Monetary Economics Lecture 1: Introduction & Recap (FEB23010) PDF

Monetary Economics (FEB23010) Lecture 1: Introduction & recap Prof. dr. Ivo J.M. Arnold Room E1-13 [email protected] Course overview Monetary economics with a focus on European monetary integration Builds on Macroeconomics and International Economics Textbook: Economics of Monetary Un...

Monetary Economics (FEB23010) Lecture 1: Introduction & recap Prof. dr. Ivo J.M. Arnold Room E1-13 [email protected] Course overview Monetary economics with a focus on European monetary integration Builds on Macroeconomics and International Economics Textbook: Economics of Monetary Union, Paul de Grauwe, 14th ed, 2022 Slides and supplementary reading materials on Canvas 7 lecture sessions, 3 question sessions Grading: final exam (80%) and group assignment (20%) Information on group assignment is on Canvas 2 Today What is money? Cryptocurrencies Quantity Theory of Money Money & inflation Inflation 3  What is money? 4 What is money? Texbook definition: “Anything that is generally accepted as payment for goods or services or in the repayment of debts” “Anyone can issue money, the problem is getting it accepted” (Minsky, 1986) “All money is credit, but not all credit is money” (Ingham, 2020) “Money depends on trust. It is accepted in exchange for goods and services only because people can confidently assume that others will accept it in the future.” (Acemoglu, 2021) 5 Money is what money does (1 of 3) Functions of money: Means of exchange / means of payments Unit of account Store of value 6 Money is what money does (2 of 3) Medium of exchange: Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs) Promotes specialization A medium of exchange must: be easily standardized be widely accepted be divisible be easy to carry not deteriorate quickly 7 Money is what money does (3 of 3) Unit of Account: Used to measure value in the economy Reduces transaction costs Store of Value: Used to save purchasing power over time Other assets also serve this function Money is the most liquid of all assets but loses value during inflation 8 Digitization of money Most of our money is already electronic/digital For money, easy transmission of information is good, but easy copying is not New forms of digital money needed progress in: cryptography distributed ledger technology Introduction of digital tokens 9 A taxonomy of money and digital currencies 10 Source: Brueghel, Cryptocurrencies and monetary policy, June 2018 CBDC=central bank digital currencies Views on money (1 of 2) Metallism vs chartalism: Whether money derives value from the commodity on which it is based or from the authority of the state Monetary system based on external anchor (e.g. gold) versus one based on the reputation of the central bank Private versus public money: Free banking/currency competition: distrust of powerful central bank Full reserve or narrow banking: distrust of banks Inside versus outside money: Inside: residual claim on private issuer’s assets (bank deposits) 11 Outside: no claim Views on money (2 of 2) Current system: combination of private inside money (bank deposits) with public outside money (banknotes) Backed by “nothing”? nothing other than private credit, the rule of law and the power of the state Bitcoin: mix of metallism and private money: aims to remove money from state and bank control nostalgia to a world of metal money (artificial scarcity) 12 Is bitcoin suitable as money? Anything but stable, thus unattractive as unit of account imagine taking out a mortgage in bitcoin Inconvenient as a means of payment due to both instability and transaction costs 2021- El Salvador experiment 13 El Salvador experiment Since 2001, the economy of El Salvador is "dollarized“. Thus dollar is legal tender 2021 Bitcoin law: bitcoin becomes legal tender (next to dollar) must be accepted when offered can be used to quote prices or pay taxes Strong incentives for population to adopt $30 dollar bonus in Chivo app lower price for gasoline when paying with bitcoin no transaction fees 14 Recent evidence The authors conduct a nationally representative face-to-face survey spanning 1800 households In El Salvador during February 2022. “we document how, despite the