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Introduction to Financial and Monetary Economics
- Read: Mishkin and Serletis, Ch. 1
- Two parts to the course:
Financial economics: economics of the financial system
Monetary economics: economics of money and monetary policy.
The Financial System:
- a set of interrelated markets for financial assets
e.g. bond, stock and money markets, deposit and loan markets
- a set of the financial institutions that deal in these assets.
e.g. banks, mutual funds, insurance companies.
- a set of government institutions and regulations
- Various regulatory bodies, e.g. OFSI, CDIC
- A “central bank” (Bank of Canada).
1
Financial economics:
It’s concerns:
- What does the financial system do? Why is it important? How well does it perform?
- Modeling and explaining financial market outcomes
- what determines asset prices and returns on various assets?
- explaining the structure of asset prices and interest rates.
- explaining the quantities and variety of financial assets.
- why do financial intermediaries exist? what do they do?
It’s Methods:
- A microeconomic approach:
- financial market outcomes reflect choices of many decision-makers.
- individual lenders and borrowers (households, businesses)
- managers of financial institutions
- governments (as lenders, borrowers and regulators)
- outcomes are explained by modeling individual decisions and their interactions.
2
Monetary economics:
It’s concerns:
- Focus is on money and the economy.
The economic roles of money
History and types of monetary systems: past, present, future
Money creation and money supply control: methods
Money and financial markets: credit conditions, interest rates.
Money and the macroeconomy: effects on inflation, output, employment.
Central banks: roles? methods?
Monetary policy: what should the central bank do? Why?
It’s approach:
- A macroeconomic approach:
a focus on aggregate variables: “interest rate”, inflation, aggregate demand and its components.
3
Why teach financial and monetary economics together?
- There is much overlap and many connections between the two fields.
For example:
- Money is one of many financial assets.
- Banks are key players in money creation and in the financial system.
- Central banks conduct monetary policy through financial markets often with the objective of influencing financial variables such as interest rates and asset prices.
- Central banks are involved in regulation of financial institutions and financial markets and promote the stability of financial institutions.
4
Money: Functions, Origins and Measurement Questions
- Read: Mishkin and Serletis, Ch. 3.
What is money?
Money: Anything that is normally accepted in exchange when goods, services and assets are sold and when debts are repaid.
- Money plays three main roles in an economy.
Money acts as a:
(1) Medium of exchange
(2) Unit of account
(3) Store of value
5
Economic Roles of Money
(1) Medium of Exchange (Means of Payment)
- Money is generally acceptable in exchange for goods and servicesi.e. it is a medium of exchange.
- An economy without a medium of exchange will be quite inefficient.
- Barter economy: no medium of exchange, exchange goods for goods.
- Problem: exchanges require a "double coincidence of wants".
- This makes exchange time consuming:
must find a matching buyer or seller, or
must arrange a sequence of exchanges.
- Results of not having a medium of exchange:
- wasted resources: more time and effort on exchange rather than onproduction or leisure.
- specialization is discouraged (specialists: must make many exchanges to meet their needs)
(modern economies are very specialized!)
6
Medium of Exchange role of money: the importance of Confidence
- To act as a medium of exchange people must be confident that others will accept “money” as payment.
- How to establish confidence?
- Could use something with intrinsic value as money e.g. gold, silver.
- historically a popular solution.
- But modern money is usually something that has little intrinsic worth.
e.g. paper or plastic bills; coins made from metals with little value.
- If money is something of little value its ability to be a medium of exchange relies on a general expectation that others will accept it.
i.e. social convention; game theoretic equilibrium.
- I accept it because I believe others will too. Others believe the same.
- Most modern monies are like this.
- This convention evolved over time (see: Evolution of Money)
- Can this social convention equilibrium break down? YES.
Failed currencies: people refuse to accept it. e.g. Zimbabwe dollar in 2009.
Why do they fail? 1. Store of value problems (see below) 2. A ‘better’ alternative arises
7
Medium of Exchange function of money: Confidence (cont’d)
- New forms of money and the confidence problem
- In recent years we have seen attempts to create new types of money.
e.g. digital cryptocurrencies like Bitcoin
- Problem for digital currencies: how do you create confidence?
