Lecture 9 Money & Banking PDF

Kosmas Marinakis, Ph.D. Previously in E&S…  Definition of growth...

Kosmas Marinakis, Ph.D. Previously in E&S…  Definition of growth exponential – catch-up – sustained growth  History of growth Lecture 9 earlier societies – Industrial Revolution – Malthusian cycles  Inequality and poverty Money & Banking  The Solow growth model production function – accumulation of capital – saving  Causes of prosperity climate, geography, culture, institutions, history and luck Economics & Society © 2019 Kosmas Marinakis, SMU Lecture 9 2 1 2 Money & Banking Lecture 9 MONEY 3 4 Money Money Money Strange money facts  Every year, the value of global GDP totals about $80 trillion  The paper currency you have on you today is most likely not going to be valid in  The total quantity of money circulating around the globe amounts to a few decades around $6 trillion  Gold is not going to be very useful to you in Sahara dessert or even at the  Money is neither a good, nor a service university food court thus, its total face value is not included in GDP  Most apartment complexes in the US will not accept cash payments for the rent  Money is an asset used in facilitating our transactions  You cannot pay the NJ turnpike tolls with an $100 bill! money is kind off the “lubricant” of the market system  You cannot buy cocaine with a credit card  Money’s basic role is to intermediate the transactions:  Is the common denominator in economic activity  All transactions are converted into a monetary value © 2019 Kosmas Marinakis, SMU Lecture 9 5 © 2019 Kosmas Marinakis, SMU Lecture 9 6 5 6  Money Money Functions of money Properties of money  Money per se is not income, is not wealth  Money is anything that is generally accepted as a medium of exchange  Alternatively, a barter system would require:  Various forms of money have existed throughout history  Double coincidence of products silver, gold, goats, chickens, horses, alcohol, cigarettes  Double coincidence of quantities  Some general properties that money is desired to have:  Double coincidence of timing.  Generally accepted  The 3 roles of money:  Portable 1. Medium of exchange: an asset generally exchanged for goods and services  Durable 2. Store of value: an asset used to transfer purchasing power into the future  Controllable in quantity 3. Unit of account: a universal standard used to count the value, price or cost  Objective value carrier  Easily denominated  Difficult to counterfeit © 2019 Kosmas Marinakis, SMU Lecture 9 7 © 2019 Kosmas Marinakis, SMU Lecture 9 8 7 8 Money Fiat money  Paper money was invented around 1,000 AD in China  Modern societies have switched to using fiat money something that is used as legal tender by government decree and is not backed by a physical commodity  Fiat money is valuable only because all people have agreed to accept it as money  Its value is not intrinsic - we accumulate dollars for exchange, for storing value, and for keeping accounts because we trust that paper currency will be used for these purposes in the future MONEY © 2019 Kosmas Marinakis, SMU Lecture 9 9 SUPPLY 9 10 Money Supply Money Supply The money supply The Central Bank  Money supply has various definitions depending on liquidity of assets  In every country, the monetary system is run by a central bank (CB) included a government institution for monetary authority  Transactions money (M1) is money acceptable for most transactions as is  The central bank operates almost completely autonomously from the rest of M1 = cash held outside banks + checkable accounts the government  Broad money (M2) additionally includes relatively less liquid assets than M1  The roles of the central bank are: 1. To monitor the financial institutions M2 = M1 + fixed-term accounts + semi-liquid financial assets 2. To set the money supply  The main advantage of M2 versus M1 is that M2 is more stable 3. To control the interest rate. a transfer from a checkable account to a mutual fund will decrease M1 but leave M2  These activities are jointly described as monetary policy unchanged © 2019 Kosmas Marinakis, SMU Lecture 9 11 © 2019 Kosmas Marinakis, SMU Lecture 9 12 11 12  Money Supply Money Supply The functions of the Central Bank The commercial banks  The CB is the coordinator of the banking system  Commercial banks are financial intermediaries that act as a link between  It performs important functions for banks: savers and investors  Regulates the banking system  Accepting deposits is a cost for banks  Assists banks in a difficult financial position profit comes from loans (and more recently, from transaction fees)  Manages exchange rates and foreign exchange reserves  Thus, in normal times, when a bank receives a deposit, it tries to immediately  Clears complex inter–bank payments loan this money out  Sets the reserve requirements for all financial institutions.  