Ch. 5 Financial markets

Question 1

Income

Definition

Answer 1

what we earn by working, plus what we receive as interest and dividends. It is a flow variable, expressed per unit of time: monthly, annual income.

Question 2

Savings

Definition

Answer 2

Savings are the part of the after-tax or disposable income that is not spent on consumption. It is also a flow variable.

Question 3

Wealth

Defintion

Answer 3

Wealth is the stock of things owned or the value of that stock. It is a stock variable: measured at a given point in time: “his wealth at the end of the year was 10 million euros.”

Question 4

Invesment

Definition

Answer 4

Investment: it refers to the acquisition of new capital goods: machines, office buildings, etc. It does not include the purchase of shares or other financial assets, that is financial investment

Question 5

Money functions

Answer 5

1. Medium of exchange: something that buyers give to sellers when they want to buy goods and services. This function is what defines money .
   
   • To facilitate exchanges, agents reach an agreement to use a medium of exchange. Think of an economy without money: a pure barter or exchange economy.
   • Bartering is very expensive: we are buyers and sellers at the same time, we must find a double match to make an exchange.
2. Unit of account: criteria that agents use to set prices and record debts. A measure is needed to compare the value of different goods and services. Because goods and services are mostly exchanged for money, it is natural to express their economic value in terms of money. In countries with very high inflation, money is not a good unit of account because prices change frequently, then agents tend to use a more stable unit of account (like the US dollar), even if everyday transactions use the domestic currency.
3. Store of value: An item that people can use to transfer purchasing power from the present to the future. Money is a store of value because it remains valuable over time. There are other assets that are a store of value: jewelry, houses, art; the difference is that the value of money comes from its function as a medium of exchange. It is valuable because we know that someone will accept it in exchange for a good or service.

Question 6

Money

Definition

Answer 6

• It’s an asset that can be used directly to purchase goods or services. It includes coins and bills, bank deposits (we will be more specific later).
• Money does not pay interest rates and it is the most liquid asset.
• It is accepted as way of payment because others can use it for the same purpose. Trust is key. It is a stock variable.

Question 7

Money: Liquidity

Answer 7

Ease with which an asset can become the economy’s medium of exchange. Money is the economic term for the stock of assets that are widely used and accepted as payment, by definition it is the most liquid assets.

The greater the liquidity of an asset, the lower its return. Money is the most liquid asset and has the lowest return of all assets. When people decide how to preserve their wealth, they consider liquidity versus return.

Question 8

Money types

Answer 8

• Commodity money: when money takes the form of a commodity with intrinsic value. Intrinsic value means that the item would have value even if it were not used as money (it has other uses). Examples: gold, silver; cigarettes in prison/war; horses.
• Fiat money: A government-issued currency not backed by a commodity (like gold).
• Fiduciary money: Money issued with the backing of a commodity

Question 9

Two financial assets we asume

The demand for money

Answer 9

1. Money: it is used as a medium of exchange (it includes cash, deposits, more details later). No positive return.
2. Bonds: they cannot be used immediately as a medium of exchange, there is a cost associated with buying and selling bonds, but they yield a positive return (interest rate).

Question 10

Portfolio decision

Given a certain financial wealth

Answer 10

The proportion of money and bonds will depend mainly on two factors:
* Transaction level: to have enough money available without having to sell bonds too frequently.
* The interest rate ( i ): the only reason for holding bonds is their return relative to money.

Question 11

Reasons to demand money

Answer 11

• Transaction demand for money: agents demand money for their transactions because it is not possible to buy goods and services directly through bonds.
• Demand for money for precautionary reasonsThe agents demand money to face unforeseen expenses (the car breaks down, they get sick) .

These two reasons depend on the agent’s income: the higher the income, more transactions and more costly unforeseen events.

Holding money has an oportunity cost: the interest rate of the bonds not being holded because holding money.