government’s “big push" and a large fraction of people downloading Chivo Wallet, usage of bitcoin for everyday transactions is low” 15 Stablecoins Stablecoins are cryptoassets that try to tie their value to fiat currency (e.g. Tether) Stablecoins allow for dollar-like transactions in the crypto-sphere without a banking connection (which many crypto-exchanges have difficulty obtaining) [vehicle currency] Most usage thus within crypto-industry, not for retail payments 16 Issues with stablecoins Fragility a stablecoin is only as stable as the collateral behind it but risk-free collateral is unprofitable incentive to invest in risky assets or even extend bitcoin-backed loans no transparency, no regulation This fragility is similar to that of currency pegs and fractional reserve banks (but banks are regulated) 17 Issues with stablecoin Financial stability concerns Run on stablecoin may trigger fire sales of collateral and disrupt regular markets (e.g. in certificates of deposits or commercial paper) Banks’ exposure to crypto assets still limited 18 What makes cryptocurrencies an attractive proposition? Libertarian political narrative anti-state anti-bank Tech-optimism Niche usages criminal activities cross-border payments (?) money in developing countries (?) Seigniorage Get-rich-quick 19 Why bother about cryptocurrencies? Resource consumption (energy, brainpower) Negative effects on society (enabling crime, gambling) Extreme speculation surrounding an innovative technology often compromises market integrity (through misinformation, false accounting, price manipulation, collusion, fraud) Financial stability issues Policy options: laissez-faire prohibit regulate 20 Central Bank Digital Currencies (CBDC) A digital alternative for cash This is currently work in progress What form: token or account? Solution in search of a problem? Or necessary to anchor the monetary system with disappearance of physical cash and to preserve the role of public money in a digital economy? 21 Issues with CBDC No obvious case for digital euro in retail payments (except maybe international payments) CBDC may erode banks’ deposit base and make bank runs easier Privacy concerns vs information needs of government Concentration of power at central banks Paradoxical conclusion in recent report for the European Parliament: “A digital euro should be present everywhere but important nowhere” (Brunnermeier & Landau, 2022) 22 ECB definitions of money The money supply can be measured in either narrow or broad terms, depending on the type of bank deposits included: M0 (base money) = currency and reserves with central bank M1 = currency + overnight deposits M2 = M1 + deposits with agreed maturity up to 2 years + deposits redeemable at notice up to 3 months M3 = M2 + repurchase agreements + money market mutual funds + debt securities up to 2 years maturity 23 The ECB’s printing press: Will M0 spill over into M3? 16 8 14 6 12 trillion euro 10 4 8 2 6 4 0 00 02 04 06 08 10 12 14 16 18 20 22 24 M0 (left axis) M3 (right axis)  Quantity Theory of Money 25 Fisher’s Equation of Exchange The following equation always holds (is an identity) : M x V=P x Y (or M x V=P x T) where: M = money supply V = velocity of money (average number of times per period that a euro is spent) P = price level Y = GDP (or T=transaction volume) 26 Quantity Theory of Money M. Friedman: “inflation is always and everywhere a monetary phenomenon” From an identity to a theory of inflation: % change in (a × b) = (% change in a) + (% change in b): %Δ𝑀𝑀 + %Δ𝑉𝑉 = %Δ𝑃𝑃 + %Δ𝑌𝑌 𝜋𝜋 = %Δ𝑃𝑃 = %Δ𝑀𝑀 + %Δ𝑉𝑉 − %Δ𝑌𝑌 Assuming velocity is constant, the quantity theory of money becomes a theory of inflation: 27 𝜋𝜋 = %Δ𝑀𝑀 − %Δ𝑌𝑌 Issues in the use of monetary aggregates Velocity of M3, Euro Area 2000-2021 Which M to choose? 