- starting out is a big problem:
- new: few use it, not generally acceptable
- so: is of little value to other possible users;
- so: few new users opt to use it – remains not generally acceptable.
- Can governments overcome the confidence problem?
- medium of exchange by law? “fiat money” or legal tender(probably not enough: still needs to be acceptable)
- government can place a floor on the value of a form of money: government states it will always accept it as payment for taxes or in exchange for government services.
i.e. always acceptable to government.
- Governments can also destroy confidence by reducing the value of money: via inflation, devaluation.
8
(2) Unit of Account Role
- Unit of Account: unit in which we measure, record and compare values. e.g., Canada: dollars and cents.
- Money is almost always denominated in terms of the unit of account.
- Importance of having a unit of account?
- Economic decisions involve comparisons of costs and benefits.
- Such comparisons are more difficult if there is no common unit of account.
- With no unit of account “prices” are in terms of units of one good per unit of another good.
i.e. many prices for any given good vs. a single money price if money serves as a unit of account.
- Lack of a unit of account complicates comparisons and raises transactions costs.
(N goods: N money prices or N∙(N-1)/2 goods-for-goods prices)
- A particular money can only play this role if others also choose to use it as a unit of account.
- Historical cases where money and unit of account differed do exist
e.g. values measured in terms of an older, defunct currency unit. France: long periods where the two differed.
9
(3) Store of Value Function of Money
- Money acts as a store of value
- Money provides a means by which purchasing power can be transferred from the present to the future.
- Why is it important to have stores of value?
- Reduces costs of exchange: don’t have to obtain new purchasing power each time an exchange is made.
- Adds flexibility to decision-making: timing of purchases can differ from when income is earned.
- Saving and borrowing become possible.
- Other real and financial assets are also stores of value.
- An advantage of money as a store of value: it is also the ‘medium of exchange’
- money is the most “liquid” store of value
Liquidity: ease and speed with which an asset can be converted into medium of exchange.
- other assets must be converted to medium of exchange (may be costly; may add risk: price can change).
- Unlike many other stores of value the nominal value of money is fixed: $1 is $1.
10
(3) Store of Value Function of Money (cont’d)
- Disadvantage of money as a “store of value”?
- inflation (rising prices) erodes its purchasing power;
- The ability of money to act as store of value depends upon its ability to retain its real value over time.
- Store of value role of money links financial markets and money.
- money is a substitute for other stores of value such as bonds.
i.e., one asset in a decision maker's portfolio.
- changing the supply of money will affect other asset markets.
- decision makers will alter their desired portfolio in response to the change in the money supply
(James Tobin’s approach to monetary economics)
11
Recessions: a Problem only for Monetary Economies?
- The three roles of money imply that the existence of money makes economies perform better, raising well-being.
- A possible problem?
- Many macroeconomists argue that recessions are caused by a shortfall in overall (aggregate) demand for goods and services.
i.e. less demand than is needed for full employment.
- Are such shortfalls only possible in a monetary economy?
Barter economy: you produce (supply) in order to trade your production for other goods and services.
- production (supply) and demand are directly linked.
- supply creates demand (an old idea: Say’s Law)
Monetary economy: produce then sell production for money.
- Seller can use money to buy goods or services (creates demand); or
- Could hoard money: this doesn't generate demand.
- Shortfalls of aggregate demand are possible if many people save/hoard money simultaneously.
(Say’s Law: see The Economist Aug. 10, 2017 https://www.economist.com/news/economics-brief/21726050-third-brief-our-series-looks-reasoning-made-jean-baptiste-say )
12
Nick Rowe (a monetary-macroeconomist) WCI blog Aug. 25, 2011 has a nice discussion of this:
“Recessions are always and everywhere a monetary phenomena” – recessions are situations of excess supply (or equivalently an excess demand for money). One of the things we notice about the things we call “recessions” is that it gets harder to sell stuff and easier to buy stuff (with money), and the volume of monetary trade (not just output and employment) declines. Barter trade, and home production, typically expand in a recession.“The unemployed hairdresser wants her nails done. The unemployed manicurist wants a massage. The unemployed masseuse wants a haircut. If a 3-way barter deal were easy to arrange, they would do it, and would not be unemployed. There is a mutually advantageous exchange that is not happening. Keynesian unemployment assumes a short-run equilibrium with haircuts, massages, and manicures lying on the sidewalk going to waste. Why don’t they pick them up? It’s not that the unemployed don’t know where to buy what they want to buy.If barter were easy, this couldn’t happen. All three would agree to the mutually-improving 3-way barter deal. Even sticky prices couldn’t stop this happening. If all three women have set their prices 10% too high, their relative prices are still exactly right for the barter deal. Each sells her overpriced services in exchange for the other’s overpriced services…. The unemployed hairdresser is more than willing to give up her labour in exchange for a manicure, at the set prices, but is not willing to give up her money in exchange for a manicure. Same for the other two unemployed women. That’s why they are unemployed. They won’t spend their money.Keynesian unemployment makes sense in a monetary exchange economy…it makes no sense whatsoever in a barter economy, or where money is inessential.”
