Chapter 37 - Money and interest rates Flashcards
What is money as a medium of exchange?
The function of money that enables transactions to take place
What is money as a store of value?
The function of money that enables it to be used for future transactions
What is money as a unit of account?
The function of money that allows the value of goods, services and other assets to be compared
What is money as a standard of deferred payment?
The function of money that allows contracts for payment at a future date to be agreed
What are the 4 roles of money?
1) a medium of exchange
2) a store of value
3) a unit of account
4) a standard of deferred payment
What are the characteristics of money?
- portability: money must be easy to carry
- divisibility: money needs to be readily divided into small parts in order to undertake transactions
- acceptability: money must be generally acceptable if it is to act as a medium of exchange
- scarcity: money cannot be in unlimited supply, nor should it be able to be counterfeited
- durability: money needs to be able to withstand wear and tear in use
- stability in value: the value of money must remain reasonably stable over time if money is to act as a store of value
What is liquidity?
The extent to which an asset can be converted in the short term and without the holder incurring a cost
How does liquidity work?
It may be possible to measure and monitor the quantity of legal money such as cash and banknotes, but other assets that also fulfil the functions of money, such as bank deposits and other financial assets, are less straightforward to observe. This helps to explain why it is difficult to measure and monitor the amount of money in the economy. These other assets have varying degrees of liquidity. Liquidity refers to the ease with which an asset can be converted into a form in which it can be used to undertake a transaction.
Cash and banknotes are the most liquid assets, as they can be used for transactions directly. Current (chequing) accounts are almost as liquid, but although savings accounts in banks may also be quite quickly converted to cash, there may be a time delay or a cost involved. Shares or government bonds are much less liquid, as it takes time to convert them into cash. Nonetheless, they are examples of several types of assets that can be regarded as being near-money. The central bank can control the quantities of some of these assets, but not all.
What is narrow money (M0)?
Notes and coins in circulation and as commercial banks’ deposits at the Bank of England
What is broad money (M4)?
M0 plus sterling wholesale and retail deposits with monetary financial institutions such as banks and building societies
What is the credit multiplier?
A process by which an increase in money supply can have a multiplied effect on the amount of credit in an economy
How does the credit multiplier work?
Think first of all about the way in which the money supply is created. This is not simply a question of controlling the amount of notes and coins the central bank issues. With so many different assets that act as near-money in a modern economy, the real picture is more complicated. The actions of the commercial banks also have implications for the size of money supply.
One of the reasons why it is difficult for a central bank to control the supply of money is the way that the commercial banks are able to create credit. Consider the way that commercial banks operate. They accept deposits from customers, and supply them with banking services. However, they also provide loans - and this is how they make profits. Suppose that the government undertakes a piece of expenditure and finances it by issuing money. The firms receiving the payment from the government are likely to bank the money they receive, so bank deposits increase. From the perspective of the commercial banks, they know it is unlikely that all their customers will want to withdraw their money simultaneously, so they will lend out some of the additional deposits to borrowers, who are likely to undertake expenditure on goods or services. As their expenditures work their way back into the banking system, the commercial banks will find they can lend out even more, and so the process continues. In other words, an increase in the amount of money in the economy has a multiplied effect on the amount of credit the banks create. This process is known as the credit multiplier.
The value of the multiplier is given by 1 divided by the cash ratio that the commercial banks decide to hold. The smaller is this ratio, the larger is the credit multiplier. If the commercial banks want to hold only 5% of their assets in the form of cash, then the credit multiplier will be 1/0.05 = 20.
The significance of this relationship is that changes in the supply of cash have a multiplied impact on the amount of credit in the economy. This makes monetary control through money supply a highly imprecise business, especially if the central bank does not know exactly what the commercial banks’ desired liquidity ratio is. In the past, one way that the monetary authorities tried to control money supply was to impose requirements on the proportion of assets that banks held in liquid form. However, this is also imprecise, as banks need not hold exactly the proportion required, in order to give themselves some leeway in the short run. This method of control was abandoned long ago, although the commercial banks are required to keep a small portion of their assets as cash at the Bank of England. This is purely for operational reasons.
What is the velocity of circulation (V)?
The rate at which money changes hands, the volume of transactions divided by money supply
What is the Fisher equation of exchange?
Specifies the relationship between money supply (M), the velocity of circulation (V), the price level (P) and real income (Y), namely MV = PY.
Equation: V = PY/M
How does the Fisher equation link to money and inflation?
This relationship suggests that prices can only increase persistently if money supply itself increases persistently, and that money (and prices) have no effect on real output.
To summarise, the analysis suggests that although a price rise can be triggered on either the supply side or the demand side of the macroeconomy, persistent inflation can arise only through persistent excessive growth in the money stock, which can be seen in terms of persistent movements of the aggregate demand curve.
How can we interpret this in terms of aggregate demand and aggregate supply? If the money supply increases, then firms and households in the economy find they have excess cash balances - that is, for the given price level they have stronger purchasing power than they had anticipated. Their impulse will therefore be to increase spending, which will cause the aggregate demand curve to move to the right. They will probably also save some of the excess, which will tend to result in lower interest rates - which then reinforces the increase in aggregate demand. However, as the AD curve moves to the right, the equilibrium price level will rise, and return the economy to equilibrium.
If money supply continues to increase, the process repeats itself, with price then rising persistently. One danger of this is that people get so accustomed to the process that they speed up their spending decisions, and this accelerates the whole process. Inflation could then accelerate out of control.
To summarise, the analysis suggests that persistent inflation can only arise through persistent excessive growth in the money stock, which can be seen in terms of persistent movements of the aggregate demand curve.
What is the evaluation of the Fisher equation?