Every bank tries to loan out the maximum possible amount of deposits:  CB requires that every commercial bank keeps a portion of the total deposits (1 – 𝑅𝑅) · 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 as reserves at the CB or as cash  The process of lending money out, in a way, creates additional money  This is known as required reserve ratio (RR) and is defined as a percentage of a commercial bank’s total deposits © 2019 Kosmas Marinakis, SMU Lecture 9 13 © 2019 Kosmas Marinakis, SMU Lecture 9 14 13 14 Money Supply Money Supply How banks create money Total money creation Assume that the RR is 10% and I walk into a bank to deposit $100  The total money creation is 1. The bank will reserve $10 and loan out $90 in cash ∆𝑀1 = +$90 100 + 1 − 𝑅𝑅 100 + 1 − 𝑅𝑅 100 + 1 − 𝑅𝑅 100 + ⋯ this $90 will be spent and eventually will end up deposited to a bank  That is 2. That bank will, too, reserve $9 and loan out $81 in cash ∆𝑀1 = +$81 1 − 𝑅𝑅 100 this $81 will also eventually be deposited to a bank  And because this is a geometric sequence the sum is 3. That bank will reserve $8.1 and loan out $72.9 in cash ∆𝑀1 = +$72.9 the $72.9 will eventually be deposited to a bank 1 1 100 = 100 = 100 10 = 1,000 𝑅𝑅 0.1 4. Again, that bank will reserve $7.92 and loan out $65.61 ∆𝑀1 = +$65.61  1/𝑅𝑅 is often referred to as the money multiplier (MM) this process will keep going so, how much money $𝟑𝟎𝟗. 𝟓𝟏 + ⋯ ? the multiple by which money supply can increase for every dollar increase in can be generated in total from the $100 initial deposit?  deposits © 2019 Kosmas Marinakis, SMU Lecture 9 15 © 2019 Kosmas Marinakis, SMU Lecture 9 16 15 16 Money Supply Money Supply How CB controls the supply of money Open market operations The CB can control the money supply in four ways:  Open market operations is the purchase and sale by the CB of government 1. Printing new or withdrawing existing money securities in the open market printing of fresh paper bills and coins  Open Market Sale: the CB sells securities to firms and households 2. Changing the RR the withdrawal of money from the system decreases the money supply changing the RR inversely affects the money supply  Open Market Purchase: the CB buys back outstanding securities from firms 3. Adjusting the discount rate and households in exchange for fresh money the discount rate is the interest rate banks pay to borrow from the CB in case they the inflow of money to the system increases money supply cannot meet the RR on their own – High discount rates incentivize banks to hold  OMOs is the preferred means by the CB of controlling supply of money reserves above the RR to avoid borrowing from the CB, decreasing the MM it is precise, flexible, and fairly predictable by the market 4. Engaging in Open Market Operations © 2019 Kosmas Marinakis, SMU Lecture 9 17 © 2019 Kosmas Marinakis, SMU Lecture 9 18 17 18  Money Supply The money supply  Through OMOs, the CB can set the r 𝑴𝑺 money supply to whatever value it wants  We will be plotting the money supply versus the “price” of money: the real interest rate, r MONEY © 2019 Kosmas Marinakis, SMU Lecture 9 Money  19 DEMAND 19 20 Money Demand Money Demand Transactions The demand for money Money demand for transactions  Money Demand (MD) is the quantity of money firms and households in the  For firms and households money inflows and outflows are not synchronized economy want to hold  They have two alternatives for their disposable income until they spend it:  There are 3 reasons for which firms and households demand money: 1. Keep it liquid in cash or checking accounts: 1. Money held for transactions  Income is conveniently available for spending 2. Money held for precautionary reasons  No interest is gained. 3. Money held for speculation. 2. Place it to interest bearing assets (fixed-term accounts or bonds etc.)  Next, we will investigate the relationship between:  Interest will be earned  Total quantity of money demanded  A transaction cost must be incurred to convert it back to spendable money  And the price of money (the real interest rate).  