Chapter Fifteen

1
Chapter Fifteen

• Money, the Banking System, and Foreign Exchange

2
Chapter Fifteen Outline

1. Introduction
2. Money
3. Banking Crises
4. Foreign Exchange
5. Bringing It All Together
6. How a Flexible Exchange Rate Regime Works
7. How a Fixed Rate Regime Works

3
Introduction

• This chapter will examine the markets for money
  and foreign exchange and
• The effect of openness on the money market.
• Perhaps the most important key to understanding
  policy options in the world macroeconomy.
• Most obvious effect involves the introduction of
  a foreign exchange market.

4
What Is Money?

• Money is an asset that its owner can use directly
  as a means of payment.
• Currency held by the public and deposits on which
  checks can be written constitute a countrys
  money stock.
• Nonmoney assets, such as stocks, bonds, real
  estate, certificates of deposit, and diamonds,
  also represent purchasing power to their owners,
  but they typically cannot be used directly as a
  means of payment.

5
What Is Money?

• In order to use the purchasing power of a
  nonmoney asset to buy a new car, the transaction
  would require two steps
• The individual must find someone to buy the asset
  (exchanging the asset for money) and
• The individual uses the money to buy the car.
• A nonmoney asset exchanged directly for an
  automobile would be an example of a barter
  exchange.

6
What Is Money?

• Nominal money stock (M) a country's money stock
  measured in current dollars.
• Stock denotes the quantity of dollars existing
  at a point in time.
• Real money stock at any time equals the nominal
  money stock divided by a price index the GDP
  deflator, P
• Real money stock Nominal money stock/Price
  index M/P

7
Demand for Money

• The demand for money reflects the quantity of
  currency and checkable deposits the public wants
  to hold to make purchases.
• Real money balances nominal money balances
  divided by the price level.
• Differential between the interest paid on NOW
  accounts and the interest paid on bonds still
  represents an opportunity cost of holding money.

8
Demand for Money

• Figure 15.1 depicts the relationship among the
  quantity of real money balances, the interest
  rate, and income.
• The negative slope of each demand curve
  represents the negative relationship between the
  interest rate and the quantity demanded of real
  money balances.
• Changes in income shift the demand curve for real
  money balances.

9
Figure 15.1 The Demand for Real Money Balances
i
(Q
gt Q
)
1
0
L(Q
, i)
1
L(Q
, i)
0
Quantity of Real
0
Money Balances
10
Where Does Money Come From?

• The central bank creates the basis for a
  countrys money stock by buying nonmoney assets
  (such as government bonds or foreign exchange)
  from the public, using checks written by the
  central bank and drawn on itself.
• Central-Bank Balance Sheet
• Balance sheet records the assets owned by an
  organization as well as its liabilities, or what
  the organization owes to others.
• Difference between an organizations total assets
  and its total liabilities equals its net worth.

11
Where Does Money Come From?

• Commercial Bank Balance Sheet
• Commercial banks hold at least three types of
  assets
• The banks reserves (not to be confused with
  their foreign reserves).
• Under the fractional reserve banking system
  adopted by most economies, banks can lend funds
  from their deposits required to hold only a
  fraction of their deposits on hand to cover
  withdrawals by customers.
• Loans
• Other assets
• Includes office buildings, real estate,
  government bonds, etc.

12
Where Does Money Come From?

• Changing the money stock by buying or selling
  government bonds.
• Policies by which the central bank does this are
  called open market operations.
• A central bank purchase of bonds increases the
  money stock.
• Example of deposit expansion Joe borrows 900
  from bank to buy stereo. Bank credits Joes
  account with 900. Joe buys the stereo and the
  900 moves into the stereo dealers bank account.
  That bank must hold only a fraction of the 900
  in reserves and can lend out the rest.
• At end of this process, the money stock will have
  grown by a multiple (called the money multiplier).

