1. Interrelations Among Macroeconomic Accounts Thorvaldur Gylfason Livingstone, Zambia 10-21 April 2006

2. Outline balance of payments  Monetary approach to balance of payments  Accounting relationships linkages Trace linkages among oBalance of payments accounts oNational income accounts oFiscal accounts oMonetary accounts financial programming Proceed from linkages to financial programming  Numerical examples

3. What is money? banking system  Liabilities of banking system to the public That is, the private sector and public enterprises M = C + T  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 M 1, M 2, M 3, etc. 1

4. Overview of banking system

5. Balance sheet of Central Bank AssetsLiabilities DGDG C DBDB B RCRC D G = domestic credit to government D B = domestic credit to commercial banks R C = foreign reserves in Central Bank C = currency B = commercial bank deposits in Central Bank

6. Balance sheet of Commercial Banks AssetsLiabilities DPDP DBDB RBRB T B D P = domestic credit to private sector R B = foreign reserves in commercial banks B = commercial bank deposits in Central Bank D B = domestic credit from Central Bank to commercial banks T = time deposits

7. D G + D P + D B + R B + R C + B = C + T + B + D B Adding up the two balance sheets D R M Hence, M = D + R

8. Balance sheet of banking system Monetary Survey AssetsLiabilities DM R D = D G + D P = net domestic credit from banking system (net domestic assets) R = R C + R B = foreign reserves (net foreign assets) M = money supply

9. A fresh view of money The monetary survey implies the following new definition of money: M = D + R where M is broad money (M 2 ), which equals narrow money (M 1 ) + 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)

10. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F Now, add them up

11. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F G – T + I – S + X – Z = 0, so left-hand sides sum to zero

12. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

13. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

14. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

15. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

16. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F So, adding them up, we get: 0 =  D -  M +  R D G + D P = D because D G + D P = D Hence, M = D + R

17. Monetary approach to balance of payments M = D + R The monetary survey (M = D + R) has three key implications: endogenous  Money is endogenous RM If R increases, then M increases Important in open economies  Domestic credit  Domestic credit affects money RDM If R increases, may want to reduce D to contain M   R =  M -  D  R = X – Z + F Here  R = X – Z + F Monetary approach to balance of payments

18.  R =  M -  D 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 DMR* D is determined as a residual given both M and R* R* R* = reserve target, e.g., 3 months of imports Essence of financial programming

19. Monetary approach to balance of payments  Domestic credit is a policy variable that involves both monetary and fiscal policy D  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

20. Linkages Balance of payments  R = X – Z + F = X – Z +  D F 2

21. Linkages Balance of payments  R = X – Z + F = X – Z +  D F National accounts Y = E + X – Z

22. Linkages Balance of payments  R = X – Z + F = X – Z +  D F National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

23. Linkages Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

24. Linkages: Reserves Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

25. Linkages: Current account Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

26. Linkages: Foreign credit Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

27. Linkages: Credit to government Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

28. Linkages Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

29. Linkages: Bonds Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

30. Linkages: Money Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

31. Linkages: Private credit Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

32. Model  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 3

33. List of variables M = money D = domestic credit R = foreign reserves  R = R-R -1 = balance of payments P = price level Y = real income v = velocity X = real exports P x = price of exports Z = real imports P z = price of imports F = capital inflow m = propensity to import Two behavioral parameters: m and v

34. List of relationships M = D + R (monetary survey) M = (1/v)PY (money demand) R = (1/v)PY – D (M schedule)  R = P x X – P z Z + F (balance of payments) P z Z = mPY (import demand) R = P x X – mPY + F + R -1 (B schedule) Estimate m and v by regression analysis

35. The M schedule Reserves (R) GNP (PY) M schedule 1 v R = (1/v)PY – D D up An increase in reserves increases demand for money, and hence also income PY = v(R + D) PY is nominal income

