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THE ECONOMICS OF MONEY AND MONETARY POLICY William D. Lastrapes

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Title: THE ECONOMICS OF MONEY AND MONETARY POLICY William D. Lastrapes


1
THE ECONOMICS OF MONEY AND MONETARY
POLICYWilliam D. Lastrapes
  • Terry at OxfordSummer 2008

2
The Nature of Money
  • The basic functions of money
  • medium of exchange
  • medium or unit of account, standard of value
  • With n goods, n(n-1)/2 relative prices.n 5 10
    relative prices with money, 5 prices n 100
    implies 4950 relative prices with money, 100
    prices

3
The Nature of Money
  • Money in the modern economy
  • Paper currency
  • Checking accounts
  • Stored-value (smart) cards
  • Local currencies
  • http//www.berkshares.org/

Berkshares
4
The Nature of Money
  • Alternatives to money
  • CreditLiquid assetsGold and silver?

5
The Nature of Money
  • Alternatives to money
  • CreditLiquid assetsGold and silver?
  • Purchasing power of money and inflation
  • ...the number of monetary units (units of
    account) it takes to buy the average good or
    service in the economy.The price level is the
    reciprocal of the purchasing power of money.
    Inflation measures the rate of depreciation in
    value of money.

6
The Nature of Money
  • Suppose that gold serves as the medium of
    exchange, and ounces of gold are the unit of
    account. Lump all the other goods and services in
    the economy together in a basket. The purchasing
    power of gold is the amount of these baskets that
    can be purchased with an ounce of gold. Suppose
    that 1 ounce buys 1/10 of a basket. Then the
    price level the ounces of gold needed to buy
    one basket is 10 ounces. Finally, suppose that
    at the beginning of next year, the basket costs
    11 ounces. Then the rate of inflation during the
    year is 10.

7
US Price level (CPI)
8
US Inflation (CPI)
9
Recent US inflation
10
The Nature of Money
  • Hyperinflation average monthly rate was 322
    from August 1922 to November 1923. In Hungary
    after WWII, prices rose 19,000 per month from
    August 1945 to July 1946.German wholesale price
    index
  •                         Index                 
    monthly rate
                                
  • 12/1914           125                             
                
  • 12/1921           3,490                           
                4.3
  • 12/1922           147,480                         
              36.6
  • 12/1923           126,160,000,000,000             
       455

11
The Nature of Money
  •  Inflation occurs when the quantity of money is
    produced at rates that exceed the desire to
    accumulate it.

12
The Nature of Money
  • Measuring moneyIn the US
  • Monetary base currency in circulation (banks
    and public)  bank deposits at central bank.
  •  
  • M1   Currency held outside of banks checkable
    deposits issued by financial institutions
    travelers checks
  • M2 M1 plus savings deposits
  • MZM M2 institutional money market mutual
    funds small denomination time deposits.

13
The Nature of Money
  • Measuring moneyIn the UK
  • M2 currency in circulation and sterling retail
    deposits with U.K. banks and building societies.
  • M4  M2  wholesale deposits with the U.K.
    banks and building societies.

14
The Nature of Money
15
The Nature of Money
16
The Nature of Money
17
The Nature of Money
  •  

18
The Nature of Money
  •  

19
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20
The Nature of Money
  • Real money balances M/P
  • M is nominal money
  • P is price level
  • Coincidence of wants and indirect barter
  •  

21
The Nature of Money
Preference Endowment First trade Final trade
Butcher Beer Meat Bread (from baker) Beer (from brewer)
Brewer Bread Beer Bread (from butcher)
Baker Meat Bread Meat (from butcher)
22
The Nature of Money
  • Carl Menger

23
The Nature of Money
  • A model of time and transactions costs
  • Types of money
  • Base money
  • Commodity money
  • Yap stone money
  • Cigarette money
  • Commodity Standard
  • Fiat money

24
The Nature of Money
Yap stone money
25
The Nature of Money
  • Modern fiat money systems
  • Case A commodity money/standard.
  • Central Bank
  • ____________________________
  • Assets Base money
  • Commercial Banks
  • ____________________________
  • Base money Notes/receipts

