Chapter VII: Money, assets,
and interest rates
A.
B.
C.
D.
E.
F.
What is money?
Monetary aggregates
Demand for financial assets
Asset market equilibrium
Liquidity preference theory
Interest rates and interest rate spreads
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What is money ?
“Money is what money does.
Money is defined by its functions”
(John Hicks).
Money is an information
processing technology that aims at
reducing
uncertainty and establishing trust.
John Hicks
1904-89
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What is money ?


Money is typically defined by describing its
functions
Important functions are:
 unit of account
 medium of exchange
(the easing of transactions of goods and services)
 the store and transfer of value (wealth)


The functions of money are embedded
into a historical process
The definition of money is thus evolving
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Stone “money”
of the island of Yap
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Evolution
of the payment system



Commodity money
Fiat money
Electronic money
 Debit cards (EC card, ATM card)
 Stored-value card (“money card”)
 Electronic cash/checks

Are we moving to a cashless society?
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Unit of account




In microeconomic theory any good can function
as a unit of account
It is more convenient to use “money” as a single,
uniform unit of account because goods may be
subject to relative price changes
At the global level it is questionable what should
be the unit of account
The U.S. dollar and the euro play an important
role, but there are also proposals to revert to
commodity money (gold, petroleum)
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Medium of exchange



The decomposition of exchange acts renders
a modern economy based on labor sharing
possible
But this requires the existence of a social
consensus, according to which money is
accepted as a general medium of exchange
A legal provision can facilitate such
acceptance, but it cannot necessarily be
enforced
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Medium of exchange:
Lack of confidence

Where there is lack of confidence in a legal
tender, there could be escape into
“substitute currencies”
(= “hard” currencies or commodity money
--> such as cigarettes, butter)

Such “monies” circulate forcibly as media of
exchange, but they are unsuitable as a
store of value (Gresham’s “Law”):
Bad money replaces good money!
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Payment function


This function permits the granting of
credit, the transfer of credits and
liabilities, and the redemption of
debentures
The prerequisite is that credit money will
be provided and is universally accepted
within a society
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Store of value

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To the extent that assets may have
monetary characteristics, money can
produce returns (interest income)
Normally, money is held interest-free
The question is: Why do individuals hold
money without interest?
This brings us to the notion of
Ability to pay or “liquidity”
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“Quasi-money”


Close substitutes to money (such as
short-term financial assets) can function
as a store of value, hence bear interest,
and still be “liquid”
Such “quasi-money” can be converted
into money without high transactions
costs
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Liquidity as a
technology of exchange


Liquidity depends on social conventions
which establish confidence among
potential trading partners and facilitate
exchange
Disobeying to the rules is costly, so
money reduces transactions costs and
gets an own “intrinsic” value or price
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Liquidity



The question is,
how to define “liquidity”.
Milton Friedman proposes
an “ideal” definition:
Liquity =
i Ai * wi,
where wi is the
“degree of moneyness” of asset Ai.
Milton Friedman
1912Nobel Prize 1976
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Empirical definition of money


Friedman’s approach had an important
influence on the empirical and operational
definition of money
The definition of “quasi-money” includes
not only central bank money and demand
deposits, but also time deposits and
savings according to their “degree of
moneyness”
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Measuring money demand



M1=
“narrow money”
M2=
“intermediate”
money
M3=
“broad money”
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Components of M3



Repurchase agreement: it is an arrangement
whereby an asset is sold but the seller has a
right and an obligation to repurchase it at a
specific price on a future date or on demand.
Such an agreement is similar to collateralized
borrowing, but differs in that ownership of the
securities is not retained by the seller.
Repurchase transactions are included in M3 in
cases where the seller is a Monetary Financial
Institution (MFI) and the counterparty is a nonMFI resident in the euro area.
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Components of M3

Money market funds:
they are collective investments
 which are close substitutes for deposits
 and which primarily invest in money market
instruments and other transferable debt
instruments with a residual maturity up to one
year,
 or in bank deposits which pursue a rate of
return that approaches the interest rates on
money market instruments.
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Money demand in the
Euro-area (end of 2007)
Billion euros
In pc of currency
in circulation
675
100
M1 = “narrow
money”
3,835
569
M2 = “intermediate” money
7,339
1088
M3 = “broad
money”
8,650
1282
Currency in
circulation
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Development of M3
in the Euro area 1999-2008
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Relationship between M3 and
the inflation rate (HIPC)
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Quantity of money