Nick Rowe WCI blog Aug. 30, 2018: The 1 vs 3 Model of Quick Recessions vs Slow Recoveries
“A simple model of a monetary exchange economy is the Wicksellian Triangle. The apple producer wants to consume bananas; the banana producer wants to consume cherries; the cherry producer wants to consume apples. But it's hard to coordinate 3 people meeting in the same place at the same time so they can do a 3-way swap in the central Walrasian market. They can only meet pairwise, so they have to use money. And let's suppose they use some 4th good as money (because my story is simpler that way). So we have a circular flow of money clockwise around the Wicksellian triangle; and a flow of fruit counterclockwise.
It only takes 1 person to reduce the circular flow of money. If the apple producer decides he wants to hold more money, he can unilaterally decide to slow down or stop spending his money. He does not need anyone else's consent to do this; because exchange requires mutual consent. Quantity traded is whichever is less: quantity demanded; or quantity supplied. The change in his stock of money equals the flow in minus the flow out; he needs the cherry producer's consent to increase his flow in, but can reduce his flow out to the banana producer unilaterally. And if the apple producer decides to slow down or stop his spending, the whole circular flow of money and fruit slows down or stops too.
13
It takes all 3 people to increase the circular flow of money. The apple producer needs to spend more quickly, the banana producer needs to spend more quickly, the cherry producer needs to spend more quickly. (And each of those 3 decisions requires the mutual consent of both parties to the trade of money for fruit, because the apple producer cannot buy more bananas unless the banana producer agrees to sell more bananas. And only if all 3 have an excess supply of fruit matched by an excess demand for money will that consent be readily forthcoming.)
The circular flow of money is like 3 cars circling a one-lane roundabout, they all need to go faster for any one of them to go faster.”
- Paul Krugman (Princeton U. and NY Times columnist) gives an intuitive illustration of the idea based on a 1978 paper by Sweeney and Sweeney.
(see "Baby-Sitting Coop" handout -- also on website)
- Monetary policy and this problem?
- Can recessions be combatted simply by increasing the supply of money?
- People don’t need to reduce spending to hoard money if money is abundant.
14
The Evolution of Money
- Early forms of money were commodity money
- something of intrinsic value that was convenient (portable, durable, divisible and scarce) served as money.
- why scarce? High value for a small amount.
- common choice: precious metals (gold, silver), usually coins.
- being of value itself promotes it as a medium of exchange: confidence.
- possible government role: standardized coinage (units; precious metal content)
- control of the money supply with commodity money?
- dependent on the supply of the commodity.e.g. new mines
Lydian Lion: the World’s First Coin? (600 B.C.)
15
Convertible paper money:
- early paper money often grew out of commodity money.
- early paper money: a claim to precious metals
- convertible into precious metals.
e.g. Early UK banks:- provided safe storage of precious metals (often coins).
- receipts or notes issued to owner.
- notes were soon used in exchange: paper money!
- banks realize that depositors ask for only a fraction of their gold or gold coins on a given day
- banks issue additional notes: as loans or in payment for goods and services.
- value of bank notes exceeds value of metals deposited.
i.e. a bigger money supply is possible.
- a danger? What happens if everyone tries to redeem their notes at the same time? (bank run)
- Sweden, China: copper money -- copper is a low value metal, need lots of it for high value exchanges.