26
The Nature of Money
  • Modern fiat money systems
  • Case B a modern fiat system with credit money
    and fractional reserves
  • Central Bank
  • ____________________________
  • Assets Base money
  • Commercial Banks
  • ____________________________
  • Base money Deposits
  • Loans

27
Commodity money systems
  • A stock-flow model of prices under a gold
    standard
  • M nominal money supply in pounds
  • Pg nominal price of gold (pounds per ounce)
    set by central bank authority
  • G stock of gold in ounces that has been mined
    and is available for use as money or other
    purposes in the economy
  • Gm gold held by central banks as monetary
    reserves
  • P price level in pounds per composite good.
  • y real quantity of composite good produced
    during the year (real GDP).
  • p expected inflation (expected rate of change
    of P).
  • k gold reserve ratio the amount of gold held
    in the central bank as a fraction of
  • nominal money supply. Determined by the central
    bank. k PgGm/M. If klt1, then we have a
    fractional reserve gold standard.
  • Pg/P relative price or purchasing power of
    gold the quantity of composite
  • good per ounce of gold. The model essentially
    determines this price in short run and long run
    equilibrium.

28
Commodity money systems
  • Basic assumptions
  • G is the stock of gold outside of the ground, and
    thus usable. At a point in time, this stock is
    fixed.
  • The economy obtains gold from two sources a)
    mining and b) flows from international trade
    when the economy exports goods, it receives
    payment in the form of gold. It loses gold for
    two reasons a) consumption or loss from use, and
    b) when it imports goods, it pays gold. Both
    sources provide and use gold only gradually over
    time, and are thus flows. The stock of gold
    adjusts gradually over time according to
    conditions of flow demand and supply. Note,
    international capital flows are ignored, which
    could buffer the gold stock from trade flows.
  • Although gold is a commodity with inherent value,
    we ignore the non-monetary use of gold to
    simplify (nothing of essence changes by this
    assumption).
  • At a point in time, the relative price of gold
    quickly adjusts so that the existing stock of
    gold (G) equals the stock demand for gold.
    However, because Pg is fixed by the nature of the
    gold standard, the adjustment comes solely
    through P, the price level.
  • The focus of the model is on price level
    adjustments, so we suppose that the economy is in
    full employment the level of output is taken as
    fixed and independent of price level adjustment.
    This makes the model a theory of the price level.

29
Commodity money systems
  • Stock demand for gold
  • M/P m(y, p)
  • kM PgG ? M (1/k)PgG
  • G k(P/Pg)m(y, p)

30
Commodity money systems
  • Flow demand for gold consumption per unit of
    time of gold and loss of gold to purchase
    imports. We assume that the flow demand for gold
    is negatively related to the real price of gold.
  • Flow supply of gold. Production or inflow from
    trade per unit of time. We assume it depends
    positively on real price of gold incentives for
    mining gold when its price is high increase
    supply of exports and thus inflow of gold when
    price of gold is high.

31
Commodity money systems
  • Equilibrium P adjusts immediately so that stock
    demand equals existing gold stock at all points
    in time (because Pg is fixed by the nature of the
    standard.)
  • Long-run stock equilibrium when stock demand
    equals existing stock of gold (G) and flow supply
    equal flow demand. Given the latter condition,
    the stock of gold is stationary over time the
    amount of gold flowing into the central bank
    equals the amount flowing out.
  • Short-run adjustment/transition to long-run stock
    equilibrium if relative gold price is high (P is
    low), flow supply will exceed flow demand and the
    stock of gold will gradually grow, reducing real
    gold price (increasing P) according to stock
    demand and supply if real gold price is low (P
    high), then flow demand will exceed flow supply,
    the gold stock will gradually fall and real gold
    price will rise (as P falls).

