To control it, authorities use an intermediate target: money supply. In using money supply as an intermediate target, the central bank first drives an estimate of money demand which is consistent with inflation target. Hence, it announces a target money supply to equilibrate the market for money. Recalling the quantity theory of money, the demand function for money takes the following form:
log m = a + b log y + c log p - d log i
where m is money demand, y = real income, p = the price level and i = nominal interest rate. The steps to determine money supply are:
i) To estimate the parameters a, b, c and d of the money demand function.
ii) To replace y with the estimate of potential growth for the following year and i with the interest rate set by the central bank itself.
iii) To replace p with the target level of inflation.
iv) To estimate the change in money demand and hence the change in money supply required to match it.
c) The previous procedure works if and only if the parameters of the equation are constant or if their change can be estimated. If this is not the case, the central bank is not able to predict that rate of expansion of money supply which is consistent with targeted inflation. In recent years money demand has demonstrated to be unstable in most countries for several reasons:
i) The velocity of circulation of money has changed (due to technical innovations as the automatic teller machines and new financial products)
ii) The velocity of money has changed differently for different definitions of money supply (velocity of narrow money has increased, of wider money has decreased).
iii) The change in velocity can be a direct consequence of monetary policy, thus creating a feedback in the equation and a bias in the estimate.
For Germany, according to Dr. Tietmeyer, demand for money has turned out to be stable. This implies that the money demand equation can be trusted and that money supply is still a useful intermediate target to control inflation.
d). If money supply exceeds money demand, a more restrictive monetary policy will be implemented using the standard tools: open market operations, discount rate changes, direct controls, persuasion etc.