LECTURE NOTES II
THE MONEY SECTOR OF THE ECONOMY
Chpts 12,13,14 of Waud
FLOW OF FUNDS ANALYSIS:
=======================
Money market flow variables vs. Real goods and services
markets flow variables:
National income accounting looks into the real sector
of the economy, and matches the Keynesian theoretical
framework. Flow of funds analysis looks into the money
sector of the economy. The two must at all times match.
According to Walras's Law, the aggregated excess
demand function of the real sector of the economy is
identically equal to that of the monetary-financial system.
The two systems are therefore identical, and it should be
possible to derive the real sector from the financial
sector. That is precisely what we do, and this is known as
the flow of funds analysis.
See Juttner: 67 + notes
Transactions:
-----------Transactions are of two types: financial and non-financial.
Financial transactions are considered as part of I
(investment: in this case, portfolio investment),
Out of the non-financial transactions, all expenditures on
current account are part of C (consumption) and all
expenditures on capital account are investment (I).
Read Juttner: 71 + 85 carefully.
----------------------------------------------------------Twin Deficits Problem:
---------------------This is the deficit both in the government spending,
G-T, (public sector deficit) as well as the current account
deficit, X-M.
See:Kearney/MacDonald:207
FINANCIAL SYSTEM
AND FINANCIAL INTERMEDIARIES
Surplus units:
Economic agents for whom receipts are higher than
expenditures are called surplus units, savers, or ultimate
lenders. Let these units earn Ys (income) and consume Cs.
Then their saving, Ss is equal to Ys - Cs. Now, some of
these savings are invested (Is) and the rest remain as
surplus, i.e., Ss = Is + surplus.
Deficit units:
Those who spend in excess of what they receive are
called deficit units, dissavers, or ultimate borrowers. The
savings of the deficit units is: Yd - Cd = Sd. Now, deficit
units invest more than they save. Therefore, Sd + deficit =
Id.
For the economy as a whole,
Ss + Sd + deficit = Is + Id + surplus
Now, in a closed economy, the surplus and deficit cancel
out, since they equal each other. Therefore, we are left
with Ss + Sd = Is + Id, or S = I
----------------------------------------------------------ROLE OF FINANCIAL INTERMEDIARIES IN THE SYSTEM:
What do the households do with their surplus, and how
do corporations and governments finance their deficits?
-
financial instruments are created to evidence the
transfer of funds from one sector to the other.
These are financial claims. These can be in the
form of notes, bills, bonds, debentures, shares,
etc.
-
To the household the financial claim consitututes
a financial asset. To the corporation/ govt. the
claim consists of a financial liability.
We see that:
surplus = net lending = change in net financial assets
= change in net credit
deficit = net borrowing = change in net fiancial
liabilities
= change in net debt
We are interested in NET figures, not gross, since some
households may be also borrowing, while corporations may be
saving. The net surplus at the macroeconomic level is what
counts.
Ex post savings equal ex post investment:
This is important. People may plan for much higher
expenditure than they ultimately do. They are forced (see
Juttner:13) to save so that ex post savings equal ex post
investment.
Why do households save and corporations invest?
-
most investment requires a minimum size of the
project, which a household cannot match.
-
households do not have the expertise to produce;
rather they are better at saving.
FINANCIAL INSTITUTIONS HAVE EMERGED TO ALLOW SAVERS TO
INTERACT WITH INVESTORS.
-----------------------------------------------------------
FINANCIAL INTERMEDIATION AND MONETARY CONSTITUTION
Financial system: comprises of
---------------borrowers,
lenders and
financial intermediaries.
This can be split into:
individuals,
firms,
institutions,
government agencies,
financial instruments,
financial services,
financial markets
conventions,
rules and regulations.
Interaction between financial institutions:
-----------------------------------------See excellent chart, P.26: Juttner
Place of the financial system in the economy:
--------------------------------------------There are the following main financial areas in the
economy:
1.
2.
3.
4.
Financial intermediaries
Nonfinancial private sector
Government and Reserve Bank
Rest of the world
Kinds of intermediaries:
-----------------------1.
Banks (savings and trading banks)
In 1980, there were 18 banking groups operating
in Australia. At the end of 1987, there were 34.
The 4 major banks are: ANZ, Commonwealth,
National Australia and Westpac. Prior to January,
1990, there was a distinction between trading and
savings banks.