13
Where Does Money Come From?

• Changing the money stock by buying or selling
  foreign exchange.
• Th central bank can obtain exactly the same
  effects on the money stock in the FX market as
  using government bonds.
• Central bank can buy the excess
  foreign-currency-denominated assets from the
  public it purchases them with its special
  check.
• The same deposit expansion process occurs.
• Current money stock (M) equals the money
  multiplier (mm) times the government bonds (GB)
  and FX reserves (FXR) held by the central bank.

14
Money Market Equilibrium

• Equilibrium in the money market requires that the
  real money stock equal the quantity of real money
  balances demanded by the public.
• Figure 15.2 illustrates this
• The equilibrium interest rate is the opportunity
  cost of holding money at which individuals
  willingly hold the existing stock of real money
  balances. Increases in income raise demand for
  money and increase the interest rate (panel a).
• Increases in the money stock produce a decline in
  the interest rate, inducing individuals to hold
  the new higher level of real money balances
  (panel b).

15
Figure 15.2 Money Market Equilibrium
(M
/P)
(M
/P)
(M
/P)
i
i
1
0
0
(M
gt M
)
(Q
gt Q
)
1
0
1
0
i
1
i
i
0
0
i
i
2
2
L(Q
, i)
1
L(Q
, i)
L(Q
, i)
0
0
Quantity of Real
0
0
Quantity of Real
Money Balances
Money Balances
(a) Money Market Equilibrium
(b) Increase in Money Stock
16
The LM Curve

• LM Curve the upward-sloping curve in Figure 15.3
  (b) shows the combinations of income and interest
  at which the money market is in equilibrium.
• Rise in income increases the demand for money.
  For quantity demanded to be reequated with the
  fixed stock of money, a rise in interest rate is
  necessary.
• Similarly, a rise in interest rate lowers the
  quantity demanded of money.

17
The LM Curve

• LM Curve and Fig. 15.3 (cont.)
• With the stock of money fixed, income must rise
  to increase the demand for money.
• Therefore, the interest rate and income
  combinations are positively related. The curve
  summarizing this positive relationship between I
  and Q is the LM curve, because at each point on
  it the quantity demanded of money (L) equals the
  money stock (M/P).
• To the right of the LM curve, the quantity
  demanded of money exceeds the money stock to
  the left of it, the quantity demanded of money is
  less than the money stock.

18
Figure 15.3a The LM Curve Represents
Equilibrium in the Money Market
i
(M
/P)
(a) Money Market Equilibrium
0
(M
/P) gt L(Q
, i
)
0
0
1
i
1
II
(Q
gt
Q
)
1
0
i
0
I
(M
/P) lt L(Q
, i
)
0
1
0
L(Q
, i)
1
L(Q
, i)
0
0
(M
/P)
Quantity of Real
0
Money Balances
19
Figure 15.3b The LM Curve Represents Equilibrium
in the Money Market
i
LM(M
/P)
0
(M
/P) gt L(Q, i)
0
(b) LM Curve
(Q
, i
)
0
1
i
(Q
, i
)
1
1
1
(Q
, i
)
0
0
i
(Q
, i
)
0
1
0
(M
/P) lt L(Q, i)
0
Q
Q
Q
0
1
0
20
The LM Curve

• Since we assume the price level is fixed, only a
  change in the nominal money stock, M, can cause a
  change in the real money stock.
• As illustrated in Figure 15.4, increases in the
  nominal money stock shift the LM curve to the
  right.
• Any given level of income now requires a lower
  interest rate for money market equilibrium.

21
Figure 15.4a Effects of an Increase in the Real
Money Stock on the LM Curve
i
(M
/P)
(M
/P)
(a) Money Market Equilibrium
0
1
(M
gt M
)
II
1
0
i
1
IV
i
3
I
i
0
III
i
2
L(Q
, i)
1
L(Q
, i)
0
0
(M
/P)
(M
/P)
Quantity of Real
0
1
Money Balances
22
Figure 15.4b Effects of an Increase in the Real
Money Stock on the LM Curve
i
LM(M
/P)
0
LM(M
/P)
1
II
i
1
i
3
IV
i
I
0
i
III
2
Q
0
Q
Q
1
0
(b) LM Curve
23
Banking Crises

• How important are banking problems?
• IMF reports that 130 countries experienced
  significant banking sector problems between
  1980 and 1996 (shown in Figure 15.5).
• Banking crises can impose large costs on an
  economy (shown in Figure 15.6).
• The U.S. had costs of 180 billion in 1984-91 to
  correct the savings loan crisis.

