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376

Quarterly Bulletin 2007 Q3

Interpreting movements in
broad money
By Stuart Berry, Richard Harrison, Ryland Thomas and Iain de Weymarn of the Bank’s Monetary Analysis Division.

Understanding the role of money in the economy has always been an important issue for
policymakers. And the pickup in broad money growth and decline in credit spreads over the past
three years together with more recent financial market turbulence has made it a particularly
pertinent issue. Monetary data can potentially provide important corroborative or incremental
information about the outlook for inflation. But understanding the possible implications of money
for the economic outlook requires a detailed assessment of the causes of money growth. Such an
assessment must recognise the interactions between money and credit creation and the
information contained in both price and quantity data. This article provides an overview of the
potential channels through which money growth may affect inflation and the Bank’s current
empirical approach to analysing developments in monetary aggregates.
Introduction
Money plays an important role in the economy. And as
Friedman (1963) famously said: ‘inflation is always and
everywhere a monetary phenomenon’. The behaviour of
money holdings by households and companies, therefore,
should be of interest for monetary policy. This article builds
on a long stream of work at the Bank on the role of money.
Following on from papers such as Goodhart and
Crockett (1970), Thomas (1996), King (2002) and Hauser and
Brigden (2002), it provides an overview of the Bank’s current
framework for thinking about money, and highlights where
innovative analysis is most needed. As such, the article
represents a starting point for a larger programme of work on
the causes of money and credit growth and their implications
for the inflation outlook.
There is a well-established long-run empirical relationship
between broad money growth and inflation across a variety
of countries and monetary regimes (see for example
Benati (2005) and King (2002)). In the short run, however,
growth in the stock of broad money held by households and
companies is affected by a number of factors, including
financial innovation and portfolio shifts, that tend to make
the relationship with inflation more variable (Chart 1). This
makes interpreting movements in money growth more
difficult over the horizons that are most relevant for
monetary policy. Understanding why money growth has
evolved as it has is key to assessing the implications for
inflation.




Chart 1 Broad money growth and inflation
Percentage changes on a year earlier

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25

Broad money(a)

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15
10
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+
0

–
5
10

ONS composite price index

15
1880

1900

20

40

60

80

2000

20

Sources: Bank of England, Capie and Webber (1995) and ONS.
(a) Based on M3 until 1963 and then M4.

In the second half of 2006, broad money growth rose to its
highest level since 1990 and has remained high. Over the
same period, interest rate spreads on household and corporate
credit declined to unusually low levels. In recent months there
has been considerable turbulence in financial markets — a
process that is still under way. A key question is what
developments in money and credit growth imply for the
inflation outlook. The first section of this article looks at what
money is and how it is created. The theoretical underpinnings
of the relationship between money and inflation are discussed
next, before considering an empirical approach to assessing
the implications of monetary developments for inflation. The

Research and analysis Interpreting movements in broad money

final section concludes and sets out potential avenues for
further investigation.

377

Chart 2 Broad money and bank credit(a)
Percentage changes on a year earlier

30

What is money and how is it created?
25

At the outset, ‘money’ needs to be defined, and this is
traditionally done through its principal function — a medium
of exchange or means of payment. Money exists because of
frictions and trading costs associated with conducting
sequences of transactions at different times across a range of
different markets. In particular, money eliminates the need to
find individuals who wish to trade one particular good for
another — known as the double coincidence of wants. Money
also facilitates timely settlement of transactions, avoiding the
need to extend credit to those about whom the seller may
know very little.(1) The ultimate means of settling transactions
is ‘central bank money’, either in the form of notes and coin or
the balances held by banks at the central bank (reserves). That
is generally referred to as narrow money. However,
households and companies settle many transactions using
their deposits with banks and building societies. These
deposits are typically included in a wider definition known as
broad money. The standard measure of broad money in the
United Kingdom is M4. At the end of 2007 Q2, the stock of
M4 was around £1.6 trillion, around 1.2 times annual nominal
GDP. Notes and coin make up only around 3% of total M4.

20

15

Bank credit

10

5

Broad money

0
1986

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92

95

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2001

04

07

(a) Monthly data. Broad money is defined as M4, while bank credit is defined as M4 lending
(excluding the effects of securitisations and loan transfers).

Money and economic theory
The traditional view of money and inflation
The cornerstone of the traditional theoretical relationship
between money and inflation is the Quantity Theory of
money. This is based on an identity known as the equation of
exchange, which relates money to the transactions it is used to
settle:
MxV≡PxT

The appropriate definition of broad money is by no means
universal or constant. Differences across countries and over
time largely reflect the structure of the financial system. For
example, alternative assets may increasingly become
‘money-like’ as they are used for settling transactions, or
some financial institutions outside the banking sector may
begin to behave more like banks. Burgess and Janssen (2007),
also in this Quarterly Bulletin, describe some recent difficulties
in defining the appropriate boundaries for money in the
United Kingdom.
Money is a key part of the transmission mechanism from
monetary policy to economic activity and inflation. Monetary
policy is typically implemented by setting the short-term
interest rate, with the central bank allowing the supply of
narrow money to expand or contract as required to meet the
needs of households and companies at that rate.(2) But by far
the largest role in creating broad money is played by the
banking sector. Banks intermediate funds by taking deposits
and lending part of that money to others. When banks make
loans they create additional deposits for those that have
borrowed the money. There is, therefore, a strong link
between the growth of money and credit (Chart 2).(3) And the
supply of broad money will depend on the behaviour of the
banking system, as well as on official interest rates.




