3. Financial Markets, the Demand for Money and Interest Rates

Transcription

1 Fletcher School of Law and Diplomacy, Tufts University 3. Financial Markets, the Demand for Money and Interest Rates E212 Macroeconomics Prof. George Alogoskoufis

2 Financial Markets, the Demand for Money and the Interest Rate Barely a day goes by without the media speculating whether the Fed (short for Federal Reserve Bank, the U.S central bank) is going to change the interest rate, and what the change is likely to imply for the economy. Janet Yellen, the chairperson of the Fed, is widely perceived as the most powerful policy maker in the United States, if not in the world. The basic keynesian model we developed in the previous lecture did not include an interest rate, so there was no role for the Fed and its chair. This was a strong simplification, and it is time to relax it. In this lecture, we shall introduce the simplest model needed to think about the determination of the interest rate and the role of the central bank, a model in which people face a simple portfolio choice, whether to hold money or to hold bonds. In that model, we can think of the interest rate as determined by the demand of money and the supply for money. Then, in the next lecture, we shall look at how the interest rate in turn affects demand and output. This simple short run model does not, however, do justice to the complexity of the financial system. When we focus on the crisis, we shall look at the financial sector in more detail. 2

3 The Roles of Money Money is a social institution that serves three important functions in an economy. 1. Unit of Account: All prices in a modern economy are quoted in terms of money. 2. Means of Payments: Money, is universally accepted as a means of payments. Thus, it greatly facilitates economic transactions and limits their costs drastically. 3. Store of Value: Money is also an outlet for holding one s savings. As such it is a store of value (asset), and in particular the asset characterized by the highest degree of liquidity. 3

4 Money as a Unit of Account Prices are determined in relation to money. This simplifies the calculation of values, as, otherwise, economic agents would have to calculate too many relative prices. For example, in an economy with N goods, plus money, there are N money prices. Without money, economic agents would have to calculate N (N-1) / 2 relative prices in order to make their transactions. As the number of goods increases, the number of relative prices to be calculated increases exponentially. With 100 goods, you need to know 100 money prices. Without money you would have to calculate 4950 relative prices among the various goods. With 1000 goods you need to calculate 1000 money prices. Without money, relative prices, almost half a million. Money thus helps to simplify the calculation of prices and is easiest to calculate values. 4

5 Money as a Means of Payments Money, being generally accepted as a means of payments, greatly facilitates economic transactions and limits their costs drastically. Without money in order to complete a transaction, the seller of a product or service would have to find a buyer who would be willing to give in return something that the seller would also desire. Transactions without money are called barter, entailing the need for a double coincidence of wants and huge search and other transactions costs on the part of buyers and sellers. A modern economy would immediately cease to function if there was not a generally accepted means of payments. 5

6 Money as a Store of Value Money is also a store of value, an asset, and in particular the one characterized by the highest degree of liquidity. This is a key feature of money. If money was not a store of value, and it lost its value quickly, it would not be generally possible to function as a means of payments and a unit of account. Then again, since money is the only store of value which is also a means of payments, by definition it constitutes the most liquid store of value. 6

7 The Supply of Money The money supply is defined as the total of banknotes and coins in the hands of the public, plus deposits of households and firms in commercial banks. Deposits of credit institutions and other institutions participating in the interbank market and the foreign exchange market are not considered as part of the money supply. A country's money supply is eventually determined by the actions of the central bank and its interactions with commercial banks. 7

8 Central Banks and their Role A central bank, reserve bank, or monetary authority, is an institution that manages a state s currency, its money supply, and interest rates. Central banks also usually oversee the domestic commercial banking system. In contrast to a commercial bank, a central bank possesses a monopoly on determining the monetary base in the state, and usually also issues notes and coins, which usually serve as the state s legal tender. The primary function of a central bank is to control the nation's monetary conditions, through active duties such as issuing notes and coins, managing interest rates, setting reserve requirements for commercial banks, and acting as a lender of last resort to the banking sector, and possibly the state, during times of financial crisis. These duties usually determine a country s monetary policy. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference. Still, limited control by the executive and legislative bodies usually exists. 8

9 The Monetary Base and the Central Bank The monetary base in an economy is defined as the sum of coins and banknotes held by the public, plus the reserves of commercial banks held at the central bank. Thus, the monetary base B is equal to, B=C+R where C is currency (coins and notes) held by the non-bank public (households and firms), and R the reserves of commercial banks. An alternative name for the monetary base is high powered money. The monetary base is under the close control of the central bank, as the central bank decides how much currency to issue, and can also control the reserves of commercial banks either directly or indirectly. 9