1.6 Can the central bank 1.5 control M? 1.4 Instability in velocity 1.3 1.2 1.1 1.0 0.9 0.8 0.7 00 02 04 06 08 10 12 14 16 18 20 28 Related to velocity: money demand Why do individuals hold money? Three Keynesian motives: Transactions motive Precautionary motive Speculative motive 𝑀𝑀𝑑𝑑 the demand for real money balances: = 𝑓𝑓( 𝑖𝑖, 𝑌𝑌) 𝑃𝑃 is negatively related to the interest rate i, and positively related to real income Y 29  Money and inflation 30  Testing the Quantity Theory: relationships between inflation and money growth Source: F. Mishkin, The Economics of Money, 31 Banking and Financial Markets But level of inflation matters… Source: P. Teles & H. Uhlig, Is Quantity Theory still alive? ECB working paper 2013 32 Since the 1990s: M out of fashion Factors Disinflation due to globalization Central bank independence Advent of inflation targeting Description of central bank policy using “Taylor rule” More attention to credit growth and the relationship with financial crises 33 From money-inflation to credit-crisis nexus Source: P. Gertler & B. Hofmann, JIMF, 2018 34  But money growth may help explain the recent inflation surge Source: Borio, et al, BIS, 2023 35  Inflation 36 Costs of Inflation: anticipated inflation Main standard costs of anticipated inflation: Shoe leather costs socially unproductive efforts to conserve on money holdings Menu costs nominal prices and wages must be changed more often Distortions due to tax system 37 Costs of Inflation: unanticipated inflation Incorrect anticipation of inflation leads to an impairment of the signal function of the price mechanism: monetary misperceptions model: unable to distinguish relative from general price changes, producers may make the wrong decisions Incorrect anticipation of inflation leads to wealth redistribution in case of long term nominal contracts: Nominal wages: between employers and employees. Nominal interest rates: between debtors and creditors. In case of financial contracts, this may require a “risk premium” leading to higher real interest rates or long-term contracting breaks down altogether => rationale for inflation-indexed bonds. 38 Benefits of inflation Reduced risk of hitting the zero lower bound (it is easier for the central bank to engineer negative real interest rates to stimulate the economy) Easier reduction in real wages in the face of downward nominal wage rigidity In the euro area: Higher average inflation allows for easier macroeconomic adjustment of less competitive members (easier means adjustment without deflation) 39 Causes of inflation: short-run aggregate supply Short-run aggregate supply curve (or Phillips Curve): positive relation between output and inflation: 𝜋𝜋 = 𝜋𝜋𝑒𝑒 + β (y-yp) + ε Demand shocks: Output gap (y-yp) causes firms to raise prices and workers to demand higher wages to benefit from good economic conditions. This will lead to higher inflation. Supply shocks (temporary: ε or permanent yp) may lead to higher inflation. Expected inflation 𝜋𝜋𝑒𝑒 causes workers to demand higher wages, which increases prices of goods and services and, thus, actual inflation. 40 Contribution of shocks to euro area inflation Phase I: the covid shock (roughly Q1 and Q2:2020); Phase II: the re- opening of the economy (roughly from Q3:2020 to Q3:2021) Phase III: the post re-opening (from Q4:2021 onwards) Source: G. Ascari et al, DNB, 2023 41 Links between inflation and inflation volatility Low inflation is a “natural” state, political consensus on keeping inflation low; With high inflation, however, there is more room for disagreement: some (conservative) policymakers may be more willing than others to bring down inflation at the risk of a recession Stop-and-go policies Influence of expectations and price rigidity due to anchoring within a tradition of price stability, institutions will work to preserve that price stability (e.g. no wage indexing) with high inflation these institutional arrangements break down and do no longer act as a brake on inflation 42 Inflation and inflation volatility Source: R. Barro, NBER paper no. 5326, 1995 43 Hyperinflation Out-of-control price increases, typically defined by a threshold of 50% inflation per month Hyperinflations are monetary in character, resulting from very rapid increases in the money supply But these always result from the printing of money to finance a budget deficit Hyperinflations tend to be produced in response to chronic failure to raise revenue. Therefore, source of hyperinflation are fiscal problems not monetary Eventually hyperinflation reduces value of money so becomes necessary to print even more money to raise same revenue - hyperinflationary spiral 44