic teaching and analysis, there has been increasing discussion of the importance of money as a disequilibrium ‘buffer’ stock (for example, Jonson, 1976a). This development allows the supply of money to be endogenously determined and yet still have important effects on the dynamics of the economy. The theoretical model presented here goes further and argues for a direct relationship between the financial demands and supplies which create money, and observed expenditures. The approach develops from the arguments presented in Coghlan (1978c, 1979a, 1980a, 1980c).

The model emphasises the importance of bank credit in the process of the creation of money. The majority of monetary analysis has tended to stress only one side of banks' balance sheets. The Radcliffe Committee, for example, emphasised the importance of bank credit, but did recognise (Radcliffe Report, 1959, para 528) that it was necessary to control credit to both the private and public sector. This latter point is mentioned because of the tendency in the 1960s to implement ‘Radcliffian’ policies by restricting only private sector credit expansion. As soon as bank lending to the public sector is included we have something similar to the current definition of £M3.

The monetarists, on the other hand, have stressed the quantity of bank deposits and have generally given little attention to the associated changes in bank credit. The work of Brunner and Meltzer has been a notable exception in this respect, although they have continued to stress a multiplier relationship based on an exogenous monetary base, and more importantly have not related credit creation to expenditure decisions; see Chapter 3 and 5. There is still a marked tendency to divide the economy into two halves, defined as ‘real’ and ‘monetary’, and to build separate models to explain each half, only combining them later on (see Chapter 2). This approach tends to emphasise the role of money in a wealth portfolio rather than as a medium of exchange and means of payment, and therefore abstracts from what is the crucial characteristic of money.

The same criticism can also be made of most presentations of the monetary approach to the balance of payments (MABP), for example, the collection of papers edited by Frenkel and Johnson (1976a). Although these identify the two sides of the banks' balance sheet by emphasising the importance of DCE, this latter variable is generally taken to be determined exogenously. Overseas flows into the money supply, therefore, respond passively to movements in the demand for money given the fixed constraint on domestic credit. But there is every reason to believe that credit demands and supplies exist independently¹ of the demand for money. Not only are the components of domestic credit likely to shift in response to behavioural factors that will make control difficult, particularly if this is to be achieved through market forces via the manipulation of a restricted set of financial rates of return, but also there must surely exist direct substitution possibilities between borrowing from a domestic bank and borrowing from abroad, certainly if the borrower happens to be a multinational company.

The model developed in the following chapters brings together both sides of the banks' balance sheets. It is important to recognise that there is a difference between the demand for money, that is, the liabilities of the banks, and the demand for bank credit, that is, the assets of the banks. The latter demand is, in fact, important for explaining the supply of money. Credit demands are in turn related to expenditure decisions which produce a relationship between the supply of money and the behaviour of the so-called ‘real’ economy. This relationship I have termed the ‘primary effect’ of monetary creation; see, in particular, Chapter 4 below.

I have argued elsewhere (Coghlan, 1980b, Ch. 2) that it is easier to make sense of the standard IS/LM diagram if the IS curve is interpreted as the ‘demand for fmance’ schedule, and the LM curve as the ‘supply of finance schedule’. In the real world it is also necessary to take account of imperfections in financial markets and such things as quantitative restrictions on the availability of finance. Such an approach at least implies that it is unrealistic to separate out ‘real’ and financial markets.

The ‘real’ outcome, in terms of, say, an increase in real investment is a combination of the increase in the incentive to invest, the availability of finance to make those desires effective and the factors determining the supply of capital goods. To propose a single equation with real investment as the dependent variable on a number of influences affecting the desire to invest, possibly including a single interest rate, seems an inadequate way of capturing these underlying relationships. When explaining the level of demand in nominal terms it is necessary to take account of the extent to which finance is available. Finance is an important element in explaining effective demand; it is not part of a separate market. The extent to which these nominal demands result in an increase in real expenditures will, in turn, depend on the real forces determining the potential supply of goods and services within the economy.

