goethe business school chapter vii: money, assets, and interest rates a.what is money? b.monetary...

Goethe Business SchoolGoethe Business School

Chapter VII: Money, assets, and interest rates

A. What is money?

B. Monetary aggregates

C. Demand for financial assets

D. Asset market equilibrium

E. Liquidity preference theory

F. 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 --> such as cigarettes, butter)

Such “monies” circulate forcibly as media of exchange, but they are unsuitable as a store of value (Gresham’s “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

Ability to pay or “liquidity”

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

Store of value


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

Friedman’s 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)

Billion euros In pc of currency in circulation

Currency in circulation

675 100

M1 = “narrow money”

3,835 569

M2 = “inter-mediate” money

7,339 1088

M3 = “broad money”

8,650 1282


Development of M3 in the Euro area 1999-2008

19


Relationship between M3 andthe inflation rate (HIPC)

20


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 assumedM = 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

950

900

850

800

750

5.3

11.1

17.6

25.0

33.0

Interest rate (%)Price of bond (€)

100 500400300200


28

The supply for bonds

950

900

850

800

750

5.3

11.1

17.6

25.0

33.0


100 500400300200


29

Market equilibrium (asset market approach)

950

900

850

800

750

5.3

11.1

17.6

25.0

33.0


100 500400300200

CP* i*


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 (%)

33.0

25.0

17.6

11.1

5.3

100 500400300200

Demand for bonds, Bd =Supply of loanable funds, Ls

Supply of bonds, Bs =Demand for loanable funds, Ld


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 (%)

33.0

25.0

17.6

11.1

5.3

100 500400300200



CD


35

Effects on the supply of funds for bonds

Wealth right

Expected interest

left

Expected inflation

left

Risk left

Liquidity right

Change invariable

Change inquantity

Change ininterest rate

Shift in supply curve


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 (%)

33.0

25.0

17.6

11.1

5.3

100 500400300200



C

D


39

Effects on the demand of funds for bonds

Profitability right

Expected inflation right

Governmentactivities right

Change invariable

Change inquantity

Change ininterest rate

Shift in demand

curve


40

Equilibrium in the market for money

Interest rate (%)

33.0

25.0

17.6

11.1

5.3

100 500400300200

Supply of money, Ms

Demand for money, Md

C


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 (%)

33.0

25.0

17.6

11.1

5.3

100 500400300200

Supply of money, Ms


C

D


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 (%)

33.0

25.0

17.6

11.1

5.3

100 500400300200

Supply of money, Ms


C D


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-> interest rates increase (income effect).

it causes the overall price level to increase-> interest rates increase (price effect)

it affects the expected inflation rate-> 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

33.0

25.0

17.6

11.1

5.3

100 500400300200

Supply of money, Ms


C D

Interest rate (%)

E


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 (%)

33.0

25.0

17.6

11.1

5.3

100 500400300200

Supply of money, Ms


C D


52

Real interest ratesin the United States

During the 1970 real interest rates were significantly below 0% in the United States (and worldwide)


And again now in the USA ….

53


54

Liquidity trap and JapanLiquidity 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

Japan´s Real Interest Rates

0

2

4

6

8

10

12

1985 1987 1989 1991 1993 1995 1997 1999


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?

goethe business school chapter vii: money, assets, and interest rates a.what is money? b.monetary...

Documents

functions of money

good money

credit money

bad money

stone money

broad money slide

definition of quasimoney

money market instruments