0115 966 7955 Today's Opening Times 10:30 - 17:00 (BST)

Literature regarding money supply and interest rates


Disclaimer: This essay has been submitted by a student. This is not an example of the work written by our professional essay writers. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

In this chapter, the theoretical model is further developed by looking at the important literature relevant for my thesis. Thus this chapter contains the review of all the articles and research works which I have researched to develop my understanding of the important variables and their relationships. Also monetary reforms and central bank's independence is talked about in the light of relevant and interesting literature.

Chapter 2: Literature Review

2.1: Money Supply and interest rates

I have given the definition of money supply in detail in my introduction while I have explained its concept in detail there. However, in the first part of my literature review, I would explicitly like to cite Anna Schwartz and her article "Money Supply" from the library of economics and liberty. In this article, Anna Schwartz goes a long way in describing the concept of money supply and the fact that money is a crucial factor in the macroeconomics of a country. She also talks in length about the Fed and its role as the chief of the monetary policy of the US.

Firstly Schwartz talks about what money supply really is, especially in the context of the US. She talks about how in 1971, the concept of money from the days of the gold standard changed to the concept of fiat money, which is what we have these days. Then she goes on to explain why money is so important and which is why she says that "Because money is used in virtually all economic transactions, it has a powerful effect on economic activity". She tells us about links between interest rates, investment, exchange rates and GDP growth to illustrate that. Then she talks about what determines interest rates and here she says that the Federal Reserve Policy is the most important determinants. She says that if the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. As each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and thus create new deposits, until all excess reserves are used up. She talks about the reserve and currency components of money multiplier to support her argument, which I already illustrated in my introduction. Here she goes on to say that "In a fractional reserve banking system, drains of currency from banks reduce their reserves, and unless the Federal Reserve provides adequate additional amounts of currency and reserves, a multiple contraction of deposits results, reducing the quantity of money. Currency and bank reserves added together equal the monetary base, sometimes known as high-powered money. The Federal Reserve has the power to control the issue of both components. By adjusting the levels of banks' reserve balances, over several quarters it can achieve a desired rate of growth of deposits and of the money supply. When the public and the banks change the ratio of their currency and reserves to deposits, the Federal Reserve can offset the effect on the money supply by changing reserves and/or currency."

Here she also gives discloses an important aspect. She says that The Fed has interpreted a rise in interest rates as tighter monetary policy and a fall as easier monetary policy. But interest rates are an imperfect indicator of monetary policy. If easy monetary policy is expected to cause inflation, lenders demand a higher interest rate to compensate for this inflation, and borrowers are willing to pay a higher rate because inflation reduces the value of the dollars they repay. Thus, an increase in expected inflation increases interest rates. Similarly, if tight monetary policy is expected to reduce inflation, interest rates could fall. And finally she says that the lesson that the history of money supply teaches, by giving the experience of the US, is that to ignore the magnitude of money supply changes is to court monetary disorder.

Anna Schwartz is one of the founders of the monetarists' school of thought. Her views regarding money supply are as spot on and respected as there are of any other economist, alongside Milton Friedman. In this article, she has illustrated some very important and impressive facts. Her explicit discussion of money supply, especially in the context of the US is highly enlightening. Also, she mentioned a very important fact which many people overlook. Its not always the case that interest rates and money supply have an inverse relationship. In some cases it is possible, as seen historically, that they might have the same relationship. She is spot on when she says that the role of the central bank, particularly in the US, in determining the growth in money supply is vital and it can't be overlooked. Here the independence and autonomy of the central bank has also been indirectly highlighted.

