Quiz 2 Flashcards
Classical political economy
- individuals are rational (self-interest)
- economies tend to operate at full capacity
- markets and price system as allocators of resources (relative prices)
- long-term economic growth
- A. Smith, J. B-. Say, D. Ricardo, T. Malthus
Currency vs Banking school time period
1825-1844
Currency school key players
Lord Overstone
Robert Torrens
George Warde Norman
Banking school key players
John Fullarton
Thomas Tooke
John Stuart Mill
Bullionists
- currency school
- Quantity theory and price specie flow
Antibullionists
- Banking School
- Law of reflux and real bills doctrine
Quantity theory
In its simplest form, it states that if the amount of money in circulation increases, while everything else remains constant, then prices will rise. Conversely, if the money supply decreases, prices will fall.
- Proportionality: prices vary in proportion to changes in quantity of money
- Causality: money supply causes change in price level, not vice versa
- neutrality: changes in money supply do not lead to changes in real economic variables
- Price level: only changes in money supply cause disturbances in price level (in long run)
- exogeneity: money supply is fixed
Price-Specie Flow: X>Y
inflow of gold–>inflation–>Y>X (domestic goods relatively more expensive)–> X=Y
Price-Specie Flow: Y>X
outflow of gold–>deflation–>X>Y (domestic goods relatively cheaper) –> X=Y
Long run price-specie flow
- automatic self-correction of BoT
- quantity of gold ( and circulating medium) determined by needs of circulation
Real Bills Doctrine
Paper money overissue is impossible as long as banks make loans representing claims to real goods in the production process, and will not cause inflation.
Law of Reflux
Excess notes would return to banks
Real Bills Doctrine and Law of Reflux
Not the same, but both challenge the validity of transmission mechanism propounded by quantity theory
Currency school arguments
- based on price-specie flow, any outflow or inflow of gold (species) resulted in a corresponding decrease or increase in quantity of currency
- gold needs to match amount of paper currency, amount of money in circulation needed to match amount of gold reserves
Banking school arguments
- besides gold and paper money, things like bank deposits and bills of exchange should also be considered part of the currency. These operated in the economy similarly to banknotes and gold coins.
-changes in the amount of gold hoarded might not always lead to changes in the amount of currency in circulation. - limiting the amount of banknotes in circulation wouldn’t be enough to ensure that the amount of currency matched the country’s gold reserves. They argued that controlling the hoarding of gold and the amount of deposits in banks was also necessary to achieve this balance.
Currency school policy
- rules-based approach based upon QTM. Stability raised from currency principle
- mixed currency should be made to operate as would purely metallic currency i. e.
making sure every issue of banknotes is 100% backed by gold for currency to keep
its value
Banking school policy
- discretionary approach through law of reflux. Stability arises from Banking principle
- control of deposits and regulation of note issue were impossible and undesirable. Amount of paper money in circulation adequately controlled by competitive banking, and under convertibility, could not exceed needs of business for long time. So long as there is confidence for acceptability of banknotes, market will operate smoothly.
Conclusion of Banking vs Currency school debate
- Currency school won the DEBATE (1844 Peel’s Act)
- gave exclusive note-issuing powers to BoE i.e., monopoly over issuance of notes
– banknotes issue 100% backed by gold reserves to avoid inflation
– separation between banking department and issue department (in charge of convertibility between gold and banknotes)
– Failed to guarantee stability given that in 1857 and 1866 convertibility was halted to prevent exhaustion of BoE gold reserves - monetarism derives from currency school
why banking school won ARGUMENT
money supply is endogenous
– Credit is demand constrained - if there are no borrowers, banks do not lend
– Anyone can issue monetary or credit instrument, problem is getting it accepted
– Instruments which are not money at some particular moment could be so at some other moment
– Banking school approach to credit creation is how financial system operates
Fed uses its control of money to…
…influence expansion of credit
Feds job is to balance:
elasticity and discipline in the monetary system as a way of controlling flow of credit
Lender of last resort
In banking, LLR is a role usually taken on by the central bank during times of panic in the fractional reserve banking system. Its job is to reassure people by promising to provide whatever money is needed to prevent a crisis, either by letting banks borrow easily (with a high-interest rate) or by injecting money into the system through asset purchases.
Thronton’s View
BoE’s responsibility in time of panic is to serve as LLR, providing liquidity to market and discounting freely paper of all solvent banks …
* but denying aid to insolvent banks no matter how large or important
Bagehot’s view
LLR consists of four principles:
* Lend, but at a penalty rate: “Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.” (Bagehot 1873)
* Make clear in advance BoE’s readiness to lend freely
* Accommodate anyone with good collateral
* Prevent illiquid but solvent banks from failing
Bagehot’s Principle Unclear
- Not stating clearly when central bank should intervene
- Not giving specific guidelines to distinguish between sound and unsound banks
- Not realizing that provision of LLR facility to individual banks would encourage them to take greater risks ☞ moral hazard!