Firms and households choose the distribution between cash and assets which  In order to do this we must first decompose the money demand into its minimizes the sum of the interest forgone cost plus the conversion cost 3 constituent parts © 2019 Kosmas Marinakis, SMU Lecture 9 21 © 2019 Kosmas Marinakis, SMU Lecture 9 22 21 22 Money Demand Transactions Money Demand Precaution Optimal cash holdings example Money demand for precaution  Assume that you have allocated $400 to uniformly spend over the next 4 weeks  Households want to hold money for unplanned spending and say that each $100 bond yields 2% per week and costs $5 to cash it:  Holding more money for precaution:  The 1st week’s $100, you must keep in cash  Feel more security for future unplanned expenses  The 2nd week’s $100, you will keep in cash because the bond yields $2 < $5  Interest is forgone.  The 3rd week’s $100, you will keep in cash because the bond yields 2·$2 = $4 < $5  That is, the opportunity cost of holding money applies to the precautionary  The 4th week’s $100, you can place in a bond to yield 3·$2 = $6 > $5. motive, too  Thus, with 𝑟 = 2%, in total, you will hold $300 in cash and $100 in bonds  As a result, money demand for precaution can reasonably be assumed to be  But if the interest rate increases to 3%, you will now hold only $200 in cash: inversely related to the interest rate because the 3rd week’s $100 will yield 2·$3 = $6 in bonds > $5 and the 4rd week’s $100 will yield 3·$3 = $9 in bonds > $5.  Thus, money demand for transactions is inversely related to the interest rate © 2019 Kosmas Marinakis, SMU Lecture 9 23 © 2019 Kosmas Marinakis, SMU Lecture 9 24 23 24  Money Demand Speculation Money Demand Speculation Speculation Bonds and interest rate  A large amount of money in the economy is held stand-by  If a bond’s face value is $100 and it contains a coupon per for short term profit opportunities year with a fixed $10 interest payment  Speculation is mainly conducted by flipping various the interest rate of such a bond is 10% FACE VALUE FACE VALUE financial assets, such as bonds, securities etc. $100  Often, bonds are re-sold (liquidized) by their owners in the $100  A bond is just a promissory note for the payment of a debt EXPIRATION: secondary market before they mature EXPIRATION: 31/12/2022 31/12/2022  The creditor provides the initial capital (face value) and  If this bond is re-sold in the secondary market for $125 receives by the debtor a bond of a pre-specified duration the coupon is still $10, so its interest rate has fallen to 8% $10 $10 $10 $10 $10 $10  The bond contains coupons that each defines a fixed 31/12/2020 31/12/2021 31/12/2022  If the bond is re-sold in the secondary market for $80 31/12/2020 31/12/2021 31/12/2022 interest payment to the creditor for every period the coupon is still $10, so its interest rate has risen to 12.5%  After the expiration of the bond, the debtor pays back the initial capital to the creditor  The price of the bond is inversely related to the interest rate because the coupon is fixed © 2019 Kosmas Marinakis, SMU Lecture 9 25 © 2019 Kosmas Marinakis, SMU Lecture 9 26 25 26 Money Demand Speculation Money Demand Money demand for speculation Money demand  In the secondary market, bond prices depend on supply and demand  All three constituent money demands r how many bonds are placed for sale in relation to how many buyers there are are negatively related to the interest rate  Also, as we saw, the prices of bonds are inversely related to the interest rate  Therefore, their sum, money demand  When the prices of bonds are high, the interest rate is low (MD), is also negatively sloped speculators want to sell bonds and hold more money  When the prices of bonds are low, the interest rate is high speculators want to buy bonds and hold less money  As a result, money demand for speculation is inversely related to the interest 𝑴𝑫 rate  Money  © 2019 Kosmas Marinakis, SMU Lecture 9 27 © 2019 Kosmas Marinakis, SMU Lecture 9 28 27 28 Money Demand Money demand shifters  Money demand will shift if people want to r hold more money at every interest rate  This can happen for various reasons:  If real GDP increases, people will want to hold more money for their transactions [L1]  If prices increase, money demand will increase  If public safety is at risk, money demand will rise.  