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Chapter VII: Money, assets, and interest rates. What is money? Monetary aggregates Demand for financial assets Asset market equilibrium Liquidity preference theory Interest rates and interest rate spreads. What is money ?. - PowerPoint PPT Presentation
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Goethe Business SchoolGoethe Business School
Chapter VII: Money, assets, and interest rates
A. What is money?
B. Monetary aggregates
C. Demand for financial assets
D. Asset market equilibrium
E. Liquidity preference theory
F. Interest rates and interest rate spreads
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What is money ?
“Money is what money does. Money is defined by its functions”
(John Hicks).Money is an information
processing technology that aims at reducing
uncertainty and establishing trust. John Hicks 1904-89
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What is money ?
Money is typically defined by describing its functions
Important functions are: unit of account medium of exchange
(the easing of transactions of goods and services) the store and transfer of value (wealth)
The functions of money are embedded into a historical process
The definition of money is thus evolving
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Stone “money” of the island of Yap
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Evolution of the payment system
Commodity money Fiat money Electronic money
Debit cards (EC card, ATM card) Stored-value card (“money card”) Electronic cash/checks
Are we moving to a cashless society?
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Unit of account In microeconomic theory any good can function
as a unit of account It is more convenient to use “money” as a single,
uniform unit of account because goods may be subject to relative price changes
At the global level it is questionable what should be the unit of account
The U.S. dollar and the euro play an important role, but there are also proposals to revert to commodity money (gold, petroleum)
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Medium of exchange
The decomposition of exchange acts renders a modern economy based on labor sharing possible
But this requires the existence of a social consensus, according to which money is accepted as a general medium of exchange
A legal provision can facilitate such acceptance, but it cannot necessarily be enforced
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Medium of exchange: Lack of confidence
Where there is lack of confidence in a legal tender, there could be escape into “substitute currencies” (= “hard” currencies or commodity money --> such as cigarettes, butter)
Such “monies” circulate forcibly as media of exchange, but they are unsuitable as a store of value (Gresham’s “Law”):
Bad money replaces good money!
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Payment function
This function permits the granting of credit, the transfer of credits and liabilities, and the redemption of debentures
The prerequisite is that credit money will be provided and is universally accepted within a society
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Ability to pay or “liquidity”
To the extent that assets may have monetary characteristics, money can produce returns (interest income)
Normally, money is held interest-free The question is: Why do individuals hold
money without interest? This brings us to the notion of
Store of value
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“Quasi-money”
Close substitutes to money (such as short-term financial assets) can function as a store of value, hence bear interest, and still be “liquid”
Such “quasi-money” can be converted into money without high transactions costs
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Liquidity as a technology of exchange
Liquidity depends on social conventions which establish confidence among potential trading partners and facilitate exchange
Disobeying to the rules is costly, so money reduces transactions costs and gets an own “intrinsic” value or price
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Liquidity The question is,
how to define “liquidity”. Milton Friedman proposes
an “ideal” definition: Liquity =
i Ai * wi,
where wi is the “degree of moneyness” of asset Ai.
Milton Friedman1912-
Nobel Prize 1976
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Empirical definition of money
Friedman’s approach had an important influence on the empirical and operational definition of money
The definition of “quasi-money” includes not only central bank money and demand deposits, but also time deposits and savings according to their “degree of moneyness”
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Measuring money demand
M1= “narrow money”
M2= “intermediate” money
M3= “broad money”
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Components of M3 Repurchase agreement: it is an arrangement
whereby an asset is sold but the seller has a right and an obligation to repurchase it at a specific price on a future date or on demand.
Such an agreement is similar to collateralized borrowing, but differs in that ownership of the securities is not retained by the seller.
Repurchase transactions are included in M3 in cases where the seller is a Monetary Financial Institution (MFI) and the counterparty is a non-MFI resident in the euro area.
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Components of M3 Money market funds:
they are collective investments which are close substitutes for deposits and which primarily invest in money
market instruments and other transferable debt instruments with a residual maturity up to one year,
or in bank deposits which pursue a rate of return that approaches the interest rates on money market instruments.
