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Chapter VII: Money, assets, and interest rates

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Title: Chapter VII: Money, assets, and interest rates


1
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

2
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
3
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

4
Stone money of the island of Yap
5
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?

6
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)

7
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

8
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 --gt such as cigarettes, butter)
  • Such monies circulate forcibly as media of
    exchange, but they are unsuitable as a store of
    value (Greshams Law)
  • Bad money replaces good money!

9
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

10
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
11
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

12
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

13
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
14
Empirical definition of money
  • Friedmans 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

15
Measuring money demand
  • M1 narrow money
  • M2 intermediate money
  • M3 broad money

16
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.

17
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.

18
Money demand in the Euro-area (end of 2007)
19
Development of M3 in the Euro area 1999-2008
20
Relationship between M3 andthe inflation rate
(HIPC)
21
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 assumed M m ? B multiplier ?
    base money

22
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

23
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

24
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)

25
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

26
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

27
The demand for bonds
Interest rate ()
Price of bond ()
500
100
400
300
200
28
The supply for bonds
Interest rate ()
Price of bond ()
500
100
400
300
200
29
Market equilibrium (asset market approach)
Interest rate ()
Price of bond ()
C
i
P
500
100
400
300
200
30
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

31
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
100
400
300
200
32
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

33
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

34
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
100
400
300
200
35
Effects on the supply of funds for bonds
Shift in supply curve
Change invariable
Change inquantity
Change ininterest rate
36
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

37
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

38
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
100
400
300
200
39
Effects on the demand of funds for bonds
Shift in demand curve
Change invariable
Change ininterest rate
Change inquantity
40
Equilibrium in the market for money
Interest rate ()
Supply of money, Ms
C
Demand for money, Md
500
100
400
300
200
41
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

42
Response to a change in income
Interest rate ()
Supply of money, Ms
D
C
Demand for money, Md
500
100
400
300
200
43
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)

44
Response to a change in money supply
Interest rate ()
Supply of money, Ms
D
C
Demand for money, Md
500
100
400
300
200
45
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-gt interest rates
    increase (income effect).
  • it causes the overall price level to increase-gt
    interest rates increase (price effect)
  • it affects the expected inflation rate-gt
    interest rates increase (Fisher-effect)

46
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

47
Increase of money supply plus demand shift
Interest rate ()
Supply of money, Ms
E
D
C
Demand for money, Md
500
100
400
300
200
48
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)

49
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

50
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

51
Liquidity trap and money supply
NominalInterest rate ()
Supply of money, Ms
Demand for money, Md
C
D
500
100
400
300
200
52
Real interest ratesin the United States
  • During the 1970 real interest rates were
    significantly below 0 in the United States (and
    worldwide)

53
And again now in the USA .
54
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

55
Real interest and Deflation
56
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?

57
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