Monetarism Flashcards
Definition Fiscal policy
- Budget Policy
- revenue
- expenses
- Ministry of finance
Definition Monetary Policy
- Managing Liquidity
- Quantitative supply
- interest rate
Are fiscal and monetary policy independent?
- nowadays in OECD countries strict independence
- earlier days Central Bank part of ministry of finance
What is the standard neoclassical theory?
- “play with price-qty-diagram”
- coordinates supply and demand
- when i rises -> higher quantity of money on market and lower demand
- inflation 2% –> nominal interest 2%, real interest 0%
- Real inflation determined by market
What is monetarism?
- Milton Freedman
- difference of money economy and real economy
- if money supply increase more than adequate
- no impact on real market
- consequence = separation of central bank and fiscal policy
- not manipulation of price AND qty, only of price
- nowadays dichotomy not as strict as in 1968
What is the interbank rate?
- short term interest rate
- heavily influenced by central banks base rate
- minimum interest rate commercial banks must pay for borrowing from central bank
What is the task of the central bank?
- provides commercial banks with liquidity
- cash
- scriptural money
- this liquidity also called “Zentralbankgeld”
- Viewpoint Commercial Bank: borrow from CB or other CommB
- Viewpoint System: all borrow from CB
What are the 4 main assumptions of monetarism?
- Long term real interest rate on capital markets is stable
- Nominal interest rate on capital market depends on interbank rate.
- Interbank rate determined by CB’s liquidity management, assumption (2) indicates that CB’s monetary policy has impact on capital markets’ nominal interest rate.
- CommB’s demand for liquidity: interest rate elasticity > 0 –> changes in interbank rate alter quantity of liquidity CommB’s hold.
- CommB aim: maximising profits –> all liquidity borrowed from the CB = lending to non banks. CB is able to manage the quantity of money non banks have for buying products (money supply / Geldmenge) by increasing/decreasing liquidity on the Interbank Market.
What is the assumtion of monetarism regarding reserves?
- CommB aim = maximising profits –> all liquidity borrowed = lending to non banks. –> CommB do not hold any reserves voluntarily
- CB requires a minimum reserve the CommB must hold (a minimum quantity of liquidity that the CommB are not permitted to lend to non banks).
- “normal/krisenfreien times”: CommB’s reserves consist of minimum reserves only.
- financial crisis (like 1929/1933 and 2008-2018 ), CommB’s are afraid of insolvency, and, therefore, might keep reserves voluntarily in addition to the minimum reserves –> excess reserves
CommB’s reserves=minimum reserve+excess reserve
What is the definition of money supply/Geldmenge?
[1/reserve rate(min)]* Liquidity
Reserve rate und Liquidity under CB control
What is the nominal GDP
GDP(real)*Price
- nominal GDP= Amount of money needed –> Money demand
What is the connection between price level and money supply?
- Money Demand: the lower the purchasing power the more money is needed (curve from top left to bottom right)
- The more Products are bought the more money is needed (shift of curve to right)
- If CB decides that Money supply=X, then vertical through money demand curve: Market equilibrium at intersection
- As GDP real is increasing then money demand goes up -> shift of curve to right.
- If money supply X stays the same than the meeting point will be higher than before –> meaning higher purchasing power–> deflation
What is the conclusion of the connection between price level and money supply?
- CB increases money supply as much as longterm average GDP grows –> stable prices
- CB increases more –> prices go up = inflation
- CB increases less –> prices go down = deflation
- true as long as money multiplier (1/r×)L mit r=m+e (minimum and excess reserves) und e=0
- To fight inflation –> decrease money supply (higher interest rate)
- to fight deflation –> increase money supply (lower interest rate)
- Wenn CB ohne Mengenanpassung Leitzins ohne Mengenanpassung erhöht, dann ist dieser losgelöst vom Gleichgewicht
- man kann Inflation auch nur über Geldmenge steuern aber nicht umgekehrt
What is the fischersche quantitätsgleichung?
Quantity of money “M”* Velocity of circulation “V”=GDP(Real)* Price level “r”
- Assumptions:
- M=1/(m+e)*L mit e=0
- V= changes very slowly and changes are foreseeable
- GDP(real): CB ignores shortterm fluctuations, therefore GDPreal can be replaced with long-term average of GDPreal
- average depends on input quantity of production factors and productivity
- Changes in M have no impact on long term average growth of GDP -> always results in change of price level
- FINAL: CB can determine Price level via Money suppy
Why do we challenge monetarism?
- after Financial crisis 2008 no clear correlation of Money supply M3 and Euro-Area inflation
- Inflation not only determined by money supply but during covid e.g. also by restrictions in restaurants etc.
What is core inflation?
- Core-Inflation: part of inflation that can be influenced by CB
- influence that is excluded: Energy, Tobacco, Alcohol, (non-processed) food
What is the development of capital market interest?
long-term-downwards trend
What are the four reasongs for the longterm downwards trend of interest rate on capital market?
- emerging markets and OPEC conutries:
- newly rich who invest outside own country
- real estate: arab capital in Mainz-Winterhagen; russian Capital in London
- Money market paper: chinese major shareholder Geely in Daimler; russian capital in cyprus banking sector; flight of richt Latin americans in Dollar bonds
- OECD: huge sums inherited, capital not invested in business but rather in capital and real estate markets
- private savings becoming a necessary supplement to statutory pension provision in Europe
–> Capital quantity increases regardless of interest rate - New economy essentially services only -> less capital needed to get started and nearly no additional capital after inital investment
- “secular stagnation”
-> regardless of interest rate, demand of capital decreases
- “secular stagnation”
What is the conclusion for the influence of CB on interest rate longterm on capital market?
- long-term trend towards lower interest rate has nothing to do with central Bank policy
- if only CB hailed for interest rate discussion –> theory turns to ideology
