Lecture 7
BEEM119 Economics of Banking
Jan Auerbach
Department of Economics University of Exeter
Contents
1 Financial Institutions and Key Concepts
1 Institutions and Concepts.
2 Understanding Interest Rates.
3 The Risk and Term Structure of Interest Rates.
4 The Efficient Markets Hypothesis.
2 Money
1 What is Money?
2 The Money Supply Process.
3 Quantitative Theory, Inflation, and the Demand for Money.
3 Banking and Financial Intermediation
1 An Economic Analysis of Financial Structure.
2 Banking Industry: Structure and Competition.
4 Banking and Policy
1 Economic Analysis of Financial Regulation.
2 Financial Crises.
Quantity Theory, Inflation and the Demand for Money
(Mishkin, chapter 20)
Quantity Theory of Money
Velocity of Money and The Equation of Exchange
where
V = PY , M
M = money supply P = price level
Y = aggregate output (income)
PY = aggregate nominal income (nominal GDP)
V = velocity of money.
The velocity of money is the average number of times per year a dollar is spent.
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Quantity Theory of Money
The Equation of Exchange
MV = PY .
According to Fisher, money velocity is fairly constant in the short run. Accounting for this view induces the quantity theory of money:
PY =MV ̄.
The quantity theory of money states that nominal income (spending) is determined solely by movements in the quantity of money M.
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Quantity Theory of Money
The velocity of money is fairly constant in the short run. Aggregate output is at full-employment level.
Changes in the money supply affect only the price level.
Movements in the price level result solely from changes in the quantity of money.
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Quantity Theory and Inflation
The percentage change of a product is approximately equal to
x′y′ −xy xy
= (1+∆x)x(1+∆y)y −xy xy
= (1+∆x)(1+∆y)−1 =1+∆x +∆y +∆x∆y −1 =∆x +∆y +∆x∆y
≈∆x +∆y.
i.e., the sum of the percentage changes in the factors.
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Quantity Theory and Inflation
So, we can rewrite the equation of exchange as %∆P + %∆Y = %∆M + %∆V .
Subtracting %∆Y from both sides of this equation, and recognizing that the inflation rate π is the growth rate of the price level,
π = %∆P = %∆M + %∆V − %∆Y .
Since we assume velocity is constant, its growth rate %∆V is zero, so the quantity theory of money is also a theory of inflation:
π = %∆M − %∆Y .
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Quantity Theory of Money
11 10 9 8 7 6 5 4 3
Velocity of M1 Money Stock
1990 2000 2010 Shaded areas indicate US recessions – 2014 research.stlouisfed.org
1960 1970 1980
Source: Federal Reserve Bank of St. Louis
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(Ratio)
Quantity Theory of Money
2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5
Velocity of M2 Money Stock
1990 2000 2010 Shaded areas indicate US recessions – 2014 research.stlouisfed.org
1960 1970 1980
Source: Federal Reserve Bank of St. Louis
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(Ratio)
Quantity Theory of Money
The relationship between inflation and money growth
It’s a good theory of inflation in the long run.
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Quantity Theory of Money
The relationship between inflation and money growth
It’s a good theory of inflation in the long run.
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Quantity Theory of Money
Growth rates, 1965-2010
It’s NOT a good theory of inflation in the short run.
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Budget Deficits and Inflation
There are two ways the government can pay for spending:
1 raise revenue by levying taxes; or
2 go into debt by issuing government bonds.
Or, the government can also create money and use it to pay for the goods and services it buys.
G−T =∆MB+∆B
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Budget Deficits and Inflation
The government budget constraint thus reveals two important facts:
1 If the government deficit is financed by an increase in bond holdings by the public, there is no effect on the monetary base and hence on the money supply.
2 But, if the deficit is not financed by increased bond holdings by the public, the monetary base and the money supply increase.
The quantity theory explains inflation in the long run: Financing a persistent deficit by money creation will lead to sustained inflation.
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Hyperinflation
Hyperinflation refers to periods of extremely high inflation of more than 50% per month.
Many economies–both poor and developed–have experienced hyperinflation over the last century.
The United States has been spared of such turmoil. During the 20th century, hyperinflation occurred 28 times.
They are often associated with the monetary chaos involving two world wars and the collapse of communism.
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Hyperinflation
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Hyperinflation
Hyperinflation is often accompanied by rapidly increasing money supply.
This is needed to finance large fiscal deficits arising from war, revolution, the end of empires and the establishment of new states.
Hyperinflation initially appeared during the French Revolution, when the monthly rate peaked at 143 percent in December 1795.
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Hyperinflation: The example of Zimbabwe
One of the most extreme examples of hyperinflation throughout world history recently occurred in Zimbabwe in the 2000s.
Zimbabwe is located in the southern region of Africa.
