Gurley shaw Theory of Monetary Economics.

In the Gurley-Shaw thesis the quantity of money' relevant for monetary theory and policy has to include the liabilities of non-bank financial intermediaries.

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

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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.

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