Chapter VII: Money, assets, and interest rates

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Chapter VII Money, assets, and interest rates

1. What is money?
2. Monetary aggregates
3. Demand for financial assets
4. Asset market equilibrium
5. Liquidity preference theory
6. Interest rates and interest rate spreads

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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
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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

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Stone money of the island of Yap
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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?

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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)

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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

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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 --gt such as cigarettes, butter)
• Such monies circulate forcibly as media of
  exchange, but they are unsuitable as a store of
  value (Greshams Law)
• Bad money replaces good money!

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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

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Store of value

• 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

Ability to pay or liquidity
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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

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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

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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
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Empirical definition of money

• Friedmans 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

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Measuring money demand

• M1 narrow money
• M2 intermediate money
• M3 broad money

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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.

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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.

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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
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Development of M3 in the Euro area 1999-2008
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Relationship between M3 andthe inflation rate
(HIPC)
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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 assumed M m ? B multiplier ?
  base money

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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

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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

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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)

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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

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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

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The demand for bonds
Interest rate ()
Price of bond ()
500
100
400
300
200
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The supply for bonds
Interest rate ()
Price of bond ()
500
100
400
300
200
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Market equilibrium (asset market approach)
Interest rate ()
Price of bond ()
C
i
P
500
100
400
300
200
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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

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A reinterpretation of the bond market
Interest rate ()
Demand for bonds, Bd Supply of loanable funds,
Ls
Supply of bonds, Bs Demand for loanable funds,
Ld
500
100
400
300
200
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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

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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

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A shift of the supply curve of funds
Interest rate ()
Demand for bonds, Bd Supply of loanable funds,
Ls
D
C
Supply of bonds, Bs Demand for loanable funds,
Ld
500
100
400
300
200
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Effects on the supply of funds for bonds
Shift in supply curve
Change invariable
Change inquantity
Change ininterest rate
Wealth right
Expected interest left
Expected inflation left
Risk left
Liquidity right
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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

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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

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A shift of the demand curve for funds
Interest rate ()
Demand for bonds, Bd Supply of loanable funds,
Ls
D
C
Supply of bonds, Bs Demand for loanable funds,
Ld
500
100
400
300
200
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Effects on the demand of funds for bonds
Shift in demand curve
Change invariable
Change ininterest rate
Change inquantity
Profitability right
Expected inflation right
Governmentactivities right
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Equilibrium in the market for money
Interest rate ()
Supply of money, Ms
C
Demand for money, Md
500
100
400
300
200
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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

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Response to a change in income
Interest rate ()
Supply of money, Ms
D
C
Demand for money, Md
500
100
400
300
200
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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)

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Response to a change in money supply
Interest rate ()
Supply of money, Ms
D
C
Demand for money, Md
500
100
400
300
200
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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-gt interest rates
  increase (income effect).
• it causes the overall price level to increase-gt
  interest rates increase (price effect)
• it affects the expected inflation rate-gt
  interest rates increase (Fisher-effect)

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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

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Increase of money supply plus demand shift
Interest rate ()
Supply of money, Ms
E
D
C
Demand for money, Md
500
100
400
300
200
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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)

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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

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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

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Liquidity trap and money supply
NominalInterest rate ()
Supply of money, Ms
Demand for money, Md
C
D
500
100
400
300
200
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Real interest ratesin the United States

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

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And again now in the USA .
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Liquidity 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

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Real interest and Deflation
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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?

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