The central bank creates “base money”,
but this is not the only money in circulation
Commercial banks also create money through
credits to their customers
However as the liquidity of commercial banks
hinges on base money, it is reasonable to
assume some relationship between total money
and base money
It is often assumed
M = m  B = multiplier  base money
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Keynes’ attitude
toward money


Money is part of a portfolio of assets and
competes with real assets, other financial
assets (such as bonds, commercial
papers), and human capital
Any change in the stock of money will
have to lead to a portfolio adjustment
which affects the price structure of the
portfolio
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Focus on demand for
financial assets


We shall look into the money supply
process and central banking in the next
chapter
We now focus on the demand for financial
assets, of which money is part of the
portfolio, and on interest rates
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The demand for financial
assets

What determines the quantity demanded
of an asset?
 Wealth (total resources owned)
 Expected return of one asset relative to
alternative assets
 Risk (the degree of uncertainty associated
with the return)
 Liquidity (the ease and speed with which
an asset can be turned into cash)
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The demand for bonds

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We consider a one-year discount bond, paying
the owner the face value of €1,000
in one year
If the holding period is one year, the return
on the bond is equal the interest rate i
It means: i = r = (F-P)/P
If the bond price is €950, r = 5.3%
We assume a quantity demanded at that price of
€100 million
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The demand for bonds


If the price falls, say to €900, the interest
rate increases (to 11.1%)
Because the return on the bond is higher,
the demand for the asset will rise, say to
€200 million, etc
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The demand for bonds
Price of bond (€)
Interest rate (%)
950
5.3
900
11.1
850
17.6
800
25.0
750
33.0
100
200
300
400
500
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The supply for bonds
Price of bond (€)
Interest rate (%)
950
5.3
900
11.1
850
17.6
800
25.0
750
33.0
100
200
300
400
500
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Market equilibrium
(asset market approach)
Price of bond (€)
Interest rate (%)
950
5.3
C
900
P*
11.1
850
17.6
800
25.0
750
33.0
100
200
300
400
i*
500
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Market equilibrium

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
Equilibrium occurs at point C, where
demand and supply curves intersect
P* is the market-clearing price, and i* is
the market-clearing interest rate
If the P  P*, there is “excess supply” or
“excess demand” of bonds
The supply and demand curves can be
brought into a more conventional form:
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A reinterpretation
of the bond market
Interest rate (%)
Demand for bonds, Bd =
Supply of loanable funds, Ls
33.0
25.0
17.6
11.1
5.3
Supply of bonds, Bs =
Demand for loanable funds, Ld
100
200
300
400
500
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Why do
interest rates change?


If there is a shift in either the supply or
demand curve, the equilibrium interest rate
must change.
What can cause the curves to shift?




Wealth
Expected return
Risk
Liquidity
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Example: Increase in risk,
and demand for bonds



If the risk of a bond increases, the demand
for bonds will fall for any level of interest
rates
It means that the supply of loanable funds
is reduced
It is equivalent to a leftward shift of the
supply curve
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A shift of the
supply curve of funds
Interest rate (%)
Demand for bonds, Bd =
Supply of loanable funds, Ls
D
33.0
C
25.0
17.6
11.1
5.3
Supply of bonds, Bs =
Demand for loanable funds, Ld
100
200
300
400
500
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Effects on the supply
of funds for bonds
Change in
variable
Change in
quantity
Shift in
supply
curve
Wealth
right
Expected
interest
left
Expected
inflation
left
Risk
left
Liquidity
right
Change in
interest rate
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The supply of bonds

Some factors can cause the supply curve
for bonds to shift, among them
 The expected profitability of investment
opportunities
 Expected inflation
 Government activities
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Example:
Higher profitability and supply of bonds



