Money Supply and the Exchange Rate

Ever wonder what happens to the foreign exchange rate when the Central Bank makes a pronouncement to either decrease money supply circulating around or slow the growth of that money supply over a number of years?

There is no simple, one-line answer to this. Firstly, when evaluating the effect of this policy on the economy, we need to decide whether we are taking on a short- or long-term perspective on its effects. Short-term effects of a policy do differ substantially from the long-term effects of such. Secondly, we need a framework, model, or theory, or a ‘lens’ if you will, with which to view the path by which the series of economic events take place after a policy trigger and that will enable us to predict outcomes.

Last week, I gave an exercise to my class in international trade and finance to analyze the economic effects of the Chinese Central Bank’s recent policy pronouncement that it will work to slow down the growth of its M2 money supply from 13.8% to 13% in 2013 (‘China reforms needed to lower M2/GDP ratio - c.bank chief’, Reuters, 8 March 2013).

China’s M2 money supply

Money supply is defined as the total monetary assets in an economy, generally consisting of the total currency in circulation including demand deposits (or checking account). There are different ways to measure the money supply, depending on how narrowly or how broadly it is defined. Thus, money supply is typically classified along a spectrum or continuum between narrow and broad monetary aggregates. Narrow measures include only the most liquid assets, the ones most easily used to spend (currency units, checking accounts). Broader measures add less liquid types of assets (savings accounts, time deposits, and other certificates of deposit).

For example, the US defines money supply into the following categories: M1, M2 and M3. M1 consists of currency (and traveler’s checks), demand deposits, and NOW and similar interest-earning checking accounts. M2 comprises M1 plus savings deposits and money market deposit accounts, small time deposits1, retail money market mutual fund balances. M3 is M2 plus large time deposits, institutional money market mutual fund balances, repurchase agreements, Eurodollars (The Federal Reserve System, 2005).  

In the Philippines, money is defined or classified into: M1, M2, M3 and M4. M1 or ‘narrow money’ consists of currency in circulation (or currency outside depository corporations) and peso demand deposits while M2 or ‘broad money’ comprises M1 plus peso savings and time deposits. M3 or ‘broad money liabilities’ is M2 plus peso deposit substitutes, such as promissory notes and commercial papers (i.e., securities other than shares included in broad money), while M4 consists of M3 plus transferable and other deposits in foreign currency.

In China, the relevant money supply for monetary policy is M2. Chinese M2 money supply consists of money and quasi-money currency, demand-, time-, savings- and foreign currency-deposits held by sectors other than the Chinese government. It stood at 85.2T yuan in 2011, which expanded by 17.3% from the previous year and by an average of 18.5% per year over the past 10 years (see Figure 1). By end of 2012, it exceeded 97.4 trillion yuan ($15.5 trillion) making it the world’s largest money pool, 1.5 times that of the United States--an economy 1.9 times larger (in terms of GDP) than China's in the same year (IMF 2012). 

Figure 1. China’s M2 stock

Further, Chinese M2 stock represented an astounding 180% of GDP for the year (see Figure 2). By 2012, Chinese M2 level reached 188% of GDP, considered the highest among major economies in the world.

Figure 2. China’s M2 as % of GDP

It is perhaps for this reason among others, that the Chinese Central Bank has set a 13% annual growth target for M2 money supply in 2013—slower than the 13.8% actual growth in 2012, and way slower than the M2 growth seen in previous years which saw a 47% growth in 1993 and a growth of 28.4% only three years ago in 2009.

With this backdrop, I asked my students to take on a long-term perspective and determine the long-run effects of such policy on key economic variables in the Chinese economy. In particular, I asked them to determine the policy’s effects on the Chinese price level, inflation, the yuan currency deposit interest rate, the Chinese yuan (CNY) exchange rate with the US dollar (USD), and on total economic output. They were also tasked to compare and contrast these effects if the policy were a one-time decline in money supply, and to explain what the Chinese monetary authority wants to achieve with this policy over the long term.