36. The B schedule Reserves (R) GNP (PY) B schedule 1 m R = P x X – mPY + F + R -1 F up, e down An increase in income encourages imports, so that reserves decline

37. Solution to model Two equations in two unknowns 1) R = (1/v)PY – D 2) R = P x X – mPY + F + R -1 Solution for R and PY

38. Multipliers: Algebra

39. Multipliers: Numbers Suppose m = ¼ and v = 4 Credit multiplier Half of credit expansion leaks abroad through balance of payments

40. Macroeconomic equilibrium GNP (PY) M schedule Equilibrium B schedule Reserves (R) D up F up, e down

41. Economic models Exogenous variables Endogenous variables Model Change in domestic credit or the exchange rate Financial programming model Foreign reserves and nominal income

42. Experiment: Export boom M schedule B schedule Reserves (R) GNP (PY) A

43. Export boom GNP (PY) M B B’ A C Exports increase Reserves (R)

44. Export boom GNP (PY) M B B’ A C Reserves (R) An increase in exports increases both reserves and nominal income

45. An interpretation Exogenous variables Endogenous variables Model Export boom or capital inflow Financial programming model Foreign reserves and nominal income increase

46. Another experiment: Domestic credit expansion GNP M B D up M’ A C An increase in D increases PY, but reduces R. Reserves (R) D up M up PY up P z Z up R down

47. Domestic credit contraction GNP (PY) M B D down M’ A When D falls, M also falls, so that PY goes down and P z Z also decreases. Therefore, R increases. Here, an improvement in the reserve position is accompanied by a decrease in income. R* C Reserves (R) Too low reserves

48. Domestic credit contraction accompanied by devaluation GNP (PY) M B F up, e down D down B’ M’ A C When D falls, M also falls, so that PY goes down and P z Z also decreases. Therefore, R increases. Further, a devaluation strengthens the reserve position and helps reverse the decline in income. R* Reserves (R)

49. Comparative statics: An overview DPxXPxXFe  R -++-- PY +++-+  = inflation

50. Experiment: Inflation goes up M B schedule Reserves (R) GNP (PY) M’ A C An increase in inflation (  ) increases v, so the M schedule becomes flatter. Hence, R goes down and PY increases in the short run.  up

51. Experiment: Inflation goes up M B schedule Reserves (R) GNP (PY) M’ A C An increase in inflation (  ) 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.  up B’  up eP/P* up X downB shifts left

52. 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 Numerical examples 3

53. 1)Make forecasts, set reserve target R* –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual: D = M – R* Financial programming step by step

54. 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:  R = X – Z + F So,  R -1 = 30 – 50 + 15 = -5, so R -2 = 15 Current account deficit, overall deficit Current account deficit, overall deficit  R -1 /Z -1 = 10/50 = 0.2 Equivalent to 2.4 (= 0.212) months of imports Equivalent to 2.4 (= 0.212) months of imports Weak reserve position Weak reserve position History

55. X grows by a third, so X = 40 F grows by 40%, so F = 25 Suppose R* is set at 15 (  R* = 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 (= 0.2512) months of imports Equivalent to 3 (= 0.2512) months of imports Forecast for balance of payments BOP fore- casts

56. 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 E.g., 5% growth and 15% inflation Forecast for real sector

57. 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 %  M = %  PY = %  P + %  Y If so, income elasticity of money demand is 1 Forecast for money ˜ M = D + R Recall M = D + R

58. 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  D/D -1 = 5/60 = 8% Quite restrictive, given that PY rises by 20% Quite restrictive, given that PY rises by 20% Implies substantial reduction in domestic credit in real terms Implies substantial reduction in domestic credit in real terms Determination of credit

59. Financial programming step by step: Recap Sequence of steps R* Z Y M D Z = X + F + R -1 – R * Z = mPY MV = PY D = M – R *

60. Conclusion These slides will be posted on my website: www.hi.is/~gylfason The End  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