Academic journal article East Asian Economic Review

Does Monetary Policy Regime Determine the Nature of the Money Supply?: Evidence from Seven Countries in the Asia-Pacific Region

Academic journal article East Asian Economic Review

Does Monetary Policy Regime Determine the Nature of the Money Supply?: Evidence from Seven Countries in the Asia-Pacific Region

Article excerpt

(ProQuest: ... denotes formulae omitted.)


Money in the modern economy is largely created by commercial banks when they offer loans to the public. The commercial bank creates its own funding in the act of lending, and does not need to procure excess reserves before lending. Such a perception is diametrically opposed to the money multiplier model, which suggests that the availability of excess reserves imposes constraints on bank lending and the money supply.

The fact that money is created in the act of lending is acknowledged largely by leading monetary policymakers and practitioners. For example, Mervyn King, former governor of the Bank of England, states that "When banks extend loans to their customer, they create money by crediting their customer's account."1 Although many policymakers and private sector practitioners understood exactly the nature of the money-supply process, most professional economists seem to have remained undisturbed by the description of the money-supply process based on the money multiplier model. Only a few economists, the majority of whom could be qualified as Post-Keynesians, have been arguing that money is endogenously supplied when commercial banks offer loans to the public2.

It is curious why the seemingly erroneous conception implied by the money multiplier model prevailed so long among academic economists. One possible explanation could be that the money multiplier model is accepted by many as a kind of parable. The logic behind such a posture might be formulated as follows: Well, it is true that money is created through lending; But newly created deposit money implies the need for more high-powered money, due to increased demand for cash and reserves; It is only the central bank which can supply the high-powered money; The central bank has the ultimate authority to say "yes" or "no" to the money-creating activities of commercial banks; Therefore, it is reasonable to describe the money supply starting from the exogenous change of the monetary base.

We think, however, that the parable needs to be verified by empirical investigation. Our conjecture is that the degree of intention and effectiveness of the control of the monetary base by the central bank depends critically on the monetary policy regime. When the central bank uses a monetary aggregate as an intermediate target, it would not willingly accommodate the demand for the monetary base arising from commercial banks' lending, in order to control the intermediate target within the announced range. Once the central bank no longer sets an intermediate monetary target, and aims to achieve its inflation target by using the policy interest rate as an operational target, then it is highly possible that the monetary aggregates and the monetary base would be supplied endogenously by the decision of commercial banks and borrowers.

Let us, however, relativize the schematic correspondence between the moneysupply process and the monetary policy regime. First, even when a central bank chooses an intermediate monetary target to achieve its goal, its operational instrument could be the short-term interest rate instead of the monetary base. That was the case for Bundesbank, and subsequently the ECB for a certain lapse of time. In such a case, the central bank would show more accommodating behavior than when it chooses the monetary base as its operational instrument. Second, when a central bank in the monetary targeting regime conducts monetary policy based on control of the monetary base, what it actually does in its operations can be quite different from the official procedure, because a strict control of the monetary base necessarily results in very high fluctuation of short-term interest rates. Third, whether the bank lending is affected by the change of policy interest rate and/or the monetary base depends on whether commercial banks can have access to non-reservable resources, such as CDs, commercial papers, repos, or foreign borrowing, in both inflation targeting regime and other monetary policy regimes. …

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