Chapter 2 of Cecchetti Money and the Payments System

Money  Money is an asset that is generally accepted as payment for goods and services or repayment of debt. 1.A means of payment. Transferability Information 2.A unit of account Allocation of resources Relative prices 3.A store of value Liquidity

Example: Island Economy Farmer Gold MinerBlacksmith Teacher 1M florins 1M oz gold CENTRAL BANK “M”=million

Example: Island Economy Central bank declares it stands ready to redeem 1 florin for 1 ounce of gold from anyone at any time. Balance Sheet of Central Bank ASSETSLIABILITIES Gold: 1M flCurrency: 1M fl

Example: Island Economy Farmer Gold MinerBlacksmith Teacher 1M florins 1M oz gold CENTRAL BANK “M”=million florins food florins food lectureflorins services florins gold

Example: Island economy Assume no banking system  No bank deposits Money supply is completely in the form of currency Money supply = 1,000,000 fl

Example: Island Economy Farmer Gold MinerBlacksmith Teacher florins Commercial Bank

Initial Purpose:  Keep florins safe Why not loan some of those florins out? Commercial Bank Balance Sheet ASSETSLIABILITIES Currency 1M flDeposits 1M fl

Example: Island Economy Bank Reserves: liquid assets held by banks to meet demands for withdrawls from investors. Central Bank mandates bank must hold some fraction of florins in vaults called reserves.

Example: Island Economy Reserve deposit ratio = currency/deposits Assume required reserve deposit ratio = 20% Commercial Bank loans out 80% of deposits  800,000 fl  These are deposited back in the bank

Example: Island Economy Commercial Bank Balance Sheet ASSETSLIABILITIES Currency 1,000,000 flDeposits 1,800,000 fl Loans 800,000 fl Total 1,800,000 fl 1,800,000 fl Reserve deposit ratio = 1/(1.8) = 60% Only need.20  1,800,000 =360,000 fl Can loan out 1,000,000 – 360,000 = 640,000 fl Deposited back in bank

Example: Island Economy Consolidated Balance Sheet of Banks ASSETSLIABILITIES Currency 1,000,000 flDeposits 2,440,000 fl Loans 1,440,000 fl Total 2,440,000 fl 2,400,000 fl Reserve deposit ratio = 1/(2.4) = 42% Only need.20  2,440,000 =488,000 fl Can loan out 1,000,000 – 488,000 = 512,000 fl Does this just go on forever..... ?

Example: Island Economy Equilibrium is achieved when Currency/deposits = ,000,000/deposits = ,000,000/0.20 = deposits 5,000,000 = deposits

Example: Island Economy Equilibrium ASSETSLIABILITIES Currency 1,000,000 fl Deposits 5,000,000 fl Loans 4,000,000 fl Total 5,000,000 fl 5,000,000 fl Reserve deposit ratio = 1/5 = 20%

Money Supply Banks have effect on the money supply Bank Deposits  Very liquid, can be used for transactions  Are counted as part of the money supply In example, no cash is held by public  Money supply = total deposits Risk of bank runs

Measuring Money Different Definitions of money based upon degree of liquidity. Federal Reserve System defines monetary aggregates: measures of money

Monetary Aggregates Link to Current Data

Growth Rates in Monetary Aggregates

Money and Inflation M2 Growth Rate and CPI Inflation Rate 2 years later.

Changes in Rates Chapter 6 of Cecchetti

Fluctuations of 1-year T-bond Rate 1-month T-bill Rate:

Bond Demand and Supply From perspective of primary market  Market in which firms issue debt, sell to investors  Suppliers: Firms and Government  Demanders: Investors Looking at secondary market, does not allow us to investigate firm behavior  Market in which investors buy and sell bonds among themselves

Supply And Demand Curves Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0% Supply Demand

Suppliers We could actually have two supply curves  Government  Firms Factors that impact one sector may not impact the other Government and Corporate rates are connected.