where M denotes the money stock, V is the number of times
the money stock circulates through the economy during a
given period of time (the velocity of circulation), P is the price
level and T is the number of transactions undertaken during
that period.
In the long run it seems plausible that the number of
transactions, T, in the economy will be determined by
non-monetary factors (such as the quantity of labour and
capital available for production and the structure of markets).
Similarly, the rate at which money circulates through the
economy, V, is likely to be determined by factors such as the
efficiency and degree of development of the financial system.
Under the assumption that these factors remain fixed, an
increase in the money stock, M, would be expected to be
associated with a proportionate increase in the price level, P, in
the long run.
The difficulty with relying on this relationship in the short run,
as highlighted in the 1980s, is that velocity is often volatile
(1) See Kocherlakota (1998) for a formal treatment.
(2) An alternative way of implementing monetary policy is to control some definition of
the supply of money such that the market-determined interest rate is in line with the
desired monetary policy stance.
(3) The two are not identical because the banking sector also conducts transactions with
institutions not covered by the money and credit data. For example, banks can fund
their UK lending by borrowing overseas. And deposits held by the public sector are
not included in the standard measures of money and credit so payments to and from
that sector will affect the gap between M4 and M4 lending.

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Quarterly Bulletin 2007 Q3

(Chart 3). Although velocity has generally declined over time,
the speed of that decline has varied considerably. As a result,
the empirical link between money growth and inflation has
been less predictable over the past 30 years.

in overall wealth can affect the demand for money if
individuals wish to maintain the share of their assets held as
money. In addition, changes in the relative attractiveness of
money compared with other assets could alter the share of
individuals’ portfolios that they wish to hold as money.
Changes in official interest rates can therefore affect the
demand for money as well as money supply. Technological
innovations that make it easier to use higher-yielding deposits
in transactions, could also make holding those types of money
more attractive.

Chart 3 Velocity of circulation(a)
Index: 1967 Q1 = 100

120

100

80

60

40

20

1967

72

77

82

87

92

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2002

07

0

(a) Nominal GDP divided by the outstanding money stock (M4).

Money demand and money supply
The equation of exchange says little about what determines
the stock of money or indeed velocity. It only describes the
relationship between those variables and a measure of the
value of transactions in the economy such as nominal
spending. But understanding the drivers of changes in the
stock — or ‘supply’ — of money and changes in velocity — a
proxy for factors affecting the ‘demand’ for money — is
important. That is because the way in which different factors
affect the interaction between the demand for money and its
supply will determine the implications for nominal spending
and, ultimately, inflation.
Monetary policy is a key driver of changes in the supply of
money. When official interest rates fall, borrowing becomes
more attractive, tending to induce higher bank lending and
greater money creation. But that is not the only factor
affecting the stock of money in the economy. In practice, the
borrowing decisions of households and companies depend on
the retail interest rates they face, rather than the policy rate.
And there is a wide range of different products with interest
rates set at various spreads to the policy rate. The quantity of
bank lending, and hence broad money creation, will also
depend on banks’ lending criteria covering factors such as the
creditworthiness of borrowers and loan to value ratios for
secured borrowing. Changes in either spreads or lending
criteria could therefore lead to changes in money growth
without any change in the official interest rate.
Much of the demand for money stems from the need to fund
transactions, as embodied in the equation of exchange. But
money is also held as part of a portfolio of assets. So changes



According to standard economic theory, households and
companies are likely to have a target level of money balances
that they wish to hold — their demand for money. But they
will often accept holding more or less than that amount in the
short term as a (possibly very temporary) means of bridging
the gap between payments and receipts. Over time they will
attempt to return to their target level following a change in
their money holdings. This is known generally as the
buffer-stock theory of money demand.(1) Theory implies that
the target level of money demand should be defined in terms
of the real value of money balances, as that represents the
purchasing power of money holdings. Given individuals’
expectations about the current and future price level this then
implies a target for the future path of nominal balances.
As noted earlier, changes in the money stock primarily reflect
developments in bank lending as new deposits are created.
Often, those who borrow will not want to keep the new
deposits, but will instead use them to purchase goods and
services or other assets. So the money passes to other
individuals as the transactions are completed. These other
individuals will also not want to hold the extra money
balances for long unless their demand for money has changed.
So over time they will spend the extra money, moving it on
once again to a different set of individuals who face the same
issue. To the extent that money balances are not used to
repay loans, they cannot be eliminated, only moved around
the economy. So an increase in money supply, other things
being equal, leads to households and companies having
temporary ‘excess’ money balances that they are prepared to
hold in the short term as a buffer, but do not want to hold in
the medium term. That leads to higher demand for goods and
services or other assets that will eventually push up their
prices.(2) As prices rise, the real value of money balances falls
back, restoring the balance between money demand and
money supply.
Figure 1 illustrates this process graphically. Initially, the
money supply is assumed to be fixed at Ms1, and Md1 shows
the demand for nominal money balances for a given level of
real money balances. The demand curve slopes upwards
(1) See Laidler (1984) and Milbourne (1988) for a discussion of buffer-stock models.
(2) See Congdon (2007) for a discussion of this mechanism.