Ultimate lenders acquire financial claims on
banks: demand deposits (ALSO CALLED current
deposits/ chequing accounts), fixed deposits,
savings deposits, CDs (certificates of deposit).
Banks use these "loanable funds" to lend to
borrowers, in exchange for primary securities.
2.
NBFIs (permanent building societies, merchant
banks, finance companies, life offices, money
market corporations)
In this case, the ultimate lender receives shares
of the building societies, debentures of
financial unions, etc.
Over the last two decades, the distinction between
bank and non-bank financial intermediaries has tended
to get blurred.
Interaction between BFIs and NBFIs: There is a huge
daily transaction between these two groups of
financial intermediaries, to the tune of about $35
billion in 1990 in Australia itself.
There has been a greater growth in the financial
intermediaries in the past 15 years than the growth in
GDP. (Juttner:24)
Process of transfer of funds:
---------------------------The transfer of funds from surplus to deficit units
may be facilitated with the aid of direct or indirect
financial securities.
i)
Direct financing: In this case the lender receives
primary securities. These are:
Treasury notes and bonds
bank bills,
promissory notes,
debentures,
corporate notes and bonds,
intercompany loans,
shares.
Most of these securities are sold by the borrowers in
the open market. Hence this is called auction market
debt.
ii)
Indirect financing:
In this, the lenders lend to the financial
intermediaries, who in turn lend ot the borrowers.
This is often preferred by the households.
Why have financial intermediaries grown so rapidly?
===================================================
1.
Financial intermediaries satisfy portfolio preferences
of lenders and borrowers: For the lenders, they
diversify the portfolio, particularly, the credit/
default risk. For the borrowers, they offer a much
wider choice of (tailor-made) credit than the ultimate
lender would have been able to provide. They get more
choice in maturity, size of loan, interest rates.
2.
Cost advantages: There is cost involved in a borrower
locating a lender, in the lender getting information
on the borrower. FIs specialise in these tasks.
3.
Risk
reduction:
Particularly
(diversification acts as a hedge).
4.
Liquidity intermediation: The lenders are able to
withdraw their funds when required, at a small cost.
5.
Government regulation: These include: Banking Act,
capital
adequacy
reqmts.,
reserve
reqmts.,
regulations
regarding
investment,
auditing
and
examinations, lender of last resort privilege. These
enhance the image of FIs in the eyes of the lenders.
for
the
lender
Further, there has been a more rapid expansion of
unregulated FIs compared with regulated FIs. These
(unregulated) FIs compensate the depositors for the
higher risk with higher rates of return.
Two theories of financial intermediation:
----------------------------------------Dowd and Lewis: Ch.3
Old theory:
This holds that the services offered by financial
intermediaries is primarily the transformation of assets.
New theory:
i)
It isolates three types of financial itermediaties:
broker, mutual fund and deposit-taking intermediary.
ii)
Financial
intermediaries
actively
manage
their
porfolios through the application of resources to
reduce costs.
iii) Financial intermediaries play a more important role in
developing economies than in developed ones.
KEY ISSUES TO BE DISCUSSED IN THIS COURSE:
-----------------------------------------STABILITY OF THE FINANCIAL SYSTEM
==================================
Throughout the centuries up to this day the greatest
concern to both economists and responsible politicians has
been the control of the means of payment and the related
question of the stability of the price level. The system
has to:
1.
allow the quantity of money in circulation to
rise or fall in line with the growth in the
output of goods and services;
(Monetary policy)
2.
provide in a situation of general crisis in the
financial system a lender of last resort facility
for designated insitutions;
(Lender of Last resort and financial crises)
3.
ensure enforcement of financial contracts and
inspire confidence in the integrity and soundness
of financial institutions, especially those that
participate in the creation of the means of
payment.
(Regulations)
POINTS FOR THE PRUDENTIAL POLICY LECTURE:
---------------------------------------A.
MONETARY CONSTITUTION
Def: The sum of all controls and regulations on the
financial system forms the monetary constitution of an
economy.
Reasons for its existence include:
i)
To ensure the safety of individual banks and the
stability of the system (Fractional reserve system)
ii)
To prevent inflation: excessive creation of financial
instruments can lead to inflation. Thus, govt.
controls
the
instruments.
creation
of
certain
financial
iii) To prevent cheating: Many instruments could be used by
dishonest FIs to cheat the customers (by not paying
them
when
they
mature).
