chapter vii money assets and interest rates l.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Chapter VII: Money, assets, and interest rates PowerPoint Presentation
Download Presentation
Chapter VII: Money, assets, and interest rates

Loading in 2 Seconds...

play fullscreen
1 / 57

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


  • 334 Views
  • Uploaded on

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 ?

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Chapter VII: Money, assets, and interest rates' - HarrisCezar


Download Now An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
chapter vii money assets and interest rates

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
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

what is money3
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
evolution of the payment system
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?
unit of account
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)
medium of exchange
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
medium of exchange lack of confidence
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!

payment function
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
store of value
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”

quasi money
“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
liquidity as a technology of exchange
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
liquidity
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

empirical definition of money
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”
measuring money demand
Measuring money demand
  • M1= “narrow money”
  • M2= “intermediate” money
  • M3= “broad money”
components of m3
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.
components of m317
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.
quantity of money
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
keynes attitude toward money
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
focus on demand for financial assets
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
the demand for financial assets
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)
the demand for bonds
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
the demand for bonds26
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
the demand for bonds27

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

the supply for bonds

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

market equilibrium asset market approach

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

market equilibrium
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:
a reinterpretation of the bond market

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

why do interest rates change
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
example increase in risk and demand for bonds
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
a shift of the supply curve of funds

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

effects on the supply of funds for bonds
Effects on the supply of funds for bonds

Shift in supply curve

Change invariable

Change ininterest rate

Change inquantity

the supply of bonds
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
example higher profitability and supply of bonds
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
a shift of the demand curve for funds

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

effects on the demand of funds for bonds
Effects on the demand of funds for bonds

Shift in demand curve

Change invariable

Change ininterest rate

Change inquantity

equilibrium in the market for money

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

shifts in the demand for money curve
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
response to a change in income

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

response to a change in the money supply
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)
response to a change in money supply

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

secondary effects of increased money supply
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)
should the ecb lower interest rates
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

increase of money supply plus demand shift

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

readings
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)
can short term interest rates fall below zero
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
liquidity trap
“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
liquidity trap and money supply

33.0

25.0

17.6

11.1

5.3

Liquidity trap and money supply

NominalInterest rate (%)

Supply of money, Ms

Demand for money, Md

C

D

500

200

300

400

100

real interest rates in the united states
Real interest ratesin the United States
  • During the 1970 real interest rates were significantly below 0% in the United States (and worldwide)
liquidity trap and japan
Liquidity 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
discussion 7 money inflation and interest rates
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?