Domestic Money Supply Research Articles

Monetary Model of Exchange Rate: Empirical Evidence from Malawi

In this paper, we examine the monetary model of the Malawi Kwacha - U.S. dollar exchange rate during the current floating exchange rate system by applying several recent developments in the econometrics of unit roots and cointegration. Several interesting and important results are found. A single cointegration equation is identified whose coefficients conform to the restriction implied by the monetary model. The short run equation indicates the following results: First, the domestic interest rate has a negative sign, which indicates that increases in the domestic interest rate lead to an appreciation of the Malawi Kwacha. Domestic money supply has a positive sign, which implies that reductions in domestic money supply lead to an appreciation of the Malawi Kwacha. These results have led to the following conclusions. First, we have demonstrated through the use of Johansen's multivariate cointegration technique that an unrestricted monetary model does provide a valid explanation of the long-run nominal Malawi Kwacha - US dollar exchange rate, thus lending support to the interpretation of the model as describing a long run equilibrium relationship. Second, money supply can be employed as a tool to influence the exchange rate. This arises because a reduction in the nominal money supply through open market operations raises domestic rate of interest rate for given money demand in the short run. The increase in domestic interest rate results in an incipient short-term capital inflow. This causes the exchange rate to appreciate. Finally, the correct sign and significance of the foreign country interest rate signify the role of currency market liberalization and it is a justification of our choice of RSA as Malawi's major trading partner in our model.

The dynamics of inflation and currency substitution in a small open economy

This paper analyzes the relationship between money and inflation in a small open economy, where domestic and foreign currencies are perfect substitutes as means of payment. It is shown that, if the path of domestic money supply is such that individuals find it optimal to change the currency in which transactions are settled, there will be an adjustment period during which domestic inflation adjusts to equal the foreign inflation rate. The model captures the stylized fact that temporary increases in the inflation rate may have permanent effects in the use of foreign currency, even without the introduction of dollarization costs.

Estimating the liquidity effect in post-reform Chile: do inflationary expectations matter?

In this paper, we estimate the dynamic effects of domestic money supply shocks in Chile over its post-reform era. We analyze Chile since inflationary expectations could be very sensitive to changes in the money supply, given past inflationary experience. In the context of a VAR model containing both Chilean and US variables, we identify money supply shocks using long-run monetary neutrality and block exogeneity restrictions. Our findings suggest that in Chile over the period from 1977 to 1998, unexpected domestic money supply shocks have had a positive impact on interest rates, in the short-run, and a negative impact on real money balances. This differs markedly from the estimated responses of the US. The findings are consistent with the notion that, at least in Chile, inflationary expectations are very sensitive to news about the nominal money supply, possibly due to high inflationary uncertainty and the lack of credibility of monetary reforms. Our results are generally robust to alternative model specification and identifying restrictions.

The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation

This paper studies a quantitative dynamic-optimizing business cycle model of a small open economy with staggered price and wage setting. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of the nominal and, especially, of the real exchange rate is noticeably higher than in standard Real Business Cycle models with flexible prices and wages. A positive domestic money supply shock is predicted to lower the domestic interest rate, raise GDP, and trigger a depreciation of both the nominal and real exchange rate. Increases in domestic productivity and in the world interest rate are also predicted to induce a nominal and real exchange rate depreciation.

Capital Flows and Their Macroeconomic Effects in India

This paper documents trends in movement and composition of capital flows into India in a comparative perspective, examines the impact of these flows upon key macroeconomic variables in the economy, and dwells on implications for economic policy. We find that an inflow of foreign capital results in a real appreciation and has a significant impact on domestic money supply. During a capital surge, these effects have been countered through intervention and sterilization. The paper concludes with a discussion on the costs of these policies in the event of a heavy inflow of foreign capital into India.

Capital Flows and their Macroeconomic Effects in India

This paper documents trends in movement and composition of capital flows into India in a comparative perspective, examines the impact of these flows upon key macroeconomic variables in the economy, and dwells on implications for economic policy. We find that an inflow of foreign capital results in a real appreciation and has a significant impact on domestic money supply. During a capital surge, these effects have been countered through intervention and sterilization. The paper concludes with a discussion on the costs of these policies in the event of a heavy inflow of foreign capital into India.

The Exchange Rate in a Dynamic-Optimizing Business Cycle Model
 with Nominal Rigidities: A Quantitative Investigation

This paper studies a quantitative dynamic-optimizing business cycle model of a small open economy with staggered price and wage setting. The model exhibits exchange rate overshooting in response to money supply shocks. Predicted standard deviations of the nominal and, particularly of the real exchange rate are noticeably higher - and closer to the data - than in standard RBC models with flexible prices and wages. The nominal rigidities structure captures 40% to 50% of the historical standard deviations of nominal and real exchange rates of Japan, Germany and the UK vis-a-vis the U.S. during the post-BW era. It also generates improved predictions for other business cycle statistics: the predicted correlation between the nominal and the real exchange rate is markedly higher (and closer to the data) than when flexible prices and wages are assumed. In addition, the structure captures more closely the historical variability of GDP, consumption, and the nominal interest rate. The model predicts that a positive domestic money supply shock lowers the domestic interest rate, raises GDP, and triggers a depreciation of both the nominal and real exchange rate. Increases in domestic productivity and in the world interest rate are also predicted to induce a nominal and real exchange rate depreciation.

