2.2 Financial activity and the level of aggregate demand

Of course, we can change the outcome by changing our assumptions. Suppose, for

example, that we relax the restriction on Y. We might, for example, suppose that the

economy was suffering heavy unemployment and that there was widespread spare

capacity. Yis no longer restricted to slow growth. An increase in spending (MsV)

could now cause an increase in Ywith little or no effect on P. If, in our example, extra

demand was met by an increase in output of 8 per cent, prices would rise by only

3 per cent. Whether the effect of increased spending falls largely on Por on Yis of

secondary interest to us, however. What matters is that we have established that if

Vis xed (or restricted to slow change), then events in the nancial system could

cause an increase in spending by causing an increase in the money supply. This will

happen if there is an expansion of banks and their deposits.

Exercise 2.2

(a)At the end of 2005, the (M4) money stock in the UK amounted to £1,363bn. For the same year, GDP was approximately £1,211bn. Calculate a gure for the velocity of M4.

(b)	At the end of 2005, the Bank of England forecast a rate of growth of 6 per cent forM4 during 2006. Output was expected to grow at about 2 per cent while the Bankwas condent of achieving its ination target of 2 per cent. What did the Bank appearto be expecting to happen to M4 velocity during 2006?

Answers at end of chapter

2.2.2Liquid assets and spending

An expansion of banking and money is the rst channel through which the nancial

system may affect the level of aggregate demand. The second channel involves non-

deposit-taking institutions, though here the mechanism is rather more complex. The

liabilities of NDTIs are not money but they are, as we have already seen, relatively

liquid assets to their holders. Imagine that NDTIs now develop some new product

which is both highly liquid and popular with lenders. As a result, people hold

additional liquid assets which, though they are not money, are partial substitutes for

money. For example, the new assets cannot be used for spending but if they can be

exchanged for money quickly and easily, they are extremely suitable as assets which

can be held in case of the need for unforeseen expenditure. If people were previously

holding money itself for these ‘precautionary’ purposes, the new assets, which will

pay interest or some other form of reward, may be a superior alternative. Instead of

holding money for precautionary purposes, the money can be used for spending. In

effect, the creation of money substitutes enables a greater proportion of the money

stock to be used for spending, or as a medium of exchange. A given quantity of M

permits a higher level of PY. In terms of the equation of exchange, money substitutes

permit an increase in Vand thus an increase in spending. Doing Exercise 2.3 may

help to clarify the process.

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Chapter 2 • The nancial system and the real economy

Exercise	2.3	Imagine an economy in which there are no liquidassetsexcept money. Imagine now
		a family whose monthly income of £2,000 is paid into their bank account on the
		rst day of the month. Suppose further that their expenditure is also £2,000 per month
		and that it takes place at a constant rate during the month. Most of their wealth consists
		of a house, a car and other consumer durables. But they also have £1,000 in bank
		deposits, saved from the past, which they feel is necessary to hold for precautionary
		purposes.

1	Draw a sketch showing how the size of their bank deposit varies over a two-month period.

2	Calculate their average holdings of money over one month (ignore any notes and coin).

3	Calculate a monthly velocity gure for their holdings of money (remember: velocity  spending money holdings).

Now imagine that an NDTI emerges which offers units in a mutual fund. These units

pay a small income and promise a capital gain if held over a long period. Furthermore,

they can be sold back to the company within seventy-two hours. Suppose that our

family now decide that their precautionary requirements can be met by cutting their

minimum bank deposits to just £100 and holding £900 worth of fund units instead.

Repeat steps 1–3.

Suppose that the £900 of deposits passed to the mutual fund company go to an ultimate

borrower who spends it with the same velocity as our family. How much additional

expenditure is generated from the £900?

Answers at the end of the chapter

In summary, then, we may say that an expansion of the nancial system is

likely to lead to an increase in the availability of liquid assets. Such an increase in

liquid assets is likely to increase the level of spending in the economy whether there

is an increase in monetary assets or in non-money assets. Using the equation of

exchange, the former channel is represented by an increase in M; the latter involves

s

an increase in V.