Feds epic failure
The Fed didn’t act effectively during 1929-33. If they had done things like buying and selling securities in the market during 1930-31, they could have prevented many bank failures and stopped a big drop in the amount of money available.
Narrow view of Lender of Last Resort
Definition: According to this view, the central bank, acting as the lender of last resort (LLR), should not support financially unsound borrowers.
Duty of the Lender: The central bank’s main duty is to prevent panics from spreading to healthy institutions, rather than bailing out unhealthy ones.
Encouraging Responsibility: Allowing insolvent banks to fail is seen as important to discourage excessive risk-taking by financial institutions.
Broader View of LLR
Definition: In this perspective, the central bank sees itself as responsible for the stability of the entire financial system.
LLR’s Responsibility: The LLR’s duty is to safeguard the overall financial system, rather than focusing solely on specific institutions.
Purpose of LLR: The LLR’s role isn’t just to prevent crises, but to minimize the impact of financial shocks when they occur.
Confidence and Support: Any bank failure, especially a significant one, can erode confidence in the financial system. Therefore, supporting insolvent banks, even temporarily, may be necessary to maintain stability.
Public Authority’s Role in LLR
- Prevention of Panics: Authorities adhering to the principles of Thornton and Bagehot can avert banking panics.
- Public Responsibility: The function of lender of last resort (LLR) must be fulfilled by a public authority.
- Central Bank Preferred: It’s preferable for the LLR function to be carried out by the central bank.
Derivative context
- Risk Management Concerns: Financial institution managers became increasingly focused on reducing risk to protect their assets.
- Role of Financial Innovation: Financial innovation emerged as a solution, introducing new assets designed to manage risk more effectively.
- Introduction of Financial Derivatives: These new assets, known as financial derivatives, have payoffs linked to previously issued securities and are highly beneficial in risk management strategies.
If derivatives are open to abuse, why do they exist?
They can be used as insurance (allowing traders to transfer risk to another party)
What is a derivative?
Characteristics: A derivative is a financial instrument whose value is tied to the value of another financial instrument, known as the underlying asset.
Zero-Sum Game: In derivative transactions, one person’s loss always corresponds to another person’s gain. It’s akin to two individuals playing poker.
Risk Transfer: Derivatives enable the buying and selling of risk. The primary purpose is to transfer risk from one entity to another, whether it’s an individual or a firm.
What is an option?
Options are agreements between two parties: the seller, also known as the option writer, and the buyer, referred to as the option holder.
- Option writers take on obligations, while option holders obtain rights.
The option seller is the ____ and the option buyer is the ____
- option writer
- option holder
Call option
Right (not obligation) to buy given quantity of underlying asset at predetermined price (strike price or exercise price), on or before specific date
call option phrases
- Whenever underlying asset price above strike
price of call option, exercising option is profitable
for holder, option is in the money - if underlying asset price equals strike price, option
is at the money - If strike price exceeds market price of underlying
asset, option is out of the money
Put option
Right (but not the obligation) to sell underlying asset at
predetermined price on or before fixed date. Again, writer is obliged to buy shares should holder choose to exercise option
Put option phrases
- Because buyer of put obtains right to sell stock, put is in the money when option’s strike price above market price
- It is out of the money when strike price is below market price
American options
can be exercised on any date from time they are written until day they expire
- As a result, prior to expiration date, holder has three
choices: (1) continue to hold option, (2) sell it to
someone else, or (3) exercise it immediately
European options
can be exercised only on day they expire
- Thus, prior to expiration date, holder of has two
choices: hold or sell
Who buys and sells options?
Hedging Reminder: A hedger is essentially buying insurance.
Call Option Buyers: Individuals who plan to purchase an asset (like a bond or stock) in the future buy call options. This ensures that the cost of buying the asset will not rise beyond a certain price.
Put Option Buyers: Individuals who plan to sell an asset in the future buy put options. This ensures that the price at which the asset can be sold will not decrease below a certain price.
exercising options as insurance
Think of the relationship between a driver and an insurance company.
The call option can only be exercised if the car is damaged in an accident before the insurance policy expires.
2 Parts of Option Price
- value of the option of it is exeerciesed immediately (intrsitic value)
- Fee paid for potential benefit from buying the option (time value)
option price =intristic value + time value
Value of any financial instrument depends on four attributes:
- Size of promised payment,
- timing of payment,
- likelihood that payment will be made
-circumstances under which payment will be
made
Money =
Currency + checkable deposits
Monetary base =
Currency + reserves
reserves =
requires reserves + excess reserves
Currency =
Final money equation
