Exam 2 Flashcards
Classical Gold Standard
Countries pegged their currencies to gold
What did WW1 do
Imposed massive fiscal burden on participating countries. Lots of deficit spending
Most countries stopped gold redeemability, essentially making their notes (fiat)
Monetary expansion resulted in bursts of inflation
Inflationary finance
Gold Exchange Standard
Monetary system under which a nation’s currency may be converted into bills of exchange drawn on a country whose currency is convertible into gold at a stable rate of exchange.
Less need for large domestic gold reserves
Precursor to Bretton Woods Monetary System
Bretton Woods
European Countries fixed their countries to the US dollar
The US dollar was redeemable in gold
Hence, a gold-exchange standard
Some capital controls
Problems with Bretton Woods
`At the end of WW2 US output accounted for nearly half of world output.
The US exported heavily to Europe and a lot of US dollars flowed overseas in the Marshall plan.
By the 1970’s, many European central banks held large reserves of USD.
Many began to question the potential of a “run” on the Treasury, where they would ask dollars to be redeemed for gold.
US expansionary fiscal and monetary policy during the Vietnam war only worsened the outlook.
By the time Nixon closed the gold window, it was readily apparent that the US could not have been ready to redeem even a fraction of foreign held dollars for gold.
Post-Bretton Woods
Developed countries tend to let their exchange rates float
Developing countries tend to fix their currencies to a premier currency (Dollar, Euro, Pound).
There is also a good deal of intermediate regimes
Dirty floats
Crawling pegs with bands
Costs and Benefits of Floating exchange rate
control of monetary policy, currency attacks less likely, more day to-day uncertainty, immunization from foreign shocks
Costs and Benefits of Fixed exchange rate
partial control of inflation, currency attacks, less day-to-day exchange rate uncertainty, “excessive” disturbances
Different degrees of “Fixed”
-Floating
-Intermediate regimes
Dirty float
Fixed with crawling pegs
Fixed with bands
-Fixed
Currency Board
Currency Union/Dollarization
Integration
Concerns towards integration lead to a fixed exchange rate regime
Lower transactions costs and more trade
Similarity
Concerns regarding similarity push toward floating exchange rates
If economic shocks are asymmetric, countries want policy flexibility to deal with it
Integration Benefits
Economic integration: growth of market linkages in goods, capital, and labor markets among regions and countries.
Lower transaction costs, a fixed exchange rate might promote integration and hence increase economic efficiency.
More integration = more volume of transactions between the two countries (or geographic areas)
More integration -> efficiency benefits of a fixed exchange rate increase.
Illustration: There is more trade between Washington and Oregon, than between Washington and British Columbia (Canada).
Integration Costs
If the region (i.e. the two countries) face different shocks: fixed exchange rate can be costly.
Example: Black Wednesday
Germany wanted tight monetary policy to offset a boom, but UK did not because they did not have the same shock.
If shocks are asymmetric, fixed exchange rates can amplify output shocks
First Generation Currency Crisis models
These models show that a speculative attack on a fixed exchange rate regime can occur due to the rational expectations of investors and arbitrageurs.
This is due to excessive deficit financing, often with central bank credit
Investors will hold the currency as long as the peg is deemed credible. Once they believe that the central bank will no longer defend the peg (at some point in the future) they run.
Central bank loses reserves and is forced to abandon the peg. The domestic currency floats.
Fiscal Dominance
Fiscal dominance serves as one mechanism which propagates first generation currency crises.
Without independence, the fiscal authority can force the central bank to directly finance new debt issue from the treasury.
Inflationary finance and seigniorage
Implication of fiscal dominance
First generation crises are often caused by fiscal/monetary policies that are inconsistent with maintaining fixed exchange rates.
Second Generation Models of Currency Crises
Occurs when a government is pursuing a fixed exchange rate regime concurrently with another policy goal (normally boosting output/employment).P
Problem of contingent commitment
The public knows that the government of weighs the costs and benefits of maintaining a fixed exchange rate.
Investors know that there are conditions which could force the government to abandon the peg.