The interest rate affects the quantity of money 𝑴𝑫 𝑴𝑫 THE MONEY demanded but not the MD © 2019 Kosmas Marinakis, SMU Lecture 9 Money 29 MARKET 29 30  Interest rate Interest rate Equilibrium interest rate Monetary policy  The CB can effectively set the desired r  Assume that the CB has committed to 𝑟 ∗ r 𝑴𝑺 𝑴𝑺 interest rate in the money market 𝑴𝑺 𝑴𝑺 𝑴𝑺 by setting 𝑀 which meets 𝑀 at A by appropriately setting the money supply  Then, an unexpected increase in prices  If, for instance, it wishes 𝑟 = 2%, causes 𝑀 to shift to 𝑀 3% B it will set 𝑀  Money becomes more scarce and the 𝑟′  If, it wishes 𝑟 = 3%, 2% interest rate will tend to increase to 𝑟′ 𝑟∗ C A it will set 𝑀  The CB can still maintain 𝑟 ∗ by adjusting  If, it wishes 𝑟 = 1%, 1% the money supply 𝑴𝑫 𝑴𝑫 𝑴𝑫 it will set 𝑀  Increasing money supply to 𝑀 will stabilize Money the interest rate at 𝑟 ∗  Money  © 2019 Kosmas Marinakis, SMU Lecture 9 31 © 2019 Kosmas Marinakis, SMU Lecture 9 32 31 32 Money & GDP Money & GDP  From the formula for the calculation for real GDP, we know that: 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 = 𝐺𝐷𝑃 𝐶𝑃𝐼 or 𝐶𝑃𝐼 = 𝐺𝐷𝑃 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃  This implies that those two must be growing at the same rate 𝑔𝑟𝑜𝑤𝑡ℎ 𝐶𝑃𝐼 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝐺𝐷𝑃 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃  From growth math we have that “the growth of a ratio is the difference of the growth of the numerator minus that of the denominator”, thus: 𝑔𝑟𝑜𝑤𝑡ℎ 𝐶𝑃𝐼 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝐺𝐷𝑃 − 𝑔𝑟𝑜𝑤𝑡ℎ(𝑟𝑒𝑎𝑙 𝐺𝐷𝑃)  Economists have observed that steadily 𝑔𝑟𝑜𝑤𝑡ℎ(𝐺𝐷𝑃) = 𝑔𝑟𝑜𝑤𝑡ℎ(𝑀 ), hence: 𝑔𝑟𝑜𝑤𝑡ℎ 𝐶𝑃𝐼 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑀 − 𝑔𝑟𝑜𝑤𝑡ℎ(𝑟𝑒𝑎𝑙 𝐺𝐷𝑃) INFLATION or 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑓 𝑀 − 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑓 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 © 2019 Kosmas Marinakis, SMU Lecture 9 𝐺𝐷𝑃 34 33 34 Money & GDP Inflation Inflation The consequences of inflation 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑓 𝑀 − 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑓 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃  If all prices moved freely when there is inflation, moderate inflation might not  This means that inflation is equal to the gap between: pose a serious problem:  The growth rate of the money supply  Prices increase by 5%  The growth rate of real GDP.  Rents increase by 5%  Salaries increase by 5%.  When this gap widens, the inflation rate increases  Purchasing power still remains the same  Inflation will result when the CB prints disproportionally more money than the change in real output requires  Yet, all prices and wages do not always move in sync at least not in the short-run  This equation makes clear predictions that we can test with economic data  An increase in the inflation rate generates losses to some and gains to others © 2019 Kosmas Marinakis, SMU Lecture 9 35 © 2019 Kosmas Marinakis, SMU Lecture 9 36 35 36  Inflation Inflation Inflation and credit Social costs of inflation I  Unanticipated inflation distorts credit 1. Inflation affects the distribution of income: relations $10,000 $10,500  Individuals on fixed incomes (collective contract employees, pensioners, public Inflation 0% + servants) cannot re-negotiate their income after inflation occurs  Consider a credit agreement for a car  Relative purchasing power changes to the benefit of those who can re-adjust their loan of $10K to be returned in one year incomes (free-lancers, contractors, entrepreneurs). with $500 interest Inflation 10%  With no inflation, the creditor will receive 2. Inflation creates administrative costs and inefficiencies: back, the full value of the car (10K) plus a Inflation 3% +  For many firms who sell a large number of products, constantly changing the premium for not having access to his money prices, requires time or resources that could have been used in production  With unanticipated inflation 10%, the creditor loses because he will receive back less  Such costs are often referred to as “menu costs”. than the full value of the car ($11K, now) 3. Inflation ruins the economic environment  Even with unanticipated inflation less than 5%, the creditor would receive back the  Unanticipated inflation causes uncertainty to firms discouraging