Long-Run Exchange Rate Model Based on Purchasing Power Parity (PPP)

The model or theory of choice for our class to analyze the impact of the Chinese Central Bank’s policy was the Long Run Exchange Rate Model Based on PPP—among the popular models floated around in standard textbooks in international economics because it is both simple and intuitive as it looks at the path by which changes in the money supply have far-reaching effects not just on the general price level but also on other economic variables such as the interest rate and the exchange rates.  

This model, in a nutshell, says that purchasing power parity (PPP) will hold in a world where there are no market rigidities to prevent the exchange rate and other prices from adjusting immediately to levels consistent with full employment (Krugman, et al, 2012, International Economics). Specifically, it assumes two (2) conditions to hold in the assets market: 1) the expected relative PPP condition, and 2) the ‘Fisher effect’.

The expected relative PPP is given by this equation:

(exp Eα/β – Eα/β)/ Eα/β  = exp π (A) – exp π (B)

where,

exp Eα/β = the (future) expected exchange rate between currency of country A, (i.e..α) and currency of   country B (β)

Eα/β = the exchange rate between currency of country A (α) and currency of country B (β)

exp π (A) = expected inflation rate in country A

exp π (B) = expected inflation rate in country B

which implies that a currency depreciation (or appreciation) is expected to offset international inflation differences or inflation differences between two (2) countries at a rate of (π – Δπ).

In this model, if people expect relative PPP to hold, the ‘Fisher effect’ shall also hold: the difference between the interest rates offered by any 2 type of currency deposits will equal the difference between the inflation rates expected over the relevant period in the 2 countries that own those currencies.

The ‘Fisher effect’ is given by this equation:

            R(α) – R(β) = exp π (A) – exp π (B)

where,

R(α) = deposit rate for currency α in country A

R(β) = deposit rate for currency β in country B

exp π (A) = expected inflation rate in country A

exp π (B) = expected inflation rate in country B

which implies that, all else equal, a rise (or fall) in a country’s expected inflation rate will eventually cause an equal rise (or fall) in the interest rate that deposits of its currency offer.

Economic Effects of a Slower M2 Growth

Using this long-run model, Chinese M2 growth slowing to 13% (assuming this is a constant rate by which M2 will grow over time) will thus require an ongoing fall in the Chinese price level at the same rate, and hence lead to a decline in inflation in order to keep real incomes in China constant.

While the model assumes such changes in the price level and inflation will not affect full employment output level and the relative prices of goods and services, it does assume to have an effect on interest rate via the ‘Fisher effect’.

By the ‘Fisher effect’, a fall in the inflation rate will eventually cause a fall in the Chinese interest rate or the CNY deposit interest rate. Thus, the continuing slowing of Chinese M2 growth will eventually affect primary interest rates in China in the long-run and cause it to decline. 

By the expected relative PPP condition assumed also to hold in the long run, the fall in the price level brought about the fall in Chinese M2 growth will also create a simultaneous proportional downward fall in the exchange rate between the Chinese yuan (CNY) and say, the US dollar (USD)—the currency of its most important and largest trading partner, the US.

Thus, all else equal, a decline in Chinese M2 growth will require the ongoing fall in the price level and hence a fall in expected inflation rate, which eventually will result in the decline of the CNY deposit’s interest rate, and by virtue of the expected relative PPP assumed to hold in the long run, will likewise cause a fall (or an appreciation) in the exchange rate between the CNY and a major currency such as the USD.

To conclude, a decline in M2 growth rate will lead to a fall in the price level and inflation, a decline in the CNY currency deposit or interest rate, and a CNY that will be stronger in the future.

(By how much or to what extent will those economic variables rise or fall in value with the decline in M2 growth can be estimated econometrically but is something beyond the scope of the course for my class.)

Meanwhile, we expect such policy to have no effect on long run full-employment output. Long run full-employment output is influenced by non-monetary factors such as changes in the level, quality, and productivity of a country’s factors of production via technological innovation, and similar causes. Further, in the long-run, as posited by Irving Fisher in his work The Theory of Interest (1930), purely monetary developments should also have no effect on an economy’s relative prices, and hence provide a cause for reallocation of consumption or production in the economy.