24
Figure 15.5 Countries Experiencing Banking
Sector Problems, 1980-1996
25
Figure 15.6 Direct Cost to Government of Banking
Crisis (Percent of GDP)
Argentina 1980

82
Chile 1981

83
Uruguay 1981

84
Israel 1977

83
C
ô
te d'Ivoire 1988

91
Venezuela 1994

95
Senegal 1988

91
Benin 1988

90
Spain 1977

85
Mexico 1995
Mauritania 1984

93
Bulgaria 1995

96
Tanzania 1987

93
Hungary 1991

93
Direct Cost of Banking Crisis (Percent of GDP)
Finland 1991

93
Brazil 1994

95
Sweden 1991
Ghana 1982

89
Sri Lanka 1989

93
Colombia 1982

87
Malaysia 1985

88
Norway 1987

89
United States 1984

91
60
50
40
30
20
10
0
26
Banking Crises

• What does it mean for a bank to be unsound?
• Bank can be unsound in one of two ways
• Illiquidity occurs when a banks assets are
  sufficient to cover its liabilities, but there is
  a time-horizon mismatch.
• Liabilities are due now, but revenue from the
  assets are not available until later.
• Insolvency occurs when the value of a banks
  assets is insufficient to cover the value of its
  liabilities.
• Net worth is negative.
• Bank must then be recapitalized, bailed out by
  the government or taxpayers.

27
Banking Crises

• What are some of the main recipes for
  banking-system problems?
• A run on an individual bank
• Economy-wide bank runs
• Bad loans
• Declines in value of non-loan assets
• Examples corporate stock, bonds, or real estate.
• Figure 15.7 reports banks local real estate
  holdings in 1997 for economies most affected by
  financial crisis.
• Figure 15.8 reports declines of Asian stock
  indices between mid-1997 and mid-1998.

28
Figure 15.7 Estimates of Asian Banks Loans to
Property Sector ( of Total Loans, End of 1997)
Philippines
South Korea
Indonesia
Malaysia
Thailand
Singapore
Hong Kong
0
100
90
80
70
60
50
40
30
20
10
Percent
29
Figure 15.8 Asian Stock Prices, June 30, 1997to
May 8, 1998 (Percent Change)
Singapore
6/30/97

12/31/97
1/1/98

5/8/98
6/30/97

5/8/98
Taiwan
South Korea
Hong Kong
Philippines
Indonesia
Malaysia
Thailand
20
10
0
2
10
2
20
2
30
2
40
2
50
30
Banking Crises

• What are some of the main recipes for
  banking-system problems (cont.)?
• Corruption and political favors
• When corruption affects a banking system, the
  economys most productive firms may have trouble
  getting loans, which go instead to the
  politically well connected.
• Figure 15.9 presents data on corruption in
  various countries.
• Foreign-exchange problems
• Figure 15.10 indicates the currency movements of
  several Asian economies during their recent
  financial crisis.

31
Figure 15.9 Corruption Index, 2001
10
Finland
LEAST CORRUPT
9
Singapore
8
Hong Kong
United States
Chile
Japan
7
Corruption Index, 2001
6
Taiwan
Malaysia
5
South Korea
4
Brazil
China
Argentina
3
Thailand
Philippines
India
Russia
2
Indonesia
Nigeria
1
MOST CORRUPT
0
32
Figure 15.10 Asian Currencies Against the
Dollar,June 30, 1997 to May 8, 1998 ( Change)
Singapore
Taiwan
South Korea
Hong Kong
6/30/97

12/31/97
1/1/98

5/8/98
6/30/97

5/6/98
Philippines
Indonesia
Malaysia
Thailand
30
20
10
0
2
10
2
20
2
30
2
40
2
50
2
60
2
70
2
80
33
Banking Crises

• Why do banks matter so much?
• Answer lies in recognizing the many central roles
  that banks play in an economy
• Banks allocate capital they channel savers
  funds to firms to finance investment projects.
• Banks play key role in economys monetary policy
  interact with both central bank and public .
• Strong banks allow countrys policy makers to
  carry out the macroeconomic policies needed by
  rest of economy.
• Banks play major role in financial intermediation
  (channeling saving to investors).
• Figure 15.11 reports 1994 figures for several
  countries.