Potential for multiple equilibria
Loanable Funds Theory of Interest Rates
Wicksellian natural interest rate: The rate that leads to a stable price level
Interest above the natural rate= contraction and deflation
Interest below the natural rate = expansion and inflation
This means that the interest rate affects the price level but isn’t determined by it.
Keynesian liquidity preference theory for interest rates
Interest is a result of money demand/supply
Purely monetary phenomenon
In classical economics the interest rate was determined solely by
the confluence of savings and investment
Higher savings, lower interest rate
Higher demand for investment, higher interest rate
Irvin Fisher interest rate theory
Interest coordinates markets intertemporally
Fisher: Interest theory is relative price theory
-“The rate of interest expresses a price in the exchange between present and future goods.”
-However, money plays no role in Fisherian interest theory (intertemporal barter only)
-The interest rate reflects the relative scarcity of present and future goods, and productive possibilities
Liquidity Preference
The rate of interest rises with the demand for money, and falls with the supply of money
Interest is a reward for parting with liquidity
No role in coordinating markets intertemporally
Since money demand/supply can be managed, no natural rate of interest either.
Can be managed by CB to be whatever rate is deemed desirable
Time Preference
the future is discounted relative to the present.
That is, future goods are discounted subjectively, relative to present goods
Subjective Time Preference
People have varying levels of time preference
High-time preference
present wants dominate
Low-time preference
willing to delay present gratification and tend to future wants
Meaning of Time Preference
An individual is more willing to trade for future goods when present goods are relatively abundant relative to claims for future goods
Loanable Funds Framework
Savings = households’ supply of present goods net of consumption (Fisherian)
Change the units from goods into monetary funds, and “present goods” become “loanable funds”
Investment is firm’s demand for present goods
The supply of LF comes from real savings and additions to the stream of money
The market interest rate equates the current supply and demand for “loanable funds”.
Meaning present funds offered in exchange for claims to future funds
Supply of LF = demand for claims
Demand for LF = supply of claims
Demanders of Loanable Funds
Firms: Borrow to invest, Increased eagerness to invest shifts DLF out. Ditto for better investment opportunities
Government: Governments are net borrowers, Treasuries no longer hold treasure
Both entities are net sellers of claims: Stock and bonds issues
Suppliers of Lf
Households: Subtract borrowing (consumption) and dissaving households, This implies that an increased demand to hold money shifts the LF suppy curve to the left, while a reduction in desired money balances shifts it to the right
Central Banks:New money created through open market purchases comes on the market as additional demand for bonds (shifts SLf to the right). Open market sales (QT) do the opposite
A one-shot increase in the MS
1) SR (Liquidity Effect): An increase in the money supply shifts out the Slf curve, reducing the nominal interest rate R
1a) Assume the nominal interest rate equals the real rate since inflation is zero at this point
2) LR (nominal income effect): The increase in the money supply causes Dlf to shift out
2a) High M leads to higher nominal income (Y) and price level (P)
2b) At higher P, firms demand to borrow more dollars to finance the same production
2c) Input and output prices have risen
2d) Real dollars borrowed are the same as before
3) The nominal income effect restores R to its original level
Effects under an increased M growth rate
1) Liquidity effect: Gradually rising M gradually shifts out Slf curve, reducing R1
2) Nominal income: Pushes R back up and P and Y rise, shifting out Dlf
3)The inflation expectations effect:
3a) This occurs once a higher inflation rate is expected
3b) Lenders demand an inflation premium, raising R above the original R0
3c) To lend/borrow the same number of real dollars
3d) The inflation premium compensates for the loan being paid back in dollars with reduced purchasing power
Wicksell’s Natural Rate
Short-term real interest rates can vary from the LR natural rate, due to monetary disturbances.
LR neutrality
Recall, if market rates are below the natural rate, economic boom (output, prices up)
If market rates are above the natural rate (output, prices down)
Austrian Theory of Business Cycle (ABCT)
Utilizes Wicksell’s concept of the natural interest rate
Increases in the money supply and the provision of cheap credit undertaken by central banks temporarily lowers the real rate of interest
Results of the Austrian Theory of Business Cycle
Economic boom that gives way to a bust
Risk Premia
Default risk
Risk that you lend to an entity that can’t pay you back.