Kindleberger: ‘wheelbarrows of coins’
- encouraged early experiments with convertible paper money.(convenience)
16
- Types of commodity standards: (see Table 2.2 from Lewis and Mizen)
- precious metal (coins)(possibly more than one type of precious metal: “bimetallism”)
- precious metal coins and convertible paper money (convertible into precious metal/coins)
- coins (not precious metal) and paper money: both convertible into precious metal.
- coins and paper money convertible into currency of another country whose currency is convertible.
(like the Early banks above: precious metals available for conversion often only a fraction of paper money outstanding)
- all of these retain a link to precious metals.
17
18
- Canada: Commodity and Convertible Money
- See: James Powell A History of the Canadian Dollar (course website) he describes the evolution of Canadian money.
- First Nations money: ‘wampum’ (shell beads), pp. 1-2
- Coins in New France; British Colonial period (pp. 3-12)
- Early convertible paper money - Playing card money! p. 5 British war finance p. 14- Private bank notes pp. 17-19- Government convertible paper money 1860s pp. 24-27
- Gold Standard 1854-1914, 1926-31: Canadian currency fixed in terms of gold and convertible. pp. 33-36, 41-43
- 1914-26: Suspends the Gold Standard (financing WWI)
- Periods of fixed exchange rates 1939-50, 1962-70: still convertible at a fixed rate into US $s which were convertible to gold (also at a fixed rate).
- Modern system by 1971 (no convertibility).
19
Fiat money:
- Modern money is legal tender by government decree or “fiat”.
- however it needs confidence of the public to be able to act as money.
- confidence that others will accept it in exchange.
- confidence that it will retain value.
e.g. Zimbabwe (see article on course website and text pp.520-521):
- hyperinflation: prices doubling every 1.3 days;
- money is no longer a store of value even for short periods.
- Zimbabwe’s currency displaced by barter and foreign currencies (esp. South African, US currency)
i.e. no longer acceptable as a medium of exchange.
- Government’s saying it can be used to pay taxes: places a floor on its value.
- Supply of fiat money is in government hands.
- this is a key role of a country’s “central bank”
Canada: Bank of CanadaUS: Federal Reserve BankEurope: European Central Bank (ECB)
- Ability to create new fiat money is a source of revenue (seigniorage) to the government .
- cost of creating a new coin or bill is below its face value: difference is revenue to the government.
(Origin of Zimbabwe’s hyperfinflation: printing money to pay government’s bills)
20
Bank money or deposit money:
- Another important form of modern money.
- Bank deposits which can perform as medium of exchange are a form of money.
- Convertible into fiat money though.
- Originally money supply measures included only:
“demand deposits”: deposits at banks that were accessible on demand.
(vs. “notice” deposits: notice period required prior to withdrawal)
- Methods of access to deposits:
- direct withdrawal e.g. from bank branch
- cheques (chequing deposits)
- More recently: debit cards, electronic bill payment systems, etc.
- Unlike bills and coins, deposits may exist only as a record (electronic or otherwise).
- Like early paper money deposits are backed by reserves to meet depositors needs.
- The supply of deposit money can be influenced by government (central bank) by altering the quantity of reserve assets.
21
- Lessons of monetary history?
- Evolution of money driven by convenience, advantages of new forms of money vs. old forms.
e.g. concerns over security of money holdings; record keeping and speed of the cheque-clearing system vs. modern electronic systems.
- Precious metals vs. other commodities: confidence, durability, divisibility.
- Convertible paper money vs. precious metals: portability, convenience.
- Fiat money vs convertible: a less costly way to providing a medium of exchange (opportunity cost of precious metals, storage costs); seigniorage income to governments. A natural step from convertible money?
- Deposit money vs. paper money: ease and low expense of transactions.- withdrawals and cheques vs. ATMs and electronic transfer: a move
to cheaper more efficient ways of doing the same thing.
22
- Future money: what’s next?
- Will cash (coins and bills) disappear or just diminish?
- convenience considerations
- should central banks encourage it’s disappearance?e.g. Ken Rogoff: yes – vs. tax evasion and crime.
Monetary policy and negative interest rates: easier?
( http://www.economist.com/blogs/economist-explains/2016/08/economist-explains-11 )
- New forms of e-money, e.g. Bitcoin (see text p. 57)- independent of central banks and government.