10 Alternative Definitions of the Money Supply The money supply is defined as the total of coins and banknotes held by the public, plus deposits of households and firms in commercial banks. Thus, the money supply M is determined by, M=C+D where D is deposits in commercial banks. If D denotes deposits in checking (current) accounts only, then the money supply is narrowly defined, a definition known as M1. If D denotes both deposits in checking accounts and savings and time deposits, the money supply is more broadly defined, a definition known as M2. If large time deposits, institutional money market funds, short-term repurchase and other liquid assets are included in deposits, then the money supply is more broadly defined, a definition known as M3. 10

11 The Monetary Base and the Money Supply The relationship between the monetary base and the money supply is given by, M = C + D C + R B = c +1 c + r B = mb where m is the so-called money multiplier. The money multiplier depends on two crucial parameters. The ratio of currency to deposits chosen by the non-bank public, c=c/d, and the reserve ratio of commercial banks, r=r/d. To the extent that these two ratios are stable, there is a stable proportional relationship between the monetary base and the money supply. Thus, by controlling the monetary base, the central bank can control the money supply. To the extent that either the ratio of currency to deposits of the non-bank public, or the reserve ratio of commercial banks are volatile, the control of the money supply by the central bank entails difficulties, because of the volatility of the money multiplier. However, the central bank can also affect the money multiplier through minimum reserve requirements for commercial banks, and other instruments, such as short term interest rates, that may affect the currency deposit ratio of the non-bank public, or the reserve ratio of commercial banks. 11

12 Commercial Banks and the Money Supply It is clear that the central bank is not the only institution that affects the money supply. The behavior of the non-bank public, in choosing to hold money in the form of either currency or deposits, and the behavior of commercial banks, in deciding the ratio of their reserves to their deposits also affect the money supply. A reduction in the reserve ratio of commercial banks causes an increase in the money multiplier and the money supply for a given monetary base. Thus, ultimately the money supply is determined by three factors. First, the amount of notes and coins issued by the central bank, second the choices of the non bank public between holding money in the form of notes and coins and deposits in commercial banks, and third the choices of commercial banks between holding reserves with the central bank against their deposits, versus lending to the non-bank public (households and firms) or investing in other interest yielding assets such as shares and bonds. However, since the central bank can largely determine the monetary base, and, indirectly, the cash deposit ratio of the non-bank public and the reserve ratio of commercial banks, it can, to a large extent, exert indirect control on the money supply. Thus, it is not too inaccurate to say that the money supply can in principle be controlled by the central bank. 12

13 The Federal Reserve Board The central bank of the United States is the Federal Reserve often called the Fed. If you look at a U.S. dollar bill, you will see that it is called a Federal Reserve Note. Decisions over monetary policy are made by the Fed s Federal Open Market Committee. This committee is made up of members of the Federal Reserve Board, who are appointed by the president and confirmed by Congress, together with the presidents of the regional Federal Reserve Banks. The Federal Open Market Committee meets about every six weeks to discuss and set monetary policy. 13

14 The Demand for Money Households and firms demand and hold money because of its services as a means of payments. In addition to being a means of payments, money is also an asset (a store of value). However, money is not the only asset in which households and firms can hold their wealth. We assume that there exists an alternative asset, one period bonds, which contrary to money pays interest, at an interest rate i. Bonds are not a means of payments, and transforming money into bonds, and vice versa, is assumed to imply some transactions cost. How much money households and firms wish to hold relative to bonds will then depend on two factors: First, the value of transactions they wish to conduct, i.e the volume of transactions and the price level. This is because the higher the value of transactions, the more frequently they will have to transform bonds into money, which implies transactions costs. Thus, the demand for money is a demand for a certain amount of purchasing power which is positively dependent on the volume of economic transactions (as measured by real GDP). Second, how much money they hold relative to bonds will depend on the opportunity cost of holding money, i.e the nominal interest rate i, as money does not pay interest, while bonds do. One can then show that the demand for money will be proportional to the price level, positively related to the volume of economic transactions, and negatively related to the nominal interest rate. It is proportional to the price level, on the presumption that an increase in the level of prices requires an analogously higher quantity of money to conduct the same volume of economic transactions. It is positively related to real output (GDP) on the presumption that an increase in output and income requires more money for transaction purposes. Finally, it is negatively related to the interest rate, as households and firms forego interest when they hold their assets in the form of money rather than bonds, which are interest bearing securities. The interest rate is thus the opportunity cost of holding money, and when it goes up, money holdings are expected to decline. 14

