Hong Kong's three-tier Banking System comprised of banks, restricted license banks, and deposit-taking companies. Hong Kong has three measures of money supply:
- Money Supply definition 1 (M1): The sum of legal tender notes and coins held by the public plus customers' demand deposits placed with banks. HKMA maintain separate measures of Hong Kong dollars and foreign currency and add them together to measure M1. Here, foreign currency does not refer to foreign coins and notes. It counts the banks' holding foreign currency deposits.
- Money Supply definition 2 (M2): M1 plus customers' savings and time deposits with banks plus negotiable certificates of deposit (NCDs) issued by banks held outside the banking sector.
- Money Supply definition 3 (M3): M2 plus customers' deposits with restricted license banks and deposit-taking companies plus NCDs issued by these institutions held outside the banking sector.
Deposit-taking companies are restricted to taking deposits of HK$100,000 or more with an original term to maturity of at least three months. They engage in a range of specialised activities, including consumer finance, trade finance and securities business.
Data and chart from HKSAR Monthly Statistical Bulletin:
Question: Why there is a negative growth of domestic credit in May 2007? According to HKMA, M1 exhibits a significant seasonal pattern, whereas there is no strong evidence of seasonality in broad money (M2 & M3).
Liquidity Preference Theory
Keynes's liquidity preference theory emphasized the sensitivity of money demand to changes in interest rates. Keynes hypothesized that people allocated their wealth between two assets: money and "bonds". The expected return on bonds is determined by the interest rate on bonds adjusted for expectations of capital gains or losses. For money, defined as the sum of currency and checkable deposits (M1), Keynes assume the return is zero (if interest rate is going to rise and hence expect a capital loss on bonds, then the zero return may outweigh the negative return on bonds).
The demand of money can be expressed by
M/P = L(i,Y,X)
M/P - real money balance = amount of purchasing power people wish to have on hand. In other words, it represent the purchasing power of money holdings.
where
M = amount of dollars that people wish to hold
P = price level
i = general level of interest rates
Y = real income
X = other factors such as the availability of money substitutes, political stability, etc.
In general, M/P decreases as interest rate increases. M/P increases as Y increases. On the other hand, consider P remains unchange, the increase of nominal money supply M will shift the money demand curve so that interest rate will fall. Finally, for constant supply of money M, the price level increases will cause the interest rate to rise.
Before Keynes, in the early 1900s, Irving Fisher introduced the term velocity of money V in his model of money demand. V represents the average number of times a dollar is spent in the economy each year on a purchase of goods and services. Fisher described velocity using transactions, rather than income or output. [Gross domestic product (GDP) is a measure of output. But it is not a perfect proxy of transactions because it does not count the purchase of assets such as bonds, mortgages, installments, etc.] Fisher defined the velocity of money as
V = PY / M,
where Y is the aggregate income, and the total spending on goods and services is P x Y.
Equation of exchange MV = PY, states that the quantity of money times the velocity of money equals nominal spending in the economy. Assume that V is constant, then the demand for real balances is proportional to the level of transactions.
M/P = (1/V) Y
As the real incomes of households and businesses increases, they will conduct more real transactions. Therefore, the public's demand for money rises with real income. Putting this into Keynes's liquidity perference theory and rewrite the equation of above we have
V = Y / L(i,Y)
Because of the elasticity of Y, it does not change as the interest rate change. Then, V will change as the interest rate i change.
Question: What will happen to Hong Kong if USA start to cut the interest rate this year?
Follow the argument of above, we can see if interest rate fall then the real money balances will increase. If Y does not change (assume there is no wealth effect on stocks rising). Then V will decrease.