Question 12

Nominal and real demand for money related to income and interest

Answer 12

Nominal income, income expressed in euros, not real income. If real income does not change but both prices and nominal income increase, individuals need more money to buy the same goods, so the nominal demand for money increases. We distinguish:

1. The nominal demand for money, 𝑀^𝑑, depends positively on nominal income and prices, and negatively on the interest rate.
2. The real demand for money or real balances: 𝑀^𝑑/P = 𝐿^𝑑 = L(Y, i), depends positively on real income (Y) and negatively on the interest rate (i).

Question 13

The demand for money - graphically: 𝐿^𝑑

Answer 13

• 𝐿^𝑑 and i have an inverse relationship: for a given income Y, at point a, the interest rate is i and the money is M.
• The curve 𝑳^𝒅 represents the relationship between the demand for money and the interest rate for a given level of income.
• It has a negative slope: the lower the interest rate (i), the larger the amount of money agents want
• The 𝐿^𝑑 curve is defined for a given level of income. If income changes, the curve will shift. From Y(0) to Y(1) the curve will shift to the right or upwards.
• For a given level of the interest rate (i ), an increase in income increases the demand for money: it shifts the demand for money to the right

Question 14

The demand for money: Linear function

Answer 14

𝑳^𝒅 = kY - hi [k, h > 0]
k: sensitivity of the demand for money to changes in income.
h: sensitivity of the demand for money to changes in the interest rate.

Question 15

Relation between price of the bonds and interest rate

Answer 15

Like and index number:
i=(Pv-Pb)/Pb
* Pb: current price of the bonds.
* Pv: the face value (the amount that the issuer pays at the time of maturity).
* i: annual return of the bonds (maturity date in one year).

Question 16

What are monetary aggregates? Why do they exist?

Answer 16

The similarities between money and other liquid assets led central banks to consider measures that included money and other assets.
A monetary aggregate is an overall measure of the money supply
Types:
1. Monetary base (M0 or MB): it includes cash (banknotes and conis) and accounts held by commercial banks at the central banks
2. M1: Money in the strict sense, it includes the currency in circulation and overnight deposits.
3. M2: it includes M1 plus deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months.
4. M3: it includes M2 plus: repos, money market fund units, money market instruments and non-share securities issued up to two years.

Question 17

The comercial banks

Definition and balance sheet

Answer 17

Banks are a type of financial intermediaries: they receive funds from individuals and companies, and make loans to other individuals and companies.
Banks keep some of the funds they receive as reserves . The reserves are partly in cash and partly in an account at the central bank.
* Balance sheet:
* Assets=Reserves+Loans+Bonds
* Liabilities= Deposits
* Net worth= Assets-Liabilities

Question 18

The banks: reasons for mantaining reserves

Answer 18

1. Cash inflows and outflows are not necessarily the same every day. They need to cover the money withdrawn by depositors.
2. Transactions between individuals from different banks generate the need to cover those payments.

These two reasons are voluntary.

3. Non-voluntary reason: forced by the monetary authority. Until January 2012, euro area banks had to hold a minimum of 2% of certain liabilities, mainly customers’ deposits, at their national central bank. Since then, this ratio has been lowered to 1%.

Question 19

Reserve ratio or reserve coefficient (rr or θ)

Answer 19

θ=Reserves (R) / Deposits (D)
It includes the minimum legal coefficient plus voluntary reserves.

Question 20

The comercial banks and money creation

Assume agents don’t hold cash

Answer 20

The total amount of money includes cash plus deposits (𝑀 = 𝐶 + 𝐷)
1. Banks recieve deposits (i.e. 100 m.u.). the reserve the estimated % (for example 10%= 10m.u. ) and the rest (90m.u.) they loan it.
2. Supose the one who loans the 90 m.u. buys goods. The seller of the good then deposits the 90m.u. in the same bank and they proceed to do the same 10% reserve and 90 % loan. Now the bank has a deposit of 100 and another one of 90 so total amount of money= 190€
3. Rinse and repeat.

