Theory Guest Lecture 9 Monetary economics

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Theory Guest Lecture 9Monetary economics

• Introductory Economics for the Treasury
• Dr. Paul Frijters

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Contents

• Basic stats on money flows, interest rates, and
  inflation rates.
• Financial markets monetary neutrality
  hypothesis, efficient market hypothesis, bubbles,
  contagion hypothesis, Purchasing Power Parity
  theory of exchange rates.
• Interest rate policy demand management, short
  term investment, inflation targeting.
• Inflation seniorage tax, price distortions,
  indexing issues.

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Basic stats interest rates
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Inflation
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Equity
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US debt
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Capital flows to emerging markets
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World capital flows
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A sense of size
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Main points from these stats

• World interest rates and inflation rates are
  currently very low.
• The main capital flow is from developed countries
  to the US.
• The main flow to the developing world is
  increasingly towards Asia, at the expense of
  Latin America.
• Capital assets and flows are enormous, dwarfing
  the size of any individual economy.
• The US and the EU have relatively speaking an
  enormous amount of capital.

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Financial market key ideas

• The monetary neutrality hypothesis holds that
  prices do not matter in any way to the real
  economy. What matters in this view is simply
  productivity deriving from the various capital
  stocks (including institutional and social
  capital).
• Prediction an across-the board price increase
  (inflation) has no effect on anyones behaviour
  and policy to influence the stock market is
  useless because the stock market only reflects
  the real economy but doesnt affect it.

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implications

• 1. In the strong version what happens on the
  financial markets does not matter at all for
  underlying economic growth and attention on it is
  wasted.
• 2. In the weak version one only need worry about
  extreme cases where price changes do have real
  effects, including mainly hyperinflation and
  large asset bubbles. One then worries about
  transmission mechanisms from price changes to
  the real economy.
• Note the weak version is probably the dominant
  economic opinion of the moment.

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EMH efficient market hypothesis

• The efficient market hypothesis holds that the
  price of any asset at any point in time reflects
  all the available information of investors at
  that time, i.e. the price is a full-information
  signal.
• Main prediction if this is true, then the only
  reason for the price to change is if truly new
  information arrives about productivity (leading
  to real business cycles). The price path should
  thus be a random walk, also known as a unit
  root process or a Wiener process. In other words
  nothing observable today should be informative
  about the change in price tomorrow.

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implications

• 1. One cannot second guess the market because it
  reflects the knowledge of millions of materialist
  investors. Hence a monkey picking a random set of
  shares should do just as well as any expert
  investor.
• 2. The aggregate market value of stocks is a
  best prediction of future aggregate profit of
  companies and thus of economic growth. Similarly,
  long-run bond yields reveal the market
  expectation of future interest rates.
• 3. If one picks a set of assets whose value is
  determined by different underlying processes,
  then one can reduce the risk of bad outcomes
  risk-pooling is about picking a bundle of
  different assets with different information
  shocks.

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.

• 4. (because the price reflects the true value)
  if the underlying asset has no productive
  investment side to it, then the price of it
  should not increase in the long run. Gold in
  particular is thus only a smart investment in the
  short run.
• 5. If the government tries to maintain an
  unrealistic price (for instance for an exchange
  rate), then eventually investors will bankrupt
  whomever tries to maintain the unrealistic price.
  Examples the UK crash out of the Exchange Rate
  Mechanism, and perhaps the Asian Financial
  crisis.
• Note virtually no-one believes the strong
  version of the EMH (because it is logically
  inconsistent it costs resources to find
  information, so it can not be the case that
  no-one has an incentive to actively find the
  information), but its weaker version where prices
  in the long run to reflect value and price shocks
  are mainly information shocks is adopted by most
  economists.

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Bubbles

• (also known as sunspot equilibria, animal
  spirits, self-confirming equilibria)
• The art of investing is guessing better than the
  aggregate investor what the aggregate investor
  will think tomorrow (Keynes)
• This entails the notion that the price of assets
  can for a long time be different from its true
  underlying value (the fundamentals) because
  everyone believes it to be so.
• Examples 1987 stock market crash, 1980s UK
  housing bubble, 2000 IT stock market rally, 2004
  Australian housing bubble?

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Implications

• 1. It would make sense to interfere with the
  asset markets if one believes the volatility to
  have bad real consequences.
• Examples of actual policies cease trading if the
  slide is too big asset buying by the government
  if the slide is too big interest rate increases
  to discourage borrowing to buy assets if the
  increase is too big (Australia).
• Note many believe in the possibility of bubbles,
  but also believe it almost impossible to tell
  when a bubble is forming. Only with hindsight do
  we dare to.