If the profitability of a firm increases,
the supply for corporate bonds will
increase for any level of interest rates
It means that the demand of loanable
funds increases
It is equivalent to a rightward shift of the
demand curve
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A shift of the
demand curve for funds
Interest rate (%)
Demand for bonds, Bd =
Supply of loanable funds, Ls
D
33.0
C
25.0
17.6
11.1
5.3
Supply of bonds, Bs =
Demand for loanable funds, Ld
100
200
300
400
500
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Effects on the demand
of funds for bonds
Change in
variable
Change in
quantity
Shift in
demand
curve
Profitability
right
Expected
inflation
right
Government
activities
right
Change in
interest rate
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Equilibrium
in the market for money
Interest rate (%)
Supply of money, Ms
33.0
25.0
17.6
C
11.1
5.3
Demand for money, Md
100
200
300
400
500
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Shifts in the demand
for money curve

Keynes considers two reasons why the
demand for money curve could shift:
 income;
 and the price level

As income rises
 wealth increases and people want to hold
more money as a store of value
 people want to carry out more transactions
using money
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Response to a change in income
Interest rate (%)
Supply of money, Ms
33.0
D
25.0
17.6
C
11.1
5.3
Demand for money, Md
100
200
300
400
500
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Response to a change
in the money supply

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

It is assumed that the central bank
controls the total amount of money
available
The supply of money is “totally inelastic”.
However the central bank can gear the
money supply by political intervention
If the money supply increases,
the interest rate will fall (liquidity effect)
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Response to a change
in money supply
Interest rate (%)
Supply of money, Ms
33.0
25.0
17.6
D
C
11.1
5.3
Demand for money, Md
100
200
300
400
500
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Secondary effects
of increased money supply


If the money supply increases this has a
secondary effect on money demand
As we have seen:
 it has an expansionary effect on the economy
and raises income and wealth
-> interest rates increase (income effect).
 it causes the overall price level to increase
-> interest rates increase (price effect)
 it affects the expected inflation rate
-> interest rates increase (Fisher-effect)
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Should the ECB
lower interest rates?



Politicians often ask the ECB to expand the
money supply in order to promote a cyclical
upturn (to combat unemployment)
The liquidity effect does in fact
reduce the level of interest rates!
But the induced effects on money demand,
 the income effect,
 the price-level effect, and
 the expected inflation effect
all increase the level of interest rates
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Increase of money supply
plus demand shift
Interest rate (%)
Supply of money, Ms
33.0
E
25.0
17.6
D
C
11.1
5.3
Demand for money, Md
100
200
300
400
500
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Readings
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
Reading 7-1: “The mandarins of money”,
The Economist, August 9, 2007
Reading 7-2: “Oceans apart”, The
Economist, February 28, 2008
Reading 7-3: “Asset Management:
European disunion”, The Economist, May
22, 2003 (optional)
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Can short term interest rates
fall below zero?

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
Not really if we talk about nominal interest
rates
Perfectly possible when we look at real
interest rates
Negative real interest rates may occur
where price inflation was not perfectly
anticipated in the loan (debt) contract
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“Liquidity trap”

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
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A situation in which prevailing interest
rates are low and cash holdings are high
In a liquidity trap, consumers choose to
avoid bonds and keep their funds in cash
because of the prevailing belief that
interest rates will soon rise
Since bonds have an inverse relationship
to interest rates, many consumers do not
want to hold an asset whose price is
expected to decline
As a result, monetary policy is ineffective
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Liquidity trap and money
supply
Nominal
Interest rate (%)
Supply of money, Ms
33.0
25.0
17.6
11.1
5.3
Demand for money, Md
C
100
200
300
D
400
500
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Real interest rates
in the United States

During the 1970
real interest rates
were significantly
below 0% in the
United States
(and worldwide)
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And again now in the USA ….
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Liquidity trap and Japan

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
During the 1990 Japan experienced a period of
economic stagnation, which the central bank
attempted to counter through expansionary
monetary policy
The BoJ reduced its interest rates from 6% in
July 1991 to 0,5% in September 1995
From February on, she started her zero interest
rate policy (ZIRP)
Despite 0% nominal interests, the real rate of
interest was positive due to falling prices
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Real interest and Deflation
Japan«s Real Interest Rates
12
10
8
6
4
2
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
0
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Discussion 7:
Money, inflation, and interest rates



What determines the demand for money?
How are money markets linked to bond
markets?
What factors influence the real interest
rate in the short and the long run?
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