Remember that the equation of exchange is a definition, and only becomes a theory if some assumptions are made. The strength of the theory therefore rests on the validity of those assumptions - namely, that the velocity of circulation is constant and that real output would always tend to the natural rate. This goes back to the debate between the neoclassical and Keynesian schools. The former argued that the economy would always return to equilibrium rapidly. The stability of the velocity of circulation is closely related to the stability of the demand for money relationship, and the monetarists thought this would be stable - if it existed at all. The Keynesians, on the other hand, did not believe that the economy would always return to equilibrium, and thought that the demand for money (and hence the velocity of circulation) could be quite volatile. Under these assumptions, the direct relationship between money and the price level would be broken.
Either way, the difficulty of identifying money supply makes it difficult to explore the real-world relationship between money and prices. The rapidity of technological progress in financial markets has complicated things even more.
What are the 3 motives for holding money?
- Transactions demand
- Precautionary demand
- Speculative demand
How does the transactions demand for money affect interest rates?
The first motive for holding money is clear - people and firms will hold money in order to undertake transactions. This is related to the need to use money when buying goods and services, and is closely associated with the functions of money as a medium of exchange and a unit of account. The demand for money for this purpose will mainly be determined by the level of income, because it is the level of income that will determine how many transactions people and firms will wish to undertake. The rate of interest (the opportunity cost of holding money) may be less important than income in this instance.
How does the precautionary demand for money affect interest rates?
People and firms may also hold money for precautionary reasons. They may wish to have liquid assets available in order to guard against a sudden need to cover an emergency payment, or to take advantage of a spending opportunity at some point in the future. The opportunity cost of holding money may come into play here, as if the return on financial assets is high, people may be less inclined to hold money in a relatively liquid form.
How does the speculative demand for money affect interest rates?
The rate of interest may affect the demand for money through another route. If share (or bond) prices are low (and the rate of interest paid is therefore high), then the opportunity cost of holding money is high, and people and firms will tend to hold shares. On the other hand, when the interest rate is low, and share prices are high, people will be more likely to hold money. This effect will be especially strong when people and firms see share prices as being unreasonably high, so that they expect them to fall. In this case, they may speculate by selling bonds in order to hold money, in anticipation of taking advantage of future expected falls in the price of bonds.
What is liquidity preference?
A theory that suggests people will desire to hold money as an asset
How does the liquidity preference for money affect interest rates?
If the interest rate may be regarded as being the opportunity cost of holding money, it can be argued that economic agents, whether households or firms, will display a demand for money, arising from the functions that money fulfils in a modern economy. This theory of liquidity preference, as it is known, was noted by Keynes in his General Theory. A graph illustrates what is implied for the money market. It is expected that the demand for money will be lower when the rate of interest rate is relatively high, as the opportunity cost of holding money is high. People will be more reluctant to forgo the rate of return that has to be sacrificed by holding money. When the rate of interest is relatively low, this will be less of a concern, so the demand for money will be relatively high. This suggests that the money demand curve (MD) will be downward sloping. If money supply is fixed at M* in the graph, then the money market will be in equilibrium at the rate of interest r *.
The existence of this relationship means that the monetary authorities have to be aware of the need to maintain (or allow) equilibrium in the money market. Interest rates and money supply cannot be fixed independently. This is a clear constraint on the use of monetary policy. An important question is the extent to which the demand for money is stable. If money demand were to be volatile, moving around from one time period to the next, then it would be virtually impossible for the monetary authorities to have any precise control over the market. The situation is further complicated by the way that interest rates influence behaviour. The degree to which the demand for money is sensitive to the rate of interest will also be important. This will be reflected in the shape of the MD curve. Notice that because the level of income is also important in determining money demand, this will affect the position of the MD curve in the diagram. An increase in income will lead to a rightward shift in money demand, as people and firms will require larger money holdings when incomes are higher.
What is the market for loanable funds?
The notion that households will be influenced by the rate of interest in making saving decisions, which will then determine the quantity of loanable funds available for firms to borrow for investment
How does the market for loanable funds affect interest rates?
Although the rate of interest can be interpreted as being the opportunity cost of holding money, this is not the only way of viewing it. From a firm’s point of view, it may be seen as the cost of borrowing. For example, suppose that a firm is considering undertaking an investment project. The rate of interest represents the cost of borrowing the funds needed in order to finance the investment. The higher the rate of interest is, the less will investment projects be seen as being profitable. If the firm is intending to finance its investment from past profits, the interest rate is still pertinent, as it then represents the return that the firm could obtain by purchasing a financial asset instead of undertaking the investment. Either way, the rate of interest is important in the decision-making process.
The rate of interest is also important to households, to whom it may represent the return on saving. Households may be encouraged to save more if the return on their saving is relatively high, whereas when the rate of interest is low, the incentive to save is correspondingly low. Within the circular flow of income, expenditure and output, it is the flow of saving from households that enables firms to obtain the funds needed for their investment expenditure. It is now apparent that the rate of interest may play an important role in bringing together these flows.
The market for loanable funds is shown in graph. The investment schedule is shown as downward sloping, because firms will find more investment projects to be worthwhile when the rate of interest rate is low. The savings schedule is shown to be upward sloping because a higher rate of interest is expected to encourage households to supply more saving. In other words, the supply of loanable funds will be higher when the rate of interest rate is relatively high.
Keynes believed that this could lead to instability in financial markets. He argued that investment and saving would be relatively insensitive to the rate of interest, such that the schedules in the graph would be relatively steep. Investment would depend more crucially on firms’ expectations about the future demand for their products, which could be volatile, moving the investment schedule around and so leading to instability in the rate of interest. Keynes therefore came to the conclusion that governments should manage aggregate demand in order to stabilise the economy.