In addition to these direct ‘credit’ effects there will also be continuing reactions to any disequilibrium between the demand for and supply of money. Although money will be accepted it may only be as an intermediary in the process of exchange and need not necessarily represent a position of long-run equilibrium. These reactions, which are discussed in Chapter 3, help to determine the lags of adjustment in response to any exogenous shocks to the system. This effect reflects the ‘buffer’ stock argument referred to above, and is what I have called the ‘secondary effect’ of money on the economy.

The primary and secondary effects between them provide a direct relationship between expenditures and the supply of money. Although the emphasis on the stock of money clearly distinguishes the approach from traditional Keynesian models, the explanation does not fit easily into standard monetarist theory in the sense that the money supply, and bank reserves, are endogenous to the system, and perfect markets are not assumed. In fact, as is explained in Chapter 3, it does not make much sense to think in terms of the effect of money on the economy. Because the supply of money is endogenously determined it operates as the channel through which the separate influences on the money supply work their way through the economy. Attention should, therefore, be directed at these underlying forces, from which it follows that monetary control should also be concerned with the particular causes of monetary growth, and not only with a single figure for the money supply (see also Coghlan and Sykes, 1980). It might be more accurate to think of this as a financial, or credit, approach to modelling the economy.

Accepting this approach has important implications for the interpretation of the results of previous studies. To see this it is worth considering the relationship between the present approach and the attempts to estimate the demand for money directly, and to establish unidirectional causality extending from money to the rest of the economy.

To take the demand for money studies first, it suggests that attempts to estimate demand for money equations for the broad definitions of money, employing non-simultaneous estimation techniques, should not be expected to produce stable results. Such equations would represent a misspecification of the relationship and we should not be surprised that such relationships have broken down in the United Kingdom following the rapid upsurge in the supply of money during the first half of the 1970s. Similar estimation procedures should, however, be reasonably successful in identifying demand functions for narrow definitions of money (see Coghlan, 1978b, and 1980b, Ch. 5). The difficulty in that case is in identifying the correct explanatory variables, particularly if competitive incentives are changed by an attempt by the authorities to control the quantity of money so defined. In general, however, the stock of money narrowly defined should remain demand determined.

Accepting this approach also suggests that attempts to identify unidirectional causality between money and nominal expenditures (see Coghlan, 1980b, Ch. 3, for a summary), under the assumption that money is exogenously determined, are unrealistic. Most studies of the United Kingdom have concluded that causality seems to run both ways, and that is indeed the conclusion suggested by the model presented here. Such studies may meet with some success, because of the suggested long-run (but not necessarily constant) relationship between the stock of money and nominal expenditure. The approach is, however, too simple, and money is itself assumed to be endogenously determined. It is more likely to respond with reasonable results if the main economic variables have been following a fairly stable growth path. If the economy has experienced more erratic movements it will be important to provide a coherent explanation of the way the system is supposed to work, and precisely how the supply of money affects the rest of the economy.

Finally, in concluding this introduction, it is worth re-emphasising the change in orientation of monetary policy and analysis that occured in the 1970s. It is only since 1971 (approximately) that the money supply has really been thought to be important, and consequently critics have attacked this rediscovery of money as due to spurious correlation (see Chapter 2). It will therefore be interesting to see whether the approach adopted here succeeds in explaining the earlier period. This is an extremely difficult test given the scepticism in the 1950s and 1960s regarding the importance of money. Most econometric models have changed substantially from those estimated during the 1960s, and it would be encouraging if some continuity could be identified. Furthermore, it would suggest that the events of the 1970s, in particular the rapid growth of the money supply and inflation, need not have taken the authorities so much by surprise.

Note

1 This independence refers to the existence of separate behavioural relationships, not that behaviour in each market is independent of behaviour in other markets.

2

Money in Macroeconomic Models

The objective of this chapter is to describe the main characteristics of existing econometric models of the monetary sector at a macroeconomic level, in ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Original Title Page
• Original Copyright Page
• Dedication
• Table of Contents
• 1 Introduction
• 2 Money in Macroeconomic Models
• 3 A Dynamic Model of the Supply of Money
• 4 A Survey of UK Monetary Policy Since 1945
• 5 A Monetary Model of the Economy
• 6 Model Simulations and 1971 Estimates
• 7 Implications for Monetary Policy and Analysis
• References
• Index