Now that we know what could happen to the economy when the money supply growth slows down, it begs asking why would the Chinese government want to do this, and what does it want to achieve with this policy?

The Goals of Monetary Policy

The purpose of the exercise I gave in class was to demonstrate monetary policy in action and to gain understanding what monetary policy wants to achieve in the economy at large and in the assets market in particular.

The goals of monetary policy are generally the same across market-oriented economies, with just slight variations on the means and extent. In the US, the goal of monetary policy is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” (Board of Governors of the Federal Reserve System, 2005).   

In the Philippines, the primary objective of monetary policy is “to promote price stability conducive to a balanced and sustainable growth of the economy” in accordance with Republic Act 7653 (Bangko Sentral ng Pilipinas, 2012), with inflation targeting as the explicit framework by which to achieve this objective and price stabilization an ultimate goal.

While monetary policy such as changing money supply levels or its growth will undoubtedly have effects on the price level and inflation, as our model has illustrated, it will likewise have concomitant effects on interest rates and currency exchange rates. In reality, it does in fact have such effects.

Why does China want to slow its money supply growth?

After 5 years of double digit growth post-1997 Asian financial crisis (2003-2007), China’s gross national income (GNI) began to slow by 2008 to 9.6%--still fast by world standards but relatively slower nonetheless. In recent years too, inflation has begun to creep in, from a mere 1.4% in 2006 to 5.4% in 2011—relatively low again compared to the world average but considering housing costs such as rent (which have been skyrocketing in recent years) have been excluded from the Chinese CPI, can lead us to surmise that this inflation trend is actually quite significant (see Figure 3).   

Figure 3. China’s GNI, GDP growth and Inflation

Theory says a policy to slow money supply will eventually lead to slow inflation, thus arresting the unnecessary price increase in the future thereby preserving the purchasing power of the Chinese consumers amidst a relatively sluggish economy.

But our prediction of economic outcomes based on theory does not stop there. The expected decline in inflation will all things equal, eventually cause CNY deposit interest rates to fall (or interest rates in general) and the expected CNY to appreciate relative to the dollar in the future.

In other words, slowing the growth of M2 in China will lead us to expect not only inflation to fall but also the price of credit (i.e. interest rates)—thereby providing a stimulating effect on domestic investments, plus a stronger CNY in the future--and along with it far reaching implications for the international movement of goods, services, capital, funds between China and the rest of the world. Whether the CNY—perhaps the most controlled currency in the world—will actually appreciate in the future--is a different story though.

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References

Bangko Sentral ng Pilipinas (BSP), ‘Glossary of Terms’. Available at: http://www.bsp.gov.ph/monetary/glossary.asp [Accessed 10 March 2013].

Bangko Sentral ng Pilipinas (BSP) Department of Economic Research, September 2012. ‘Primer on Inflation Targetting’, Available at: http://www.bsp.gov.ph/downloads/Publications/FAQs/targeting.pdf [Accessed 10 March 2013].


Board of Governors of the Federal Reserve System, 2005. The Federal Reserve System: purposes and functions. Washington, DC (USA): US Board of Governors of the Federal Reserve System.


Fisher, Irving, 1930. The Theory of Interest, New York: Macmillan.


International Monetary Fund, 2012. World Economic Outlook Database, October 2012, Available at: http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx [Accessed 13 March 2013].


Krugman, et al, 2012. International Economics: theory and policy, 9th edition, Boston, MA (USA): Addison-Wesley.


Reuters, [Online], ‘China reforms needed to lower M2/GDP ratio - c.bank chief’ Reuters [Online]. March 8, 2013, Available at: http://www.reuters.com/article/2013/03/08/china-economy-m-idUSL4N0C00BI20130308 [Accessed 9 March 2013].


The World Bank. World Bank Open Data--China Metadata. Available at:  http://data.worldbank.org/ [Accessed 10 March 2013].