-Bank loans
-Government bonds
-CD’s and banking panic
Inflation/Interest Rate Risk
In order to shore up a constant return: The risk of inflation/interest fluctuations must be priced into interest rates
Gold standard and thicker bond markets.
Inflation
increase in the general level of prices
Hyperinflation
when inflation reaches an very high level
Costs of inflation
Shoe-leather Coats, Menu Costs, Complicates Financial Planning, unpredictability of relative prices, rigid tax laws, unexpected inflation makes consequences of contracts unpredictable
Shoe-leather Costs
the time and effort spent to minimize the effects of inflation on the eroding purchasing power of money.
Menu Costs
the transaction costs of changing menu prices in response to inflation.
How do unexpected inflation makes consequences of contracts unpredictable?
Redistributes from debtors to creditors and hurts people on fixed pensions
Causes of hyperinflation
Hyperinflation happens through excessive growth in the money supply.
Typically initiated to finance government debt.
Hyperinflation causes tax revenue to fall, as there is a delay between time taxes are issued and the time tax revenue is received.
Thus, there is a greater need for the gov’t to finance the debt by increasing the money supply.
Deadly Downward Spiral Ensues!!
Consequences of hyperinflation
Menu prices become incredibly large.
Extreme inconvenience and shoe-leather costs.
Hyperinflation could decrease revenue due to lags between the issuing of taxes and the retrieval of tax revenue.
Relative prices are distorted, affecting the ability to reflect relative scarcity.
Currency ceases to function, as barter becomes more feasible as a means of exchange.
Quantity theory and meaning
MV=PT
𝑀 is the quantity of money, and 𝑉 is the transactions velocity of money per period of time, so 𝑀𝑉 is also the number of dollars exchanged in a year.
𝑇 represents the amount of transactions per period of time, and 𝑃 represents the price of a transaction, so 𝑃𝑇 represents the number of dollars exchanged in a year.
This relationship is an identity, which is true BY DEFINITION.
Quantity Theory transitioning from Transactions to Income
MV=PY
𝑌 refers to total income (output), and 𝑃𝑌 refers to the dollar amount of output.
𝑉 now refers to the income velocity of money, or the amount of times a dollar bill enters someone’s income in a given period of time.
By definition: V= P *Y/M
Currency (C)
is defined as the amount of paper money and coins in circulation in the economy
M1 before May 2020
M1 money stock = 𝐶 PLUS…
Demand deposits at commercial banks (i.e., funds that people hold in checking accounts)
excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions.
Traveler’s checks (antique before ATMs)
Other checkable deposits (OCDs)
Consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, share draft accounts at credit unions, and demand deposits at thrift institutions
M2 before may 2020
M2 money stock = 𝑀1 PLUS…
Savings deposits (including money market deposit accounts)
Small-denomination time deposits (time deposits less than $100,000)
Balances in retail money market funds (MMFs)
M1 after 2020
savings deposits not considered in both M1 and M2
thus
M1=C+demand deposits at commercial banks+traveler’s checks+other checkable deposits+saving deposits
Y=
Y=nominal aggregate income = annual money expenditure on final goods (GDP, GNP etc.) in $ per year
By combining the P’s and y’s Y=
Y=Py
Where P is an index of prices in $ per basket
y= an index of real output in baskets/year
Normalize to one basket at base year prices
National income accounts do this when they calculate real GDP by using base-year prices paired with the current year’s output quantities.
Measures of P
CPI and GDP deflator
The Quantity Theory of Money
- Take equation of exchange, PLUS some assumptions:
-Assume that velocity is constant (𝑉=𝑉̅; %∆𝑉=0)
-This is a simplification, but this is a USEFUL simplification.
-It means that the dollar amount of an economy’s output (𝑃𝑌) is ONLY affected by the money supply (𝑀). - The desired ratio of money balances to income (M/Py) is determined by real factors, independent of the nominal quantity of money, except for the transitory effects of money growth.
Marshall worked with k = M/Py
Fisher with V = Py/M - Real income is determined by real factors independent of the nominal quantity of money (long-run neutrality), barring transitory short-run effects that money might have on income.
Results of QTM
- Exogenous changes in the level of M cause endogenous (equilibrating) changes in the price level.