This
requires
close
supervision by the govt.
----------------------------------------------------------KINDS OF REGULATIONS: (Capital adequacy requirements)
(A) Primary reserves requirements:
1.
NCD (Non-callable deposits): ONE PER CENT
The SRD (Statutory Reserve Deposit) was phased out in
1988 and replaced by NCD reqmt.
Under this, trading
and savings banks have to hold 1 per cent of their
liabilities (excluding shareholders' funds) in the
form of NCDs with the Reserve Bank. The balances in
this account are not available to banks in a crisis.
2.
RWA (Risk-Weighted Assets): EIGHT PER CENT
Australian banks now have to hold 8 per cent of their
risk-weighted assets in capital. (see Juttner:44)
(B)
Secondary reserve reqmt:
1.
PAR (Prime Asset Ratio): SIX PER CENT
Banks now have to hold a fixed minimum percentage (6
per cent) of their total liabilities
(except
shareholder's funds) which are invested in Australian
dollar assets within Australia in the form of
prescribed assets, comprised of notes and coin,
balances with the Reserve Bank, Treasury notes, other
Commonwealth government securities and certain loans
to AMMDs.
MONETARY POLICY:
===============
STABILISATION OF MONEY GROWTH AND PRICES:
========================================
Two methods have been used to do this.
1.
External stabilisation:
Gold standard: (1870-1914) This was the most strict system,
wherein if a the amount of money in a country
increased, leading to increase in its price level, it
was forced to ship out gold to other countries to
match its balance of payments deficit. The classical
gold standard ensured that (1) money supply is
strictly linked to the growth rate of the economy, and
(2) automatic adjustment mechanism is there to
eliminate balance of payments disequilibria.
Foreign exchange rates play a major role in the prices
in an economy. If the exchange rate depreciates, the
prices go up. Therefore, when considering control of
prices, external factors play a significant role,
apart from domestic money supply.
Till Keynes came on the scene, monetary policy was
involved in maintaining the gold standard. This
ensured
that
domestic
prices
and
incomes
were
controlled in relation to an external standard. This
standard later on changed into the US dollar (gold
exchange standard) under the Bretton Woods system.
This was the period of external stabilisation.
Domestic money supply and interest rates were not the
chief concern.
2.
Internal stabilisation:
The fall of the gold standard in 1914 saw the introduction
of various "managed" monetary standards. Under this
system, the central bank of each country controls the
amount of currency in circulation as well as the
quantity of bank deposits. A central bank is essential
to this process.
But the system broke down ultimately, in the early
1970s. The US stopped convertibility of the US dollar
into gold in Nixon's time. This resulted in most
countries
seeking
internal
stabilisation
of
the
economy. The chief method adopted was monetary growth
targets, or targeting.
Money targeting in Australia
commenced in 1976. M3 was targeted. In the 1980s,
however,
various
factors
combined
(such
as
deregalation) to produce a de-emphasis on monetary
targets, and there has been some drift back towards
fixed exchange rates, e.g., the UK entered the ERM in
1990 (only to leave it in 1992, recently. In
Australia, targeting was abandoned in 1985.
3.
Combination of the two:
Since the last two decades, the ability to control
liquidity in the economy has been eroded by the
process of financial innovation. Such innovations
create
highly
liquid
near-money
titles
and
revolutionise the payments system. At the beginning of
1985, deregulation and financial innovations forced
the monetary authorities to abandon monetary targeting
because they were unable to assess properly ongoing
changes in the financial system. Therefore, from 1986,
a check-list approach has been adopted in Australia,
which is "discretionary", and includes, inter alia,
the exchange rate as one of the checklist items, apart
from monetary aggregates, interest rates, inflation,
etc. This has meant a combination of external as well
as internal stabilisation. The economies are becoming
more globally entwined, and there is no alternative
but to have an increasing combination of external
stabilisation in the future.
FINANCIAL INNOVATION:
===================
1.
2.
3.
REASONS FOR GROWTH OF FIN. INNOVATION:
1.
Increase in risk and uncertainty in financial
markets in 1970s and 1980s.
2.
Deregulation of financial markets:
3.
Technological factors: computers and
telecommunications.
