MONEY

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MONEY

• What is Money?
• 3 Distinguishing Features of Money
• .Medium Of exchange
• .Unit of Account
• .Store of Value

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Medium of Exchange

• Facilitates efficient economic transactions
• Advantage over Barter Economy
• Double Coincidence of Wants Not Necessary
• Promotes Specialization Division of Labor

3
Unit of Account

• Measure of Value in the Economy
• Common Yardstick to Value Different Goods and
  Services

4
Store of Value

• Enables agents to shift consumption across time,
  i.e., save now, consume later.
• Other financial Non-financial assets may also
  have this property. Money is distinguished by its
  Liquidity.
• Money is unattractive as a store of value in an
  inflationary environment.

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Forms of Money

• Commodity Money Money that is inherently
  valuable, e.g., Gold Silver
• Paper Money Initially paper money used to be
  convertible into an equivalent amount in precious
  metals. More recently, no such convertibility
  fiat money.
• Checkable Deposits Convenient, Safe Useful for
  Large Transactions
• Electronic Money Debit Cards, Wire Transfers
  (FedWire, Clearing House Interbank Payments
  System)
• Efficient
• Concerns about Safety Security

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How Do We Measure Money?

• Different Measures of Money Depending Upon What
  is Included and What is Not.
• Usual Criterion for Qualifying as Money
  Acceptability as Medium of Exchange

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M1

• Also known as Narrow Money
• Includes
• Currency
• Travelers Checks
• Demand Deposits
• Other Checkable Deposits

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M2

• Also known as Broad Money
• Includes
• M1
• Small Denomination Time Deposits
• Savings Money Market Deposits
• Non-Institutional Shares in Money Market
  Mutual Funds
• Overnight Repos
• Overnight Eurodollar Deposits

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M3

• Includes
• M2
• Large Denomination Time Deposits
• Institutional Shares in Money Market Mutual Funds
• Term Repos
• Term Eurodollar Deposits

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L

• Includes
• M3
• Short Term Treasury Securities
• Commercial Paper
• Savings Bonds
• Bankers Acceptances

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DETERMINATION OF INTEREST RATES

• How are Interest Rates determined by the Market ?
• 2 Analytical Frameworks
• Loanable Funds Framework
• Liquidity Preference Framework

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Loanable Funds Framework

• Supply Demand for Bonds
• Supply of Bonds is Equivalent to Demand for
  Loanable Funds. Similarly, Demand for Bonds is
  equivalent to Supply of Loanable Funds
• Therefore, Demand-Supply Analysis for Bonds is
  equivalent to Demand-Supply Analysis for Loans

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Demand for Bonds

• As Bond Prices Increase, Demand for Bonds
  Declines
• But Higher Bond Prices Imply Lower Interest Rates
• Therefore, as Interest Rates Increase, Demand for
  Bonds Increases

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• Given the equivalence between Bonds Market
  Analysis and Loans Market Analysis, these figures
  can be represented as
• The equilibrium interest rate is determined at
  the level at which Demand equals Supply

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Changes in Equilibrium Interest Rates

• Distinction between movement Along a Curve and
  Shifts in a Curve
• ? Change in quantity caused by a change in price,
  or interest rate Movement along the curve
• ? Change in quantity caused by a change in any
  other factor Shift in the curve

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Example of a Shift in the Demand Curve

• People Want to buy more bonds
• At every price (interest rate) level, more bonds
  are demanded than before

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Shifts in demand for bonds occur due to changes in

• Wealth
• When Aggregate Wealth in the Economy Increases,
  people have more money to invest in Financial
  Assets
• ? Demand for Bonds Increases, i.e., Bond Demand
  Curve Shifts to the Right

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Shifts in demand for bonds occur due to changes in

• Expected Returns on Bonds Relative to Other
  Assets
• When interest rate increases relative to other
  asset returns, people invest more in bonds
• ? Demand for Bonds Increases, i.e., Bond Demand
  Curve Shifts to the Right

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Shifts in demand for bonds occur due to changes in

• .Risk of Bonds Relative to Other Assets
• When Bond Riskiness increases, people move
  investments away from bonds into other assets
• ? Demand for Bonds Decreases, i.e., Bond Demand
  Curve Shifts to the Left

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Shifts in demand for bonds occur due to changes in

• .Liquidity of Bonds Relative to Other Assets
• When Bond Liquidity increases, people invest more
  in bonds
• ? Demand for Bonds Increases, i.e., Bond Demand
  Curve Shifts to the Right

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Shifts in the supply of bonds occur due to

• Expected Profitability of Investment
  Opportunities
• When expected profitability of investment
  opportunities increases, firms want to make
  bigger investments. To finance these increased
  investments, more bonds are issued. Therefore,
  the supply curve for bonds shifts to the right.

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Shifts in the supply of bonds occur due to

• Expected Inflation
• When inflation is expected to be high, the real
  rate of interest is expected to be low.
  Therefore, firms want to borrow more. This shifts
  the bond supply curve to the right.

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Shifts in the supply of bonds occur due to

• Government Activities
• Increased government activities imply increased
  government spending which has to be financed by
  issuing more Treasury debt. Thus the bond supply
  curve shifts to the right.