32
Commodity money systems
  • Analysis and implications
  • Gold discovery
  • Reduction in gold reserve
  • Devaluation

33
Commodity money systems
  • Bimetallism
  • Greshams Law bad money drives out good money.

Sir Thomas Gresham, 1519-1579
34
Commodity money systems
  • Bimetallism
  • Example A gold coin is defined to be worth 10,
    while a silver coin is defined to be 0.5. The
    relative price of gold in terms of silver
    implicitly guaranteed by the central bank is thus
    Pg/Ps i.e. 20 oz silver per oz gold. Suppose an
    increase in the demand for gold (relative to
    silver) raises the market price of gold to 25 oz
    silver. Since the market price of gold is 25 oz
    silver and the mint price of gold is 20 oz
    silver, gold is the good (undervalued at mint
    price) money and silver the bad. Suppose you
    want to buy something that cost 10 one option
    is to offer a gold coin. The other is to melt
    down the gold coin and sell the gold in the
    market for 25 oz silver. Convert this silver to
    12.5 of silver coins at the central bank. Pay
    the 10 debt with silver coins and have 2.5 left
    over.

Sir Thomas Gresham, 1519-1579
35
Commodity money systems
  • Bimetallism
  • The law works when governments enforced two
    prices with legal tender laws which required
    acceptability at par values.

Sir Thomas Gresham, 1519-1579
36
Commodity money systems
Assignats Accept or die.
37
Commodity money systems
  • International exchange under commodity money
    standards
  • Price-specie flow mechanism.
  • Central bank control
  • Interest rates and capital flows. Suppose that
    during a trade deficit, the central bank acts to
    raise interest rates (by selling assets) to
    encourage lending by foreigners to domestic
    citizens. This lending could help finance the
    trade deficit without the necessity of official
    gold outflows, thus bringing external adjusts
    more quickly. With a trade surplus, the central
    bank could buy assets to reduce interest rates
    and therefore relieve the pressure on gold
    inflows. This was called the rules of the game
    by Keynes in describing the post WWI gold
    standard.
  • Gold sterilization. Central bank can sterilize
    gold flows, selling assets as gold flowed in a
    vice versa. In effect, the central bank could
    alter k in the same direction as the change in
    gold to buffer the money supply by adjusting the
    amount of gold held. This would offset the
    effects of gold flows on the money supply, at
    least temporarily.
  • Suspension. To counter this natural mechanism
    they could also suspend convertibility of paper
    money i.e. temporarily (or permanently) go off
    the gold standard.

38
Commodity money systems
  • International exchange under commodity money
    standards
  • Foreign exchange
  • When two countries are on the gold standard, but
    have different currencies (i.e. media of exchange
    and unit of account), there currencies will have
    a fixed rate of exchange. The price of one
    currency in terms of another is called the
    exchange rate. Suppose for example that in the
    US, the fixed nominal price of gold (the price in
    terms of the dollar unit of account) is 35 per
    ounce, while in the UK it is fixed by the central
    bank at 20 per ounce. If we assume there are no
    transactions costs in converting to gold, to
    gold, and to , then the / exchange rate will
    be 1.75 per . Suppose that you could convert
    pounds to dollars at a rate of 2 per pound. Then
    you could profit by arbitrage convert an ounce
    of gold into 20 pounds, with the 20 pounds buy
    40, and convert the 40 to 1.143 ounces of gold.
    Since there is no risk involved or transactions
    costs, many would attempt to sell pounds to buy
    dollars (the supply of pounds would rise),
    causing the pound to fall from 2 until there are
    no profit opportunities i.e. when the exchange
    rate returns to 1.75.

39
Banking institutions
  • The establishment of commercial banks
  • A banks balance sheet prior to lending
  • ______________________________________
  • 1000 coins 1000 receipts

40
Banking institutions
  • The establishment of commercial banks
  • A banks balance sheet prior to lending
  • ______________________________________
  • 1000 coins 1000 receipts
  • Balance sheet after lending 300 of coins
  • ______________________________________
  • 700 coins 1000 receipts
  • 300 loans

41
Banking institutions
  • The establishment of commercial banks
  • A banks balance sheet prior to lending
  • ______________________________________
  • 1000 coins 1000 receipts
  • Balance sheet after lending 300 of coins
  • ______________________________________
  • 700 coins 1000 receipts
  • 300 loans
  • Balance sheet after lending with a smaller need
    for reserves
  • __________________________________________________
    ______
  • 100 coins 1000 notes/checkable deposits
  • 900 loans

