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Chapter VII: Money, assets, and interest rates PowerPoint Presentation
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Chapter VII: Money, assets, and interest rates

Chapter VII: Money, assets, and interest rates

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Chapter VII: Money, assets, and interest rates

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  1. 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

  2. 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

  3. 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

  4. Stone “money” of the island of Yap

  5. 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?

  6. 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)

  7. 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

  8. 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!

  9. 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

  10. Store of value • 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 Ability to pay or “liquidity”

  11. “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

  12. 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

  13. 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

  14. 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”

  15. Measuring money demand • M1= “narrow money” • M2= “intermediate” money • M3= “broad money”

  16. 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.

  17. 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.

  18. Money demand in the Euro-area (end of 2007)

  19. Development of M3 in the Euro area 1999-2008

  20. Relationship between M3 andthe inflation rate (HIPC)

  21. 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

  22. 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

  23. 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

  24. 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)

  25. 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

  26. 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

  27. 950 5.3 900 11.1 17.6 850 800 25.0 750 33.0 The demand for bonds Price of bond (€) Interest rate (%) 500 200 300 400 100

  28. 950 5.3 900 11.1 17.6 850 800 25.0 750 33.0 The supply for bonds Price of bond (€) Interest rate (%) 500 200 300 400 100

  29. 950 5.3 900 11.1 850 17.6 800 25.0 750 33.0 Market equilibrium (asset market approach) Price of bond (€) Interest rate (%) C i* P* 500 200 300 400 100

  30. 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:

  31. 33.0 25.0 17.6 11.1 5.3 A reinterpretation of the bond market Interest rate (%) Demand for bonds, Bd =Supply of loanable funds, Ls Supply of bonds, Bs =Demand for loanable funds, Ld 500 200 300 400 100

  32. 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

  33. 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

  34. 33.0 25.0 17.6 11.1 5.3 A shift of the supply curve of funds Interest rate (%) Demand for bonds, Bd =Supply of loanable funds, Ls D C Supply of bonds, Bs =Demand for loanable funds, Ld 500 200 300 400 100

  35. Effects on the supply of funds for bonds Shift in supply curve Change invariable Change ininterest rate Change inquantity

  36. 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

  37. 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

  38. 33.0 25.0 17.6 11.1 5.3 A shift of the demand curve for funds Interest rate (%) Demand for bonds, Bd =Supply of loanable funds, Ls D C Supply of bonds, Bs =Demand for loanable funds, Ld 500 200 300 400 100

  39. Effects on the demand of funds for bonds Shift in demand curve Change invariable Change ininterest rate Change inquantity

  40. 33.0 25.0 17.6 11.1 5.3 Equilibrium in the market for money Interest rate (%) Supply of money, Ms C Demand for money, Md 500 200 300 400 100

  41. 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

  42. 33.0 25.0 17.6 11.1 5.3 Response to a change in income Interest rate (%) Supply of money, Ms D C Demand for money, Md 500 200 300 400 100

  43. 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)

  44. 33.0 25.0 17.6 11.1 5.3 Response to a change in money supply Interest rate (%) Supply of money, Ms D C Demand for money, Md 500 200 300 400 100

  45. 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)

  46. 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

  47. 33.0 25.0 17.6 11.1 5.3 Increase of money supply plus demand shift Interest rate (%) Supply of money, Ms E D C Demand for money, Md 500 200 300 400 100

  48. 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)

  49. 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

  50. “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