Research and analysis Interpreting movements in broad money

because a higher price level, P, requires a proportionate
increase in the holdings of nominal money balances, M to
achieve a given level of real money holdings. The slope of the
money demand curve depends on the velocity of circulation as
shown by the equation of exchange discussed earlier. Money
demand and money supply are equal at the price level P1. If
the supply of money then increases to Ms2, and money
demand remains unchanged at Md1, the higher short-run level
of real money balances will push up spending until prices are
bid up to P2, where money supply is again in line with money
demand and real money balances are unchanged.
Figure 1 Changes in money demand and money supply
Prices

Ms

1

Ms2
Md1

Md2

P2

P1

M1

M2 Nominal money balances

By contrast, if the increase in the money stock is accompanied
at the same time by an increase in money demand, individuals
will want to hold some or all of the extra money balances
rather than spend them. As a result, the rise in money supply
will have less effect on the demand for goods and services or
other assets and hence inflation. A shift in money supply to
Ms2 met entirely by a shift in money demand to Md2, leaves
prices unchanged at P1.
So monetary policy clearly plays an important role in
movements in money supply and money demand. And in
many ways the transmission mechanism through to activity
and inflation suggested above, can be described in an
equivalent way using changes in official interest rates. But,
importantly, the drivers of money supply and demand are not
confined to the effects of changes in official interest rates.
Developments in the banking sector and the financial sector
more broadly also play a key role. So to the extent that these
other monetary factors are likely to affect inflation, there
could be incremental information in money growth over and
above that contained in official interest rates.
It is also possible that there are other channels through which
money specifically, rather than interest rates, can influence
inflation. For example, some economists argue that
temporary excess money balances can lead to additional
changes in asset prices, which will affect nominal spending and



379

inflation through their impact on wealth. If assets are
imperfect substitutes, individuals care about the composition
of assets within their portfolio. As Tobin (1969) highlights,
changes in money holdings would require the prices, and
therefore returns, on other assets to adjust to induce them to
want to hold that new level of money balances. That could be
because the marginal value of additional money held for
prudential reasons falls as more money is held (such that the
risk of needing such large sums diminishes). The potentially
imperfect substitutability of some types of asset is also a key
part of the traditional monetarist view as set out, for example,
in Meltzer (1995).
The influence of the banking sector on money and the
imperfect substitutability of assets do not necessarily mean
that policymakers need to focus on money growth. Looking at
the full range of yields on other assets and banks’ lending and
deposit criteria could provide similar information. But money
may be a useful summary statistic for this diverse set of data.
And some yields, such as the liquidity benefits from holding
certain assets, may be unobservable. Indeed, Friedman (1956)
suggested that human wealth — the expected value of future
earnings — might also influence the demand for money.
Overall, this section has highlighted a number of ways in which
monetary developments can go beyond the impact of changes
in official interest rates. And that is particularly relevant in the
context of modern macroeconomic models, which are
discussed in the next section.

The role of money in modern macroeconomic models
The current practice of central banks to implement monetary
policy through changes in interest rates rather than changes in
money supply has been reflected in modern macroeconomic
models. In standard New Keynesian models, for example,
aggregate demand is determined by expected real interest
rates, with monetary policy characterised by an interest rate
rule. There is no explicit role for money at all in such models.(1)
This is also true for many of the larger models of this type used
by central banks and others for forecasting purposes, including
the Bank’s quarterly model BEQM (see Harrison et al (2005)).
Indeed, Woodford (2003) highlights that the relationships in
New Keynesian models would hold even if the quantity of
money in circulation became vanishingly small.(2)
Implicitly, these standard models assume that movements in
interest rates adequately capture changes in other asset prices
as well. That is the case if there are complete and flexible asset
markets, such that the risk-adjusted returns on all assets are
equalised. But the monetarist view suggests that this might
not be the case, and so excluding money could be important

(1) See for example Clarida, Gali and Gertler (1999) and Rotemberg and Woodford
(1997).
(2) However, the current framework for the implementation of monetary policy depends
crucially on the banking system’s demand for central bank money. See for example
Clews (2005).

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Quarterly Bulletin 2007 Q3

unless all yields are included in the model. By necessity,
economic models are simplifications of the real world. And
these additional monetary channels can sometimes be difficult
to capture. So it could also be that standard models ignore
these particular channels because their effects are small and
do not significantly affect the model’s performance.

Reynard (2004) finds that rising wealth in the United States
has played a significant role in increasing participation in asset
markets, and may help to explain changes in money demand.