- The price level is proportional to the nominal quantity of money, ceteris paribus
- Money is neutral in the long run
It cannot permanently change V or y
i.e. M only affects nominal variables in the long-run, not real variables
Nominal Variables
Measured in current $
Without reference to the purchasing power of the dollar
Ex) Price level, nominal income (Py), nominal money stock (M)
Real Variables
Measured in “real” or “constant” dollars of defined purchasing power, or in non-monetary units.
Ex) Real income (y), real money stock (m), unemployment rate
Money Balances
Serve as a buffer stock (think inventory) that are useful since we live in a world of positive transaction costs.
With income, we let money balances rise within some range
With purchases, we let money balances fall within some range
We do this instead of immediately offsetting purchases or sales to maintain our exact amount of desired MB
Nominal Quantity of Money (M)
Dollars, pounds, Euros
Real Quantity of Money (m)
Expressed in purchasing power
Real money balances relative to real income can be expressed as how much income is being held (M/Py or m/y)
Assuming MV is fixed what is the relationship between Y and P?
if Y increase , P decrease , and vice versa.
Real supply shocks affect scarcity, and therefore prices.
Assumning Py is fixed what is the relationship between M and V
if M increase, V decrease, and vice versa.
If more money is introduced to the economy, the speed at which individual units circulate will decline.
Nominal Income Targeting
-Offset changes in V with changes in M, to maintain stable Py (nominal income
i.e. Velocity increases as the economy re-opens during Covid, contract M.
-Allow changes in y to to manifest in P changes, to reflect
Real income falls while the economy is shut-down, allow prices to rise.
Demand to hold money
the desired average level of nominal money balances
Phi desired M/Py is a function of
Real income or wealth
- if the quantity of money needed to serve the buffer stock role doesn’t increase with income
+ in shopping-time models of money demand
These models take the time costs of “shopping” or engaging in consumption into account.
Higher real money balances reduces the time or costs associated with shopping
Higher income = more consumption = more shopping time = higher real money balances
Opportunity costs: interest rates on alternative assets (-)
Pecuniary interest yield on money deposits (+)
Transaction costs of moving in and out of higher-yielding assets (+)
Payment technology factors
Simplified real money demand:
Y is “scale”, r is “opportunity cost”
How sensitive is money demand to changes in the interest rate?
Demand deposits:
-If the interest on deposit accounts moves with interest yields on substitute assets, such as short-term time deposits, bonds, or money market mutual funds, then perhaps hardly at all.
-However, some policies reduce interest yields on checkable deposits
-Increasing reserve requirements
Increases banks demand for M0 instead of deposits
-Regulation
Due to “Regulation Q”, commercial banks were banned from paying interest on demand deposit accounts from 1933-2011.
Cash:
Currency pays no interest and therefore has a 0% rate of return.
Therefore, paper currency will be much more interest-sensitive
Role of the Central Bank
1.Banker’s bank
2.Monopoly of note issue
3.Regulator of commercial banks
4.Lender of last resort
5.Monetary policy
Whenever a bank receives some amount of money from a saver, it could so two things…
The bank could lend the money out to borrowers, who are seeking money from the bank.
The bank could deposit the money in a reserve for the saver.
The bank could initiate one of two reserve policies…
100-percent reserve banking (i.e., 0% of the deposit is lent out to others)
Fractional reserve banking (i.e., some non-zero percentage of the deposit is lent out to others)
With fractional reserve banking, there exists some
financial intermediation (the process of transferring money from savers to borrowers)
Monetary Base (B)
is the total amount of money held by the public as currency (𝐶) and by the banks as reserves (𝑅) such that 𝐵=𝐶+𝑅. The monetary base is directly controlled by the Federal Reserve.
The monetary base is directly controlled by who?
The federal reserve
The reserve-deposit ratio (𝑟𝑟)
is the fraction of deposits (𝐷) that banks hold in reserve (i.e., 𝑟𝑟=𝑅/𝐷). It is determined by business policies of banks and the laws regulating banks.