MIROECONOMIC IMPLICATIONS
1.
Markets are not considered particularly efficient
now
2.
Rational expectations have become more important
now, with attempts to have forward looking
expectations.
3.
Market specialisation and competition: Banks are
now either wholesale or retail banks.
EXAMPLES OF FINANCIAL INNOVATION
1.
2.
3.
4.
5.
Forward contracts
Foreign currency options
Currency futures markets
Currency swaps
Invoicing strategy
6.
4.
Money market hedge
MACROECONOMIC IMPLICATIONS:
1.
Breakdown in the traditional transmission
mechanism: see seminar notes p.2.
2.
Changes in the income velocity of money
3.
instability of monetary aggregates
4.
loss of macroeconomic policy instruments such as
quantitative lending guidelines, SRD etc.
The sequencing problem:
5.
There is a difference of opinion on the sequence
of financial deregulation. According to one view,
anti-inflationery policy should have preceded
financial deregulation. This would have prevented
recession.
6.
In particular, the AUD fell in value
WEALTH
Definition:
There is no accepted definition of wealth. Wealth is a
stock variable (not a flow variable, like GDP). Most of
wealth comprises items that have been produced in the past
and not consumed, destroyed or otherwise used up. It can be
broadly broken up into human and non-human wealth. Nonhuman wealth has been variously analysed. One method
includes:
residential land + buildings
household durables
rural wealth
privately owned capital stock
Australian ownership of foreign stock
non-official domestic holding of govt. securities
base money (paper money/coins + bank reserves at RBA).
Base money is only 1.5% of this wealth.
In Australia, it has been estimated that GDP is
approximately 3.5 per cent of total wealth. Thus, wealth
has a huge dimension. In 1985 this amounted to about $800
billion.
To the above measure of private wealth, the following
need to be added:
-
public buildings and structures (capital stock
owned by the public sector)
-
land and subsoil assets of government
-
net foreign debt has to be subtracted from this.
Other forms of wealth need to be included, but there
are difficulties in this:
i.
works of arts and antiques
ii. known mineral resources
iii. human capital.
National wealth clearly does not coincide with the sum
of personal wealth.
What about shares, debentures?
----------------------------Shares, debentures, deposit accounts in financial
institutions, etc., are excluded, since these have
already been counted while calculating the capital
stock of the private sector. After all, these are all
claims on the existing stock. They do not constitute
wealth on their own.
What about paper money?
---------------------Base money:
This comprises paper money (notes), coins, and bank
reserves at RBA. This constitutes non-interest bearing
claims against the central government which are not
offset by corresponding private liabilities. Hence it
is part of wealth.
Flight from money: During a period of serious
financial upheaval with rampant inflation, legal
tender is often repudiated by private agents, who
prefer to hold real assets instead.
What about bonds? (Ricardian equivalence)
----------------Debt Neutrality:
---------------Are government bonds net wealth?
Simply put, this argument alleges that debt fianancing
(bonds) and the levying of taxes are essentially the
same; the issuance of government bonds amounts to the
imposition of deferred taxes, as bonds have to be
serviced and eventually repaid.
If Ricardian equivalence holds, then bonds do not form
part of wealth. Government bonds represent both an
asset and a liability of the same value. The Ricardian
Equivalence Theorem, which is a hypothesis, states
that taxes and public debt are equivalent methods of
financing government expenditure. (p.61, Juttner)
Implication: An increase in financial assets may not
contribute to an increase in net worth.
However, FISCAL ILLUSION is generally assumed to take
place, according to which, the private sector ignores
the future tax liability, and thus the bonds
constitute a part of wealth.
MONEY SUPPLY
============
Definitions:
============
Until 1984 there were three definitions of money
supply in Australia:
1.
M1:
------This included only current deposits at trading banks.
M1 now includes some deposits that were formerly
current deposits at savings banks.
M1 =
C + D
where C = currency, D = demand deposits
Notes and coin C: Only about 8.5% of M3 comprises
notes and coins in Australia. Currency in circulation
displays strong but predictable seasonal fluctuations,
e.g., in Christmas/ weekly/ fortnightly fluctuations.
Note: cash holdings of the RBA and government are
not included, since, theoretically, the RBA can
print as much currency as it wants, while the
Treasury can mint as much coin as it wants to.