The total money supply will increase by the sum of all deposits:
100 + 100 x 0,9 + 100 x 0,9^2 +100 x 0,9^3… = 100 x (0,9+0,9^2+…)
Calling D1 to the first deposit and θ the reserve ratio:
D1 x (1- θ) + (1- θ)^2 + … That converges to D1/θ

Question 21

Banks: Money multiplier

Answer 21

The money multiplier is the amount of money that the financial system generates for each euro of monetary base. The ratio **1/θ ** is called the money multiplier or bank multiplier (under the assumption that agents do not hold cash).

Since reserve ratio is ≤ 1 then bank multiplier (1/θ)≥1

Question 22

The comercial banks and money creation + Money multiplier

Assume agents hold a constant proportion of cash

Answer 22

For simplicity, we assumed in our example that agents did not keep any cash. Now we see what happens if agents keep a constant proportion of loans in cash: cr=C/D.
cr= cash ratio
Money supply (M):
* Legal cash (C)
* Deposits (D)
Monetary Base (MB):
* Reserve or bank reserves (R)
* Legal cash (C)

The bank multiplier is defined: m= M/MB → m= (C+D) / (C+R) common denominator D makes it → m= (C/D + D/D) / (C/D+R/D) simplifying:
→m=(cr+1) / (cr+θ)

Question 23

What are the central banks?

Answer 23

Central banks are in charge of the monetary policy: “the set of decisions and measures taken by the monetary authority of a country – or, as in the euro area, a monetary union – to influence the cost and availability of money in the economy.”
Central banks have different instruments to achieve their objectives. We highlight three general instruments: the purchase and sale of bonds in the so-called open market operations, the control of the discount rate, and the minimum reserve requirements

Question 24

Central banks instruments of monetary policy: Open market operations

Answer 24

Open market operations: A central bank can buy or sell securities, including government securities. They are called “open market” because the central banks do not buy securities directly from the government. Securities dealers compete on the open market.

• If the central bank buys securities, like government bonds, it deposits funds into the accounts of the sellers. This payment becomes part of the reserve balances of commercial banks, increasing the amount of funds that banks have available to lend. The central bank is injecting money into the economy and increasing the money supply. This injection of money puts downward pressure on the market interest rates, encouraging more borrowing by the different agents in the economy. Policymakers refer to this as “easing” or expansionary monetary policy.
• If the central bank sells securities, buyers pay with money from their accounts, reducing the amount of funds that banks have available to lend. The central bank is withdrawing money from the economy and decreasing the money supply, creating upward pressure on the interest rates, since banks have fewer reserves available to lend and will charge more to lend them. As the interest rate increases, agents are less likely to borrow and more likely to save. Policymakers call this “tightening” or contractionary monetary
  policy.

Question 25

Central banks instruments of monetary policy: Discount rate

Answer 25

the interest rate that the central bank charges on loans it makes to banks. The central bank sets the interest rate that credit institutions must pay to the central bank to obtain financing. This interest rate directly affects agents’ financing costs and the remuneration of savings.

• A decrease in the discount rate stimulates commercial banks to borrow from the central bank, their reserves increase, increasing the amount of funds that banks have available to lend. The central bank is injecting money thus increasing money supply.
• An increase in the reference interest rate discourages banks from borrowing, reducing bank reserves and the money supply

Question 26

Central banks instruments of monetary policy: Reserve requirements or reserve ratio

Answer 26

The central bank can modify the amount of money by changing the minimum reserve requirements (the amount of reserves that banks must maintain to support deposits ).
If the reserve ratio increases, banks have less capacity to create money, reducing the amount of money (contractionary monetary policy).

Question 27

Determination of the interest rate

Answer 27

The equilibrium in the money market occurs when the real supply of money (exogenous) is equal to the real demand for money (which depends on real income Y and the interest rate i):
𝑴𝒔/𝑷= 𝑳(𝒊, 𝒀)
Ms= Money supply (exogenous)

The equilibrium interest rate is the value for which the supply of money (which is independent of the interest rate: vertical line in the graph) is equal to the demand for money (which depends negatively on the interest rate: decreasing curve in the graph).