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Changes in Equilibrium Interest Rates

• Changes in expected inflation
• Bond Demand Curve shifts to the Left
• Bond Supply Curve shifts to the Right
• Interest Rate Increases
• Fisher Effect

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Changes in Equilibrium Interest Rates

• Business Cycle Expansions
• Bond Demand Curve shifts to the Right
• Bond Supply Curve shifts to the Right
• Quantity of Bonds Increases
• Interest Rate may Increase or Decrease
• Empirical evidence indicates that interest rate
  increases

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Liquidity Preference Framework

• Alternative Method for determining Interest Rates
• Closely related to (alternative representation
  of) the Loanable Funds framework

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• Basic Assumption All individuals hold their
  wealth either as interest earning assets (bonds)
  or as non-interest earning cash.
• Bonds are desirable because of the interest they
  earn
• Cash is desirable because of the liquidity.
• Therefore, allocation between bonds and money
  represent a trade-off between interest income and
  liquidity demands.

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Demand Curve for Money

• If interest rates are high, more wealth will be
  held in bonds
• If interest rates are low, more wealth will be
  held as liquid money, because the opportunity
  cost, i.e., the income foregone, is low.

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Supply Curve for Money

• Supply of Money is Unilaterally fixed by the
  Central Bank. For USA, it is the Federal Reserve
  System.
• At equilibrium, money demand money supply

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Shifts in Demand for Money

• Income effect Increase in income increases the
  amount of money individuals want to hold.
  Therefore, an increase in GNP/Income shifts the
  money demand curve to the right.
• Price Level Effect Increases in price levels
  reduce the real value of money. Therefore, more
  money is held by individuals, thus shifting the
  money demand curve to the right.

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Shifts in Supply of Money

• Supply of money is controlled by the Federal
  Government through the Central Bank. Money Supply
  is thus an important tool used by the Fed in
  trying to control the economy.

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Changes in Equilibrium Interest Rates

• Changes in Income
• Money demand curve moves to the right
• Money supply curve remains at previous level
• Interest rate increases

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Changes in Equilibrium Interest Rates

• Changes in price level
• Money demand curve moves to the right
• Money supply curve remains at previous level
• Interest rate increases

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Changes in Equilibrium Interest Rates

• Changes in Money Supply
• Money demand curve remains at previous level
• Money Supply curve shifts to the right
• Interest rate decreases.

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• Impact of changes in Money Supply on Interest
  Rates has been a topic of controversy. In
  addition to the direct liquidity effect above,
  other effects have also been hypothesized.
• ? Income Effect Increase in money supply
  increases demand for money and thus shifts the
  demand curve to the right, thereby increasing
  interest rates.
• ? Price-level Effect
• ? Expected Inflation Effect
• These 3 effects work against the liquidity effect
  on the direction of interest rate movements. In
  reality, the final outcome depends upon which
  effect is stronger and which one comes into play
  earlier.

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TERM STRUCTURE OF INTEREST RATES

• Bonds which are otherwise identical but have
  different maturities have different
  yields-to-maturity (YTM).
• Yield Curve Curve depicting YTM of par bonds as
  a function of their maturities.

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• Term Structure Curve depicting the yields on
  Zero-Coupon Bonds as a function of their
  maturities.
• Yield Curves and Term Structures take on a
  variety of shapes upward sloping, downward
  sloping, flat, humped, inverted humped, etc. Most
  often, however, the Yield Curve is upward sloping.

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What explains the shape of the Yield Curve?

• ? Expectations Hypothesis
• ? Preferred Habitat Hypothesis
• ? Liquidity Preference Hypothesis.

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Expectations Hypothesis

• The interest rate on a long term bond equals the
  average of short-term interest rates that people
  expect to occur over the life of the long-term
  bond.
• Example The interest rate on a 5 year bond will
  equal the average of interest rates on the 5
  successive 1 year bonds starting today.

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Expectations Hypothesis

• Upward sloping Yield Curve denotes the markets
  expectation that short-term interest rates will
  rise in the future
• Downward sloping Yield Curve denotes the markets
  expectation that short-term interest rates will
  decline in the future
• Flat Yield Curve denotes the markets expectation
  that short-term interest rates will remain stable
  in the future.

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Expectations Hypothesis

• Simple theory that explains the empirically
  observed phenomenon of interest rates of
  different maturities moving together over time.
• However, it is difficult to explain the fact that
  the Term Structure is upward sloping most of the
  time. This would seem to indicate that short term
  interest rates should be rising most of the time.
  However, in an efficient market, they should be
  as likely to move up as down. This is a serious
  weakness of the Expectations Hypothesis.

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Preferred Habitat Hypothesis

• The market for bonds of each maturity is largely
  separate and segmented from the markets for bonds
  of all other maturities. The equilibrium interest
  rate in each maturity bond market is established
  by demand and supply in that market alone, with
  absolutely no across-market effects.

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Preferred Habitat Hypothesis

• Not a very satisfactory theory.
• Does not explain the smooth nature of observed
  Yield Curves
• Does not explain the comovements of several
  interest rates.

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Liquidity Preference Hypothesis

• The interest rate for a long term bond equals
  the average of short-term interest rates expected
  to occur over the life of the long-term bond plus
  a term premium that depends upon demand and
  supply for bonds of that term.

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Liquidity Preference Hypothesis

• Emphasis on liquidity Investors prefer to hold
  more liquid, i.e., shorter term bonds. Therefore,
  they need a higher return, or a term premium, on
  longer term bonds.
• Satisfactory explanation for the normally
  observed upward sloping nature of the term
  structure.

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Liquidity Preference Hypothesis

• A sharply upward sloping Yield Curve denotes the
  markets expectation that short-term interest
  rates will rise in the future
• A flat or downward sloping Yield Curve denotes
  the markets expectation that short-term interest
  rates will decline in the future
• A moderately upward sloping Yield Curve denotes
  the markets expectation that short-term interest
  rates will remain stable in the future.
• Synthesis of the previous two theories.