MONEY, ECONOMIC ACTIVITY AND FINANCIAL MARKETS

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• MONEY, ECONOMIC ACTIVITY AND FINANCIAL MARKETS

Loïc Sadoulet (loic.sadoulet_at_insead.edu)
MGE Session 6 Jan Feb 2009
Loic.Sadoulet_at_insead.edu
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Money, Banking, and Real Activity

• (1) Money is liquidity assets easily
  convertible into transactions
• We need enough money to satisfy all transactions,
  which we approximate by GDP in current prices
• How much money (liquidity) should the central
  bank have in circulation?

M ? V Y ? P
Number of bills needed (liquidity needed)
to complete transactions
EXCESS LIQUIDITY SUPPLY LEADS TO INFLATION
or
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Money, Banking, and Real Activity

• (2) Process of money creation central banks buy
  assets and issue domestic currency

CENTRAL BANK BALANCE SHEET
Assets

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(3) Banks play a critical role in providing
liquidityFractional reserve banking and the
money multiplier
Money, Banking, and Real Activity
Etc
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MONEY SUPPLY

• What happened to money supply?
• Before credit expansion
• M1 currency in circulation deposits
• After credit expansion
• M1 currency in circulation deposits

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FRACTIONAL RESERVE BANKINGAND THE MONEY
MULTIPLIER

• What determines the money multiplier?
• Reserve-deposit ratio (Central bank requirements,
  excess reserves for safety)
• Currency-deposit ratio (financial innovation,
  confidence in banking sector)
• (ie how much people hold in their wallets vs put
  in their bank)

Money multiplier
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How much money is created?
Bank Balance Sheet
1. Depends on banks willingness to buy/sell
assets
2. Depends on banks willingness to extend loans
3. Depends on consumers/firms willingness to
borrow
4. Depends on trust in the banking sector
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Money, Banking, and Real Activity

• (4) Money multiplier determines how much
  liquidity is available over a given period

M ? V Y ? P
Liquidity supply
Market value of transactions completed
Velocity how fast transactions can happen
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MONEY DEMAND (DEMAND FOR LIQUIDITY) and INTEREST
RATES

• Money is a highly-liquid asset that is used to
  finance transactions (by consumers, firms,
  governments, and foreigners)
• Purchases of goods and services
• Purchases of other assets (bonds, real estate,
  foreign currencies, etc.)
• The alternative for firms and households is to
  store their savings in other assets,less liquid
  and thus with a higher market risk

consumption
Savings

Assets
Interest rate
interest rate
Amount of liquiditydemanded
money demand
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MONEY DEMAND, MONEY SUPPLY AND INTEREST RATES
(1) Hi there, I want to sell my asset for money

Assets
(2) More demand for money ? lower going price of
asset ? higher return
Assets

Assets
Fixed money supply
Interest rate
(3) This shift in liquidity demand given the
fixed money supply leads to a higher interest rate
Return on asset
Initial interest rate
Amount of liquiditydemanded
Initial money demand
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MONEY DEMAND, MONEY SUPPLY AND INTEREST RATES

• An increase in liquidity demand to for
  consumption (for example) leads to consumers
  trying to sell some assets
• The price of the assets fall, raising the return
  on those assets
• The opportunity cost of liquidity has thus gone up

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MONEY DEMAND, MONEY SUPPLY AND INTEREST RATES
Hi there, Id like to borrow money

Assets
Assets

Assets
Price of funds (interest rate)
Savings
Fixed money supply
Interest rate
Initial interest rate
Initial interest rate
Investment
Funds for Investment
Initial amount of Investment
Amount of liquiditydemanded
Initial money demand
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MONEY DEMAND, MONEY SUPPLY AND INTEREST RATES

• Higher demand for Investment funds at current
  interest rates (a shift in the I curve)
• The available amount of funds (Savings) on the
  financial markets is insufficient to finance the
  Investment demand. The interest rate (cost of
  funds) thus increases
• This interest rate increases attracts more
  savings into the financial market
• The economy ends up with higher Investment

Price of funds (interest rate)
Savings
1. Higher demand for Investment funds
3. S?
2. r?
Initial interest rate
1. I?
Investment
Funds for Investment
Initial amount of Investment and Savings
4. New amount of Investment
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MONEY DEMAND AND INTEREST RATES

Assets
Hi there, Id like to borrow money

Assets
Price of funds (interest rate)
Savings
Fixed money supply
Interest rate
Initial interest rate
Investment
Funds for Investment
Initial amount of Investment
Amount of liquiditydemanded
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BANK BEHAVIOR AND INTEREST RATES

• For banks, reserves are money that is not
  working
• but fractional reserve banking makes banks
  vulnerable
• Self-fulfilling expectations (fear of unsound
  bank will make it unsound)
• Protecting banks against runs
• Required reserves (what is the tradeoff?)
• Excess reserves (Y2K scare)
• Restriction of withdraws (Argentina)
• Deposit insurance (FDIC)

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Required Reserve Ratios
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REQUIRED RESERVES AND THE OVERNIGHT MARKET
BANK 1
BANK 2
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The Overnight market

• Banks have to hold

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Overnight market and Interest rates
corporate bonds
Bank prime
FFR
Gvt bonds
Source http//www.federalreserve.gov/releases/H15
/data.htm
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Summary How Do Central Banks affect money supply?
CENTRAL BANK BALANCE SHEET

• Central banks can affect money supply through one
  of the following
• Open market operations buying and selling of
  government bonds
• Foreign exchange market interventions
• Lending to commercial banks
• Direct credit to the government
• Changes in reserve requirements

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CENTRAL BANKS INSTRUMENTS AND MONEY SUPPLY
BANK 1
BANK 2
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Money Why do we care?

• Money (Liquidity) is used for transactions
• Not enough money leads the economy to slow down
  (downwards price stickiness)
• Too much money leads to inflation
• Central banks affect amount of liquidity in
  circulation, but do not control it perfectly
• Liquidity demand affects interest rates
• Effectiveness of monetary policy on money supply
  depends on private behavior
• Important role of confidence in banking sector
  (deposits)
• Important role of confidence in the economy
  (loans, reserves)
• Effect on interest rates
• Money (liquidity) demand shifts affect interest
  rates
• Financial innovations and interest rates
  (velocity)
• Consumer spending and interest rates
  (transactions)