34
Figure 15.11 Banks Share in Total Financial
Intermediation, 1994
Argentina
Brazil
Hong Kong
Venezuela
Indonesia
Mexico
Colombia
Taiwan
India
Japan
Germany
Thailand
Singapore
Malaysia
Chile
South Korea
United States
100
90
80
70
60
50
40
30
20
10
0
Percent
35
Foreign Exchange

• Equilibrium in the foreign exchange marketagain.
• Let CAB denote the current-account balance and
  KAB denote the capital-account balance
• When the sum of the current-account and
  capital-account balances equals zero, the overall
  balance of payments is in equilibrium.
• The foreign exchange market is also in
  equilibrium, since the quantity demanded of
  foreign-currency-denominated assets equals the
  quantity available
• CAB KAB 0 for BOP equilibrium
• Also CAB -KAB for BOP equilibrium

36
Foreign Exchange

• Figure 15.12 represents graphically this
  requirement for equilibrium in the balance of
  payments or the foreign exchange market by a
  negatively sloped 45-degree line.
• Below and to the left of the line, there is a
  deficit.
• Above and to the right of the line, the BOP is in
  surplus.

37
Figure 15.12 Balance of Payments Equilibrium
Requires that the CAB KAB Sum to Zero
BOP 0

)
(Q

, Q, R
CAB
1
BOP gt 0
2
(Surplus)
6
45o

(
)
KAB
i

, i, e
e
,e
f
3
BOP lt 0
5
(Deficit)
4
CAB

KAB
38
Foreign Exchange

• For the remainder of this chapter, we assume that
  foreign income, relative prices of domestic and
  foreign goods and services, foreign interest
  rates, the spot exchange rate, the forward rate,
  and the expected future spot exchange rate are
  fixed.
• Will examine relationship between domestic income
  and interest rate that must hold for equilibrium
  in the foreign exchange market.

39
Foreign Exchange

• Figure 15.13 illustrates the effects of domestic
  income and interest on the market for foreign
  exchange.
• Starting from a point of BOP equilibrium (point
  I) in panel (a), an increase in domestic income
  moves the CAB toward a deficit, resulting in a
  BOP deficit at an unchanged interest rate (point
  II).
• To cause increased capital inflows with which to
  offset the decreased current-account surplus, the
  interest rate must rise (point III).
• At point III, the BOP is again in equilibrium,
  but with a smaller current-account surplus and
  capital-account deficit than at point I.

40
Figure 15.13a Effects of Domestic Income and
Interest on the Market for Foreign Exchange
_
(
)
Q
CAB
BOP 0
Surplus
CAB(Q
)
0
I
III
CAB(Q
)
1
II
Deficit

45o
KAB(i)
KAB(i
)
KAB(i
)
0
1
BOP 0
(a) Balance-of-Payments Equilibrium
41
Foreign Exchange

• The BOP Curve
• The upward-sloping line of Figure 15.13 panel
  (b).
• Reflects all combinations of income and interest
  rates that correspond to BOP (and FX)
  equilibrium.
• Because increases in income move the CAB toward a
  deficit while increases in interest rates move
  the KAB toward a surplus, the BOP line is upward
  sloping.
• Points I and III in panel (b) refer to those
  combinations of income and interest resulting in
  equilibrium points I and III in panel (a).

