Financial Programming Thorvaldur Gylfason An Introduction

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  Analytical model Financial programming in action

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, etc. 1

Overview of banking system

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

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

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

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

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).

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

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

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

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

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

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

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

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

 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

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 slow down

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Multipliers: Algebra

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

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

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

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

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

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

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

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

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

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)

Comparative statics: An overview DPxXPxXFe  R PY  = inflation

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

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

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 example 4

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

Known at beginning of program period:  M -1 = 800, D -1 = 700, R -1 = 100 Recall: M = D + R  P x X -1 = 750, Z -1 = 800, F -1 = 50 Recall:  R = P x X – P z Z + F So,  R -1 = 750 – = 0 Current account deficit, overall balance Current account deficit, overall balance  R -1 /P z Z -1 = 100/800 = Equivalent to 1.5 (= ) months of imports Equivalent to 1.5 (= ) months of imports Weak reserve position Weak reserve position History 1.5 months = 6 weeks

P x X grows by a third, so P x X = 1,000 F doubles, so F = 100 Suppose R* is set at 240. Then P z Z = P x X + F + R -1 – R* = 1, – 240 = 960 Level of imports is consistent with R* R * /P z Z = 240/960 = 0.25 Equivalent to 3 (= ) months of imports Equivalent to 3 (= ) months of imports Forecast for balance of payments BOP fore- casts

Increase in P z Z from 800 to 960, i.e., by 20%, is consistent with R * equivalent to 3 months of imports Now, recall that P z 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

If PY can increase by 20%, then, if income elasticity of money demand is 1, M can also increase by 20% Recall quantity theory of money MV = PY Constant velocity means that %  M = %  PY = %  P + %  Y Hence, M can expand from 800 to 960 Forecast for money ˜ M = D + R Recall M = D + R

Having set reserve target at R* = 240 and forecast M at 960, we can now compute level of credit that is consistent with our reserve target, based on M = D + R So, D = 960 – 240 = 720, up from 700  D/D -1 = 20/700 = 2.9% 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

P x X grows by a third, so P x X = 1,000 F doubles, so F = 100, as before R* is now set at 200, not 240. Then P z Z = P x X + F + R -1 – R* = 1, – 200 = 1,000 Level of imports is consistent with R* R * /P z Z = 200/1000 = 0.2 Equivalent to 2.4 (= 0.212) months of imports Equivalent to 2.4 (= 0.212) months of imports Forecast for balance of payments BOP fore- casts So try again

Increase in P z Z from 800 to 1,000, i.e., by 25%, is consistent with R * equivalent to 2.4 months of imports Now, recall that P z 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 25% E.g., 5% growth and 20% inflation, roughly E.g., 5% growth and 20% inflation, roughly Forecast for real sector

If PY can increase by 25%, then, if income elasticity of money demand is 1, M can also increase by 25% However, if income elasticity of money demand is 0.8, M can increase by only 20% as before Hence, if the income elasticity is 1, M can expand from 800 to 1,000 Forecast for money M = D + R Recall M = D + R

Having set reserve target at R* = 200 and forecast M at 1,000, we can now compute level of credit that is consistent with our reserve target, based on M = D + R So, D = 1,000 – 200 = 800, up from 700  D/D -1 = 100/700 = 14% Still restrictive, given that PY rises by 25%, but less restrictive than before Still restrictive, given that PY rises by 25%, but less restrictive than before Determination of credit

Known at beginning of program period:  M -1 = 800, D -1 = 700, R -1 = 100 Recall: M = D + R  X -1 = 500, Z -1 = 600, F -1 = 50 Recall:  R = P x X – P z Z + F So,  R -1 = 500 – = -50 Current account deficit (-100), smaller overall deficit Current account deficit (-100), smaller overall deficit  R -1 /P z Z -1 = 100/600 = Equivalent to 2 (= 0.167*12) months of imports Equivalent to 2 (= 0.167*12) months of imports Weak reserve position Weak reserve position History Once more

P x X grows by 40%, so P x X = 700 F doubles, so F = 100 Suppose R* is set at 180. Then P z Z = P x X + F + R -1 – R* = – 180 = 720 Level of imports is consistent with R* R * /P z Z = 180/720 = 0.25 Equivalent to 3 (= 0.25*12) months of imports Equivalent to 3 (= 0.25*12) months of imports Forecast for balance of payments BOP fore- casts

Increase in P z Z from 600 to 720, i.e., by 20%, is consistent with R * equivalent to 3 months of imports But P z 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

If PY can increase by 20%, then, if income elasticity of money demand is 1, M can also increase by 20% Hence, M can expand from 800 to 960 Forecast for money M = D + R Recall M = D + R

Having set reserve target at R* = 180 and forecast M at 960, we can now compute level of credit that is consistent with our reserve target So, D = 960 – 180 = 780, up from 700  D/D -1 = 80/700 = 11% Quite restrictive, given that PY rises by 25% Quite restrictive, given that PY rises by 25% Implies substantial reduction in domestic credit in real terms Implies substantial reduction in domestic credit in real terms Determination of credit

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

Conclusion These slides will be posted on my website: The End  Financial programming is an oral tradition that spans the entire history of the IMF  When expressed in simple algebra, financial programming is not to be taken literally as a one-size-fits-all model 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