The currency-deposit ratio (𝑐𝑟)
is the amount of currency (𝐶) people hold as a fraction of their holdings of demand deposits (𝐷; i.e., 𝑐𝑟=𝐶/𝐷)
Formula for money multiple (m)
m = (cr+1)/(cr+rr)
Conclusions from the model of money supply
(1) The monetary base (𝐵) is proportional to the money supply (𝑀), and grows by the same percentage rate.
(2) As the reserve-deposit ratio (𝑟𝑟) decreases, the more loans banks make, and the more money banks create from every dollar of reserves. Therefore, a decrease in 𝑟𝑟 INCREASES 𝑚 and 𝑀.
(3) As the currency-deposit ratio (𝑐𝑟) decreases, the fewer dollars of the monetary base the public holds as currency, the more base dollars banks hold as reserves and the more money banks can create. Thus, a decrease in 𝑐𝑟 INCREASES 𝑚 and 𝑀.
Tightening or contractionary Monetary Policy
Increases the policy rate FFR and IOR
If using OMO, quantitative tightening
Increases market interest rate
Reduces the money supply
Easing or Expansionary Monetary Policy
Lowers the policy rate (FFR) and IOR
If using OMO, quantitative easing
Lowers market interest rates
Increases the money supply
Whats on the Fed’s Balance Sheet
Assets: Securities, loans to financial institutions
Liabilities: currency in circulation, reserves
What two ways can the Fed influence the money supply (M)
Influencing the monetary base and influencing the reserve-deposit ratio
Ways of influencing the monetary base
(𝐵; recall 𝐵↑⇒𝑀↑)
Open market operations, lender of last resort, discount rate
Ways of influencing the reserve-deposit ratio
(𝑟𝑟; recall 𝑟𝑟↑⇒𝑚,𝑀↓)
reserve requirements and interest on reserves
Open Market Operations
(𝐵; recall 𝐵↑⇒𝑀↑)
Buying bonds -> “selling” currency -> 𝐵 increases.
Selling bonds -> “buying” currency -> B decreases
Discount Rate
(interest rate the Fed charges on loans)
If the rate falls, it’s cheaper for banks to borrow from the Fed, so 𝐵 increases.
Reserve Requirements
(banks have to have a minimum reserve amount)
An increase in requirements tends to increase 𝑟𝑟, but is less effective when banks hold excess reserves.
Interest on Reserves
(paid to banks for holding reserves)
If the rate rises, it’s more beneficial for banks to hold reserves, so 𝑟𝑟 increases.
FDIC Insurance
The Federal Deposit Insurance Corporation (FDIC) protects deposits up to $250,000 when a bank fails.
It is intended to preserve public confidence in the banking system.
Therefore, mitigates large swings of the currency-deposit ratio (𝑐𝑟), and allow the Fed to have more control over the money supply.
Moral Hazard of FDIC Insurance
Bail out insolvent savings and loans institutions (1980s and early 90s)
Moral Hazard.
As the likelihood of being bailed out for risky behavior increases, the cost of engaging in risky behavior decreases.
Instrument Independence
A central bank is given a task or goal to pursue but is allowed to achieve that goal in whatever manner it sees fit.
That is, the central bank can use any monetary policy tool, or combination of tools to achieve it.
Seems to be intuitively a good thing
I.e. Central banks should know better which levers to pull to achieve a given policy outcome, in comparison to politicians.
Goal Independence
The central bank is free to choose what monetary policy goals it pursues
Activist or stabilization policy
Rule-based monetary policy
Choice of rule and implementation
Benefits of Goal Independence
A central bank with goal independence is ostensibly immune to pressure from the government or treasury
Without goal independence, this pressure often results (especially in developing countries) in the central bank being forced to directly finance government deficits
Inflationary finance
Currency, debt, and banking crises
Being immune to political pressures has benefits
Costs of Goal Independence
Political economy
Lack of political accountability
A central bank with goal independence is a technocratic institution
It runs afoul of basic democratic notions regarding citizens in a representative democracy being able to directly/indirectly choose government policy.
Public choice considerations
Central banks hire loads of economists. If constrained to the enforcement/implementation of a simple monetary policy rule, the payroll could be decimated.
The fact that inflation generates seigniorage presents an eternal conflict of interest
And the Fed doesn’t send 100% of seigniorage revenue back to the treasury
Fedwatching industry
Time Inconsistency
