Leandro Conte

Leandro Conte

UniSi, Department of Economics and Statistics

Money, Macroeconomic Theory and Historical evidence

SSF_ aa.2017-18

ASSESS AND INTERPRET THE EMPIRICAL EVIDENCE ON THE VALIDITY OF THE THEORIES OF MONEY DEMAND:

• -. Identify the context under which budget deficits can lead to inflationary monetary policy.

• -. Identify the factors underlying the portfolio choice theory of money demand.

• -. Identify the central bank current procedures for operating the discount window.

Learning Objectives

Topic : 1 _context

• Equation of Exchange and Quantity Theory of Money

Equation of Exchange

M = the money supply P = price level

Y = aggregate output (income)

P × Y = aggregate nominal income (nominal GDP)

V = velocity of money (average number of times per year that a dollar is spent) V = P × Y

M

Equation of Exchange M ×V = P × Y

Velocity of Money and The Equation of Exchange:

Equation of Exchange

• Velocity fairly constant in short run

• Aggregate output at full-employment level

• Changes in money supply affect only the price level

• Movement in the price level results solely from change in the quantity of money

Equation of Exchange

Demand for money: To interpret Fisher s quantity theory in terms of the demand for money…

Divide both sides by V

When the money market is in equilibrium

M = M^d Let

•Because k is constant, the level of transactions generated by a fixed level of PY determines the quantity of M^d.

•The demand for money is not affected by interest rates.

V PY M = 1 ×

k = V1

PY k

M ^d = ×

Quantity Theory of Money

• From the equation of exchange to the quantity theory of money:

• Fisher’s view that velocity is fairly constant in the short run, so that ,

transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by

movements in the quantity of money M.

P Y × = M V ×

Quantity Theory and the Price Level

• Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level .

• Dividing both sides by , we can then write the price level as follows:

P M V Y

= ×

Y

Quantity Theory and Inflation

• Percentage Change in (x ✕ y) = (Percentage Change in x) + (Percentage change in y)

• Using this mathematical fact, we can rewrite the equation of exchange as follows:

• Subtracting from both sides of the preceding equation, and recognizing that the inflation rate, is the growth rate of the price level,

• Since we assume velocity is constant, its growth rate is zero, so the quantity theory of money is also a theory of inflation:

% M + % V = % P + % Y

% P % M % V % Y

= = +

% M % Y

=

Fig. 1 Relationship Between Inflation and Money Growth

Sources: For panel (a), Milton Friedman and Anna Schwartz, Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867–1975; Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed .org/fred2/. For panel (b), International Financial Statistics. International Monetary Fund, http://www.imfstatistics.org/imf/.

Fig. 2 Annual U.S. Inflation and Money Growth Rates, 1965–2015

Sources: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Topic 2: Factors

• Budget deficits and Inflation

Budget Deficits and Inflation

• There are two ways the government can pay for spending: raise revenue or borrow

• Raise revenue by levying taxes or go into debt by issuing government bonds

• The government can also create money and use it to pay for the goods and services it buys

Budget Deficits and Inflation

• The government budget constraint thus reveals two important facts:

• If the government deficit is financed by an increase in bond holdings by the public, there is no effect on the monetary base and hence on the money supply.

• But, if the deficit is not financed by increased bond holdings by the public, the monetary base and the money supply increase.

Hyperinflation

• Hyperinflations are periods of extremely high inflation of more than 50% per month.

• Many economies—both poor and developed—have experienced hyperinflation over the last century, but the United States has been spared such turmoil.

• One of the most extreme examples of hyperinflation throughout world history occurred recently in 1 th WW;

• inflation is the present Argentina 2017 (21,6%)

Topic 2.1 Factor

us result of agent’s behaviors

• Keynes s liquidity preference theory

• Why do individuals hold money? Three motives:

• Transactions motive

• Precautionary motive

• Speculative motive

• Distinguishes between real and nominal quantities of money

Transactions Motive

• Keynes initially accepted the quantity theory view that the transactions component is proportional to income.

• Later, he and other economists recognized that new methods for payment, referred to as payment technology, could also affect the demand for money.