- Is this the future? Will they replace cash and deposits?- confidence problem- volatility problem.- convenience: is it easy enough to use?- computing power expense problem.
- Is e-money issued through a central bank the next step?- Households and firms with accounts at the central bank.- The end of traditional banks? - See Andolfatto; Cochrane; Murray (Assignment 1)
http://andolfatto.blogspot.ca/2015/02/fedcoin-on-desirability-of-government.html
23
Money Today: the Composition of the Canadian Money Supply
Types of money:
(1) Currency: coins and bills
(2) Deposit money or "bank money"
- Should all types of deposit be included?
- Some types of deposits:
- Sensible to include deposits whose funds are easily accessible e.g. by cheque or debit.
- Demand deposits: chequable deposits, repayable on demand.(also called current accounts: businesses)
- included in all definitions of the money supply.
- Personal chequeing deposits (households), other Chequable savings deposits: accessible by cheque or debit
- Non-chequable savings deposits- not always included in money supply measures.- it does not serve as readily as a medium of exchange.
- Term deposits: can be withdrawn only after a certain date.- often not included as part of money supply – illiquid.
24
- Should any other assets be included in money supply?
- newer forms of ‘e-money’: stored-value or smart cards(quite important in some countries)
- any liquid asset could be counted as part of the money supply.
i.e. liquid if can be readily converted to purchasing power.
- some Bank of Canada measures even include some types of mutual funds as part of the money supply.
- how do credit cards fit in?- a common method of payment.- is a credit card balance money? It is a debt not purchasing
power.
- There is no single, correct measure of the money supply: central banks monitor several measures.
- Narrow and Broad measures of the money supply
-Narrow: assets used directly in exchangee.g. M1+ below.
- Broad: narrow money plus assets that are readily convertible into assets that can be used in exchange
i.e., at the extreme: any liquid asset.
25
Measures of the Canadian money supply:
- Text Table 3-1, Figure 3-1 contains several Canadian money supply measures.
- The Bank of Canada currently publishes data on several measures.
-See: http://www.bankofcanada.ca/publications/bfs/ Part E (updated each month)
- Statistics Canada provides some of the Bank of Canada data (Table 10-10-0116-01 old CANSIM Table 176-0025):
https://www150.statcan.gc.ca/n1/en/type/data
Data from Bank of Canada website for June 2019:
Money supply measures:
M1+ $1031 billion (narrow)
M2+ $2173 billion
M2++ $3371 billion (broad)
26
Some details (June 2019):
M1+ - currency outside of banks ($89 billion)($1031 b) - Chequable deposits at chartered banks and “near banks”
(“near banks”: credit unions, trust companies) ($942 billion)
M2+ - M1+ ($1031 billion)($2173b) - Other deposits at banks and near banks ($1117 billion, with about
$700 billion in term deposits; rest are non-chequable but not term deposits)
- Money market mutual funds ($25 billion)
M2++ - M2+ ($2173 billion)($3371 b) - Canada Savings Bonds ($2 billion)
- Non-money market mutual funds ($1195 billion).
27
- Composition and size of the money supply
- M1+ is over 10 times as large as currency outside banks.
- currency is a small component of the measures of the money supply.
- The broadest measure M2++ is over 3 times the size of M1+.
- Deposit types and currency: size and importance are not always the same thing.
- turnover or "velocity" also matters
i.e. what value of transactions is financed by $1 worth of a specific component of the money supply during some period?
- chequable deposits and currency finance a higher volume of transactions per $1 than other types of deposit.
- The money supply measure used can leave very different impressions of what is occurring in the economy.
28
- Growth in narrow and broad measures was quite different in the past few decades (see text Figure 2.3 and figures below).
- inflation increased attractiveness of deposits that pay interest leading to a change in composition of money supply.
- other innovations in transactions technologies, e.g., credit cards, debit cards, bank machines also affected the size and velocity of each money measure.
- regulatory changes in the 1980s and 1990s affected the relative size of banks vs. near banks.
