Week 4 (1) Flashcards
Influences on Markets
What is the Quantity Theory of Money?
M = the amount of money in an economy
V = the velocity of money – the number of times money
circulates around the economy over a specified period
P = the average price level of goods, services and assets
Q = the volume of goods, services and assets
produced/transacted
According to the Quantity Theory of Money, if the money
supply doubled, it would not necessarily make people
better off unless it was accompanied by an increase in
the volume of goods, services and assets produced. A
doubling of the money supply would likely lead to a
doubling of prices.
What is a fiat currency?
A fiat currency is one
without any intrinsic value.
What was the Bretton Woods Agreement?
On 15 August 1971, the US officially terminated the
convertibility of the US Dollar into gold, thereby making
the US Dollar a fiat currency.
This brought to an end the
Bretton Woods agreement for the management of
international monetary regimes established at the end of
World War II, whereby internationally currencies, not
backed by gold, could be converted into US Dollars,
which was convertible into gold.
The Bretton Woods agreement was a quasi-gold
standard. Before Bretton Woods, the gold standard was
in operation whereby international currencies were
mostly convertible into gold.
Since 1971, the money of most countries does not have
any intrinsic value. Historically in such regimes the
money eventually became worthless as governments
began to print increasing amounts of it. As Voltaire put it,
“Paper money eventually returns to its intrinsic value”.
What is Broad Money?
Broad money (M3) is defined by the OECD as currency,
deposits with an agreed maturity of up to two years,
deposits redeemable at notice of up to three months and
repurchase agreements, money market fund
shares/units and debt securities up to two years.
The graph shows that money supply in most developed
countries has increased at a significant rate since the
end of Bretton Woods.
What is Quantitative Easing?
- The central bank prints new money.
- It uses the money to purchase assets – mainly bonds
and corporate bonds but also equities (purchases may
be made indirectly by buying ETFs of the relevant
assets). - This causes asset prices to rise in each of these
markets – and bond yields to fall.
Ripple Effects of QE
- There will then be further ripple effects:
- The bond investors who sold bonds typically will want
to hold other assets in their place so will buy corporate
bonds and/or other assets – in turn pushing their
prices up. - The corporate bond investors who sold to the bond
investors will typically want to hold other assets so
they will buy other assets, e.g. equities. - Speculators will likely purchase bonds, corporate bonds
and other assets in anticipation of the increased demand
for these assets and the consequent price increases.
Corporates will likely want to take advantage of the low
corporate bond yields and issue more bonds. This will
partially offset the price rises in the corporate bond
market. In some cases, the proceeds of the bond sale
may be used to buy back their shares; this will further
exacerbate the price increases in the equity markets.
QE impact on Asset Prices
Quantitative Easing is likely to cause asset price inflation
as the central bank’s purchases of bonds (and/or other
assets) pushes up bond prices (and/or other asset
prices), which then causes a ripple of asset price
increases in other asset markets as the sellers of the
bonds look to buy other assets to replace them, and
these sellers in turn look to buy replacing assets.
Speculation will further add to the asset price inflation.
QE Impact on Wealth and Economic Inequity
Asset owners will see their wealth increase– causing a
wealth effect. Those with no assets will see no gains –
and will be relatively worse off having not participated in
the windfall. The overall result is likely to be an increase
in economic inequality.
QE impact on Economic Growth
Economic growth is likely to increase due to the wealth
effect. Those who receive wealth gains will have higher
purchasing power and when these gains are spent the
economic activity created should also mean increased
employment. The impact will mostly be in areas with a
higher concentration of asset owners. Those without
assets will gain from seeing more jobs being created, as
money ‘trickles down’ to them. Overall, the impact is
unlikely to be significant and also possibly transitory if the
asset prices revert to their mean levels in time.
QE Impact on Price Inflation
Retail price inflation rates are likely to stay low. Less
wealthy people will not see any significant gains from
QE. Indeed, retail price inflation may even fall or turn into
deflation, as the relatively less well-off may be worse off,
meaning average demand for a normal basket of goods
may fall, leading to lower prices.
QE impact on Wages
Nominal wages should see small and marginal gains.
The economic growth impact is unlikely to be very
significant – so the demand-pull effect will be small. Most
of the increase in employment is likely to be in the
service industry to service those with greater levels of
wealth. These jobs are often poorly paid.
Real wage increases may only be very small due to low
inflation, however due to increased asset prices the
purchasing power of those real wages may be
considerably lower.
QE Impact on Bank Lending
Banks will have more cash from selling bonds to the
central banks, so banks will have the potential to lend
more. However, they will only lend more to those who
they think will be able to repay the loans – and these will
mostly likely be those who have greater levels of assets
as they become wealthier.
Also, low interest rates – as caused or maintained by QE
– have a detrimental impact on banks’ lending margins,
which dampens the overall willingness of banks to lend.
Risks arriving from QE
QE is likely to lead to significant bubbles in asset markets.
Low interest rates mean that future equity earnings will be
discounted using very low interest rates. As these move
towards zero, theoretical equity prices move to infinity. If
asset prices are overvalued due to the impact of QE, then
future expected asset return assumptions are likely to be
much lower than historical data. QE is also likely to impact
corporate finance decisions, meaning otherwise poor
projects will get finance as they show profitability using the
low interest rates, even though they might not show
profitability under normal interest rates.
Aims of Regulation
- Correct market inefficiencies and to promote efficient
and orderly markets. - Protect consumers of financial products.
- Maintain confidence in the financial system.
- Help reduce financial crime.