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whats bad about volatility?

• The argument if you can insure yourself against
  many forms of insecurity via options and future
  markets, then why would one be worried about
  volatility?
• Answer 1 insurance costs extra to the extent of
  the profit of the insurer.
• Answer 2 for many big-ticket shocks there is
  still no insurance.
• Answer 3 the very presence of volatility in
  combination with asymmetric information may lead
  to a lemons market problem. Leading to
  under-investment. This requires a degree of
  irrationality though.

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Financial contagion

• Many version of this idea, but the basic notion
  is that unrealistic pessimism may move from one
  market to another.
• Main example the financial market crises in Asia
  in the late 90s where whole stock markets and
  currencies crashed in several countries
  consecutively. Indonesia still hasnt recovered.
  The argument is whether this was actually
  contagion or simply new information about actual
  circumstances (such as the bad debts of
  Indonesian companies).

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Implications

• (like with bubbles) if the volatility has real
  effects then it makes sense to interfere.
• How?
• - Tobin tax a small tax on financial
  transactions, which would discourage very
  short-term loans and thus excessive betting.
• - An international guarantor of currencies and
  stock markets, like the IMF, to increase
  credibility of prices.
• - Having futures market where investors can
  insure against shocks. Some however argue that
  these futures markets increase volatility.

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Purchasing power parity

• Purchasing power parity holds that in the long
  run, exchange rates should be such that the same
  tradeable good should cost exactly the same thing
  in all countries.
• Main prediction prices for tradeable goods
  should become more and more the same with the
  demise of trade barriers and transportation
  costs. The Big Mac index (index of the price of
  a Big Mac in various countries) shows only very
  weak convergence.

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Implications

• 1. You cant buck the market if you maintain an
  exchange rate or tax regime that does not respect
  PPP, it will crash eventually. What makes it
  crash? Arbitrage and speculation.
• 2. The only prices that will vary consistently
  over countries are non-tradeables, such as land,
  labour, housing, scenery, perishables, and
  anything non-traded that is produced with the
  former as inputs.
• Note intuitively, most economists believe PPP to
  have to hold in the long run, but barriers,
  transportation, and trade costs leave a lot of
  room for exchange rates to move in.

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Interest rates

• What does the domestic interest rate affect?
• 1. The price of borrowing domestically and thus
  investment and mortgages.
• 2a. The return to savings domestically and thus
  saving rates and, more importantly in the short
  run, the international capital flow towards this
  country.
• 2b. The costs of holding money in ones pockets
  or, more generally, the costs of holding liquid
  assets (M1 and M2 the higher the M, the less
  liquid the asset). This in turn means interest
  rates affect inflation.

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Demand management via interest rates

• Setting

Recession due to pessimism
Normal
farmer Baker
farmer Baker
Engineer
Engineer
Basic idea the baker will borrow even if he is
pessimistic when interest rates are low, thus
preventing a break down.
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implications

• 1. One can stimulate the economy by having low
  interest rates one essentially tries to increase
  the incentive to invest in future production
  rather than to lend to others. This is the reason
  for the US fed to have a clear policy of
  extremely low interest rates.
• Problem in the long run, this is not
  sustainable someone somewhere in the world has
  to save the money that is invested. Hence
  interest rates (especially rates determining
  lending to others) in the long run have to be
  equal to the return on productive investment
  because otherwise no-one will lend to anyone else
  for non-productive purposes.
• Hence in the long run, government does not
  control interest rates, especially not in an
  active international capital market.

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Interest rate convergence in the G7?
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Short-term investment

• Issue when domestic interest rate is high
  relative to foreign interest rates, this gives
  foreign investors an incentive to buy local
  currency and obtain these higher interest rates.
• Prediction international capital flows in
  massive amounts to the places with higher
  interest rates. Is indeed to a large degree
  observed.
• Problem this interest-rate shopping is often not
  in the form of long-term investment in companies,
  but often investment in bonds or accounts,
  leading to potentially very high volatility if
  interest rates are uncertain (it goes out of the
  country just as quick as it came in).

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implications

• 1. Being predictable about interest rates is very
  important to prevent volatility. This is one
  reason for central bank independence, where one
  relies on the benevolence of the central bankers.
• 2. Domestic reasons to manipulate interest rates
  can be dwarfed by an international response (in
  the short run, interest rate increases may
  actually increase local capital instead of
  decreasing it).
• 3. Exchange rates will tend to appreciate at the
  same rate as interest rates are higher than the
  foreign interest rates.

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Inflation targeting

• Idea because higher interest rates have strong
  reducing effects on borrowing, inflationary
  pressures get reduced with higher interest rates.
• Prediction inflation can be reduced by higher
  interest rates. This indeed has turned out to be
  the case in recent decades.
• Problem inflation can also be increased by
  increasing M1 and M2 (money printing). Hence both
  the monetary base and interest rates affect the
  same thing and thus must be coordinated.

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implication

• 1. Interest rates are used to reach target levels
  of inflation in many countries. The EU-central
  bank has this in its statues, as does the
  Australian equivalent.
• 2. Because borrowing involves many future
  activities, credibility of interest rates is
  important for them to have effect. This again is
  a reason for central bank independence.
• 3. The increase in M1 and M2 is usually tied to
  the increase in real production.

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Inflation

• Inflation arises when the price of a fixed amount
  of goods and services goes up.
• Definition and measurement issues.
• Real impacts of inflation
• - Inflation as taxation seniorage.
• - Relative price shocks signal distortion.

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Definition issues

• The ideal measure of inflation means asking how
  much more money one needs to obtain the same
  welfare now than it took in an earlier period.
• This means the main measurement issues are about
  quality (current goods are better), and
  composition (what is consumed over time changes).
• Two basic types of practical indices the Paasche
  index and the Laspeyres index.

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• The Paasche index compares the cost of purchasing
  the current basket of goods and services with the
  cost of purchasing the same basket in an earlier
  period. The prices are weighted by the quantities
  of the current period. This means that each time
  the index is calculated, the weights are
  different.
• The Laspeyres index compares the cost of
  purchasing the basket of goods and services in an
  earlier period with the cost of purchasing the
  same basket today.
• Note the Paasche index requires updating the
  weights and is thus more data intensive. It is
  also more responsive though to changes in tastes
  and substitution effects. This means it usually
  gives lower estimates of inflation.

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.

• Issues
• 1. What to include into the relevant bundle of
  goods? This depends on whom the inflation measure
  is for. Thats why there are several inflation
  measures (for the consumer, with or without
  housing, for manufacturing, an import price
  index, etc.)
• 2. How to deal with changing composition and
  quality? Sometimes, quality indices are developed
  (e.g. with computers), sometimes the composition
  of the baskets changes greatly. Political
  considerations are often important here because
  many wages and benefits are linked to inflation
  measures.

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Real impacts of inflation

• How could inflation have real impact?
• Inflation can be a tax. Consider an initial
  situation where consumers hold 100 in savings.
  Then, the government prints another 100. That
  means there are 200 to buy the same goods,
  meaning inflation of 100. What effectively has
  happened is that half the previous real value of
  the savings has been taxed and is now at the
  discretion of the government.
• This tax is called seniorage and is one of the
  easiest taxes to collect. It taxes savings more
  than production though (because one can index
  salary, but one cannot index savings because
  indexing savings would merely mean the borrower
  would have to pay the tax).

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implications

• - seniorage tax discourages domestic savings and
  promotes putting the saving abroad, called
  capital flight.
• - a domestic investors would have to bid an
  interest rate that is greater than the inflation
  rate, meaning the investors start bearing the
  tax.
• - over time seniorage tax can be avoided by
  adopting other means of exchange, such as a
  foreign currency.

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Other real effects

• Signal distortion precisely because an
  anticipated seniorage tax can be avoided by
  capital flight, a government has an incentive to
  print money unexpectedly.
• This means inflation comes in bursts, leading to
  great volatility.
• Information about the bursts is not equally fast
  in all areas of the economy (some prices such as
  often traded commodities can adapt faster than
  others such as not-often traded commodities).
• The information strain becomes too great and
  relative prices start to fluctuate wildly,
  leading to a loss of specialisation and thus
  economic downturn.

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Comments on exchange rates

• The higher the exchange rate, the richer one as a
  country is, but the higher priced ones goods are
  abroad.
• An ever appreciating exchange rate is thus the
  result of being successful on the foreign
  markets.
• A depreciating one does in the longer run help
  exports but is the result of being uncompetitive.
• Depreciation brings in inflation from abroad
  (imports increase in price).
• In the short run, various contracts are fixed and
  changes in the exchange rate have no effect on
  trade.
• In the short run, exchange rates are almost
  entirely dictated by (large) capital flows. In
  the long run, trade flows matter also.