Feb-75Jul-7
6
Dec-77
May-79Oct-
80
Mar-82
Aug-83Jan-85
Jun-86
Nov-87Apr-8
9
Sep-90
Feb-92Jul-9
3
Dec-94
May-96Oct-
97
Mar-99
Aug-00Jan-02
Jun-03
Nov-04Apr-0
6
Sep-07
Feb-09Jul-1
0
Dec-11
May-13Oct-
14
Mar-16
Aug-17Jan-19
0500,000
1,000,0001,500,0002,000,0002,500,0003,000,0003,500,0004,000,000
Money Measures 1975-2019 ($ millions)
M2+ M2++ M1+
Mar-76Jul-7
7
Nov-78
Mar-80Jul-8
1
Nov-82
Mar-84Jul-8
5
Nov-86
Mar-88Jul-8
9
Nov-90
Mar-92Jul-9
3
Nov-94
Mar-96Jul-9
7
Nov-98
Mar-00Jul-0
1
Nov-02
Mar-04Jul-0
5
Nov-06
Mar-08Jul-0
9
Nov-10
Mar-12Jul-1
3
Nov-14
Mar-16Jul-1
7
Nov-18-5
0
5
10
15
20
25
30
35
Monetary Aggregate Annual Growth Rates (%) 1976-2019
M2+ M2++ M1+
29
- Does this make it too dangerous to focus on money supply measures when monitoring the economy or conducting monetary policy?
e.g. Bank of Canada focused on narrow (M1) measures during the mid-late 1970s
- Why? strong statistical relationship with the nominal level of output / income (GDP) prior to 1970.
- relationship seemed to break down in the 1980s.
- Inflation problems of the l970s, early 1980s: was it due to focus on a misleading measure of the money supply?
i.e., M1 was the focus; but broader money supply grew much faster.
- Has stability returned?
Bank of Canada's view in 2012 (based on statistical work):
- Growth rate in M1+ us a good indicator of value of future output.
- Broad money supply measures (like M2+): good leading indicator of future inflation.
(https://www.bankofcanada.ca/wp-content/uploads/2010/11/canada_money_supply.pdf )
- Recent years: Bank of Canada has focused on interest rates rather than money supply size.
- Changes in technology continue to make control of the money supply difficult:
- communications improvements, debit cards, ATMs, e-money: same quantity of money can support more payments
(just as if the money supply had grown)
- technology changes the composition of the money supply.
30
The Quantity Theory of Money:
- A simple, early macroeconomic model that focuses on money.
- Mishkin and Serletis, see Ch, 20, pp. 521-526.
- Start with an identity called the “Equation of exchange” or "Quantity equation":
M ∙VT ≡ P∙T
M = money stock VT = velocity of money (transactions)P = price level T = some measure of number of transactions (hard
to measure in practice)
- Now: P∙T = value of transactions in some time period, must equal M ∙VT given definition of velocity.
- Since T is difficult to measure this is usually rewritten as:
M ∙VY ≡ P∙Y
where Y measures real GDP (assumed to be proportional to T i.e. Y = cT) and VY is the velocity of money relative to Y (VY=cVT)
- Now: P∙Y is nominal GDP.
- note: M, P and Y can all be measured; VY is found using the equation of exchange.
- this is still just an identity!
31
- Turning this into the Quantity Theory requires two assumptions.
(1) Assume VY changes slowly over time for reasons outside the model.
- Idea behind this? velocity is determined by "transactions technology" and custom.
e.g. type of money, stage of development of the banking system, technology more broadly (computers? info technology?)
- Result? VY is unaffected by other variables in the model (constant value of VY*)
- Consequence? change M by some proportion then nominal GDP (P∙Y) changes by the same proportion.
(note: Bank of Canada's view of M1+ growth as a good
indicator of future GDP -- suggests that they think VY is stable for M1+)
(2) Assume real GDP (Y) is determined by:
(a) available production technologies, (b) quantities of available resources (labour, raw materials,
land, etc.); and (c) frictions and imperfections that affect the share of inputs that are
employed at any point in time.
- Later we will call this Long-run aggregate supply or Potential GDP.
- technologies, quantities of inputs, frictions and imperfections are determined outside the Quantity theory model.
- so: treat Y as fixed at Y* in this model.
32
- So the Quantity Theory combines equation of exchange with the two assumptions to give:
M ∙VY* = P∙Y*
- Consequences?
-Inflation (the rate of increase in P) is a ‘monetary phenomenon’:
- change M by some proportion (say +10%) prices change by the same proportion (+10%).
