M.Sc. in Economic Policy Studies

M.Sc. in Economic Policy Studies John FitzGerald, room 3012, jofitzge@tcd.ie 02/10/2015 1

Outline of lectures 3: October 16 th Money and the macro-economy Demand for money The demand for money The quantity theory of money Money supply Factors affecting supply Velocity Policy on money demand and supply Targeting money growth The Lucas critique 02/10/2015 2

The Demand for Money Transactions demand for money to pay for goods and services If money expensive (opportunity cost, interest rate) use less Affected by technology Example Hold money in bonds and transfer to current account only daily need. This would reduce holdings of money. Precautionary demand a rainy day fund Portfolio demand for money Depends on wealth, expected interest rates on alternative assets, perceived riskiness of alternative assets. (Effects of bank risk). Example: if expect interest rates on bonds to rise then their value will fall in the future. Don t invest and hold cash to avoid a capital loss. Thus the return on a range of assets will affect demand for money 02/10/2015 3

Money and the Macro-Economy Money, growth and inflation They are closely related There are no cases of: High money growth and low inflation Low money growth and high inflation When inflation moves from 1% a year to 2% a year does this change behaviour? Buy now before the price increase? Announced increases in VAT and excise However, if inflation moves from 2% a year to 2% a week may change behaviour Use your money before it loses its value wheelbarrows! Inflation and money supply are related: http://www.tara.tcd.ie/bitstream/handle/2262/60367/vol%2035_3frain.pdf?sequence=1&isallowed=y 02/10/2015 4

Money and Inflation ECB targets inflation Also concerned with growth in money supply Fed rarely talks about money supply, though it is concerned, inter alia, with inflation. Why the difference? Money different definitions M1 currency M2 currency + current accounts M3 currency + current and deposit accounts http://www.centralbank.ie/polstats/stats/cmab/pages/money%20and%20banking.aspx Table A3 02/10/2015 5

Money Supply - Ireland 18000 16000 14000 12000 10000 8000 6000 4000 2000 0 1960 1965 1970 1975 1980 1985 1990 M1 M2 M3 02/10/2015 6

Costs of inflation Changes in rate of inflation costly Contracts are written based on an expected inflation rate e.g. upward only rent reviews Tax distortions capital gains not treated same as income Tax on savings when it rises What is the optimal rate of inflation? Hyperinflation Print money to finance government rather than taxing Using the seignorage More money higher inflation People expect inflation to rise try and game it by raising prices Higher inflation to buy same services need to print even more money To end hyperinflation need to stop printing money and fund services by taxes http://jae.oxfordjournals.org/content/11/3/309.full.pdf+html https://www.tcd.ie/iiis/documents/discussion/pdfs/iiisdp293.pdf 02/10/2015 7

Money and consumer prices, Ireland 24 % change, moving average of 4 years 20 16 12 8 4 0 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 M2 Inflation 02/10/2015 8

% Money and consumer prices, Iceland 100 Chart Title 80 60 40 20 0 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011-20 CPI M3 02/10/2015 9

The Quantity Theory of Money Money in circulation is controlled by the Central Bank However, money is used in many transactions. Every transaction in the economy (GDP) is paid for with money GDP at current prices (PY) = Quantity of money (M) X Velocity (V) P is the price level and Y is the volume of output PY=MV Money growth + velocity growth = inflation + growth in output Irving Fisher early in 20 th c. assumed: V is constant and money does not change Y Therefore the growth in money supply = inflation 02/10/2015 10

Measures of velocity in Ireland 25 20 15 10 5 0 1960 1965 1970 1975 1980 1985 1990 Velocity-M1 Velocity-M2 Velocity-M3 02/10/2015 11

The Quantity Theory of Money With moderate inflation growth in money exceeds inflation Because output is growing. If velocity is constant then growth in money = growth in value of output However: Central Bank controls M1, currency. Relation to M2 may vary Velocity may change. e.g. will rise if expect inflation to rise. V=PY/M=GDP/M Some stability with M3, not with M1 Why? Implications for post-1992 world? 02/10/2015 13

Papers modelling Irish demand for money http://www.tara.tcd.ie/bitstream/handle/2262/64176/21%20oct%2089%20hurley.pdf?sequence=1&isallowed=y http://www.tara.tcd.ie/bitstream/handle/2262/64458/21%20jul%2090%20hurley.pdf?sequence=1&isallowed=y First paper finds M3 best measure however, no good relationship Second paper found a stable relationship for M3, explained by sales, inflation, and an interest rate measure. The justification for including inflation is that when it is high you will hold less cash and have a higher velocity because money is losing its value faster. However, even this model did not prove stable over the coming decades Problem for ECB there is not a stable (predictable) demand for money function for the Euro area. To target inflation need a more sophisticated approach Instead of using the actual supply of money to target its inflation objective use interest rates to indirectly influence the factors driving inflation 02/10/2015 14

Supply of Money Central Bank prints money cash Issue cash (M1) in return for assets Central bank changes money supply (M1) by open market operations Buy short-term debt raise price of debt reduces interest rates. Results in higher cash in hands of public. Sell short-term debt to increase interest rates and take money out of economy However, cash is small relative to other forms of money - 02/10/2015 15

Interest rate, i The Liquidity Trap M d M s 1 M s 2 M s 3 Money, M 02/10/2015 16

ECB s Strategy Based on Bundesbank s Initially targeted money supply and inflation rate Targeting money supply e.g. Assume: Real GDP growth of 2%. Price inflation of 2%. Therefore PY=4% MV=PY with PY growing by 4% then MV needs to grow by 4% Assume V falling by 0.5% - money, M, needs to grow by 4.5% Before crisis a more stable demand for money However, targeting money supply unsatisfactory because V unstable Also the deflator for GDP is not the same as inflation for consumers 02/10/2015 17

Implications for monetary policy ECB should target inflation in medium term. Short term not possible because noise in data and long lag in effects of policy How can the ECB implement its inflation objective An unstable demand for money Using market interventions (short-term interest rates) Because short interest rates are zero use long interest rates quantitative easing Why does the ECB have problems raising inflation today? What has happened to velocity and why? 02/10/2015 18

Implications for monetary policy Technological change How have ATMs affected holdings of cash? Money in transit changes in system affects cash in clearing The effects of the crisis on household and firm behaviour Rush to liquidity changing portfolio choice Option value of cash increased Change in opportunity cost of holding cash With zero interest rate just give the money back to the ECB unable to change supply Negative interest rate to force the economy to absorb the cash 02/10/2015 19

Model of money demand and supply M d = M3 ( including deposit and current accounts) M = money supply CU d = demand for currency by the public D d = demand for deposit accounts i = interest rate Y = real GDP P = price of GDP R = bank reserves H d = demand for central bank money H = supply of central bank money 02/10/2015 20

Model of money demand and supply Money demand M d = f(yp, i) (1) Money supply = money demand M = f(yp, i) (2) Demand for currency and deposit accounts is a fixed % of money demand, c CU d = cm d (3) D d = (1-c)M d (4) