Money Tom Porter, 2014

Money There are two dimensions to money and two markets used to understand money. 1.Loanable Funds Markets – Savings and investment create the supply and demand for loanable funds. Remember that Savings is the Supply of loanable funds. 2.Money Markets – Supply and Demand for money determines the price level. Copyright © 2014 Dr. Tom Porter 2

Loanable Funds Market Loanable funds link the real economy to money markets. The balance of the supply (savings) and demand (investment) determines the real interest rate in the economy. The difference between this interest rate and the world real interest rate determines capital flows. Copyright © 2014 Dr. Tom Porter 3

FIGURE 13.3: The Real Equilibrium in a Small Open Economy

Money Market The money market balances the supply and demand for currency. There are two prices for money: 1.Prices: the value of money in terms of what it can purchase. 2.Interest Rates: this captures the change in the value of money over time. Copyright © 2014 Dr. Tom Porter 5

FIGURE 11.1: How the Supply and Demand for Money Determine the Equilibrium Price Level

FIGURE 15.4: Equilibrium in the Money Market

Money Supply and Demand Two money equations: 1.Quantity Theory of Money: M x V = P x Y 2.Fisher Equation: R = π + r This relates interests rates and inflation (noted as π) and leads to the second market – for loanable funds. Copyright © 2014 Dr. Tom Porter 8

Cause and Effect Expectations. 1.Investment depends on expectations about future prices – investors want future gains (relative improvements). 2.Changes in investment shift aggregate demand. 3.Investment outcomes shift output in the future. 4.Corrections in expectations lead to additional changes in aggregate demand and output. Copyright © 2014 Dr. Tom Porter 9

FIGURE 14.6: Long-Run Growth and Inflation in the Model of Aggregate Demand and Aggregate Supply

Mechanics of Investment Investment is financed by savings: –Directly through own-savings –Indirectly through borrowing In either case, there is a cost of borrowing. –An opportunity costs of foregone savings –An explicit interest cost for borrowing Real investment reflects the choice to invest for future benefit based on expected future prices relative to current opportunities. Copyright © 2014 Dr. Tom Porter 11

Debt Debt as investment (investment increases) Borrowing funds to go to school or open a business is productive or potentially productive. Debt as consumption (savings decrease) Borrowing for a house or car is consumption that is spread out over time, and we are planning to use future income for the purchase. Borrowing for current consumption (a vacation) is taking from future income for current consumption – that is, you are reducing future income and future consumption for current non-productive purposes. 12 Copyright © 2014 Dr. Tom Porter

Investment Savings finance some combination of: Good Investment Productive! Bad Investment Investment that are expected to be productive, but fail to improve productivity. Funds are lost and have to be paid out of future consumption (by the investor or by the lender) Speculation This is the buying and selling of assets based on changes in relative asset prices. 13 Copyright © 2014 Dr. Tom Porter

Monetary Policy Government management of money markets. Successful intervention will: –Increase investment –Increase purchase of goods and services (as inputs) –Increase hiring of labour (e.g., construction) Productive investment increases output and increases in output require more labour. 14 Copyright © 2014 Dr. Tom Porter

Two money equations represent long-run and short-run dynamics. 1. Long-run forces adjust so that: M x V = P x Y 2. Investment decisions are determined by: R = π + r Copyright © 2014 Dr. Tom Porter 15 Monetary Policy and Markets

Monetary Policy Government manages money markets and influences short-run investment decisions: through interest rates (the bank rate), and by influencing bank lending (reserve and other financial capital requirements) that determines the stock of money. 16 Copyright © 2014 Dr. Tom Porter

FIRST NATIONAL BANK AssetsLiabilities Reserves$10Deposits$100 Loans90 * The money supply (currency + deposits) = $190 Money Creation with Fractional-Reserve Banking

The Money Multiplier PORTER’s NATIONAL BANK AssetsLiabilities Reserves$9Deposits$90 Loans81 * The money supply = $100 + $90 + $81 = $271

MORE REALSITIC NATIONAL BANK AssetsLiabilities Reserves$200Deposits$800 Loans700Debt150 Securities100 Capital50 Bank Capital, Leverage, and the Financial Crisis of

 The BoC can alter the money supply by changing the bank rate.  This causes an equal change in the overnight rate.  A lower overnight rate encourages banks to borrowing reserves from the BoC; thus increasing reserves in the banking system.  The money supply grows as banks are able to lend more funds to borrowers (including lending for real investment). The BoC’s Tools of Monetary Control: Changing the Overnight Rate

 Open-market operations : the purchase or sale of Government of Canada bonds by the Bank of Canada  To increase the money supply, the BoC buys bonds (or/and Treasury bills) from the public.  To reduce the money supply, the BoC sells bonds (or/and Treasury bills) to the public. The BoC’s Tools of Monetary Control: Open-Market Operations

Monetary Policy Lowering bank rates and otherwise “printing money” causes: 1.Higher prices in the long-run (according to the Quantity Theory of Money) 2.Potentially higher investment in the short-run because investment is cheaper 3.Potentially lower savings because the returns are also lower 22 Copyright © 2014 Dr. Tom Porter

Monetary Policy Lowering bank rates and “printing money”: –Increases good investment –Increases investments that ultimately fail –Increases speculation By continuing to lower bank rates, then the proportion of bad investments and speculation grows relative to good investment grows. The Bank of Canada has to set the “correct rate”. 23 Copyright © 2014 Dr. Tom Porter

Monetary Policy Bank of Canada’s objective is to choose a bank rate that: 1.Balances supply and demand in the markets for loanable funds. 2.Stabilizes money markets: –Stable prices improves price expectations –Increases confidence for greater productive investment 24 Copyright © 2014 Dr. Tom Porter

Monetary Policy Liquidity Crisis: Company and bank failures (1930s) Company and bank failures (2008) The Bank of Canada will provide emergency monetary stimulus to prevent financial panic. Monetary stimulus saves productive investments as well as speculators. The great trick in financial regulation is to separate productive from unproductive investment. 25 Copyright © 2014 Dr. Tom Porter