It is about the size of California, with a population the UN estimated to have been 12.7 million in 2011.
At independence of UK, annual inflation was 5.4 percent.
The largest currency denomination was Z$20, and the Zimbabwean dollar was the most widely used currency–involved in more than 95 percent of transactions.
Three decades later bills in thousands, then millions, and then trillions were introduced as inflation diminished the value of money.
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Hyperinflation: The example of Zimbabwe
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Hyperinflation: The example of Zimbabwe
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Hyperinflation: The example of Zimbabwe
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Hyperinflation: The example of Zimbabwe
Zimbabwe’s economic crisis and subsequent hyperinflation were preceded by several years of economic decline and mounting public debt.
Weakening began in 1999, coinciding with periods of drought that adversely affected the agriculturally dependent nation.
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Hyperinflation: The example of Zimbabwe
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Hyperinflation: The example of Zimbabwe
External debt as a share of GDP increased to 119 percent in 2008 from 11 percent in 1980.
Deprived of conventional means of raising revenue, such as taxation, governments borrow without limit from the central bank.
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Hyperinflation: The example of Zimbabwe
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Hyperinflation: The example of Zimbabwe
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Hyperinflation: The example of Zimbabwe
In late 2008, the Zimbabwe dollar was replaced in transactions by widespread dollarization amid hyperinflation.
The official demise of the currency occurred in February 2009. Authorities established a multicurrency system.
In reality, the U.S. dollar became the principal currency.
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Keynesian Theories of Money Demand
Keynes’ Liquidity Preference Theory
Why do individuals hold money? Three Motives:
1 Transactions motive
2 Precautionary motive
3 Speculative motive
The theory distinguishes between real and nominal money.
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Transactions Motive
Keynes initially accepted the quantity theory view that the transactions component is proportional to income.
Later, he (and others) recognized that new methods for payment (‘payment technology’) could also affect the demand for money.
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Precautionary Motive
Keynes also recognized that people hold money as a cushion against unexpected wants.
Keynes argued that the precautionary money balances people want to hold would also be proportional to income.
As interest rates rise, the opportunity cost of holding money as precautionary balances rises.
The precautionary demand for money is negatively related to interest rates.
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Speculative Motive
Keynes also believed people choose to hold money as a store of wealth, which he called the speculative motive.
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Putting the Three Motives Together
Let the demand for real money balances Md be given by P
Multiply both sides by Y and replacing Md with M:
V=PY= Y . M L(i,Y)
Md P
= L(i,Y),
and f decreases with the interest rate i and increases with income Y .
Rewriting yields
P=1. Md L(i,Y)
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Putting the Three Motives Together
Velocity is not constant:
The procyclical movement of interest rates should induce procyclical movements in velocity.
Velocity will change as expectations about future normal levels of interest rates change.
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Quantity Theory of Money
11 10 9 8 7 6 5 4 3
Velocity of M1 Money Stock
1990 2000 2010 Shaded areas indicate US recessions – 2014 research.stlouisfed.org
1960 1970 1980
Source: Federal Reserve Bank of St. Louis
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(Ratio)
Quantity Theory of Money
2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5
Velocity of M2 Money Stock
1990 2000 2010 Shaded areas indicate US recessions – 2014 research.stlouisfed.org
1960 1970 1980
Source: Federal Reserve Bank of St. Louis
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(Ratio)
Portfolio Theories of Money Demand
Theory of Portfolio Choice and Keynesian Liquidity Preference:
The theory of portfolio choice can justify these assumptions made on Keynesian liquidity preference function.
Demand for an asset depends positively on wealth, relative expected return, relative liquidity; and negatively on relative risk.
Higher incomes likely come with higher wealth; increasing interest rates increase the returns on bonds–opportunity costs of holding money.
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Portfolio Theories of Money Demand
Other Factors That Affect the Demand for Money:
• Wealth;
• Risk: changes in risk characteristics of other assets; inflation;
• Liquidity of other assets–the liquidity of money is constant–increases.
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Empirical Evidence on the Demand for Money
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Interest Rates and Money Demand
We have established that if interest rates do not affect the demand for money, velocity is more likely to be constant–or at least predictable.
So the quantity theory view that aggregate spending is determined by the quantity of money is more likely to be true.
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Stability of Money Demand
If the money demand function is unstable and undergoes substantial, unpredictable shifts as Keynes believed, then velocity is unpredictable.
Then, the quantity of money may not be tightly linked to aggregate spending, as the quantity theory would suggests.
The stability of the money demand function is also crucial to whether the Federal Reserve should target interest rates or the money supply.
If the money demand function is unstable and so the money supply is not closely linked to aggregate spending, then the level of interest rates the Fed sets will provide more information about the stance of monetary policy than will the money supply
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