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The evaluation of different monetary policy concepts and operating procedures requires a clear understanding of the underlying process of money supply. The mechanistic money multiplier models that can be found in every standard textbook have several shortcomings. In discussion paper No 1257, Research Fellow Peter Bofinger and Andrea Schächter develop a framework that integrates the interdependent transactions of the three sectors (banks, non-banks and the central bank) that are involved in the process of money supply. Special emphasis is placed on the central bank's control options for achieving a targeted money stock. In their two-stage model they argue (and this is implicitly assumed in all mechanistic money supply models and in McCallum's model) that the money market is a perfect mirror of the credit market under certain simplifying assumptions. Money demand always goes along with credit demand and money supply simultaneously provokes credit supply. Thus it is sufficient to formulate behavioural functions for only one of the two market sides. They derive the credit supply function from profit-maximizing bank behaviour. Then credit supply depends positively on the price of credits (credit market rate), and negatively on the price of the `input factor' high-powered money (central bank rate) and the default costs. Money demand and equivalently credit demand can be derived from standard money demand theories and are assumed to depend positively on income and negatively on the credit market rate. The equilibrium money stock and the credit market rate are determined on this macroeconomic market for money (credit). It is shown that within the concept of monetary targeting the choice of the optimal control procedure critically depends on the relative strength of different shocks: if disturbances on the credit market dominate, monetary base targeting is to be preferred; conversely, if money multiplier shocks dominate, interest rate targeting should be favoured. Alternative Operating Procedures for Monetary
Policy – A New Look at the Money Supply Process |