Money can be added to standard models. But this is typically
done in a way that makes it an additional output of the model
rather than part of the transmission mechanism, for example
through a ‘cash in advance’ constraint that forces money to be
held to conduct transactions. Woodford (2007) shows that
adding a money demand equation to a standard New
Keynesian model in this way does not alter the paths of
inflation, output and interest rates; it only provides extra
detail about the outcome. So an active role for money is still
missing. In addition, the standard macroeconomic models do
not usually include a banking sector, a key part of the broad
money creation process.
The exclusion of money from standard macroeconomic
models raises two possibilities. It could be that money is
indeed not needed or at least plays only a very small
incremental role. It may contain only the same information
about future inflation as other variables in the model, such as
interest rates and output, and so have no incremental value.
There is some empirical support for this. Studies such as
McCallum (2001) and Ireland (2004) find only small effects
from including money.
But it is also possible that the simplifications made by the
standard models exclude important channels of the monetary
transmission mechanism. Alternative models that attempt to
capture some of the key features of money more explicitly
generally fall into two groups: those that focus on the frictions
and transaction costs that can influence the demand for
money; and those that incorporate elements of the banking
sector which can affect money supply. As noted above, two
key frictions that generate a demand for money as a medium
of exchange are the need to find buyers and sellers willing to
trade (the double coincidence of wants), and the desire to
avoid extending credit when little is known about other
traders. These frictions are modelled, albeit in a stylised way,
by Kiyotaki and Moore (2002) and Kiyotaki and Wright (1989).
More recently, work has focused on integrating these features
into broader macroeconomic models (see for example Aruoba
and Chugh (2006)).
Frictions also affect the demand for money as a store of value.
A key strand of this literature has looked at the extent to
which transactions costs prevent some people from switching
money into higher-yielding, but less liquid, assets such as
bonds or equities. In these ‘limited participation models’,
changes in technology that reduce transaction costs can affect
money demand and therefore the prices of other assets.



Transaction costs in asset markets can also lead to different
types of assets being imperfect substitutes. That would add to
the value placed on liquid assets such as money. And as
monetarist theories highlight, this can lead to changes in the
quantity of money holdings affecting asset prices. Andres,
Lopez-Salido and Nelson (2004) incorporate these features
into an empirical model, and find that changes in money
balances can have significant effects on asset prices.
A large part of the literature looking at how the banking sector
may influence the supply of money is focused on the
transmission of changes in monetary policy. For example,
Bernanke, Gertler and Gilchrist (1999) develop a ‘financial
accelerator’ model, where changes in interest rates can also
affect the creditworthiness of potential borrowers,
exacerbating the impact on bank lending and therefore the
generation of deposits. Other papers, such as
Markovic (2006), have looked at how the cyclical influence of
monetary policy might also affect banks’ own capital and
hence their willingness to lend. But a second strand of the
literature considers whether changes emanating from the
banking sector itself may affect the supply of money. Gaspar
and Kashyap (2006) introduce a spread between the policy
rate and banks’ lending rate into a standard New Keynesian
model, with the implication that changes in the spread can
affect spending and inflation. Goodfriend and
McCallum (2007) model the banking sector more explicitly
and find that changes in banking sector productivity can have
substantial effects on spreads and therefore borrowing and
spending decisions. Such models may prove to be useful tools
for analysing the possible effects of recent financial market
turbulence. Despite such advances, it is not straightforward to
apply these findings in a policymaking context. In particular,
most studies have focused on specific channels, and do not
bring together money demand and money supply in a
coherent way that can be incorporated in wider
macroeconomic models.

Money as an indicator
Even if money plays no incremental role in the transmission
mechanism, it may still be a useful additional indicator. As
noted earlier, it can be a useful summary statistic for the wide
range of yields that must be taken into account in a world with
imperfect asset markets, or the range of lending and deposit
criteria that affect the role of the banking sector in the
economy. Nelson (2003), for example, suggests that
developments in monetary aggregates can be informative for
this reason. Money can also provide an important cross-check
for other indicators of inflationary pressures within the
economy. For example, a key variable for judging
medium-term inflationary pressure within the standard New

Research and analysis Interpreting movements in broad money

Keynesian model is the output gap — actual output relative to
its sustainable level. But this gap can only be measured
imperfectly. The sustainable level of output is not directly
observable, and early estimates of actual output are subject to
considerable uncertainty. So money growth may provide
corroborative evidence to the extent its role as a medium of
exchange means it is correlated with movements in activity.
Monetary data can be used, therefore, to complement the
analysis of other economic data. They also have the advantage
that they are typically published in a more timely manner. And
estimates are not subject to sampling error as they are based
on data from the entire population of banks. However,
identifying the correct definition of the money stock can be
difficult (see Burgess and Janssen (2007)). And as noted
above, it is hard to judge the level of money growth that would
be consistent with a given level of inflation, due to changes in
money demand. For example, Coenen, Levin and
Wieland (2005) find that, in recent years, the extent of
changes in money demand in the euro area have meant that
money has fairly limited information content as an indicator.
And Dotsey and Hornstein (2003) find similar results for the
United States. But this could simply highlight the need to
understand better the drivers of money demand. Choi and
Oh (2003) find that taking into account uncertainty over
output and inflation can improve estimates of money demand
in the United States. And that could make money more useful
as an indicator.