Another very important paper concerning money supply and interest rates is "Money supply and the implementation of interest rate targets" by Andreas Schabert. Now to summarize the article briefly the analysis in this paper leads to results which seem to be inconsistent with the conservative view. Firstly, it is found that the relation between money supply and interest rate targets is less impulsive. In particular, an increase in money supply is in general associated with higher nominal interest rates. This result, which is due to the lack of a liquidity effect, implies that an expansionary money supply is accompanied by a change in the interest rate, which looks like a contractionary monetary stance. However, the empirical evidence on liquidity effects is not unambiguous. Hence, the link between money and interest rate as revealed in the analysis is not necessarily counterfactual, though it is different than anticipated or described in most undergraduate macroeconomic textbooks. Secondly, it turns out that highly stylized interest rate goals cannot be implemented by non-destabilizing adjustments of the outstanding stock of money, i.e., by money supply procedures that for instance avoid hyperinflations.

Overall, the findings in this paper show that the conjectural relation between money supply and interest rate targets is less inborn than anticipated. On the one hand, the lack of a strong liquidity effect implies that an immediate rise in the interest rate in response to higher inflation can only be brought about by an obliging money supply. Further, it is responsible for the central bank not to be able to implement an aggressive interest rate target by a stabilizing money supply process, if the interest rate target is purely forward looking. On the other hand, standard macroeconomic theory predicts that interest rate targets, which are consistent with empirical evidence, can be implemented by a non-accommodating money supply, though in a non-unique way. These findings indicate that the common assumption of frictionless financial/ money markets hinders a full comprehension of monetary policy implementation. Nonetheless, this assumption, which facilitates the macroeconomic analysis of monetary policy, can be viewed as a reasonable generalization, provided that it matters only for the impact of changes in money supply on interest rates. Otherwise, money market frictions might be non-negligible even for macroeconomic effects of monetary policy.

This paper highlights key aspects of the relationship, which was earlier pointed out by Anna Schwartz, between money supply and interest rates, which isn't always inverse. In fact, on many occasions it is direct and positive. Also the paper talks about the role of the central bank for a strong monetary policy in the country which is very true. The fact that central banks are responsible for the monetary policy of the country means that they have to act independently and with full effectiveness to make sure that a country is heading towards optimal monetary policy.

2.2: Monetary Policy in Pakistan

In terms of the monetary policy pursued in Pakistan, there were many articles which I found of immense relevance. I will just briefly mention about them. Firstly, the paper 'Monetary Policy Objectives in Pakistan: An Empirical Investigation' by Wasim Shah Malik from Pakistan Institute of Development Economics Islamabad, talks about the core objectives of the SBP and its performance with regards to those policies. The paper states that the Taylor rule (1993) focuses only on two objectives: output and inflation. In practice, the central bank's loss function (especially in developing countries) contains objectives other than these two, like the interest rate smoothing, exchange rate stabilization, etc. In this study, the monetary policy reaction function has been anticipated, including five objectives for monetary policy as well as controlling for the effect of three other factors. The author has chosen short term interest rates as the indicator of money supply. Whereas the results confirm the counter-cyclical response of monetary policy to the factors in the loss function, the response of interest rate to changes in the foreign exchange reserves and the government borrowing has been negative.. Other variables, in explaining variation in the interest rate, can be ranked as inflation, government borrowing, exchange rate, output gap, trade deficit, and, finally, the foreign exchange reserves.

Now in terms of the 5 variables that the author has chosen, he has given authentic and right justification and theoretical clarification for choosing them, while the 5 variables mirror those which I have chosen for my research as well. Thus this paper is extremely important for my theoretical foundation. The paper clearly wants to highlights that the SBP isn't too concerned about output or inflation, which is bizarre as it is its fundamental objective, while trade deficit and government borrowing is more of an issue for the SBP. The author is highly critical of the SBP.

Another paper I should talk about is 'Monetary Policy Transparency in Pakistan: An Independent Analysis', by Wasim Shahid Malik and Musleh-ud Din. The paper talks about the fact that the SBP is very opaque in its monetary policy. This paper analyses monetary policy transparency of the central bank (SBP) using the Eijffinger and Geraats (2006) index. The results show that the SBP scores 4.5 out of 15, which is lower than any of the central banks' score in Eijffinger and Geraats (2006). The SBP is completely opaque on the procedural issues, whereas it is the least transparent in the policy transparency. On the political and the economic matters, the SBP is partially transparent. An area where the SBP is quite transparent, with moderate score, is operational transparency. In comparison with the other central banks, the SBP is at par with some of the central banks in political and operational transparency but ranks behind in all other respects. Again this paper is highly critical of SBP's opaque and back-channel monetary 'diplomacy' and policymaking which compromises the monetary policymaking.