42
Figure 15.13b Effects of Domestic Income and
Interest on the Market for Foreign Exchange
i
(b) BOP Curve
BOP gt 0
BOP
III
i
1
I
i
II
0
BOP lt 0
0
Q
Q
Q
0
1
43
The BOP Curve (cont.)

• Increases in the foreign interest rate, expected
  depreciations of the domestic currency, or
  increases in the forward rate encourage capital
  outflows, moving the KAB toward a deficit.
• An offsetting move toward a surplus in the
  current account requires a fall in domestic
  income to reduce imports.
• Because a lower level of domestic income is
  required at each interest rate, the BOP curve
  shifts to the left.
• Figure 15.14 summarizes these results.

44
Figure 15.14 Changes in Foreign Income,
Relatives Prices . . . Shift the BOP Curve
i
Decrease in Q

BOP'
Increase in R
Increase in i

BOP
Increase in e
e
or e
f
BOP"
Increase in Q

Decrease in R
Decrease in i

Decrease in e
e
or e
f
Q
0
45
The BOP Curve (cont.)

• Two special cases capital mobility and the BOP
  curve.
• Figure 15.15 shows how the degree of capital
  mobility determines the slope of the BOP curve.
• Perfectly mobile capital means no transactions
  occur in the nonofficial capital account in
  response to changes in i or i.
• The BOP includes only the CAB, which equals zero
  at a single level of income, Qca, in panel (a).
• Perfectly mobile capital means that small changes
  in the interest rate generate large global
  capital flows, implying a horizontal BOP curve as
  in panel (b).

46
Figure 15.15 The Degree of Capital Mobility
Determines the Slope of the BOP Curve
i
i
BOP
(BOP gt 0)
A
B
(BOP
lt 0
)
(BOP
gt 0
)
BOP
(BOP lt 0)
0
Q
0
Q
Q
ca
(a) Perfectly Immobile Capital
(b) Perfectly Mobile Capital
47
Bringing It All Together

• Figure 15.16 brings together the IS, LM, and BOP
  curves that represent equilibrium in the markets
  for goods and services, money, and foreign
  exchange, respectively.
• A general equilibrium requires that the three
  curves share a common point of intersection.
• At such a point, the markets for goods and
  services, money, and FX are all in equilibrium
  simultaneously at the given combination of Q, i,
  and e.

48
Figure 15.16 Combining the IS, LM, and BOP Curves
i
LM
BOP
IS
Q
0
49
How a Flexible Exchange Rate Regime Works

• Under a perfectly flexible exchange rate regime,
  the exchange rate continually adjusts to keep the
  BOP in equilibrium and, equivalently, to keep the
  quantity demanded of FX equal to the quantity
  supplied.
• Figure 15.17 indicates how this happens the BOP
  surplus at point I causes the domestic currency
  to appreciate, shifting the BOP and IS curves to
  the left.
• Point II represents equilibrium with income equal
  to Q1, the interest rate at i1, and the
  domestic-currency price of foreign currency at e1.

50
Figure 15.17 Automatic Adjustment from Position
of BOP Surplus under a Flexible Exchange Rate
51
How a Flexible Exchange Rate Regime Works

• General observations about this process of
  shifting the IS, LM, and BOP curves
• A general equilibrium requires a combination of
  income, interest rate, and exchange rate such
  that all three markets are in equilibrium
  simultaneously.
• Even with prices held fixed, the economy contains
  self-adjusting mechanisms for bringing the three
  major markets into equilibrium.
• The model highlights the pitfalls of drawing
  conclusions from analysis of only one market.

52
How a Fixed Exchange Rate Regime Works

• Fixed exchange rates and the nominal money stock.
• Within a fixed exchange rate regime, the central
  bank maintains the pegged exchange rate by
  intervening to buy any excess supply of foreign
  exchange or to sell foreign exchange to cover any
  excess demand.
• Such intervening restores FX market equilibrium
  at the pegged exchange rate.

