Theories Of Financial Crisis - Austrian And Monetarist Flashcards
Role of money
Holding money makes transactions easier because it can be traded against anything at any time with anyone - generalised purchasing power
Holding money has opp cost = optimisation problem: cost of holding one additional unit of money balances has to be equal to the benefits of holding it
Individuals are interested in real (not nominal) money balances (RMB= M/P)
Monetary expansion
Assume after individual chosen optimal RMB, gov decides to increase money supply: agents now hold more money than planned
People will exchange their excess money balances for goods and thus money prices will increase.
On other hand, increase in prices will lead to reduction of real money balances
When monetary policy creates too much money relative to real growth there will be inflation and RMB decrease
Quantity theory of money
PY=MV
Logs to each side - lnP + lnY = lnM + lnV
Differentiating - changeP/P + changeY/Y = changeM/M + changeV/V
Money printing and inflation
Assume velocity of money is constant, then change V/V = 0
And inflation =changeM/M - changeY/Y
This shows that inflation is given by the gap between the rate of growth of the quantity of money and the rate of growth of real output
If rate of growth of real output doesn’t change then an increase in money growth raises inflation
When there is inflation, real value of money balances decreases. Opposite occurs when growth of quantity of money is less than growth of economy = deflation
Real cash balance effect
The more nominal cash balances the Gov is creating (monetary expansion) the less real cash balances agents wish to hold, because money isn’t performing its function well and is losing value
Means money creation can’t stimulate the economy, but can make economic activities less efficient
Redistributive effects of money creation
When banks create credits, this increase simultaneously its assets and its liabilities
However the effects of money creation aren’t same on public: those who borrow first obtain a gain in purchasing power (because general level of prices hasn’t increased yet)
Those who don’t borrow at some point will see an equivalent decrease RMB
Money creation creates uncertainty given unpredictability of the change in structure of prices
Different monetary policy rules: Keynesian
M policy can have +ve effect: monetary expansion leads to lower interest rates which stimulate investment, this stimulates total demand and hence production
However liquidity trap rests on assumption that economic agents are irrational : in fact when interest rates are very low (people want to save instead of spending and investing), this should stimulate investment
But Keynes is assuming (but not proving) in elasticity of investment to low interest rates
Different monetary policy rules: monetarists
Showed that Phillips curve (inverse relationship inflation and unemployment) can only exist in SR, because eventually agents realise that rise in wages = monetary illusion
Gov increases even more inflation rate but this eventually destroys the price signalling mechanism and confidence in money
Thus best rule is for monetary authorities to announce low and credible rate of growth of quantity of money and act consistently
Different monetary policy rules: Taylor’s rule
Prescribes inflation rate target. 2%
i = r(dash)+ (pie) + 0.5y. + 0.5(pie-pie dash)
i= interest rate set by central bank ; r dash = equilibrium real short rate; pie = rate of inflation ; pie dash = targeted inflation rate and y. = gap between observed and potential output
–> central bank real interest rate r= i+pie must be greater than real equilibrium rate, r dash if GDP,exceeds its potential ie Y>0 and or inflation rate is above target ie pie>pie dash
Taylor set both r dash and pie dash at 2%
Problems with Taylor rule
Implies continual loss in purchasing power of money
Prices don’t increase uniformly: price of assets, raw materials, houses increase first, whereas consumption goods increase with a lag.
But the latter are mainly used to measure inflation
Thus the latter is underestimated when targeted by central banks
For this reason targeting growth of quantity of money (preferably at 0%) instead of rate of inflation is better
Different monetary policy rules: market monetarism
Sumner recently proposed to replace targeting inflation with targeting nominal GDP
However this approach will create even more inflationary pressures than Taylor’s rule
Reduce RMB but not solve problems of real economy
When instability of output is due to real shocks (eg increase taxation) thus can’t be solved by monetary policy which would increase inflation and taxation (via inflation tax)
If a shock is due to monetary policy, then the solution would be to maintain low and stable money growth and not higher inflation
Different monetary policy rules: Austrians
Cyclical fluctuations determined by distorted signals caused by monetary expansion, via artificially low interest rates
Money creation lowers interest rates
Lower interest rates induce investors to borrow more to invest more and factors of production are shifted from production of consumer goods to production of producer goods
However this doesn’t correspond to desire of consumers because is a consequence of distorted price signals
This mismatch leads to ‘malinvestment’ which can’t last for long. When monetary authorities try to stop it by raising interest rates, LT projects must be discontinues and crisis begins
Calvo (2013) has applied this theory to recent BOP crises, showing why credit booms tend to precede financial crises and sudden stops
Money creation and exchange rate
ER= price of one currency in terms of another
LR- change in ER reflects difference in inflation rate between 2 countries. Because under no arbitrage, price of a given basket of goods in real terms should be same across world
With flexible ER, m policy is independent, whereas under fixed rates its interdependent
Decision on inflation in 1 country will affect other counties. When inflation raises in country A, if there are fixed ER, then country A will lose competitiveness
Effects of devaluation
Devaluation not always best solution
If debt is denominated in domestic currency, the increase in prices will reduce burden of debt (favours private debtors and gov) and harm creditors who were promised a certain nominal interest (when inflation was low)
This will raise borrowing costs in future as people won’t trust gov any longer
If debt is denominated in foreign currency, devaluation may make debt repayment unsustainable
Thus devaluation only work flexible rates if it reflects loss of competitiveness of a country and to allow for an improvement of current account
But entails reduction in real wages which shouldn’t be counteracted by raising inflation
US and Japan
FED had pursued expansionary monetary policy since 2008 = caused nominal GDP grow 4% since 2010, but not helped real economic recovery
Japan 1990s - adopted restrictive m policy but decrease in growth rates of nominal GDP been parallel to decrease in money growth rates. Thus rather than deflation there was price stability
Japan pursued active fiscal policy 90s with huge budget deficits between 2% and 10% of GDP causing debt/GDo ratio close 240%
If Japan was in a liquidity trap and Keynesian theory worked, then japan should have exited from stagnation thanks to activist f policy. But this has completely failed