One more paper of note is 'Transmission Mechanism of Monetary Policy in Pakistan', by Asif Idrees Agha, Noor Ahmed, Yasir Ali Mubarik and Hastam Shah. This paper uses vector autoregressions to examine the monetary transmission mechanism in Pakistan. The results indicate that monetary tightening leads first to a fall in domestic demand, primarily investment demand financed by bank lending, which translates into a gradual reduction in price pressures that eventually reduces the overall price level with a significant lag. In addition to the traditional interest rate channel, the results point to a transmission mechanism in which banks play an important role. The authors have also found an active asset price channel. The exchange rate channel has been less significant by comparison.

Furthermore, another article, 'Effectiveness of monetary policy' rightly affects the effectiveness of SBP's monetary policy in reducing inflation and improving economic growth and lists the following for improving efficiency:

• Institutionalizing the process of strategy formulation and demeanor,

• Stepping up movement towards a more market based credit allocation mechanism,

• Developing its critical and operational capacity,

• Bettering its capabilities to assess future developments to proceed proactively, and

• Improving upon the communication of policy stance to the general public.

Also, the article states that the improved efficiency of the Monetary and Fiscal Coordination Board is a must, while timely and quality information is extremely important and that government borrowing must be curtailed to improve the effectiveness of SBP's monetary policy. I for one highly praise the author for bringing up the importance of monetary policy's effectiveness and the role of government and the MFPCB is its ineffectiveness.

Finally another research paper, 'Monetary Overhang in Pakistan' by Moinuddin, firstly talks about what monetary overhang really is and states its impact on Pakistan's economy. According to the paper, "Generally, the term monetary overhang refers to a situation of excess money supply relative to nominal GDP. The term monetary overhang has also been used to describe the situation where people have money holding but unable to spend it due to price controls or/and quantity rationing". Then it estimates through a model that monetary overhang is a major determinant of inflation in Pakistan, and rightly so since excess money in the hands of people will always leads to higher inflation. It also talked about how our monetary aggregate should be M3 rather than M2.

2.3: Determinants of Money Supply besides interest rates

2.3.1: GDP growth

In terms of the determinants of money supply, the first major determinant is GDP growth. There were a number of readings which I consulted which proved this fact. There are many economists, particularly the Fisher, Keynesian and finally monetarist school of thought who have talked about this relationship which GDP growth has on money supply growth. Many books have mentioned the theories of these great economists, which I have already quoted in my introduction. In terms of the research papers and articles, the first article is titled 'Relationship between the Money Supply and Nominal GDP'. This article talks about the major relationship between GDP growth and money supply through the Fisher equation ;M=PY/V, where money supply is directly and positively related to economic growth. The article states that this is the original equation which shows the relationship between money supply and growth, while also stating his proposed equation to state a relationship. However, he himself states that it is flawed but in the future with some refinement it can be improved. Another paper titled 'Money Supply And Real GDP: The Case Of The Czech Republic', by Radek Bednarik states that there is a mutual and important relationship between money supply and economic growth, and states the relationship in the context of Czech Republic. Again it talks about the quantity theory of money as being the major equation for the determination of this relationship. The author says that there is a evidence in the Republic that the relationship is indeed important and mutual, with a direct and positive relationship evident, just as the quantity theory of money relationship states. This paper is a direct reflection of my work in this thesis where I provide enough evidence throughout this thesis to point out the mutual and direct relationship between economic growth and money supply.