42
Banking institutions
  • Comments
  • 1) System-wide, this fractional reserve banking
    system led to a large increase in
    money/liquidity. The payments system has evolved
    to one of bank or credit (or inside) money,
    leading to a large expansion in liquidity, since
    banks liabilities are part of the money supply.
    For example, if there were 1000 coins in the
    economy as a whole, and bankers kept 10 on
    reserve, this could support a total money supply
    (the value of notes and checkable deposits) of
    10,000. This expansion could occur because
    bankers could simply make new loans not with
    coins, but with notes or checkable deposits.
  • 2) The system is potentially vulnerable or
    fragile what happens if all depositors want to
    claim base (gold) money. Under fractional
    reserves, this cant be done systematically. Such
    a system is very dependent on trustworthiness of
    the banks. If not, we might expect bank
    panics/runs.

43
Banking institutions
Banknote redemption and clearinghouses
Issued by A Issued by B Issued by C Total claim
Held by A 1000 2000 3000
Held by B 4000 2000 6000
Held by C 2000 2000 4000
Total debt 6000 3000 4000
44
Banking institutions
  • Implications for money and prices
  • Banking panics and runs money stock falls
    deflation. Potential solutions 1) deposit
    insurance 2) central bank (lender of last
    resort)
  • Banknote over-issue too much money inflation.
    But note redemption is a natural discipline
    limiting excess monetary expansion.

45
Banking institutions
  • Central banks
  • Bank for other banks private commercial banks
    can hold deposits and borrow from the central
    bank, but others (besides the government)
    generally cannot
  • Reserves centralized at the central bank
    private banks hold claims on the central bank.
  • Note and deposit issue serve as high-powered
    money, and are not typically redeemed (but could
    be under commodity standards). They have a
    monopoly over note issue, and the notes are
    usually legal tender. Without adverse clearings,
    this is very profitable.
  • Other special privileges from the government (if
    they are not actually part of the government)
    e.g. they keep government deposits.
  • Because of their large holding of reserves and
    ability to issue high-powered money they can
    determine liquidity and the quantity of money,
    and therefore are responsible for monetary
    policy.
  • Lender of last resort make loans to other banks
    in times of liquidity crises
  • Authority to regulate banks and the financial
    system.

46
Banking institutions
  • Origins and rationale of central banking
  • Seignorage revenues earned from the creation of
    money/issue of currency
  • Banking panics and the lender of last resort
  • Thornton and Bagehot lend to any healthy bank,
    at a penalty rate, that is need of liquidity, by
    buying (discounting) their assets.

Walter Bagehot, 1826-1877
47
Banking institutions
  • Other ways to prevent banking panics
  • Deposit insurance
  • Branch banking
  • Temporary suspension of convertibility
  • Clearinghouses
  • Free Banking versus Goodhart
  • Bear-Stearns, 2008

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49
Banking institutions
  • The Bank of England
  • Monetary background
  • April 25, 1694 Chartered as private bank to buy
    public debt
  • 1697 Monopoly of chartered banking and limited
    liability
  • 1708 Allowable capital doubled, and note issue
    was prohibited to any bank (except the Bank of
    England) with more than six partners
  • 1797 War-time suspension of convertibility
  • 1797-1821 Inflation discovery of monetary
    policy
  • 1821 Resumption to gold (after much to do)
  • 1826 Joint-stock banks (non-partnerships) 65
    miles away from London were allowed note issue to
    provide some financial stability outside London.

50
Banking institutions
  • The Bank of England
  • 1833 Bank of England notes made legal tender
  • 1844 Bank Charter Act split BoE into Issue and
    Banking departments. BoE becomes a central
    bank.
  • Private (profit-maximizing) bank until
    nationalization in 1946.
  • http//www.bankofengland.co.uk/banknotes/denom_gui
    de/index.htm

51
The evolution of money and banking in the US
  • The colonial and revolutionary war periods
  • Colonial period monetary standards bimetallic
    (gold and silver) pounds, shilling, pence
  • Revolutionary War Finance and the Continentals
  • The first US Banks The Pennsylvania Bank and the
    Bank of North America
  • Constitutional money standards US dollar equal
    to 371.25 grains (0.7734 ounces) of pure silver
    or 24.75 grains (0.05156 ounces) of pure gold,
    free coinage (nominal silver price was 1.29 per
    ounce and that of gold 19.39 per ounce.) mint
    ratio 15 to 1.