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Money demand in the Euro-area (end of 2007)
Billion euros In pc of currency in circulation
Currency in circulation
675 100
M1 = “narrow money”
3,835 569
M2 = “inter-mediate” money
7,339 1088
M3 = “broad money”
8,650 1282
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Development of M3 in the Euro area 1999-2008
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Relationship between M3 andthe inflation rate (HIPC)
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Quantity of money The central bank creates “base money”,
but this is not the only money in circulation Commercial banks also create money through
credits to their customers However as the liquidity of commercial banks
hinges on base money, it is reasonable to assume some relationship between total money and base money
It is often assumedM = m B = multiplier base money
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Keynes’ attitudetoward money Money is part of a portfolio of assets and
competes with real assets, other financial assets (such as bonds, commercial papers), and human capital
Any change in the stock of money will have to lead to a portfolio adjustment which affects the price structure of the portfolio
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Focus on demand forfinancial assets
We shall look into the money supply process and central banking in the next chapter
We now focus on the demand for financial assets, of which money is part of the portfolio, and on interest rates
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The demand for financialassets What determines the quantity demanded
of an asset? Wealth (total resources owned) Expected return of one asset relative to
alternative assets Risk (the degree of uncertainty associated
with the return) Liquidity (the ease and speed with which
an asset can be turned into cash)
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The demand for bonds We consider a one-year discount bond, paying
the owner the face value of €1,000 in one year
If the holding period is one year, the return on the bond is equal the interest rate i
It means: i = r = (F-P)/P If the bond price is €950, r = 5.3% We assume a quantity demanded at that price of
€100 million
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The demand for bonds
If the price falls, say to €900, the interest rate increases (to 11.1%)
Because the return on the bond is higher, the demand for the asset will rise, say to €200 million, etc
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The demand for bonds
950
900
850
800
750
5.3
11.1
17.6
25.0
33.0
Interest rate (%)Price of bond (€)
100 500400300200
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The supply for bonds
950
900
850
800
750
5.3
11.1
17.6
25.0
33.0
Interest rate (%)Price of bond (€)
100 500400300200
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Market equilibrium (asset market approach)
950
900
850
800
750
5.3
11.1
17.6
25.0
33.0
Interest rate (%)Price of bond (€)
100 500400300200
CP* i*
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Market equilibrium
Equilibrium occurs at point C, where demand and supply curves intersect
P* is the market-clearing price, and i* is the market-clearing interest rate
If the P P*, there is “excess supply” or “excess demand” of bonds
The supply and demand curves can be brought into a more conventional form:
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A reinterpretation of the bond market
Interest rate (%)
33.0
25.0
17.6
11.1
5.3
100 500400300200
Demand for bonds, Bd =Supply of loanable funds, Ls
Supply of bonds, Bs =Demand for loanable funds, Ld
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Why do interest rates change? If there is a shift in either the supply or
demand curve, the equilibrium interest rate must change.