15 The Demand for Money Function The form of a typical demand for money function is, M d = PL(Y,i), or M d /P = L(Y,i) where M d is the demand for the nominal stock of money, P the price level, Y is real income and i is the nominal interest rate. L denotes the demand for money function, which is a demand for real money balances, and which depends positively on real income and negatively on the nominal interest rate. A special case of the demand for money function is the so called quantity theory equation, which assumes a unitary income elasticity of money demand, i.e that money demand is proportional to real output and income. This takes the form, M d /P =k(i)y where k is a negative function of the nominal interest rate. Note that the demand for money function is a behavioral equation, much like the consumption function in our analysis of the output market. For a given level of output (and income), it can be depicted diagrammatically as a negative relation between real money demand and the nominal interest rate. A rise in real output and income raises the demand for money function for any level of the nominal interest rate. 15

16 The Demand for Money and the Nominal Interest Rate L(Y 0 ) Nominal Interest Rate, i Real Money Balances M/P 16

17 A Rise in Real Output (GDP) and Money Demand L(Y 1 ) Y 1 > Y 0 L(Y 0 ) Nominal Interest Rate, i Real Money Balances M/P 17

18 Equilibrium in the Money Market when the Central Bank Controls the Money Supply Suppose the central bank decides to supply a fixed amount of money equal to M 0, so M s = M 0 The superscript s stands for supply. Short Run equilibrium in financial markets requires that the money supply must be equal to money demand, i.e that, M s = M d Then, using M s = M 0, the equilibrium condition in financial markets is given by. M 0 /P = L(Y,i) This equation tells us that the interest rate i must be such that, given their real income Y, households and firms are willing to hold an amount of money equal to the existing money supply M 0. This equilibrium relation is called the LM relation. The letter L stands for liquidity and the letter M for the money supply. The LM relation, which was first derived by the British economist J. R. Hicks, in a 1937 article on the General Theory, implies that, for a given money supply, and under the assumption that the price level is given in the short run, for equilibrium in the money market to hold, a rise in real output must be accompanied by a rise in the nominal interest rate. Thus, the LM relation, can be depicted diagrammatically as a positive relation between real income and the nominal interest rate. 18

19 Short Run Equilibrium in the Money Market L(Y 0 ) Nominal Interest Rate, i i 0 M 0 /P Real Money Balances M/P 19

20 Short Run Effects of Changes in Real Output L(Y 1 ) L(Y 0 ) L(Y 2 ) Nominal Interest Rate, i i 1 i 0 i 2 M 0 /P Real Money Balances M/P 20

21 The LM Curve: Equilibrium in Financial Markets Nominal Interest Rate, i LM (M 0 /P) i 1 i 0 i 2 Y 2 Y 0 Y 1 Real Output Y 21

22 Short Run Interest Rate Effects of a Money Supply Increase L(Y 0 ) M 1 >M 0 Nominal Interest Rate, i i 0 i 1 M 0 /P M 1 /P Real Money Balances M/P 22

23 An Increase in the Money Supply and Shifts in the LM Curve LM (M 0 /P) LM (M 1 /P) Nominal Interest Rate, i Real Output Y 23

24 Monetary Policy and Open Market Operations We can get a better understanding of monetary policy by looking more closely at how the central bank actually changes the money supply, and what happens when it does so. Open market operations: In economies with developed financial markets, the way central banks change the supply of money is by buying or selling bonds in the bond market. If a central bank wants to increase the amount of money in the economy, it buys bonds and pays for them by creating money. If it wants to decrease the amount of money in the economy, it sells bonds and removes from circulation the money it receives in exchange for the bonds. These actions are called open market operations because they take place in the open market for bonds. The assets of the central bank are the bonds it holds in its portfolio. Its liabilities are the stock of money in the economy. Open market operations lead to equal changes in assets and liabilities. If the central bank buys, say, $1 million worth of bonds, the amount of bonds it holds is higher by $1 million, and so is the amount of money in the economy. Such an operation is called an expansionary open market operation, because the central bank increases (expands) the supply of money. If the central bank sells $1 million worth of bonds, both the amount of bonds held by the central bank and the amount of money in the economy are lower by $1 million. Such an operation is called a contractionary open market operation, because the central bank decreases (contracts) the supply of money. 24