52
33 cent US Note a Continental. Issued February
1776
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Spanish dollars, 1776 and 1739
55
The evolution of money and banking in the US
  • Early 19th century and antebellum money and
    banking
  • (First) Bank of the United States. Private bank
    with 20 year charter, 1791-1811. Hamiltons
    motivation a) finance new government b)
    facilitate payment of taxes c) convenience and
    resource saving of paper money. Privileges a)
    Convertible notes accepted by government for
    taxes and payments b) government depository c)
    could branch in any state d) no other banks to
    be established during life. Charter lapsed in
    1811.

56
The evolution of money and banking in the US
  • Early 19th century and antebellum money and
    banking
  • Suspension of convertibility during War of 1812
    resumption in 1821
  • Second Bank of the United States 1816 to 1836
  • Coinage Act of 1834 gold in, silver out.
  • The Suffolk Bank System 1824-1866.
  • The Free-Banking Period

57
The evolution of money and banking in the US
  • Early 19th century and antebellum money and
    banking
  • Composition of the money stock and high-powered
    money, pre-Civil War By 1859, the money stock in
    the US (M1, essentially) was just over 670
    million 40 specie in circulation (gold and
    silver coin and bullion), 27 state bank notes,
    33 bank checking deposits. During this period,
    bank reserves of specie fluctuated between 20 and
    35 of note and deposit liabilities.

58
The evolution of money and banking in the US
  • From the Civil War to the Founding of the Fed
  • The monetary standard during and after the Civil
    War the Greenback period
  • The Crime (Coinage Act) of 1873
  • The National Banking System
  • The Founding of the Federal Reserve System
  • Federal Reserve Act
  • Elastic currency
  • Federal Reserve notes

59
The evolution of money and banking in the US
  • From the Civil War to the Founding of the Fed
  • The monetary standard during and after the Civil
    War the Greenback period
  • The Crime (Coinage Act) of 1873
  • The National Banking System

Bank note issued by Quakertown National Bank 1897
60
The evolution of money and banking in the US
  • From the Civil War to the Founding of the Fed
  • The Founding of the Federal Reserve System
  • Federal Reserve Act
  • Elastic currency
  • Federal Reserve notes

Woodrow Wilson
Nelson Aldrich
61
The evolution of money and banking in the US
  • World War I and beyond
  • Gold standard during WWI
  • The Great Depression
  • Banking Holiday reforms
  • The Bretton Woods system
  • and its collapse

62
The Financial System
  • Overview of the financial system
  • Intertemporal exchange trading current
    consumption for future consumption i.e. lending
    and borrowing
  • Services provided by the financial system
  • Reducing transactions costs.
  • Risk-sharing intertemporal exchange entails
    uncertainty since it deals with time and the
    future. The financial system provides a way for
    lenders especially to manage risk, primarily
    through diversification and the ability to trade
    risk.
  • Liquidity the ability to quickly convert wealth
    to money.
  • Information provision financial transactions are
    fraught with asymmetric (private) information
    borrowers and lenders have different information
    about how funds will be used. The financial
    system can help alleviate the costs of asymmetric
    information.

63
The Financial System
  • Overview of the financial system
  • Financial markets
  • Securities
  • Primary vs secondary
  • Debt vs equity
  • Financial Intermediation and asymmetric
    information
  • Adverse selection
  • Moral hazard

64
The Financial System
  • Understanding interest rates
  • Interest rates are prices determined in financial
    markets that measure the trade-offs of
    intertemporal exchange rate of increase in
    wealth (future consumption) that lenders get for
    sacrificing current consumption, and the rate of
    borrowers decline in wealth (future consumption)
    to get current consumption.
  • A bond or debt security is a contract
    characterized by 1) price 2) payoff and 3) the
    timing of the payoff/payments (maturity).