2.3.2: Government Borrowing

Government borrowing is another very important and fundamental determinant of money supply. According to the research paper 'Government Borrowing from the Banking System: Implications For Monetary And Financial Stability', the paper gives a background of the persistent government borrowing in Pakistan over the years and how it has had an impact on the fiscal and monetary imbalances. It states that for one, borrowing from the central bank is akin to printing money, and feeds directly into inflationary pressures. In effect, such monetization of the fiscal deficit dilutes the monetary policy stance, as has been the case in Pakistan where the impact of monetary tightening in controlling inflation has only been partially successful given government's heavy reliance on borrowing from the SBP. Also financing from the central bank jeopardizes monetary stability. Empirical evidence suggests that persistently high inflation has a negative correlation with economic growth. This is particularly evident when government borrows from the SBP. For this article it is pretty clear that government borrowing is indeed a nuisance no on both the fiscal and monetary front of the economy. The government has to curb this increasing trend in order to improve the macroeconomic indicators, and to curb the increase in money supply growth.

Another article 'Does Volatility in Government Borrowing Leads to Higher Inflation? Evidence From Pakistan' by Adnan Haider and Safdar Ullah Khan talks about government borrowing and its effects on inflation through increased money supply. It talks about how increased government borrowing has led to an increased growth in the money supply which has compounded the inflationary problems in the country. Also, it then states that inflation has several adverse effects on the economy and the citizens of the country in general, which means that volatile and high money growth leads to several other adverse consequences on the country. Thus it is important, as the authors are trying to point out, to control and limit the growth of money supply to adjustable and tolerable levels.

2.3.3: Exchange Rate Volatility

Another important determinant of money supply is exchange rate volatility. Ever since Pakistan is following a floating exchange rate system, the country has seen significant volatility in exchange rates. The only article of note which I could find which explained the relationship between exchange rate volatility and money supply is titled 'How External Shocks and Exchange Rate Depreciations Affect Pakistan? Implications for Choice of an Exchange Rate Regime' by Shaghil Ahmad, Iffat Ara and Kalim Haider. This research paper shows that external shocks are important in driving economic fluctuations in Pakistan and their importance has increased since September 11, 2001. The primary source of external shocks is foreign remittances, while foreign productivity has a restricted outcome. Keeping fixed external factors, an exogenous real exchange rate depreciation shock worsens output-a positive effect on real net exports (largely resulting from import density rather export expansion)-is more than offset by a decline in domestic demand. The absence of common shocks with major trading partners, the importance of remittances, conventional expansionary effects on the trade balance following a real currency depreciation, and only partial evidence that credibility of anti-inflationary policy would improve with a currency peg support greater exchange rate flexibility. However, the rather large contractionary effects of real exchange rate depreciation on domestic demand suggest that greater exchange rate flexibility could destabilize aggregate output. In terms of the relationship between exchange rates volatility and money supply, the paper says that greater the exchange rate volatility, greater is the volatility in the growth of money supply. In case of developing countries with a floating exchange rate regime, against the much stronger US dollar, their currencies have shown a historic trend of depreciation, which leads to a decline of their currency as compared to the world currency making their goods cheaper. Thus more people buy their goods which mean a greater transfer of money to their country, thus increasing their growth in money supply. The similar is the case with Pakistan, which is why we have seen this same trend.

2.3.4: Money supply and political regime

One article of importance to support the relationship between money supply growth and various political regimes is titled 'Monetary and Fiscal Policy Coordination: Evidence in Pakistan' by M.F Arby. This article basically points out the importance of monetary and fiscal policy coordination for the betterment of the economy in general. The author states that in military regimes there have been more instances of coordination recorded as compared to civilian regimes. That has meant that money supply has in fact fallen than in previous years in the military regimes, since coordinating policymaking has led to important findings which have necessitated a decline in money supply in military regimes owing to high levels of money supply growth in civilian regimes for the government's own purposes. This article paints a true picture of what has happened in the civilian regimes where due to the governments' own gains, they 'influenced' the government into increased money printing for election purposes as well as to finance ever growing deficits, which has not been so high in military regimes.