Unissued currency is an asset of the RBA, whereas
the currency in circulation is a liability of the
RBA.
Demand or current deposits D:
Since Aug., 1984, Australian banks have been
allowed to pay interest on current deposits.
2.
M2:
------Existed at that time, and was equal to M1 plus other
trading bank deposits. M2 IS NOW DEFUNCT, since there
is no longer any distinction between trading and
savings banks.
3.
M3:
--------
equals M2 plus all savings bank deposits. M3 IS ALSO
called the VOLUME OF MONEY by the RBA. It is also
commonly known as the MONEY STOCK.
M3 =
C + D + F + S
Here, F is fixed/ time deposits and S is savings
deposits. S comprises:
current deposit accounts
investment accounts
statements savings accounts
passbook accounts
certificates of deposit
Following the decision as of 1.8.84, that private
savings banks could also offer cheque accounts, two
more definitions were created:
How is M3 created?
-----------------MONEY SUPPLY MODEL:(applicable in all cases)
This
-
comprises:
monetary base (in this case, B3),
money multiplier (m3) and
volume of money M3 (Not velocity)
M3 = m3 x B3
Therefore,
C + D + F + S = m3 (C + R)
Here, B3 = C + R (this is a reduced version of B3 as
defined below)
Now,
Currency to deposit ratio: k
k =
C
--------D + F + S
Reserve ratio: s
s =
R
---------D + F + S
Therefore, dividing the above eqn. on multipier, by
D + F + S, we get:
k + 1
m3 = -----k + s
This is the money multiplier formula.
Thus there are 3 influences on the stock of money:
i)
currency-to-deposit ratio
ii) reserve ratio
iii) base money
Usually, i) and ii) remain fairly stable, and the
change in monetary base is regarded as the major
source of growth of the money stock.
Liquidity:
--------Def: An asset held by the non-bank
liquidity if it can be turned
interval with minimum risk of
nominal sum of currency fixed
public possesses
within a given time
loss into a
in advance.
non-bank public - time interval - minimum risk of loss
- sum of currency fixed in advance.
An asset achieves liquidity through efficient markets.
if the spreads in these markets are large, the assets
become relatively less liquid.
Near money:
Financial assets which are very close
in the liquidity continuum to money, broadly defined,
are sometimes known as near-money titles.
4.
Money (or Cash) Base - THE HIGH POWERED MONEY:
---------------------------------------------------
It comprises the private sector's holdings of notes
and coins plus the deposits of the private sector with
the RBA.
B = C + R + OR
where B = money base, C = currency in the hands of the
public, R = bank reserves, OR = other reserves of
NBFIs.
where
R = NCD + CD + VC
(NCD = non-callable deposits, CD = callable deposits,
VC = vault cash)
Therefore, B3 =
C + (NCD + CD + VC) + OR
where B3 is the monetary base relating to the volume
of money.
USES OF B:
--------By definition, B is put to the following uses:C, R, OR
SOURCES OF B:
------------see Juttner:98-100
From where is B generated?
1.
Reserve Bank credit:
a)
Holdings of securities (GSRB)
b)
Loans, advances, etc. (RBL)
2.
Gold and Foreign Exchange (GFEX)
3.
Coins on issue
Less:
4.
Capital and reserves of RBA + NCD
5.
Other liabilities (O),
including Treasury deposits at RBA
5.
Broad Money: This comprises M3 plus deposits with
specified non-bank financial institutions. M3
comprises about 60% of broad money.These NBFIs are (in
order of importance):
-
money market corporations
finance companies
permanent building societies
credit co-operatives
cash management trusts
AMMDs
general financiers
pastoral finance companies
Growth of money aggregates in Australia in last 10 years:
--------------------------------------------------------Since 1990, approximately, there has been a sharp slow down
in the growth of the broad indicators of money, viz., M3
and broad money. In addition, credit has slowed down
considerably
(except
the
housing
sector).
M1
has
surprisingly picked up rapidly in the same period.
Explanation:
1.
Broad aggregates:
Demand factors:
i)
Decline in aggregate spending
ii) borrowers reducting their gearing and retiring
debt + going in for equity.
Supply factor:there have been major bad debts and
write offs particularly in intermediaries, making
the lenders conservative in giving loans
However, it appears that the demand factors have been
the major factors in this slow-down.
2.