Question 28

Relation between money supply and interest rates

Answer 28

1. A decrease in the money supply leads to an increase in the equilibrium interest rate.
   
   • If money supply decreases, with the initial (low) interest rate, the public will want to get rid of bonds and increase the amount of money they own: there is excess demand for money and excess supply of bonds.
   • If there is an excess supply of bonds, there will be a decrease in the price of the bonds. The lower price of the bonds produces an increase in their return (the interest rate).
   • The quantity of money demanded falls until excess demand is completely eliminated and equilibrium is reached with a higher interest rate.
2. An increase in the money supply leads to a decrease in the equilibrium interest rate.
   
   • After an increase in the money supply, with the initial interest rate, there is an excess supply of money and an excess demand for bonds (the interest rate is temporarily very high).
   • If there is excess demand for bonds, there will be an increase in the price of bonds. The increase in the price of bonds produces a decrease in their return (the interest rate).
   • The quantity of money demanded will increase until the excess supply of money is completely eliminated, which is achieved with a lower equilibrium interest rate.

Question 29

The liquidity trap

Answer 29

There is a point in the demand for money (i over M graph type) in which i=0 at this point demand for money becomes a vertical line.

Question 30

Monetary neutrality

Answer 30

The irrelevance of monetary changes to explain real variables is called monetary neutrality or neutrality of money: money affects only the price level and not real variables.

Question 31

Quantity theory of money

Answer 31

a simple theory that argues that the amount of money available determines the price level and that the rate of growth in the amount of money available determines the rate of inflation.

Question 32

Velocity of money

Quantity theory of money

Answer 32

Speed at which money changes hands: the number of times the average euro is used in a given time period.
* Example: an economy only produces cars, 500 cars are produced per year and they are sold for 10 thousand euros each: the total value of the transactions in the economy is 500 x 10,000 = 5 million euros. Suppose the amount of money in the economy is 1 million euros. The velocity of money would be the total amount of transactions over the amount of money: 5 million euros/ 1 million euros = 5.
Agents in this economy spend 5 million euros a year, since there are 1 million euros available, each euro changes hands an average of 5 times a year.

P being the price level (GDP deflator), Y being real GDP and M being the amount of money, the velocity V is then:
𝑽 = (𝑷 × 𝒀)/M
The velocity of money is assumed to be constant (at least relatively).

Question 33

Quantitative equation of money

Answer 33

𝑽 x M= 𝑷 × 𝒀

To obtain the growth rates we divide the equation at t by the equation at t-1:
𝑴𝒕/𝑴𝒕−𝟏 = 𝑷𝒕/𝑷𝒕−𝟏 × 𝒀𝒕/𝒀𝒕−𝟏
𝑴𝒕/𝑴𝒕−𝟏= 1+m, m is the growth rate of money
𝑷𝒕/𝑷𝒕−𝟏= 1+π, π is the inflation rate
𝒀𝒕/𝒀𝒕−𝟏=1+g, g is the growth rate of real GDP

Then quantitavive equation in growth rate is
𝟏 + 𝒎 = (𝟏 + 𝝅) × (𝟏 + 𝒈)
For low values of g and π, we use the aproximation m=g+π

Question 34

Taylor’s rule

Answer 34

𝒊𝒕 = 𝒊 ∗ + 𝒂 𝝅𝒕 − 𝝅 ∗ − 𝒃(𝒖𝒕 − 𝒖𝒏)
𝜋𝑡 : current inflation rate; 𝜋∗: target inflation rate
𝑢𝑡: current unemployment rate; 𝑢𝑛: natural unemployment rate
𝑖∗: target nominal interest rate
𝑖𝑡: nominal interest rate that the central bank will set
Parameters a and b are both positive.