2.4: Monetary and Financial reforms

Many countries around the world have at some stage gone through rigorous financial reforms aimed at improving the efficiency and effectiveness of the financial and monetary systems. Most of the developing countries have gone through these reforms in the 1990's and Pakistan is one of those countries. There are a couple of important articles which talk about these reforms and their impact. The first article is 'Financial Reforms and Dynamics of Capital Structure Choice: A Case of Publically Listed Firms of Pakistan' by Khalid Shah. The author talks about how financial reforms of the 1990's have affected the financial institutions of the country. The article finds that the reforms have had an adverse effect on these companies. Their leverage has decreased drastically since the 1990's, while the paper also finds that the adjustment process of capital structure was very slow by these companies. Companies have shifted from debt to equity in these financial reforms which, according to my analysis proves that the companies in Pakistan have been extremely wary of the financial reforms in Pakistan and aren't too confident with the reforms and their impact on the financial systems of Pakistan.

Another article which talks about the effectiveness and usefulness of monetary reforms is 'The credibility of monetary reform - New evidence' by Andreas Freytag. The author tries to point out the factors which make monetary reforms useful. The paper allows for the conclusion that monetary commitment, the consideration of institutional constraints and abstinence from the money press are crucial for the success of a monetary reform. It is necessary to also consider detailed institutional circumstances of the country. This is why I believe Pakistan hasn't been as successful in its monetary reforms as it its institutions aren't as strong as they should have been. Also the government's role and its credibility and its seriousness are very important, which can also be questioned of all the governments since the 1990's in Pakistan. These are strong reasons to indicate why financial/monetary reforms haven't produced the desired results in Pakistan.

2.5: Autonomy of central banks and SBP

This is where I come down to the most important part of my literature review; to analysis how previous research papers, articles or journals have described the effect that central bank independence/autonomy has on money supply growth and the economy in general. The greater the autonomy, greater is the control of the central bank on money supply growth and less is the meddling of the federal government in monetary policymaking and more is the control on government borrowing. This is exactly what the first article which I went through discussed. The article 'The Impact of Central Bank Independence on Political Monetary Cycles in Advanced

and Developing Nations' which examines the extent to which monetary policy is manipulated for political purposes during elections. We do not detect political monetary cycles in advanced countries or developing nations with independent central banks. We do find evidence, however, in developing countries that lack central bank independence. The same is the case with Pakistan. Central banks in developing countries are less independent from the central government compared to their advanced economy counterparts. There are two primary channels through which political manipulation of monetary policy might operate before or during election years. The first is what we call the Phillips curve channel, in which politicians pressure the central bank to loosen monetary policy to stimulate the economy. The second is the fiscal-financing channel, whereby politicians force the central bank to finance election-related increases in government spending. Throughout its history, the SBP has been the subject of this government meddling and we have seen increasing trends of government borrowing and government pressures on the SBP to loosen up the monetary policy, even after the perceived and so-called independence and declared autonomy in 1994.

Another research paper which talks about central bank independence is 'Political Institutions and Central Bank Independence: a cross-sectional analysis' by Fatholla Bagheri and Nader Habibi. This paper talks about how political stability and political freedom positively affects the central bank's independence.

Finally a State Bank publication 'Pakistan 10 Year Strategy Paper for Banking Sector Reforms' talks about banking sector reforms which includes the autonomy of SBP. The paper gives a detailed plan for banking reforms, and talks about how well the banking sector has been doing over the past few years. But in the end, the paper talks about greater autonomy and independence of SBP in monetary policy. It says that it is imperative, for a strong financial system and a good monetary policy governance to have an independent and autonomous SBP. It is important that the law give SBP a clear focus and necessary powers to ensure monetary and financial stability. Also, the article rightly points out that there is a need to change the SBP act, while most modern central banks are being given autonomy because countries realize for improved monetary and financial performance and for the betterment of the economy in general, it is imperative for central banks to be autonomous. There is a need for money supply growth to be controlled and independent of the central government which always manipulates it for its own betterment while making the economy worse off.

To export a reference to this article please select a referencing stye below:

Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

More from UK Essays

We can help with your essay
Find out more