65
The Financial System
  • Understanding interest rates
  • 1) Discount bond a bond without an explicit
    interest payment, but that sells at a price below
    its face value.
  • i (F P) / P
  • Example
  • P 98
  • F 100.
  • ? i (100-98)/98 0.0204 2.04.

66
The Financial System
  • Understanding interest rates
  • 2) Multi-period debt with fixed interest
    payments
  • P C/(1i) C/(1i)² C/(1i)T
    F/(1i)T

67
The Financial System
  • Understanding interest rates
  • 2) Multi-period debt with fixed interest
    payments
  • P C/(1i) C/(1i)² C/(1i)T
    F/(1i)T
  • Example
  • P 975
  • F 1000
  • T 10
  • x 5 (0.05)
  • C 50
  • ? i 5.329

68
The Financial System
  • Understanding interest rates
  • (web calculator on http//www.moneychimp.com/calcu
    lator/bond_yield_calculator.htm )
  • Example
  • P 980 (all else the same)
  • ? i 5.262

69
The Financial System
  • Understanding interest rates
  • 3) Rate of return. Measures an interest rate over
    a given holding period. Rate of return over one
    holding period (t is the date)
  • R P(t1) C(t1) P(t) / P(t)
  • where C is a payment received during the period,
    and t denotes the particular time. P is the price
    of the security.

70
The Financial System
  • Understanding interest rates
  • 3) Rate of return. Measures an interest rate over
    a given holding period. Rate of return over one
    holding period (t is the date)
  • R P(t1) C(t1) P(t) / P(t)
  • Example Initial purchase price of the 10 year
    bond is 980, the coupon received is 50, and
    the sales price after a year is 990.
  • R (990 50 980)/ 980 6.12

71
The Financial System
  • Understanding interest rates
  • 3) Rate of return. Measures an interest rate over
    a given holding period. Rate of return over one
    holding period (t is the date)
  • R P(t1) C(t1) P(t) / P(t)
  • Example Stock return
  • Buy shares for 100, receive dividend of 5, sell
    for 110 after one year.
  • R 110 5 100 / 100 15.

72
The Financial System
  • Understanding interest rates
  • 3) Rate of return. Measures an interest rate over
    a given holding period. Rate of return over one
    holding period (t is the date)
  • R P(t1) C(t1) P(t) / P(t)
  • Example Consider purchasing a two period
    discount bond, P 90, F 100 (the annual ytm
    when purchased is 5.41). After one period,
    yields on debt rise so the price of the discount
    bond falls to 85 and you need to sell. R (85
    90) / 90 5.56.

73
The Financial System
  • Understanding interest rates
  • 4) Amortized (fixed payment) securities. This
    example does not solve for the yield to maturity,
    but uses the concept of present value to show how
    fixed payment securities are determined. Instead
    of the principal being repaid at maturity, the
    principal is amortized over the payment period.
    Use the present value formula to solve for the
    payment, which is constant.
  • C 1/(1i) 1/(1i)2 1/(1i)T-1P

74
The Financial System
  • Understanding interest rates
  • Real versus nominal interest rates
  • r i p
  • Indexed bonds TIPS and indexed-linked gilts.
  • 1000 TIP (face value), 2 year maturity, coupon
    rate 5. Inflation rate 3 each year
  • First interest payment 0.051000(1.03)
    51.50
  • Second interest payment .0510001.031.03
    53.045
  • Adjusted principal received at maturity
    1060.90
  • Real yield 5 (since purchased at face value)

75
The Financial System
  • Understanding interest rates
  • Determining interest rates the loanable funds
    model

76
The Financial System
  • Understanding interest rates
  • Determining interest rates the loanable funds
    model
  • Key behavioral assumptions. 1) Lenders (say
    households) interest rates have a positive
    effect on the quantity of saving anything
    besides the interest rate that effects desired
    saving will shift loanable funds supply. 2)
    Borrowers (say firms, government) the interest
    rate reflects future consumption given up to be
    able to spend now thus, there is a negative
    relationship between the interest rate and the
    demand for loanable funds. Anything else besides
    the interest rate that affects demand shifts
    demand curve.