Precautionary Motive

• Keynes also recognized that people hold money as a cushion against unexpected wants.

• Keynes argued that the precautionary money balances people want to hold would also be proportional to income.

Speculative Motive

• Keynes also believed people choose to hold money as a store of wealth, which he called the speculative motive.

Putting the Three Motives Together

M ^d

P = f (i,Y ) where the demand for real money balances is negatively related to the interest rate i,

and positively related to real income Y Rewriting

P

M^d = 1 f (i,Y )

Multiply both sides by Y and replacing M^d with M V = PY

M = Y

f (i,Y )

Putting the Three Motives Together

• Velocity is not constant:

• The procyclical movement of interest rates should induce procyclical movements in velocity.

• Velocity will change as expectations about future normal levels of interest rates change

Portfolio Theories of Money Demand

• Theory of portfolio choice and Keynesian liquidity preference

• The theory of portfolio choice can justify the conclusion from the Keynesian liquidity preference function that the demand for real money balances is positively related to income and negatively related to the nominal interest rate.

Factors That Determine the Demand for Money

Topic 3: Way

• Agents’ behaviours and Conventional Way

Conventional Monetary Policy Tools

• During normal times, the Federal Reserve uses three tools of

monetary policy—open market operations, discount lending, and reserve requirements—to control the money supply and interest rates, and these are referred to as conventional monetary policy tools.

On the Failure of Conventional Monetary Policy Tools in a Financial Panic 2007-2009

• When the economy experiences a full-scale financial crisis,

conventional monetary policy tools cannot do the job, for two reasons.

• First, the financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment

spending and the economy collapse.

• Second, the negative shock to the economy can lead to the zero- lower-bound problem.

Topic 3. NON conventional behaviours

• Quantitative easing: 2007-9 and Today

Quantitative Easing and the Money Supply, 2007-2014

• When the global financial crisis began in the fall of 2007, the Fed

initiated lending programs and large-scale asset-purchase programs in an attempt to bolster the economy.

• By June 2014, these purchases of securities had led to a quintupling of the Fed s balance sheet and a 377% increase in the monetary base.

Quantitative Easing and the Money Supply, 2007-2014

• These lending and asset-purchase programs resulted in a huge expansion of the monetary base and have been given the name

quantitative easing.

• This increase in the monetary base did not lead to an equivalent change in the money supply because excess reserves rose

dramatically.

Fig. 3 M1 and the Monetary Base, 2007-2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Fig. 4 Excess Reserves Ratio and Currency Ratio, 2007-2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Fig. 5 Quantitative Easing and Money Supply

The Market For Reserves and the Federal Funds Rate

• Demand and Supply in the Market for Reserves

• What happens to the quantity of reserves demanded by banks,

holding everything else constant, as the federal funds rate changes?

• Excess reserves are insurance against deposit outflows

• The cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves, i_or

Demand in the Market for Reserves

• Since the fall of 2008 the Fed has paid interest on reserves at a level that is set at a fixed amount below the federal funds rate target.

• When the federal funds rate is above the rate paid on excess reserves, i_or, as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises.

• Downward sloping demand curve that becomes flat (infinitely elastic) at i_or

Supply in the Market for Reserves

• Two components: non-borrowed and borrowed reserves

• Cost of borrowing from the Fed is the discount rate

• Borrowing from the Fed is a substitute for borrowing from other banks

• If i_ff < i_d, then banks will not borrow from the Fed and borrowed reserves are zero

• The supply curve will be vertical

• As i_ff rises above i_d, banks will borrow more and more at i_d, and re-lend at i_ff

• The supply curve is horizontal (perfectly elastic) at i_d

Fig. 6 Equilibrium in the Market for Reserves

R^s

R^d

2

iff

ff1

i

id

Federal Funds Rate

ior

Quantity of Reserves, R NBR

With excess supply of reserves, the federal funds rate falls to iff^*.

With excess demand for reserves, the federal funds rate rises to _iff^*_.

* 1

iff

How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

• Effects of open an market operation depends on whether the supply curve initially intersects the demand curve in its downward sloped section versus its flat section.