25 Bond Prices and Interest Rates Open market operations affect interest rates through their effects on bond prices. To see this, note that we have assumed that bonds in our model are one-year bonds bonds that promise a final payment of a given number of dollars, say F, a year from now. In the United States, bonds issued by the government promising payment in a year or less are called Treasury bills or T-bills. Let the price of a bond today be B. If you buy the bond today and hold it for a year, the rate of return on holding the bond for a year is, Therefore, solving for B, we get that, i=(f-b)/b B=F/(1+i) The price B of the bond today is equal to the final payment F divided by 1 plus the interest rate i. Bond prices are negatively related to the nominal interest rate. Hence, when bond prices go up, interest rates necessarily go down and vice versa. Consider first an expansionary open market operation, in which the central bank buys bonds in the bond market and pays for them by creating money. As the central bank buys bonds, the demand for bonds goes up, increasing their price B. Therefore, the interest rate on bonds goes down. Note that by paying for the bonds with money, the central bank has increased the money supply. Hence, the increase in the money supply has resulted in lower nominal interest rates. Consider instead a contractionary open market operation, in which the central bank decreases the supply of money. It sells bonds in the bonds market. This leads to a decrease in their price B, and an increase in the interest rate. Note that by selling the bonds in exchange for money previously held by households, the central bank has reduced the money supply and increased interest rates. 25

26 Central Bank Instruments: The Money Supply vs Interest Rates We have described the central bank as choosing the money supply and allowing the interest rate be determined at the point where the money supply equals money demand. Instead, we could have described the central bank as choosing the interest rate and then allowing the money supply to adjust so as to achieve the interest rate it has chosen. Why is it useful to think about the central bank as choosing the interest rate? Because this is what modern central banks, including the Fed, typically do. They typically think about the interest rate they want to achieve, and then adjust the money supply so as to achieve it. This is why, when you listen to the news, you do not hear: The Fed decided to increase the money supply today. Instead you hear: The Fed decided to decrease the interest rate today. The way the Fed did it was by increasing the money supply appropriately. Equilibrium in the money market in such a case is then not determined by the interest rate adjusting to equate money demand with the money supply, as determined by the central bank, but by the money supply adjusting so as to be equal with money demand, at the nominal interest rate determined by the central bank. Such a case can be depicted diagrammatically in a fashion similar to the previous one. When the Central Bank controls the nominal interest rate, an increase in real income does not bring about an increase in nominal interest rates, but an increase in the money supply. 26

27 Interest Rate Pegging and Financial Market Equilibrium L(Y 0 ) L(Y 1 ) L(Y 2 ) Nominal Interest Rate, i i 0 M 2 /P M 0 /P M 1 /P Real Money Balances M/P 27

28 The LM Curve under Interest Rate Pegging Nominal Interest Rate, i LM (M 2 /P) LM (M 0 /P) LM (M 1 /P) i 1 i 0 LM (i 0 ) i 2 Y 2 Y 0 Y 1 Real Output Y 28

29 The Zero Lower Bound and the Liquidity Trap Nominal Interest Rate, i L(Y 0 ) M 3 >M 2 >M 1 >M 0 i 0 i 1 0 M 0 /P M 1 /P M 2 /P M 3 /P Real Money Balances M/P 29

30 The Zero Lower Bound and the Liquidity Trap If interest rates have already fallen almost to zero, then perhaps monetary policy is no longer effective. Nominal interest rates cannot fall below zero. Rather than making a loan at a negative nominal interest rate, a person would just hold cash. In this environment, expansionary monetary policy raises the supply of money, making the public s asset portfolio more liquid, but because interest rates can t fall any further, the extra liquidity might not have any effect on nominal interest rates. As we shall see later, such a situation poses important questions with regard to the effectiveness of monetary policy. In the United States in the 1930s, interest rates reached very low levels. U.S. interest rates were well under 1 percent throughout the second half of the 1930s. A similar situation occurred after the recent financial crisis in

31 The Effective Federal Funds Rate The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate. The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target. The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. This rate influences the effective federal funds rate through open market operations or by buying and selling of government bonds (government debt). More specifically, the Federal Reserve decreases liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks. Similarly, the Federal Reserve can increase liquidity by buying government bonds, decreasing the federal funds rate because banks have excess liquidity for trade. The federal funds rate is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer- term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence. 31

32 The Effective Federal Funds Rate % 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%