Monetary Economics

1. Gurley Shaw
• Gurley and Shaw suggest a liquidity definition of money in which money
is regarded as “a weighted sum of currency and demand deposits and
substitutes with weights assigned on the basis of the degree of
substitutability ranging from one to zero”.
• The more imperfect substitute, the less the weight.

2. Introduction
• Gurley-Shaw thesis was based on the implications of the rapid growth of
financial intermediaries in the post-War II period.
• Gurley and Shaw were particularly inspired by the work of Raymond
Goldsmith which showed that while all financial intermediaries grew rapidly
during the first half of the 20th century.
• The claims of non-bank intermediaries increased much more than the
demand deposit claims of the commercial banks, thus causing the
commercial banks to diminish in importance among all intermediaries.

3. Contributions…
• (a) The relative decline of commercial banks weaken the ability of the central
bank to control economic activity,
• (b) Direct control of non-bank intermediaries is necessary,
• (c) Non-bank financial intermediaries are to be treated in exactly the same
way as commercial banks if the amount of lending in the economy is to be
controlled.

4. Policy Implications of Non-Bank Financial
Intermediaries:
• All financial intermediaries except banks are non-bank financial intermediaries. The
basic difference between commercial banks and non-bank financial intermediaries is
that the former possess, while the latter do not possess, the demand deposits or
credit creating ability.
• According to Gurley and Shaw, currency and demand deposits are not unique assets
(except as means of payment); they are just two among many claims against
financial intermediaries.
• The claims against all types of financial intermediaries are close, though not perfect,
substitutes as alternative liquid stores of value or as temporary abodes of
purchasing power.

5. Savings Deposits and Demand Deposits
• The saving deposits of different types of non-bank financial intermediaries
are more or less the same as the demand deposits of commercial banks
because saving deposits can be easily converted into cash or demand
deposits.

6. Non-bank financial intermediaries and
Monetary policy
i. Secular Monetary Policy:
• The long run monetary policy must maintain some optimum rate of interest over time to be
consistent, say, with full employment.
• Gurley and Shaw believe that in a monetary model with a variety of money substitutes, no
simple rule can be adopted for ascertaining the growth in the conventionally defined money
supply necessary for keeping interest rate on an optimum full-employment trend.
• The determination of a long-run monetary policy (i.e., determination of the necessary
increase in the money supply) is not a simple function of trends in income but of a host of
other factors, like the share of spending that is externally financed (specially by long-term
securities), the growth in demand by spending units for direct, relative to indirect financial
assets.

7. ii. Cyclical Monetary Policy:
• If the central bank wants to adopt a tight money policy to reduce money apply, it
can do so only by restricting the credit creating activities of the commercial banks.
• But, on the other hand, the non-bank intermediaries tend to offset the
decline in money supply by increasing the velocity of money in two ways:
• (a) By selling government securities to holders of idle demand deposits in the
commercial banks, the non-bank intermediaries can activate the deposits and raise
velocity.
• (b) By raising the rate of interest to be paid on deposits, the non-bank
intermediaries can attract idle demand deposits away from commercial banks and by
relending them the velocity of money can be raised.

8. How it
works
An anti-inflationary monetary policy - the central bank reduces the money
supply in order to control inflation. Among other effects, the interest rates on
market securities rise in anticipation of higher yields and profits. NBFIs will
raise the interest rates on their savings deposits to attract more funds in order
to invest them in higher yielding securities.
Persons already holding securities find that their prices have fallen because of
the rise in interest rates on present securities. They will, therefore, sell them
and deposit their funds with intermediaries in order to earn higher interest
rates on savings deposits. In the meantime, attracted by higher interest rates,
others holding idle cash balances will also deposit them with intermediaries.
So when NBFIs raise the interest rates on their savings deposits, the public
reduces its demand for money which, in turn, reduces the market rate of
interest. Thus NBFIs make tight monetary policy less successful or effective.
Similarly, NBFIs can make an expansionary monetary policy ineffective by
reducing liquidity.

9. Diagram

10. Broad Conclusions of the Theory
• (i) According to the liquidity theory of money, the relation between money and the
volume of economic activity (or the general price level) cannot be explained either
by the classical quantity theory or by the Keynesian income theory, but by the role
played by the whole structure of liquid assets which can serve as a substitute for
money.
• (ii) It is not the quantity of money in the economy; but the liquidity of the economy,
that is more significant in the monetary analysis.
• (iii) The definition of liquidity is not limited to the amount of money in existence.
Liquidity consists of the amount of money people think they can get hold of
whether by receipt of income, by disposal of capital assets, or by borrowing.

11. Conclusion
• (iv) Aggregate spending in the economy is influenced not by the currency and the bank
deposits, but also by the near-money assets as created by the non-bank financial institutions.
• (v) The non-bank financial institutions through their near-money assets increase the liquidity
in the economy. Increase in liquidity causes a rise in the velocity of money which, in turn,
expands general business activity.
• (vi) The traditional monetary policy which influences only the total volume of money
supply and not the total volume of liquidity in economy is inadequate and ineffective.
• (vii) Non-bank intermediaries are to be treated in exactly the same way as commercial banks.

12. Financial Disintermediation
• Financial Disintermediation:
• Radcliffe-Gurley-Shaw view that the growth of non-bank financial
intermediaries weakens the monetary policy remained popular during the late
1950s and early 1960s in the U.S.A. and U.K.
• But, during the 1960s and the 1970s, financial disintermediation
(opposite of financial intermediation) occurred in both these countries
because of two reasons:

13. How it Works
• (i) During periods of tight money, interest rates rose. In order to take advantage of this rise
in the interest rates, the public tended to withdraw their funds from the non-bank
intermediaries and started lending directly to investors by buying primary securities.
• (ii) The financial Reserve System imposed ceiling on the deposit rates of the financial
intermediaries. The rationale behind this ceiling was to make tight money policy effective.
• (iii) A ceiling on the deposit rates would induce individuals to withdraw their funds from
financial intermediaries and invest directly in primary securities. This would reduce the bank
reserves and curtail their ability to create credit. Financial disintermediation thus
undermined the significance of Radcliffe- Gurley-Shaw approach.

14. News
• https://www.outlookindia.com/outlookmoney/investment/mothers-day-
2021-smart-gifting-ideas-to-secure-your-mothers-financial-future-7138