• An open market purchase causes the federal funds rate to fall

whereas an open market sale causes the federal funds rate to rise (when intersection occurs at the downward sloped section).

How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

• Open market operations have no effect on the federal funds rate when intersection occurs at the flat section of the demand curve

(infinitely elastic)

• If the intersection of supply and demand occurs on the vertical

section of the supply curve, a change in the discount rate will have no effect on the federal funds rate.

How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

• If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate.

How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

• When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls.

Fig. 7 Response to an Open Market Operation

Step 1. An open market purchase shifts the supply curve to the right …

Step 2. causing the federal funds rate to fall.

Step 1. An open market purchase shifts the supply curve to the right …

Step 2. but the federal funds rate cannot fall below the interest rate paid on reserves.

(a) Supply curve initially intersects demand curve in its downward-sloping section

(b) Supply curve initially intersects demand curve in its flat section

1

Rd 1 1

iff

2 2

iff

id

ior

Federal Funds Rate

id

Federal Funds Rate

Quantity of Reserve, R

1

Rd

2

1

Rs

NBR1

2

Rs

NBR2 2

Rs

NBR2 NBR1

1

Rs

1 2 1

ff = ff = or

i i i

Quantity of Reserves, R

Figure 8 Response to a Change in the Discount Rate

(a) No discount lending (BR = 0) (b) Some discount lending (BR > 0) Step 2. but does not lower the

federal funds rate.

Step 1. Lowering the discount rate shifts the supply curve down…

Step 1. Lowering the discount rate shifts the supply curve down…

Step 2. and lowers the federal funds rate.

NBR Quantity of

Reserves, R R₁s

R₂s

d1

R

Federal Funds Rate

ior ^BR1

BR₂

Quantity of Reserves, R NBR

Rs₁

Rs₂

1d

R

= _d

iff² i² 2

1 1

d ff =

i i

1

1 1 iff

Federal Funds Rate

d1

i

d2

i

ior

d2

i

Figure 9 Response to a Change in Required Reserves

NBR Quantity of

Reserves, R

R₁^s

R₂^d R₁^d

Federal Funds Rate

i_d

ior

i_ff² 2

i_ff¹ 1

Step 1. Increasing the reserve requirement causes the demand curve to shift to the right . . . Step 2. and the federal funds rate rises.

Figure 10 Response to a Change in the Interest Rate on Reserves

R^s

R₁^d R₁^d

R^s

NBR Quantity of Reserves, R

NBR Quantity of Reserves, R i_d

Federal Funds Rate

id

i_or²

Federal Funds Rate

i_or¹ i_ff¹ =i_or¹

1

i_ff¹ 1

Step 2. leaves the federal funds rate unchanged.

Step 1. A rise in the interest rate on reserves from toi_or¹ i_or² ...

Step 1. A rise in the interest rate on reserves from toi_or¹ i_or² ...

Step 2. raises the federal funds rate to i_ff²=i_or².

> _or iff¹ i¹

(a) initial (b) initiali_ff¹ =i_or¹

R₂^d R₂^d

=

i_ff² ii_oror^{22 2}

Reserve Requirements

• Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository

institutions.

• 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 million

• The Fed can vary the 10% requirement between 8% to 14%.

Figure 11 The Expansion of the Federal

Balance Sheet, 2007-2014

Relative Advantages of the Different Monetary Policy Tools

• Open market operations are the dominant policy tool of the Fed since it has complete control over the volume of transactions, these operations are flexible and precise, easily

reversed and can be quickly implemented.

• The discount rate is less well used since it is no longer binding for most banks, can cause

liquidity problems, and increases

uncertainty for banks. The discount window remains of tremendous value given its ability to allow the Fed to act as a lender of last resort.

Cause - Agent – Behaviour – Procedure

Court Power Claim Duty

Liability Liberty

Privilege Incapacity

Figure 12 The Policy Trilemma

Fixed Exchange Rate

Option 2 (Hong Kong)

Option 3 (China)

Independent Monetary Policy Free Capital

Mobility

Option 1 (United States)