Narrow aggregates:
i)
There have been various administrative and tax
changes since Jan. 1990. e.g., requirement to
report transactions over $10,000 to the Cash
Transaction Reports Agency; more stringent
identification required to open accounts in
banks. This has led to increased demand for
money.
ii)
shocks resulting from the failures of many NBFIs.
People have tended to convert deposits into
money.
iii) Fall in interest rates: this has led to increase
in demand for money.
iv)
Technical
changes
during
1991:
banks
have
developed
cheque-linked
savings
accounts
facilities, leading to a re-classification of
such deposits. These have increased M1.
Though in the past, increase in M1 has always arisen
on account of greater investment, this time, it is probably
due to the above factors, and not due to increasing
investment.
Money supply and inflation:
Juttner 92 (diagram). This seems to confirm the claim of
the quantity theory of money that excessive increases in
the money supply (i.e., the expansion of liquidity beyond
the requirements of the real growth of the economy) have
been inflationary.
-----------------------------------------------------------
OPEN MARKET OPERATIONS AND CASH RATES:
=====================================
LIQUIDITY MANAGEMENT BY RBA: directed towards the short run
This is subordinate to the objectives of monetary policy.
RBA influences financial activity by
i)
imposing balance sheet ratios (NCD:non callable
deposits).
ii)
manipulation of financial prices by buying and
selling assets and issuing liabilities (more
emphasis now, particularly after derugalation)
The RBA controls cash through OMO (Open Market Operations).
Cash is means currency and ESAs (exchange settlement
accounts).
AMMDs have ESAs (authorised money market dealers). There
are 9 AMMDs. A credit balance in the ESA is known as cash.
To inject cash into the economy (loose monetary policy),
the RBA purchases foreign exchange, government securities,
repurchase agreements. To withdraw cash (tight monetary
policy), RBA sells foreign exchange, government securities
and repurchase agreements.
MONEY DEMAND
============
1.
Keynesians:
--------------a)
Transactions demand. This is also known as active
money.
b)
Asset demand, where money is held idle as an
asset. Asset demand is chiefly precautionary. But
it also includes speculative demand.
2.
Monetarists:
---------------They believe that money is primarily demanded for
transactions purposes (for its use as a medium of exchange)
According to Friedman, people demand money because of
the inherent utility of cash balances, the price level, the
level of their real income, the rate of interest and the
rate of change of the price level, i.e.,
Md = f(U,P,y,i,delta P)
where:
U
P
y
i
=
=
=
=
utility of money balances,
price level
level of real income
rate of interest
delta P = change in price level.
----------------------------------------------------------The Keynesians define the real sector equation as:
C+I+G= NDP
The Quantity theorists define the financial sector as:
MV = PQ, or Py.
Both the equations represent the same thing, viz., the
money value of the physical goods and services produced in
the economy.
Thus, MV = C+I+G
The monetarists find that M (money supply) closely
parallels the growth of GDP. Thus they feel that money
supply causes GDP change. Whereas Keynesians doubt this
causation.
KEYNSIAN IS-LM ANALYSIS
=======================
(also called Hicksian IS-LM analysis):
LM curve: (eqbm. in financial sector)
-------L = demand for money function
M = supply of money function
The LM curve is the locus of those combinations or
pairs of aggregate money income and the rate of interest at
which the money market is in equilibrium in the sense that
there is equilibrium between the total demand and the total
supply of money. (Vaish:285)
LM curve is the locus of all the equilibria values of
real incomes and real interest rates that are consistent
with equilibrium in the money market sector.
Money market equilibrium:
M
--- = L (r, Y)
P
See Auerbach:440,572
Here, M/P
= money supply (stock)
L = demand for real balances
r = nominal interest rate on bonds
(opportunity cost of holding money)
Y = Real income
The demand for money is directly related to income, and
negatively related to the real interest rate.
This equation is referred to the LM curve.
(Kearney/MacDonald:10)
IS curve (eqbm. in real sector)
-------I = investment
S = savings
We know that investment is determined by the rate of
interst and that saving is determined by income. It follows
that some combination of interest and income will result in
saving and investment being equal. In fact, there are a
variety of such combinations.
IS curve is the locus of all those combinations of
income and rate of interest at which aggregate savings
equals aggregate investment, i.e., S = I , showing that
aggregate supply equals aggregate demand. This curve shows
the equilibrium in the real sector of the economy.