Supply – A Closer Look Three agents in economy  Government  Business  Households Initial Situation Increased Gov Borrowing

Shift in Supply Increase in Government Borrowing Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0% Government Bond Supply Curve

Changes in Government Borrowing An increase in Government borrowing  The supply curve shifts to the right  Prices to decrease  Yields to increase A decrease in Government borrowing  The supply curve shifts to the left  Prices to increase  Yields to decrease

Shift in Supply Declining Business Conditions Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0% Corporate Bond Supply Curve

Changes in Business Conditions An improvement in business conditions  The supply curve to shift to the right  Prices to decrease  Yields to increase A decline in business conditions  The supply curve to shift to the left  Prices to increase  Yields to decrease

Shift in Supply Increase in Corp. Tax Subsidies Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0% Corporate Bond Supply Curve

Changes in Corp.Tax Subsidies An increase in Corp. Tax Subsidies  The supply curve to shift to the right  Prices to decrease  Yields to increase A decrease in Corp. Tax Subsidies  The supply curve to shift to the left  Prices to increase  Yields to decrease

Shift in Supply Increase in Expected Inflation Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0% Corporate/Government Bond Supply Curve

Changes in Expected Inflation An Increase in Expected Inflation  The supply curve to shift to the right  Prices to decrease  Nominal Yields to increase A decrease in Expected Inflation  The supply curve to shift to the left  Prices to increase  Nominal Yields to decrease

Demand – A Closer Look Three agents in economy  Government  Business  Households Initial Situation Increased Household Saving

Shift in Demand Increased Household Wealth Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0%

Changes in Household Wealth An Increase in Household Wealth  The demand curve to shift to the right  Prices to increase  Yields to decrease A decrease in Household Wealth  The demand curve to shift to the left  Prices to decrease  Yields to increase

Shift in Demand Increase in Expected Stock Return Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0%

Changes in Expected Relative Bond Returns An Increase in Bond Yield – Return Alt.  The demand curve to shift to the right  Prices to increase  Yields to decrease A decrease in Bond Yield – Return Alt.  The demand curve to shift to the left  Prices to decrease  Yields to increase

Shift in Demand Decrease in Relative Risk of Bonds Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0%

Changes in Relative Bond Risk A decrease in Bond Risk – Risk Alt.  The demand curve to shift to the right  Prices to increase  Yields to decrease An increase in Bond Risk – Risk Alt.  The demand curve to shift to the left  Prices to decrease  Yields to increase

Example: Crowding Out Increased government borrowing “crowds out” firms from borrowing PriceYield Primary Market for Government Bonds Price Yield Primary Market for Corporate Bonds

Shift in Demand Increase in Relative Bonds Liquidity Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0%

Changes in Relative Bond Liquidity An Increase in Bond Liq. – Liq. Alt.  The demand curve to shift to the right  Prices to increase  Yields to decrease A decrease in Bond Liq. – Liq. Alt.  The demand curve to shift to the left  Prices to decrease  Yields to increase

Shift in Demand Increase in Expected Inflation Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0%

Changes in Expected Inflation A Decrease in Expected Inflation  The demand curve to shift to the right  Prices to increase  Yields to decrease An increase in Expected Inflation  The demand curve to shift to the left  Prices to decrease  Yields to increase

Expected Inflation Expected inflation shifts both curves Consider a decrease in expected inflation

Decrease in Expected Inflation Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0%

Decrease in Expected Inflation A decrease in expected inflation unambiguously causes bond prices to rise and yields to fall.

Business Cycles Business Cycles can shift both curves  Consider what happens when economy emerges from a recession. Jobs are created, household wealth increases Business conditions improve

Economy Emerges from Recession Quantity of Bonds ($ billions) Price % Yield % 17.6% 25.0% 33.0%

Economy Emerges from Recession During expansions  Wealth increases (demand shifts right)  Business Conditions improve (supply shifts right) Effect could be ambiguous Data shows during expansions  Bond prices decline, yields increase

Credit Markets August 28 Relative Risk of U.S. treasuries has dropped. Demand curve shifts right. Prices jump up, yields decline. Relative return of U.S. treasuries is higher. Demand curve shifts right. Prices jump up, yields decline.

Credit Markets July 2 Softer inflation causes demand curve to shift right, supply curve to shift left. Both effects cause prices to increase, yields to decrease.