77
The Financial System
  • Understanding interest rates
  • Determining interest rates the loanable funds
    model
  • Equilibrium real interest rate such that supply
    of loanable funds equals demand for loanable
    funds.

78
The Financial System
  • Understanding interest rates
  • Determining interest rates the loanable funds
    model
  • Factors explaining fluctuations and spreads in
    interest rates
  • Change in Default risk
  • Difference in default risk (risk premium)
  • Government deficits
  • Financial intermediation
  • Expected inflation (the Fisher effect)

79
Irving Fisher, 1867-1947
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The Financial System
  • Understanding interest rates
  • The term structure of interest rates yield
    curves and the expectations hypothesis.
  • Example 2-year planning horizon
  • 1) buy a two-year discount bond (T2)
  • 2) buy a discount bond with T1, then when that
    bond matures after one year, buy another one-year
    bond.
  • Expectations hypothesis
  • 1 2i i² 1 r1 Er2 r1 Er2
  • i ½ (r1 Er2)

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The Financial System
  • Understanding exchange rates
  • Exchange rates and trade
  • Assume the price (p) of the wine from California
    is 200 (per case) and the price (q) of the
    French wine is 120. If the dollar-euro exchange
    rate (s) is 1.50/, then the dollar price of
    French wine is p_e qs 1201.5 180. The
    real exchange rate (relative price of French wine
    in terms of California wine) is then z p_e/p
    180/200 0.9 cases of California wine for a case
    of French wine.

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The Financial System
  • Understanding exchange rates
  • Exchange rates and trade
  • Assume the price (p) of the wine from California
    is 200 (per case) and the price (q) of the
    French wine is 120. If the dollar-euro exchange
    rate (s) is 1.50/, then the dollar price of
    French wine is p_e qs 1201.5 180. The
    real exchange rate (relative price of French wine
    in terms of California wine) is then z p_e/p
    180/200 0.9 cases of California wine for a case
    of French wine.
  • The Law of One Price prices of perfect
    substitutes should be the same in terms of a
    given currency, no matter where they are sold.

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The Financial System
  • Understanding exchange rates
  • Purchasing power parity real exchange rates are
    independent of changes in national price levels
    that are caused by changes in money supplies
  • Z SQ/P (/)(/UK)/(/US) US/UK
  • Z real US/UK exchange rate
  • S /
  • Q price level in UK
  • P price level in US
  • Z is the relative price of average goods in the
    UK in terms of average goods in the US. The real
    exchange rate depends on the nominal exchange
    rate,
  • S (P/Q)Z

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The Financial System
  • Understanding exchange rates
  • Comments
  • Smooth price level ratio
  • Base year for both CPIs is 2005, In base year,
    nominal real exchange rate by construction.
  • Since the price levels are based on an index, all
    we can really do is compare over time. Relative
    price of UK goods to US citizens is high, but not
    unprecedented UK goods were actually more
    expensive in 2007, late 2004, 1988, and mostly
    from 1990 through 1992/

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The Financial System
  • Understanding exchange rates
  • PPP measures of GDP
  • Current GDP in the US 14 trillion (45,000 per
    capita)
  • Current GDP in the UK 1.5 trillion (25,000
    per capita)

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The Financial System
  • Understanding exchange rates
  • PPP measures of GDP
  • Current GDP in the US 14 trillion (45,000 per
    capita)
  • Current GDP in the UK 1.5 trillion (25,000
    per capita)
  • Must convert to common currency, but how?
  • 1) Use market rates (e.g. multiply UK GDP by
    current / rate)
  • 2) Use exchange rate implied by PPP (z1) S
    P/Q
  • Country list https//www.cia.gov/library/publicat
    ions/the-world-factbook/rankorder/2001rank.html

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The Financial System
  • Understanding exchange rates
  • Exchange rate determination in the short-run
  • Interest parity condition rates of return on all
    assets must be the same, regardless of currency
    or country.
  • ius iuk (?S/S)

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The Financial System
  • Understanding exchange rates
  • Exchange rate determination in the short-run
  • 1) Increase in US interest rates ? pound
    depreciation/dollar appreciation
  • 2) Increase in the expected appreciation of the
    pound ? pound will appreciate immediately
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