Money demand and money supply in practice
Whether money is useful purely as an additional corroborative
indicator or as an incremental source of information, the key
to the practical task of assessing the implications of
developments in monetary aggregates for inflation is
understanding why money growth has evolved as it has.
Unanticipated events — ‘shocks’ — can occur for many
different reasons. But ultimately the aim is to identify the
extent to which different shocks have affected money demand
and money supply. Changes in money growth must reflect
changes in supply, but the key question, as illustrated in
Figure 1, is whether that change to supply occurred in
isolation, or whether it was accompanied by a change in the
demand for money.

output. Economists routinely try to assess whether
movements in output reflect demand pressures or changes in
the underlying capacity of the economy. In the same way,
careful analysis is required of the likely causes of changes in
money growth, in order to assess the potential risk posed to
inflation by monetary developments. This point was also
emphasised recently by Goodhart (2007). The next section
sets out an initial step towards an analytical approach that can
be employed to help form that judgement.

Identifying the causes of money growth
When analysing monetary aggregates, the aim is to be able to
build up a detailed picture of the likely impact of each
potential factor affecting the growth in money. Overall
growth can then be assessed to consider the extent to which
changes in money supply have been accompanied by changes
in money demand. In practice, estimates of the impact of
different factors on money supply and demand are likely to be
highly uncertain. And it is unlikely that money growth will be
entirely ‘explained’ by the factors identified. But this process
should at least provide a guide to the balance of risks. A range
of information that can be used to identify potential factors
affecting money growth is set out below.

The standard determinants of money demand
As noted earlier, part of the growth in money is associated
with rising demand for transactions balances as nominal
spending increases over time. So one simple indicator of
temporary ‘excess’ money balances is the extent to which
money growth exceeds nominal spending (Chart 4).(1)
However, as there are many other reasons why the demand for
money may have changed, this indicator only really signals
that further investigation is required.
Chart 4 Annual money growth less nominal spending
growth(a)
Percentage points

20
15
10
5

+
0

–

In practice, assessing how shocks affect money demand and
money supply is difficult. And that has led to problems in the
past in judging the appropriate policy response to monetary
developments. The box in this article on page 382 highlights
examples of substantial changes in both money demand and
money supply in the 1980s. But difficulties in understanding
the underlying drivers of the data are not unique to monetary
aggregates. And they do not mean that money should simply
be ignored. As King (2007) notes, the same issues arise when
assessing developments in other economic variables, such as



381

5
10
15

1971

75

79

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87

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2003 07

20

(a) Growth in M4 less growth in nominal GDP.

(1) Using the equation of exchange terminology, money growth in excess of nominal
demand growth is equivalent to a falling velocity of circulation.

382

Quarterly Bulletin 2007 Q3

Examples of money demand and money
supply shocks in the 1980s

The 1980s were a period of substantial financial liberalisation
and innovation. That boosted money growth through
deregulation of the financial sector. Bank credit became easier
to obtain, leading to more rapid creation of deposits. This was
accompanied by innovations that made holding money
balances more desirable. For example, current accounts began
to pay interest and credit and debit cards made the use of
interest-bearing deposits for settling transactions much easier.
The move away from the very high and volatile inflation in the
1970s is also likely to have made holding money balances
more attractive. In the early 1980s, money growth was high,
but it did not feed through to nominal spending, and hence
higher inflation, because households and companies wanted to
hold more money balances.

The 1980s provide a useful example of the difficulties of
assessing the implications of strong money growth from the
headline data alone. Annual growth in broad money remained
high throughout the 1980s, averaging around 15%. But
inflation followed a quite different path. It fell back rapidly in
the early part of the decade before picking up sharply towards
the end (Chart A). During that decade, there were substantial
changes to both money supply and money demand. And as
the balance between the different factors driving these
changes evolved, the implications for inflation also changed.
Chart A Broad money growth and inflation
Percentages changes on a year earlier

30

25

20

Broad money

15

10
RPI
5

1971

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2003 07

0

The impact on money demand of changes in spending, and
other key determinants such as relative returns and wealth,
can be estimated more formally through econometric
equations. Such equations have often proved to be unstable in
the past, reflecting the fact that they omit other influences on
money demand.(1) These other factors are often difficult to
capture in a single equation, either because they are a series of
one-off events or are difficult to quantify. In spite of these
difficulties, a simple mechanical approach, using standard
determinants, can provide a useful starting point for
estimating a measure of ‘excess’ money supply that might feed
through to inflation. When estimated gaps arise, as they have
in recent years, the key task is then to build up a more
informative picture of other factors that may have influenced
money demand or money supply through more detailed
analysis.