What can cause the curves to shift? Wealth Expected return Risk Liquidity
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Example: Increase in risk, and demand for bonds If the risk of a bond increases, the demand
for bonds will fall for any level of interest rates
It means that the supply of loanable funds is reduced
It is equivalent to a leftward shift of the supply curve
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A shift of the supply curve of funds
Interest rate (%)
33.0
25.0
17.6
11.1
5.3
100 500400300200
Demand for bonds, Bd =Supply of loanable funds, Ls
Supply of bonds, Bs =Demand for loanable funds, Ld
CD
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Effects on the supply of funds for bonds
Wealth right
Expected interest
left
Expected inflation
left
Risk left
Liquidity right
Change invariable
Change inquantity
Change ininterest rate
Shift in supply curve
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The supply of bonds
Some factors can cause the supply curve for bonds to shift, among them The expected profitability of investment
opportunities Expected inflation Government activities
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Example: Higher profitability and supply of bonds
If the profitability of a firm increases, the supply for corporate bonds will increase for any level of interest rates
It means that the demand of loanable funds increases
It is equivalent to a rightward shift of the demand curve
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A shift of the demand curve for funds
Interest rate (%)
33.0
25.0
17.6
11.1
5.3
100 500400300200
Demand for bonds, Bd =Supply of loanable funds, Ls
Supply of bonds, Bs =Demand for loanable funds, Ld
C
D
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Effects on the demand of funds for bonds
Profitability right
Expected inflation right
Governmentactivities right
Change invariable
Change inquantity
Change ininterest rate
Shift in demand
curve
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Equilibrium in the market for money
Interest rate (%)
33.0
25.0
17.6
11.1
5.3
100 500400300200
Supply of money, Ms
Demand for money, Md
C
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Shifts in the demand for money curve Keynes considers two reasons why the
demand for money curve could shift: income; and the price level
As income rises wealth increases and people want to hold
more money as a store of value people want to carry out more transactions
using money
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Response to a change in income
Interest rate (%)
33.0
25.0
17.6
11.1
5.3
100 500400300200
Supply of money, Ms
Demand for money, Md
C
D
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Response to a change in the money supply It is assumed that the central bank
controls the total amount of money available
The supply of money is “totally inelastic”. However the central bank can gear the
money supply by political intervention If the money supply increases,
the interest rate will fall (liquidity effect)
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Response to a change in money supply
Interest rate (%)
33.0
25.0
17.6
11.1
5.3
100 500400300200
Supply of money, Ms
Demand for money, Md
C D
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Secondary effects of increased money supply If the money supply increases this has a
secondary effect on money demand As we have seen:
it has an expansionary effect on the economy and raises income and wealth-> interest rates increase (income effect).
it causes the overall price level to increase-> interest rates increase (price effect)
it affects the expected inflation rate-> interest rates increase (Fisher-effect)
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Should the ECB lower interest rates? Politicians often ask the ECB to expand the
money supply in order to promote a cyclical upturn (to combat unemployment)
The liquidity effect does in fact reduce the level of interest rates!
But the induced effects on money demand, the income effect, the price-level effect, and the expected inflation effect
all increase the level of interest rates
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Increase of money supply plus demand shift
33.0
25.0
17.6
11.1
5.3
100 500400300200
Supply of money, Ms
Demand for money, Md
C D
Interest rate (%)
E
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Readings
Reading 7-1: “The mandarins of money”, The Economist, August 9, 2007
Reading 7-2: “Oceans apart”, The Economist, February 28, 2008
Reading 7-3: “Asset Management: European disunion”, The Economist, May 22, 2003 (optional)
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Can short term interest ratesfall below zero? Not really if we talk about nominal interest
rates Perfectly possible when we look at real
interest rates Negative real interest rates may occur
where price inflation was not perfectly anticipated in the loan (debt) contract
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“Liquidity trap” A situation in which prevailing interest
rates are low and cash holdings are high In a liquidity trap, consumers choose to
avoid bonds and keep their funds in cash because of the prevailing belief that interest rates will soon rise
Since bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset whose price is expected to decline
As a result, monetary policy is ineffective
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Liquidity trap and money supply
NominalInterest rate (%)
33.0
25.0
17.6
11.1
5.3
100 500400300200
Supply of money, Ms
Demand for money, Md
C D
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Real interest ratesin the United States
During the 1970 real interest rates were significantly below 0% in the United States (and worldwide)
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And again now in the USA ….
53
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Liquidity trap and JapanLiquidity trap and Japan During the 1990 Japan experienced a period of
economic stagnation, which the central bank attempted to counter through expansionary monetary policy
The BoJ reduced its interest rates from 6% in July 1991 to 0,5% in September 1995
From February on, she started her zero interest rate policy (ZIRP)
Despite 0% nominal interests, the real rate of interest was positive due to falling prices
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Real interest and Deflation
Japan´s Real Interest Rates
0
2
4
6
8
10
12
1985 1987 1989 1991 1993 1995 1997 1999
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Discussion 7: Money, inflation, and interest rates
What determines the demand for money? How are money markets linked to bond
markets? What factors influence the real interest
rate in the short and the long run?
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