- So model says inflation is caused by increases in the money supply.
(‘too much money chasing too few goods’)
- A hyperinflation, like Zimbabwe’s, is caused by massive growth in M (studies of hyperinflations confirm this).
- Here monetary policy (changes in M) only affects prices.
- Central banks can affect nothing but prices and inflation.
- Bank of Canada’s goal: “inflation-targeting” – a similar view.
- This is an early example of a model where money is “neutral”.
- neutral? affects only nominal or money denominated variables rather than real variables.
- Is neutrality intuitively appealing?
why should issuing twice as much paper money raise employment or make us richer?
33
- The Quantity theory and the Choice Between Commodity and Fiat Money:
- Commodity standard:
- Money supply is determined by supply of precious metals available for use as money.
- Government and the money supply?- role is limited compared to fiat money. - debasement possible (lower precious metal content of coins)
- Say Quantity theory is correct (velocity is stable, Y is unaffected by M though Y can change via technology change or more inputs)
- How will P evolve over time in such a system?
- if M stable and Y not growing, P is stable too.
-if M and Y grow at the same rate P is stable.
- if M grows faster than Y: rising P (inflation)
- if Y grows faster than M: falling P (deflation)
34
- UK in 19th century: Y outpaces M – deflation: average prices declined over the century.
1813 1819 1825 1831 1837 1843 1849 1855 1861 1867 1873 1879 1885 1891 1897 1903 19090.6
0.8
1
1.2
1.4
1.6
1.8
2
UK Price Level (P) 1813-1913 (P=1.0 in 1865)
- Spain 16th century: Silver-rich conquests in the Americas M outpaced Y – inflation!
- Stability of prices (and exchange rates): is a more stable value of money a possible advantage of commodity
standards?
1751 1765 1779 1793 1807 1821 1835 1849 1863 1877 1891 1905 1919 1933 1947 1961 1975 1989 20030
20
40
60
80
100
120
UK: Price Level 1751-2012 (2012 equals 100)
35
- Fiat money, inflation and the value of money:
- supply of money is not tied to something external like gold supplies.
- government (central bank) can affect growth in M.
- will this be inflationary? Government incentive to finance its spending by raising M.
- Some early episodes with paper money suggested inflation a problem e.g. US Civil war, France 18th century.
- Hyperinflations: all occurred in fiat money systems.
- But: 1930s move from Gold standard – no inflation
more recently (since 1990s) inflation-targeting has given low inflation in many countries (though almost always>0).
- suggests this problem can be controlled.
(see Hanke “Friedman on Inflation, Hanke on Hyperinflation” Forbes Aug, 2018)
- Commodity money: a costly/wasteful way to solve need for money – ties up a valuable commodity, use of labour etc. to mine it
(Harrod: "dig it up then bury it again in bank vaults")
- Bitcoin and limits of money supply:
- A limited supply of Bitcoins: rises gradually (via “mining” – computers “mine” Bitcoins by completing calculations) to some upper limit.
- Message: value won’t collapse due to oversupply. Confidence created?
- Still wasteful: use resources to create Bitcoins – can’t you achieve the same thing for less with fiat money?
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- Problems with the Quantity theory?
- Velocity determination is more complicated than the model assumes
e.g. US 2008-present – velocity has collapsed! same thing happened in the Great Depression.
- modern models: more complex stories about V.
- likely to depend on other financial variables e.g. interest rates and other determinants of the demand for money.
- Is Y determined outside the model?
- Many modern macroeconomics models say yes (in the long-run).
- these models: have money neutrality in the long-run.
e.g. 1st year economics AD-AS model usually set up like this.
Bank of Canada’s much more complex forecasting models have this idea built in.
Bank of Canada view that broad money supply measures are good indicators of inflation is consistent with this view.
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- In short-run? some prices (wages especially?) are "sticky" or rigid, or
expectations are wrong and this allows monetary policy to have short-run effects on Y.
- What about models of financial crisis and depression? Why doesn’t the model seem to work then? What's missing?
- prolonged recessions (low Y), situations where measures that usually massively raise M don't.
e.g. number of commentators predicting hyperinflation in US in past few years – seems consistent with Quantity theory but clearly wrong!
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