To what degree do central banks sterilize the effects of capital flows on domestic money supply?

Under the current system of managed float exchange rates, large countries are able to absorb changes in their balance-of-payments by either manipulating international reserves to sterilize capital flows or by accepting changes in their exchange rates. In this system, the monetary authorities of the G7 countries have found it beneficial to sterilize capital flows thereby stabilizing their exchange rates and gaining greater control of their domestic money supply. Previous empirical work on the effects of sterilization were conducted using shortrun models on fixed exchange rates. Using the monetary approach to the balance-of-payments which emphasizes the money market from which balance-of-payments imbalances are derived, this article combines the current managed float system of exchange rates with cointegration techniques in considering the long-run relationship that has developed between the monetary base and money demand of the G7 countries from sterilized capital flows.

Dollarization and Seignorage: How Much is at Stake?

When a government decides to dollarize its economy, that is, to replace the domestic currency with the U.S. dollar, it automatically ceases to collect the stream of seignorage revenue, which is instead redirected toward the U.S. government. A central issue in the debate about dollarization is the distribution of seignorage between U.S. and the economies that are considering the adoption of the dollar as the sole legal tender. A pre-requisite for designing meaningful seignorage sharing rules is to asses the amount of resources that are at stake. A common misconception is that the amount of seignorage income involved is simply equal to the interest income on the amount of foreign reserves required to exchange the entire domestic money supply for dollars. This way of measuring the loss of seignorage income is in general biased for it implicitly assumes no growth in monetary assets. In this note we show that this bias can lead to enormous underestimations of the amount of seignorage revenue lost by governments of countries that dollarize.

An empirical study of the foreign trade balance in China

The objective of this letter is to investigate the dynamic relationship between China's trade balance (T) and macroeconomic variables: domestic and foreign output (Y and Y*), real exchange rate (E), domestic and foreign money supply (M and M*). The ADF unit root results show that the variables are all integrated of order I(1). The trade balance in China is not cointegrated with a number of variables, including the exchange rate. Absorption, elasticity, and monetary models are compared, and the elastic model performs better. There has been J-curve in China, and the devaluations have had significant effect on the trade balance.

The external financing of Italian electric companies in the interwar years

This article describes the contribution of foreign funds to the development of Italian electric power companies and the placing of loans in New York in the late 1920s. The effect of foreign loans on the financing structure of nine important Italian electric power companies in a period in which domestic long term funds were lacking is discussed. The transformation into a holding structure followed a path common to electric producers in many countries; at the same time holding companies' securities proved more marketable in the international market and the process of financing was made easier. The eventual macro effects of foreign loans on the domestic money supply and on the level of the Lira exchange rate are examined and some questions are raised concerning the relationship set up between the State, financial intermediaries and private savers during the Fascist regime.

The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation

This paper studies dynamic-optimizing model of a semi-small open economy with sticky nominal prices and wages. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model predicts that a positive domestic money supply shock lowers the domestic nominal interest rate, that it raises output and that it leads to a nominal and real depreciation of the country’s currency. Increases in domestic labor productivity and in the world interest rate too are predicted to induce a nominal and real exchange rate depreciation.

The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation

This paper studies dynamic-optimizing model of a semi-small open economy with sticky nominal prices and wages. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model predicts that a positive domestic money supply shock lowers the domestic nominal interest rate, that it raises output and that it leads to a nominal and real depreciation of the country’s currency. Increases in domestic labor productivity and in the world interest rate too are predicted to induce a nominal and real exchange rate depreciation.

Sterilization of Money Inflows: Difficult (Calvo) or Easy (Reisen)?

Some countries undergoing exchange-rate-based stabilization and financial liberalization in Latin America and elsewhere have faced large capital inflows since 1991. Many have tried to sterilize the reserve inflows. Calvo and co-authors argue essentially that sterilization is more difficult than generally realized, due to the interest costs on sterilization bonds. Reisen argues essentially that sterilization is easier than generally believed. This paper reviews the issues in the simplest textbook model. The conclusions are that local interest rates are not likely to rise if the source of the disturbance is an exogenous capital inflow, but will rise if the disturbance is an increase in money demand or an increase in exports. In every case, sterilized intervention will leave interest rates higher than they would be if the inflow took place unsterilized. The case where the domestic money supply and the rest of the economy are insulated from foreign disturbances despite perfect capital mobility and a fixed exchange rate, which Reisen attributes to Southeast Asia, is seen to be the case where domestic agents are unresponsive to interest rates.

Comparing the intensity of exchange market intervention with Frenkel and Aizenman's index of managed float

The large literature on the optimum intensity of foreign exchange market intervention contains two different characterizations of the central bank's policy choice variable. Most of the literature focuses on the central bank's intensity of intervention in the foreign exchange market and its implications for the domestic money supply. An important contribution by Frenkel and Aizenman (1982), however, carries out its analysis in terms of a so-called index of managed float. This note clarifies the relation between these policy measures by deriving the Frenkel-Aizenman index from a standard specification of financial market equilibrium.