53
How a Fixed Exchange Rate Regime Works

• Figure 15.18 shows the effect of intervention on
  the money stock under a fixed exchange rate.
• At the pegged rate, ep, the quantity of foreign
  exchange supplied exceeds the quantity demanded.
• To prevent the dollar from appreciating, the U.S.
  central bank must buy the excess pounds.
• The purchased pounds are added to the central
  banks foreign exchange reserves.
• The central bank check with which the pounds are
  bought creates the basis for an expansion of the
  U.S. money stock.

54
Figure 15.18 Effect of Intervention on the Money
Stock under a Fixed Exchange Rate
e /
S
Intervention
e
p
FXR
D
M mm
D
FXR
D
D
0
Quantity of -Denominated Deposits
55
How a Fixed Exchange Rate Regime Works

• Figure 15.19 illustrates the effect of
  intervention on money and foreign exchange
  markets.
• When the central bank intervenes by buying the
  excess supply of foreign-currency-denominated
  deposits in the FX market (panel b), the
  domestic money stock rises (panel a).
• The larger domestic money stock pushes down the
  equilibrium interest rate in (a), lowers the rate
  of return on domestic-currency deposits, and
  raises the demand for foreign-currency deposits
  in (b).
• The intervention restores interest parity at the
  original rate (ep) and a lower domestic interest
  rate.

56
Figure 15.19a Effect of Intervention on the
Money Market and Foreign Exchange Rate
i
(M
/P)
(M
/P)
0
1
mm
FXR
D
(a) Money Market
i
0
i
1
L(Q
,i)
0
0
Quantity of
Real Money
Balances
57
Figure 15.19b Effect of Intervention on the
Money Market and Foreign Exchange Rate
e
S
(b) Foreign Exchange Market
FXR
D
e
p
D

(i
, i, e
e
, e
f
)
1
D

(i
, i, e
e
, e
f
)
0
0
Quantity of
Pound-Denominated
Deposits
58
How a Fixed Exchange Rate Regime Works

• The money stock and automatic adjustment.
• As long as a BOP surplus exists, the central
  banks FX market intervention will cause the
  money stock to expand, shifting the LM curve to
  the right (just the opposite for a BOP deficit).
• These adjustments ensure that the LM curve will
  move to the point of intersection with the IS and
  BOP curves, resulting in a general equilibrium
  for the economy.

59
How a Fixed Exchange Rate Regime Works

• The money stock and automatic adjustment (cont.).
• Figure 15.20 graphically shows how a surplus in
  the BOP causes the money stock to rise, shifting
  the LM curve to the right.
• The BOP surplus corresponds to an excess supply
  of FX. To maintain the pegged exchange rate, the
  central bank intervenes and buys FX and adding it
  to the banks reserves.
• The increase in reserves raises the domestic
  money stock from M0 to M1.

60
Figure 15.20 A Surplus in the BOP Causes the
Money Stock to Rise, Shifting LM Curve
61
How a Fixed Exchange Rate Regime Works

• Figure 15.21 represents how a deficit in the BOP
  causes the money stock to fall, shifting the LM
  curve to the left.
• The deficit corresponds to an excess demand for
  FX. To maintain the pegged exchange rate, the
  central bank must intervene, supplying FX from
  its reserves.
• The loss of reserves lowers the domestic money
  stock from M0 to M1.

62
Figure 15.21 A Deficit in the BOP Causes the
Money Stock to Fall, Shifting the LM Curve
63
Note for Case Two Where the Foreign Exchange
Reserves Are

• Central banks hold foreign reserves in case they
  want to intervene in the foreign exchange market.
• Figure 15.22 reports the 6 countries with the
  largest reserve holdings, including gold, in
  1999.
• Of all foreign exchange held in reserves, dollars
  make up about 68 of the total, down from about
  80 twenty years ago.

64
Figure 15.22 Foreign Exchange Reserves Including
Gold, 1999 (Billions)
65
Key Terms in Chapter 15

• Money
• Barter
• Nominal money stock
• Real money stock
• Real money balances
• Opportunity cost of holding money
• Fractional reserve banking system

66
Key Terms in Chapter 15

• Deposit expansion
• Money multiplier
• Open market operation
• LM curve
• BOP curve