(Vaish:292)
The IS shedule shows all possible combinations of
interest and income where investment equals saving and
hence shows all possible points of equilibrium in the real
sector.
Liquidity trap:
It is that interest rate (usually about 2%) at which
people withdraw all their money from bonds, etc., and keep
it in the form of money. Lowering interest rates beyond
this point will convert the entire bonds into money: it
traps all the money. Hence the name (Keynes)
Vaish:272
----------------------------------------------------------MONEY
======
What is money?
Money is:
-
a
a
a
a
standard of value
store of value
unit of account
medium of exchange
In a barter economy, there is operational and
allocational inefficiency.
This is overcome by an exchange economy with money.
Drawbacks of money:
-
absence of an explicit interest income from
the holding of money
-
loss of purchasing power during inflationary
periods
----------------------------------------------------------Why do people hold money?
There is no theoretically convincing explanation why
money exists and why it is used. Various viewpoints
-
exchange (barter) involves the absorption of
costly resources. Money is thus introduced as a
device to promote allocational and operational
efficiency.
-
Money buys goods and goods buy money; but goods
do not buy goods.
-
Uneven distribution of information induces
individuals to search for, and social groups to
accept, alternatives to barter.
----------------------------------------------------------What is the price (or cost) of money?
1.
Classical: The price of money is the reciprocal of the
absolute price level. The absolute price level is
measured by a standard basked of commodities.
Let P be the price level, or the money required
to buy a standard basket of currencies (say, 1000
dollars).
Then the price of money is 1/P, or 1/1000.
If the price level doubles, i.e., you require
2000 dollars to buy the same basket of goods,
then the price of money is halved, 1/2000.
Thus 1/P measures the internal purchasing power of
money.
2.
Neo-classical and Keynesian notion: According to this
view, the price of money is =
the alternative opportunity cost of holding cash
balances, which is, in other words,
the rate of interest on alternative investment
opportunities, where interest rate is the rental price
of money.
ROLE OF MONEY IN THE ECONOMY
===========================
Why should we bother to study money in economics.
Presumably, money is studied because it is non-neutral in
its effect on the real sectors of the economy. But first, a
few concepts:
Money illusion:
---------------
In case price level increases by 5% and the incomes
increase by 5%, then money illusion refers to the illusion
of increase in income in such circumstances. There has been
of course, no real increase in incomes. (Don Patinkin) If
people suffer from money illusion they will spend more of
their
illusionary
increase
in
income,
thus
causing
increased consumption.
Money neutrality:
----------------According to this view, increase in money supply has
merely served to increase the price level proportionately,
and no one is better off; money has played a neutral role
in the economy. All economists agree that money is neutral
in the long run, but both Keynesians and monetarists agree
that money is non-neutral in the short run, and that
increase
in
money
supply
does
not
increase
prices
immediately, on the other hand, it increases aggregate
demand/ output. However, the new classicals, who support
the rational expectations hypothesis, believe that money is
neutral both in the short and long run, since people know
that prices are going to rise, and therefore tend to
increase the prices immediately, rather than going through
the complicated process of increase in Y, etc.
(A) MONEY IS NEUTRAL EVEN IN THE SHORT RUN:
==========================================
Given:
MV = PY (equation of exchange)
Extreme classical view:
----------------------In this case, V is constant since it is determined by
payments technology. Further, Y is independent of the
variables above, since it is determined by factor supplies
. Accordingly, increase in M leads to increase in P. Thus,
according to this view also, money has no impact on the
real economy.
Extreme Keynesian view:
----------------------According to this, the velocity of money, V, is inversely
proportional to M, i.e., MV is constant. In this case,
increasing M simply reduces the velocity of money, and
there is no change either in P or in Y. Thus, money has no
role whatsoever in the real sector of the economy.
(B) MONEY IS NON-NEUTRAL IN THE SHORT RUN:
==========================================
1.
Keynesian view:
------------------Change in monetary policy -> change in trading bank
reserves
-> change in money supply -> change in the interest
rate -> change in investment
Keynesians distinguish between the real sector and
financial sector. They regard money as just one financial
asset among many. They analyse the transmission of changes
in money supply as follows:
Increase in quantity of money leads to buying of
short-term debt instruments. This is portfolio adjustment.