Money, income and sterilization: tests for causality in the oil economy of Kuwait

The purpose of this investigation is to provide some evidence on two widely held hypotheses dominating monetary analysis in the small oil economy of Kuwait and other Gulf states. The first posits that causality should run from money to income, while the second emphasizes the neutral impact of external transactions on the domestic money supply.

EXCHANGE RATE OVERSHOOTING, CURRENCY SUBSTITUTION AND MONETARY POLICY

In this paper, the authors introduce the possibility of currency substitution in an extended version of the sticky-price model of exchange-rate behavior, and examine its implications for the behavior of a small, open economy following an (unanticipated) contraction in the domestic money supply. It is shown that currency substitution is, in general, associated with two effects: the expectations effect and the income effect. The former is stabilizing in the sense that it reduces both the possibility that overshooting of the exchange rate takes place at all, as well as the extent to which it occurs if it does occur; the latter effect, however, can be destabilizing. Copyright 1988 by Blackwell Publishers Ltd and The Victoria University of Manchester

The Impact of International Factors on U. S. Inflation: An Empirical Test of the Currency Substitution Hypothesis

A common argument for flexible exchange rates is that they insulate the domestic economy from external monetary shocks. Consequently, the domestic rate of inflation and income growth are related directly to the behavior of the domestic money supply. The insular properties of a flexible exchange rate system have been challenged over the past few years by proponents of the theory of currency substitution. Advocates of currency substitution argue that the domestic demand for money is a function of the relative opportunity costs between domestic and foreign holdings of monetary assets. Failing to recognize these international influences yields a domestic money demand function that appears to be highly unstable.' Consequently, depending on the particular set of international forces affecting the domestic demand for money, a given rate of domestic money growth can lead to a variety of rates of domestic inflation.

Monetary policy in the BOF3 quarterly model of the Finnish economy

This paper describes the modelling of monetary policy in BOF3, a quarterly econometric model of Finland built at the Research Department of the Bank of Finland. BOF3 is a 198-equation, ‘amended Keynesian’ model which is used regularly in policy analysis and forecasting at the Bank. The modelling of the Finnish monetary sector has been complicated by the fact that most interest rates applied by the banks have so far been institutionally regulated. In spite of this, model builders have attempted to follow the conventional IS-LM approach as closely as possible, assuming that interest rates equilibrate financial markets outside the banking sector. The reported simulation experiments describe the effects of a change in nomical interest rates, of a change in the domestic money supply, and of a fiscal stimulus with and without monetary accomodation.

A Neoclassical Model of the Balance of Payments

This paper analyses the transitory and long run effects of devaluation and tariffs, as well as the effects of alterations in the domestic money supply and the terms of trade, for a small country on fixed exchange rates. These issues are investigated in a self-contained dynamic optimization model of the sort popularized by Brock (1974, 1975). Familiar results in the trade literature are thereby explicated for the nonspecialist who is nonetheless familiar with Brock's work. There are some new results regarding the role played by income and substitution effects in determining the consequences of terms-of-trade shifts. This paper introduces a perfect foresight optimizing model of the monetary approach to the balance of payments for a small country on fixed exchange rates. The model is then used to analyse the effects on the balance of payments of devaluation, of a tariff, and of changes in the terms of trade. The effects of devaluation, tariffs, and changes in the terms of trade have been analysed previously within the framework of nonoptimizing models: Dornbusch (1973, 1980) and Anderson and Takayama (1977) have studied the effect of devaluation, Mussa (1974, 1976), Anderson and Takayama (1978, 1981) and Batra and Ramachandran (1980) have studied the effect of tariffs, and Rodriguez (1976), Batra and Ramachandran (1980), and Anderson and Takayama (1981) have studied the effect of changes in the terms of trade. Optimizing models in which real balances appear as an argument in the utility function are increasingly popular in international economics. The general approach was inspired by Sidrauski (1967) and Brock (1974, 1975). Recent contributions to the trade literature using this framework include Dornbusch and Mussa (1975), Calvo (1980, 1981), Liviatan (1981), and Obstfeld (1981 a, 1981 b, 1982). The purpose of this paper is to translate the conventional small country/fixed exchange rate model into this framework. The results are generally congruent with those in the nonoptimizing literature, which suggests that the money-in-the-utility-function approach works well here. Compared to the nonoptimizing literature, the real advance is that price adjustment and price expectations are endogenous and rational. Among the benefits are that one need not postulate the ad hoc price adjustment mechanism used by Anderson and Takayama, nor the backward-looking (and hence irrational) permanent income formulation used by Rodriguez.' Furthermore, there has been controversy over the balance of payments effects of a shift in the terms of trade. While the model's predictions on this issue are theoretically ambiguous, the model shows that the answer depends crucially on the magnitude of income effects. This clarifies the conditions required for a terms of trade shift to improve or worsen the balance of payments.