By Invitation:
Dr Azar is Full Professor, Faculty of Business Administration and Economics, Haigazian University, Beirut, Lebanon. The views expressed in this note are his and do not necessarily reflect the views of BLOMINVEST Bank.
After having covered the demand side of the money market in Lebanon[1] this note will cover the supply side. A common misperception by students is that demand is a function of supply, while, in fact the two are independent. For those economists who believe in a stable money supply creation their view is that there is a direct transmission channel from the reserves of the banking system at the central bank to the money stock, taken here to be M2. Briefly, the money supply is considered by these economists to be a function of these reserves and of the money multiplier, the latter being the ratio of the total money supply M2 over the monetary base. The monetary base consists of the bank reserves and currency in circulation. Nonetheless, this is not sufficient to define a stable money supply function. Additionally, the central bank must have either a complete or a partial control over the monetary base. This is in essence the traditional model of the money supply function.
This note extends the analysis by looking at the causes of the change in bank reserves. These are said to be determined either by open market operations by the central bank or foreign exchange market operations, or both. Open market operations occur when the central bank purchases or sells Treasury bonds by crediting or debiting bank reserves. Foreign exchange market operations occur when the central bank buys or sells part of its foreign exchange reserves principally to banks, and credits or debits the bank reserves. Of course it is understood that positive bank reserves changes lead to positive changes in the money supply. This approach that assumes a link from central bank assets towards bank liabilities like M2 has not been studied adequately enough for no known reason. To complete the picture various interest rates will be included in the money supply function that helps explain and “cause” money supply in an indirect way. Four rates are chosen: the interbank rate, the bank loan rate, and the deposit rates on domestic and foreign assets. If the interbank rate is higher than the loan rate banks will tend to hold more excess reserves, hence money creation is slowed down or delayed. If the rate on loans is higher than either the domestic or the foreign deposit rates, banks will in all likelihood increase their loan exposure, and hence multiple deposit money creation results. This happens because the enlargement of margins between the loan rate and the deposit rates, either because of a higher interest rate revenue or because of the reduced cost of funds encourage banks to benefit from the issuance of loans on a net basis. Finally, the money supply function should be specified in nominal and not in real terms, meaning that the monetary authorities have no control over current inflation rates that deflate money, but have some control over the size of the money stock.
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