Information from the sectoral breakdown of money
growth
The UK M4 data provide a breakdown of who holds deposits:
households, private non-financial companies or non-bank (and



In the mid-to-late 1980s, money growth was further boosted
by monetary policy easing. This led to households and
companies temporarily holding ‘excess’ money balances. In
turn, that put upward pressure on the demand for goods and
services and other assets which ultimately lead to higher
inflation. But because rapid changes in money demand were
still taking place, it was less clear at the time that strong
money growth was signalling rising inflationary pressures.
A detailed analysis of the likely impact of financial market
developments on money demand as well as money supply
may have given a clearer picture of the risks to inflation. But
the 1980s episode also highlights the importance of looking at
other indicators in conjunction with money growth to assess
inflationary pressures. For example, credit growth was even
stronger than money growth in the late 1980s, with the annual
rate peaking at almost 25% in 1988.

non-building society) financial companies (known as OFCs —
other financial corporations). A similar breakdown is provided
for bank lending. That can help to identify the potential causes
of changes in money demand and supply by narrowing the
focus onto a particular sector. But care is needed when using a
sectoral approach. Changes in money supply may be
generated by lending in one sector, but lead to temporary
‘excess’ money holdings in a different sector, as the additional
money balances circulate around the economy.
In recent years, for example, much of the pickup in overall M4
growth has been driven by OFCs (Chart 5). OFCs’ money
growth tends to be much more volatile than other sectors, but
the latest pickup has been sustained: deposits have risen by
more than 85% over the past three years. This sector has
become increasingly important over the past 25 years, with its
share of overall deposits rising to around a quarter. In part,
that reflects a growing share of households’ assets being held
(1) For a discussion of the instability of estimated money demand equations and
potential explanatory factors, see Ireland (1995).

Research and analysis Interpreting movements in broad money

indirectly through financial intermediaries such as pension
funds. But the OFCs sector comprises a diverse range of
businesses. And for some of the other companies within the
sector, less is known about their motives for holding money.
Improving the understanding of money growth in the OFCs
sector is a key challenge for the Bank’s current work on
monetary analysis (see Burgess and Janssen (2007) for a
discussion of some key issues relating to OFCs’ deposits).
Chart 5 Broad money holdings by sector
Percentage changes on a year earlier
Other financial corporations

35
30
25

Private non-financial corporations

20
15
10
Households

5

+
0

–
2000

01

02

03

04

05

06

07

5

Temporary holdings of excess money balances in different
sectors are likely to have different implications for activity and
inflation. An overhang of money in the household sector
might lead to higher consumption, while an overhang in
non-financial companies might lead to increased investment
spending. Excess money holdings by OFCs are perhaps more
likely to feed through to asset prices, as those companies
attempt to rebalance their asset portfolios. Disaggregated
money data can be useful, therefore, as an indicator of specific
components of spending (see Hauser and Brigden (2002) and
Thomas (1997a, b) for more detail), as well as highlighting
where corroborative evidence of a money overhang might
arise.

Understanding developments in the banking sector
and financial markets
Innovations in the financial sector are another key source of
changes in money growth. For example, the box in this article
on page 382 highlights the impact of financial liberalisation in
the early 1980s on both money supply and money demand.
That reflects the fact that the banking sector plays such an
important role in the creation of money. Changes in the terms
for deposits will affect the demand for money, while changes
in the terms for loans will affect the amount of bank lending
and hence money supply.
There are a number of different sources of information that
can be used to identify and evaluate changes in banking sector
behaviour that may have affected money growth. For
example, data are collected on the retail interest rates faced by



383

households and companies. And time-series data are available
on some bank lending criteria, such as loan to value and loan
to income ratios. Changes in lending terms and conditions can
also reflect innovations in the structure of banks’ balance
sheets which can be monitored. Indeed, in some
circumstances credit rationing may occur, in which case data
on the size and composition of banks’ balance sheets may
contain more information than quoted interest rates.
But other changes may be less apparent in standard statistical
series. In such cases, market intelligence can often provide an
important additional source of information. The Bank
maintains a dialogue with participants in the banking sector
and the financial markets more generally through a variety of
channels. These range from the new Credit Conditions Survey
(see the article by Driver (2007) in this edition of the
Quarterly Bulletin for more details) to reports from the
financial market contacts of the Bank’s regional Agents and
other, less formal, regular working level discussions. The
importance of developments in the banking sector and
financial markets for interpreting movements in money
growth is highlighted in the discussion below of recent trends
in money growth.

Judging the implications of money shocks
Once the candidate drivers of money demand and money
supply have been identified, the next step is to understand
how they might, on balance, feed through to inflation. That
can be difficult because the impact on the transmission
mechanism of the interaction between such a potentially wide
range of factors is not well specified in the theoretical
literature. This is an area where further research may prove
useful. But the lack of good models should not lead
policymakers to ignore the shocks. Instead, as is often the case
with other economic developments, judgement must be
exercised. That will involve generating a pragmatic assessment
of the risks posed by the various monetary shocks. In that way,
policymakers can then decide on the appropriate policy
response. As part of that process, it is also important that the
potential implications of developments in money for other
variables, such as asset prices, are taken into account, to avoid
double counting the news contained in those indicators.

