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Goethe Business School Chapter VII: Money, assets, and interest rates A.What is money? B.Monetary aggregates C.Demand for financial assets D.Asset market.

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Presentation on theme: "Goethe Business School Chapter VII: Money, assets, and interest rates A.What is money? B.Monetary aggregates C.Demand for financial assets D.Asset market."— Presentation transcript:

1 Goethe Business School Chapter VII: Money, assets, and interest rates A.What is money? B.Monetary aggregates C.Demand for financial assets D.Asset market equilibrium E.Liquidity preference theory F.Interest rates and interest rate spreads

2 Goethe Business School 2 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

3 Goethe Business School 3 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

4 Goethe Business School 4 Stone money of the island of Yap

5 Goethe Business School 5 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?

6 Goethe Business School 6 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)

7 Goethe Business School 7 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

8 Goethe Business School 8 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 --> 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!

9 Goethe Business School 9 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

10 Goethe Business School 10 Ability to pay or liquidity 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 Store of value

11 Goethe Business School 11 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

12 Goethe Business School 12 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

13 Goethe Business School 13 Liquidity The question is, how to define liquidity. Milton Friedman proposes an ideal definition: Liquity = i A i * w i, where w i is the degree of moneyness of asset A i. Milton Friedman 1912- Nobel Prize 1976

14 Goethe Business School 14 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

15 Goethe Business School 15 Measuring money demand M1= narrow money M2= intermediate money M3= broad money

16 Goethe Business School 16 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.

17 Goethe Business School 17 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.

18 Goethe Business School 18 Money demand in the Euro-area (end of 2007) Billion eurosIn 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

19 Goethe Business School Development of M3 in the Euro area 1999-2008 19

20 Goethe Business School Relationship between M3 and the inflation rate (HIPC) 20

21 Goethe Business School 21 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

22 Goethe Business School 22 Keynes attitude toward 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

23 Goethe Business School 23 Focus on demand for financial 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

24 Goethe Business School 24 The demand for financial assets 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)

25 Goethe Business School 25 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

26 Goethe Business School 26 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

27 Goethe Business School 27 The demand for bonds 950 900 850 800 750 5.3 11.1 17.6 25.0 33.0 Interest rate (%) Price of bond () 100 500 400300200

28 Goethe Business School 28 The supply for bonds 950 900 850 800 750 5.3 11.1 17.6 25.0 33.0 Interest rate (%) Price of bond () 100 500 400300200

29 Goethe Business School 29 Market equilibrium (asset market approach) 950 900 850 800 750 5.3 11.1 17.6 25.0 33.0 Interest rate (%) Price of bond () 100 500 400300200 C P* i*

30 Goethe Business School 30 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:

31 Goethe Business School 31 A reinterpretation of the bond market Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Demand for bonds, B d = Supply of loanable funds, L s Supply of bonds, B s = Demand for loanable funds, L d

32 Goethe Business School 32 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

33 Goethe Business School 33 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

34 Goethe Business School 34 A shift of the supply curve of funds Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Demand for bonds, B d = Supply of loanable funds, L s Supply of bonds, B s = Demand for loanable funds, L d C D

35 Goethe Business School 35 Effects on the supply of funds for bonds Wealthright Expected interest left Expected inflation left Riskleft Liquidityright Change in variable Change in quantity Change in interest rate Shift in supply curve

36 Goethe Business School 36 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

37 Goethe Business School 37 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

38 Goethe Business School 38 A shift of the demand curve for funds Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Demand for bonds, B d = Supply of loanable funds, L s Supply of bonds, B s = Demand for loanable funds, L d C D

39 Goethe Business School 39 Effects on the demand of funds for bonds Profitabilityright Expected inflation right Government activities right Change in variable Change in quantity Change in interest rate Shift in demand curve

40 Goethe Business School 40 Equilibrium in the market for money Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C

41 Goethe Business School 41 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

42 Goethe Business School 42 Response to a change in income Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C D

43 Goethe Business School 43 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)

44 Goethe Business School 44 Response to a change in money supply Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C D

45 Goethe Business School 45 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 -> interest rates increase (income effect). it causes the overall price level to increase -> interest rates increase (price effect) it affects the expected inflation rate -> interest rates increase (Fisher-effect)

46 Goethe Business School 46 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 allincrease the level of interest rates

47 Goethe Business School 47 Increase of money supply plus demand shift 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C D Interest rate (%) E

48 Goethe Business School 48 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)

49 Goethe Business School 49 Can short term interest rates fall 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

50 Goethe Business School 50 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

51 Goethe Business School 51 Liquidity trap and money supply Nominal Interest rate (%) 33.0 25.0 17.6 11.1 5.3 100 500 400300200 Supply of money, M s Demand for money, M d C D

52 Goethe Business School 52 Real interest rates in the United States During the 1970 real interest rates were significantly below 0% in the United States (and worldwide) During the 1970 real interest rates were significantly below 0% in the United States (and worldwide)

53 Goethe Business School And again now in the USA …. 53

54 Goethe Business School 54 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

55 Goethe Business School 55 Real interest and Deflation

56 Goethe Business School 56 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?

57


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