business activity full value of the car, but would lose part of the $500 premium, that was agreed  © 2019 Kosmas Marinakis, SMU Lecture 9 37 © 2019 Kosmas Marinakis, SMU Lecture 9 38 37 38 Inflation Inflation Social costs of inflation II Hyperinflation 4. Inflation changes the relative prices causing market distortion:  Hyperinflation refers to particularly high rates of inflation  Vendors who buy supplies with long-term contracts will be able to keep their  Germany in 1922-23 after the end of World War I prices lower than their competition inflation at 3.25 × 106 % (takes 49 hours for prices to double)  Competitors may be driven out of the market, changing the industry structure.  Hungary in 1946 after the end of World War II 5. Inflation causes misinformation about prices: inflation at 4.19 × 1015 % (prices double every 15 hours)  Under inflation, consumers may have trouble keeping up with the price changes  Yugoslavia in 1993-94 after the civil war  This may cause them to misallocate their income among products. inflation at 5 × 1015 % (prices double every 14 hours) 6. Stopping inflation requires counterproductive policies:  Venezuela in 2018 after the political crisis  Governments tend to fight inflation with price controls (price ceilings) inflation at 130,060% (prices double every 7 days)  This lowers market efficiency, creates DWL and causes shortages and black projected to be at 9,586% in 2019 markets © 2019 Kosmas Marinakis, SMU Lecture 9 39 © 2019 Kosmas Marinakis, SMU Lecture 9 40 39 40 Inflation Inflation Inflation rates Inflation as a tax 30% Singapore  Through the CB, the government can exercise the printing privilege USA 25% Germany that is, the government can have the CB print more money in order to fund Japan government spending or pay back debt 20% China India  This is referred to as seignorage 15% Malaysia  Seignorage will generate revenue for the government but it will create inflation 10% Greece  When the increase in quantity of money is not accompanied by an equal increase in 5% real GDP, prices will increase 0%  Those who hold money, lose purchasing power from the inflation  This purchasing power goes to the government, as it spends newly printed money. -5%  Seignorage acts like a tax to all money holders 1975 1980 1985 1990 1995 2000 2005 2010 2015  indiscriminately where their money have come from © 2019 Kosmas Marinakis, SMU Lecture 9 41 © 2019 Kosmas Marinakis, SMU Lecture 9 42 41 42  Inflation Inflation and economic activity  In periods of high inflation, the real cost of labor decreases this is because firms can raise their prices without having to raise wages of contract workers  Revenue adjusts upwards for inflation, while cost tends to be sticky Thank you!  This increases profitability and stimulates economic activity  Firms want to increase production, and thus, try to hire more workers causing a decrease in unemployment [email protected] www.kmarinakis.org  Thus, unemployment and inflation are negatively correlated: t.me/kosmas_teaching this is known as the “Phillips relationship” Kosmas Marinakis  However, the Phillips relationship is a S-R effect Kosmas Marinakis @Kos_Marinakis because labor contracts expire in the L-R © 2019 Kosmas Marinakis, SMU Lecture 9 43 kosmas_marinakis 43 44 WARNING! FYI-1 The slides in this handout are created This handout is provided in.pdf form because the original with the intention to serve a visual aid presentation is a large file, requires specific software to for the audience during the live run the animations and may not be executable in most presentation of the material in the presentation clients. lecture. As such, they are not designed to be standalone reading material and should be used strictly as reference, side by side with notes FYI-2 taken in the lecture. Studying solely Slides are purposely made available to students after the from the slides is not recommended lecture because they are designed to be the first contact and might in some cases mislead point for students with the topics. These slides are carefully those who have not attended the animated to point the attention, to stimulate student relevant lecture. Less than 5% of interest and to enable a high-energy presentation. Access tasks in test and exam can be to the slides ahead of time, would severely deteriorate the answered solely from the slides. quality of the delivery of the relevant material in class. 45