This increases the interst rate, including the long-term
interest rate. Till now, all transactions have taken place
only in the financial sector.
Increase in interest rates begins affecting the real
sector through reducing investment. This is the
transmission mechanism.
However, Keynesians say that there are a lot of
factors which affect the portfolio adjustment and the
transmission mechanism, and it is quite possible that the
effects of the increase in money supply may not be
transmitted to the real sector at all.
Thus they discount the influence of money as the
primary policy variable in the economy. They lay greater
stress on fiscal policy, and believe in a mixture of
monetary and fiscal policies. They are also called
fiscalists. Keynesianism supports a liberal political
approach with greater involvement of government in the
economy.
See diagram, Waud:opp.289
Keynesians believe that the velocity of money, V,
changes with the interest rates. It is intimately linked to
the demand for money.
2.
Quantity theorists (or monetarists)
---------------------------------------Trans.mech:
change in monetary policy -> change in money supply ->
change in GDP
Monetarists believe that the velocity of money, V, is an a
steady, long-term trend.
According to the monetarists (who believe in the quantity
theory of money), however, there is no great difficulty in
transmitting the effects of increase in money supply to the
real sector. This is because of the quantity equation. If
people have more quantity of money, they spend it and this
leads to increase in investment. The monetarists discount
the value of fiscal policy. They feel that an increase in
government spending will be offset by a decrease in private
spending, as a result of which total spending will rise
very little. Monetarism supports a conservative political
approach, with monetary policy playing its role in the
background.
The quantity theory starts from the equation of
exchange which is an undisputed truism. It is a
tautological identity. MV = PT. It cannot be false. And it
is not a theory of money any more than a balance sheet is a
theory. However, this equation helps us develop a theory
of money, the quantity theory. When we criticise the
quantity theory of money, we are not disputing the quantity
equation; only the behaviours that are allegedly derived
from it.
INTEREST RATES AND MONEY SUPPLY CANNOT BE TARGETED
SIMULTANEOUSLY. (See Jackson:303)
Difference between Keynesians and Monetarists:
---------------------------------------------(a)
Monetarists think that the short run is much shorter
than the Keynesians. The real effects of money are
therefore temporary on the real economy, but much
faster on inflation.
(b)
There is the difference in transmission. Keynesians
transmit to the real economy through INTEREST RATES.
Monetarists transmit through INCREASE IN CONSUMPTION.
3.
New Classical View: (after Robert Lucas (1972)
Rational expectations)
This view is similar in its results to the money
neutrality, but does not go through the equation of
exchange. It simply presumes that since people know that
prices are going to increase, they will do so at once.
Rational expectations logic shows that government need
not follow discretionary policy, and resembles monetarists
to that extent. According to this view, the govt. would be
best to follow a steady growth in M, rather than allow
spurts, since these will be merely translated into
inflation, and will cause destabilisation in the economy.
Read Juttner:572-574
Other differences between Keynesians and Monetarists:
---------------------------------------------1.
Quantity theorists tend to believe that monetary
policy is all that is needed to stabilise the economy
and that fiscal policy isn't effective anyhow.
Keynesians feel that fiscal policy is a powerful force
in the economy and that both monetary and fiscal
policy are needed to avoid inflations and recessions.
2.
In the quantity theory, the quantity of money impinges
directly on spending decisions of all types.
Keynesians see the quantity of money as influencing
the economy indirectly, primarily through interest
rates.
3.
Quantity theorists see major disturbances in the
economy as arising in the monetary sector while
Keynesians see them as arising in the real sector
(especially in private business investment I). Thus,
monetarists argue that monetary policy should be
conducted according to a fixed rule (non-
discretionary), e.g. it should be increased at, say,
4% p.a., come what may. The Keynesians argue that
instability occurs due to different levels of business
investment at different points of time, and argue that
this can be levelled out only by applying different
interest rates at different times, (i.e., the policy
should be discretionary).
Others:
a)
Monetarists and neo-Keynesians (new Classicals),
favour a more laissez-faire or free-market economy, with
government intervening mainly to restrain monopoly and
other forms of anticompetitive behaviour. They fear that
fiscal policy gives rise to too much direct government
intervention in the economy. Keynesians believe that the
government can and should play a more effective and active
role in correcting the shortcoming of the market mechanism.