Interpreting recent movements in broad
money
In practice, policymakers consider a range of evidence on the
potential drivers of monetary data. The pickup in money
growth, declining credit spreads over recent years and the
incipient tightening of credit conditions associated with the
financial market turbulence over recent months, provide useful
examples. The rapid money growth and declining credit
spreads over the past few years are discussed first before

384

Quarterly Bulletin 2007 Q3

turning to the developments associated with the more recent
financial market turbulence.

Chart 7 LBO loan issuance(a)
US$ billions

As noted earlier, much of the pickup in broad money growth
over the past three years can be accounted for by OFCs. In
large part that has been generated by increases in the growth
of bank lending to that sector. But there has also been a
pickup in the growth of lending to private non-financial
corporations (PNFCs) (Chart 6).

70
60
50
40
30
20

Chart 6 M4 lending by sector(a)
10
Percentage changes on a year earlier

35
30

Other financial corporations

1987

89

91

93

95

97

99

2001

03

05

0

07

Source: Dealogic.

25

(a) Leveraged buyout loans taken out by UK companies. Half-yearly data as at 6 September.

20
Households

15
10
5

Private non-financial
corporations

+
0

–
2000

01

02

03

04

05

06

07

5

(a) Excludes the effects of securitisations and loan transfers.

In part, these movements are likely to reflect changes in the
structure of financial markets. Burgess and Janssen (2007)
highlight two substantial changes. First, the expansion of
OFCs intermediating between banks is likely to have boosted
both money and credit growth in that sector. And second, the
rapid growth in securitisations of loans could have led to
increases in both aggregate money and credit (though this
depends on how the deals were structured and on the
behaviour of the aggregate banking system in response).
Tucker (2007) notes that securities dealers may also have
expanded their borrowing and deposits through greater repo
activity with banks. Much of this may net out for the dealer
concerned, but will still appear on both sides of banks’
balance sheets, boosting money and credit growth. Such
transactions between the bank and OFCs sectors are unlikely
to have any direct implications for inflation — additional
deposits are willingly held so the increase in money supply
has been associated with an equivalent increase in money
demand.
Other changes could affect asset prices. For example, the
rapid growth in debt-financed merger and acquisition activity
led to sharp increases in lending to companies (Chart 7). The
deposits generated by such lending may be held by the
acquiring companies temporarily, but will ultimately be used
to buy other assets which may be associated with higher asset
prices. The extent to which asset prices have already adjusted
in anticipation of such activity is unclear.



These changes are unlikely to explain all of the pickup in
money growth over the past three years. Another
contributory factor could have been a loosening of credit
conditions by the banking sector over the same period.
Spreads on bank lending to both households and companies
narrowed between 2004 and mid-2007 (Chart 8). To the
extent that this was not offset by increases in other price
components of lending, such as fees, it is likely to have
increased bank lending, generating stronger money growth.
Further, the proportion of new mortgages taken out at higher
loan to value and loan to income ratios increased during that
period (Chart 9), suggesting that banks may have loosened
their non-price criteria for household secured lending. That is
consistent with evidence from banks, which also indicated an
easing of non-price terms on corporate borrowing in recent
years. These developments are likely to have boosted the
supply of money.

Chart 8 Changes in bank lending spreads between
January 2003 and July 2007(a)
Percentage points

0.2

+

Private non-financial corporations

0.0

–
0.2
Households

0.4
Other financial corporations
0.6

0.8
2003

04

05

06

07

Sources: Bank of England and Bloomberg.
(a) Effective retail interest rates on the stock of outstanding loans relative to an appropriate
funding rate. For floating-rate products, that is assumed to be Bank Rate. For fixed-rate
products, Libor and swap rates of similar maturities are used (averaged over the relevant
horizon and lagged one month). Prior to 2004, the shares of each product within the total
borrowing for each sector are held constant due to lack of data.

Research and analysis Interpreting movements in broad money

Chart 9 Median loan to value and loan to income ratios
on new mortgages(a)
3.5

Ratio

Percentage of house value

100
90

3.0
Loan to value
(right-hand scale)

80

2.5

385

balances boosted the prices of other assets. The extent to
which the demand for money increased independently of the
credit supply shock, therefore, is unclear. And at least part of
the past increase in money growth may have reflected an
increase in supply alone, which could ultimately feed through
into inflation.

70
Loan to income
(left-hand scale)

2.0

60

Chart 10 Broad money as a share of financial assets(a)

50
Percentages of total financial assets

1.5

40
30

1.0

Households

30

25

20
0.5
10

20
Private non-financial corporations

0.0

1980

83

86

89

92

95

98

2001

04

07

0
15

Source: CML/BankSearch Regulated Mortgage Survey.
(a) New loans for house purchases by both first-time buyers and home movers. Changes to the
methodology and sample of the survey in 1992 Q2 and April 2005 mean that the figures
before and after those dates are not strictly comparable.

