Monetary Policy Strategy in Rwanda

2.3.2.2 Money Supply Rule

Some economists, called monetarists believe that fluctuations in the money supply are responsible for most large fluctuations in the economy. They argue that slow and steady growth in the money supply would yield stable output as well as stable rises in employment, and prices (Mankiw, 2000). This view has been expressed in many works in terms of the quantity theory following Fisher's equation of exchange.

From Fisher's equation:

MV=PY

Where M is the money supply, V is velocity, P the price level and Y the real output level.

The term on the right (PY) is therefore nominal income or nominal output.

Dynamizing the Fisher equation into growth rates:

(dM/dt)/M + (dV/dt)/V = (dP/dt)/P + (dY/dt)/Y

Or

g_M + g_V = g_P + g_Y where g_M = (dM/dt)/M, etc.

The equation of exchange holds by definition. The quantity theory is reached by only adding certain assumptions about what is the cause and what is the effect.

From the above equation thus, assumption are imposed:

- Nominal money M is assumed to be exogenous and considered under the full control of the Central Bank,

- Velocity is assumed constant,

- The aggregate nominal demand component is assumed to cause changes in nominal income (causality runs from MV to PY),

- Output Y is fixed at the full employment level.

If velocity is assumed to be constant, g_V = 0, and causality is held as in the third assumption, then movements in nominal output (PY) are driven by movements in the supply of money (M). If real output is assumed to be constant at the full employment level, and g_Y = 0, then

g_M = g_P, meaning that money supply growth feeds entirely into price inflation. As real variables (velocity and output) are unchanged by an increase in the money supply, the quantity theory thus claims that money is neutral (at least in the long-term).

When some assumptions are relaxed, especially by allowing for output growth, g_Y ? 0 and changes in velocity, g_V ? 0, then these growth rates are relatively stable and predictable. In other words, output is assumed to grow at a stable rate of resource growth while velocity is assumed to increase at some relatively stable rate of institutional evolution. Similarly,

g_M - (g_Y - g_V) = g_P so that inflation is driven by the degree to which money supply growth exceeds the term (g_Y - g_V) which means output growth minus velocity growth. As the stability assumption implies that the term (g_Y - g_V) is constant, then, once again excess money supply growth above this determines the inflation rate. (www.cepa.newschool.edu/hot/essays/monetarism/policyhtm-39lc)

In practice, much of Friedman's assumptions were criticised. For instance, the assumption of constant or stable velocity is considered as not realistic. From empirical evidence, velocity may be subject to unpredictable fluctuations caused by unpredictable changes in institutional factors. Consequently, if velocity is not stable, the policy is not useful since its effects will be unpredictable.

In addition, Mankiw (2000) argued that «although a monetarist policy rule might have prevented many of the economic fluctuations the world has experienced historically, most economists believe that it is not the best possible policy rule. Steady growth in the money supply stabilizes aggregate demand only if the velocity of money is stable. But sometimes the economy experiences shocks, such as shifts in monetary demand that cause velocity to become unstable» (Mankiw, 2000: 397). As a result, several economists think that a policy rule should allow the monetary supply to adjust to various shocks to the economy.