Presentation Transcript

1. Money Supply Comments M1 focuses on money as a medium of exchange such as for settling a debt. M2 includes money as a “store of value.” There are also other money supply measures M3, MZM, etc. No single correct measure of money supply. Different money supply measures are studied because they have different abilities to help understand employment, inflation, interest rates,...
2. Money Supply Comments Money supply is what is believed to be important, but Fed can only control it imprecisely through monetary base. Reason is that most money supply aggregates are determined by private decisions which Fed can’t precisely control.
3. How Pair Trading Works (a) 75 70 65
4. How Pair Trading Works (b) liq,goshort 75 liq,golong liq liq,golong goshort liq,goshort liq,golong 70 liq,goshort liq 65 golong
5. How Pair Trading Works (c) liq,goshort +500 75 -200 liq,golong liq +800 liq,golong goshort liq,goshort +0 liq,golong +700 70 +500 +500 liq,goshort -300 liq +500 +500 65 golong Plausible rule: Say mean spread 3.0 with stdev 1.6 Go into action, say, when spread +1.5 or -1.1 stdevs. Funds use math and statistics to figure out best strategy.
6. Hedge Funds Hedge -- an investment intended to offset adverse price movements in another investment. A basic hedging strategy is pair trading. Involves matching a long position with a short position. Funds use math and statistics to identify pairs with good spread reversion characteristics. Done with stocks, options, commodities, currencies, etc. By law, hedge funds only offered to institutional investors or individuals of substantial wealth. Government then doesn’t regulate much.
7. Actual Fed Funds Rates 1954-2008
8. Fed Funds Rates 2004-2008
9. Target Rate vs. Actual Sep07 to Sep08
10. Monetarist Economists Monetarists believe key explanatory variable is the money supply people will buy more if feel they have “more money,” and spend less if feel they have “less money.” idea is to use monetary policy to influence the money supply. in this way, adding reserves should promote economic growth, reducing reserves should slow the economy.
11. Keynesian Economists Keynesians believe key explanatory variable is the interest rate John Maynard Keynes was influential British economist of 1930s. money supply does not make that much difference believe economic growth is stimulated by falling interest rates, and slowed by rising rates
12. Effects of Increasing Reserves Increases amount of loans that can be made Increases purchases of real estate. Increases consumer expenditures for durablegoods (>3 years: cars, boats, electronics, appliances,…) which are often bought on credit. Increases business investment in real assets. Increases specter of inflation (for a short time may even spur buying before prices go up). Reverse happens if Fed moves to a “tight” money policy.
13. Open Market Injection of $30 Billion k = 10%
14. Velocity of Money Velocity is annual money supply turnover rate. Velocity * Money supply = GDP Velocity is difficult to predict. For given change in money supply, the Fed can expect direction of change in economy, but cannot ensure the degree.
15. Monetary Base Graph
16. M1 Graph
17. Technical Factors Cash drains Cash holdings by public decrease banking system reserves. US Treasury transactions Many Treasury transactions cause shifts in reserves Fed attempts to offset with calibrated open market operations (typically with repos and reverse repos)
18. Closer Look at a Cash Drains Situation Cash drains – increased cash holdings by public decrease banking system reserves. Example: People take money out of their checking accounts in advance of a big weekend. Reduces vault cash Banks have harder time meeting RRs Puts upward pressure on Fed Funds rate to rise Fed initiates a reverse repurchase agreement to increase temporarily depository institution reserves Puts downward pressure on Fed Funds rate
19. Limitations Fed can manipulate reserves and create incentives but can not compel results. Businesses are mostly rational and profit-maximizing Consumers are partly rational and partly emotional Why? Because many elements of the money supply are determined by private transactions and are not under the control of the Fed.