10
Other financial corporations

The loosening in credit conditions between 2004 and
mid-2007 could have partly reflected an increase in banks’
ability to intermediate funds. For example, the expansion of
the securitisation market allowed banks to obtain funding for
their lending at lower interest rate spreads relative to the
policy rate. And to the extent that banks used securitisations
to shift credit risk off their balance sheets, they may have been
able to expand their lending more rapidly for a given capital
base. Gieve (2007) also highlights the potential role of
developments in information technology and derivatives
markets that may have allowed banks to manage their risk
exposures more effectively. Another possible explanation for
the loosening in credit conditions may have been greater
competition within the banking sector.
The implications for activity and inflation of this possible boost
to credit and the money supply in the past few years will
depend, as noted above, on whether there was an associated
increase in the demand for money. Money demand may have
increased to some extent. Over the past three years, deposit
rates for OFCs have increased relative to Bank Rate, increasing
their attractiveness. That could have been a counterpart to
the expansion of credit, if banks were trying to attract deposits
as a way of funding their lending. However, over this period
spreads on deposit rates for private non-financial companies
have been broadly stable while household deposit rates have
fallen relative to an appropriate set of market interest rates.
Another possibility is that rising wealth could have boosted
the demand for money by households and companies, as they
sought to maintain the share of their overall asset portfolios
held as money. Despite the rapid growth in money holdings,
the proportion of financial asset portfolios accounted for by
money has remained broadly constant since 2004 (Chart 10).
However, the key issue is what caused wealth to increase over
this period. The increase in wealth may have been the result of
the credit supply shock as the faster creation of money



1987 89

91

93

95

97

99

2001 03

5

05

07

0

(a) Non seasonally adjusted quarterly data.

So developments in the banking sector and financial markets
appear to have affected both money demand and money
supply in recent years. But quantifying the scale of the
different factors, and hence any potential overhang of
temporary excess money balances, is difficult. Further
development of the analysis set out above, using a wide range
of quantitative and qualitative information, may help to
provide more robust estimates. In addition, other economic
indicators can be used as a cross-check on the potential effects
of strong money growth. For example, the recovery in
business investment during 2006 is consistent with the pickup
in corporate borrowing.
Some of the factors discussed above reflect structural changes
in the financial sector that are likely to persist. But it is
possible that at least part of the developments in the
monetary data over the past few years was cyclical. Indeed, a
key judgement for policymakers is the likely persistence of
such effects. The turbulence in financial markets in recent
months and the likely associated tightening of credit
conditions suggests that market participants may be
re-evaluating the riskiness of lending portfolios. This could
ultimately lead to a slowdown in bank lending and potentially
lower spending and inflation. While the extent to which credit
conditions might tighten is highly uncertain at this stage, this
episode highlights the important role of monetary data in
assessing the situation. In exceptional times, substantial
liquidity and risk premia may affect financial market prices so
that quantity information — on both broad money and credit
— can be particularly useful for analysing the behaviour of the
financial sector. Continued monitoring of developments in

386

Quarterly Bulletin 2007 Q3

money and credit in the coming months will help to shed light
on recent events.

And assessing these very recent developments is certainly not
an easy task. But to put the recent events in context requires
an analysis of the developments in broad money and credit
over the past few years. And judging their likely impact on
inflation going forward requires continued monitoring of
money and credit data.

Conclusions and future work
Standard macroeconomic models are largely silent on the role
of money in the economy. And empirical relationships
between money and inflation have tended to be unreliable
over short horizons. But that does not necessarily mean that
developments in monetary aggregates are irrelevant. At the
very least they provide a cross-check for other economic
indicators that are subject to uncertainty. And there may also
be channels through which monetary quantities contain
incremental information for inflation.
Broad money growth has picked up sharply over the past
three years. Understanding why that has happened is crucial in
assessing the possible implications for inflation. Looking at the
potential factors in more detail, a number of these appeared to
boost money supply and, to some extent, money demand.
While money growth associated with changes in money
demand is likely to have few implications for inflation, changes
in supply that generate an overhang of temporary ‘excess’
money balances could lead to higher demand for goods and
services and other assets, pushing up inflation. Over recent
months, credit conditions are likely to have tightened in light
of global financial market turbulence. It is too early to judge if
these effects will persist, which could lead to a slowdown in
bank lending and potentially lower spending and inflation.




The basic approach set out in this article provides a starting
point for thinking about movements in broad money. And it
has underpinned the analysis of recent monetary
developments in the Bank, as discussed in recent Inflation
Reports and the minutes of recent meetings of the Monetary
Policy Committee. But further development of this analysis is
required. Three main areas of work are planned. First,
innovations in the banking sector raise measurement issues
regarding the appropriate definition of money. The article by
Burgess and Janssen (2007) in this Quarterly Bulletin is a first
step in setting out the issues in this area. Second, the rapid
pace of technological change in the financial sector means
that it is important to utilise market intelligence to
understand the implications of these changes. The Bank is
continuing to develop its market intelligence function, and the
new Credit Conditions Survey (outlined in the article by
Driver (2007) in this edition of the Quarterly Bulletin) is an
important element of this process. Finally, further work on
modelling the role of money in the economy may allow the
insights from monetary aggregates to be captured more
formally.

Research and analysis Interpreting movements in broad money

387

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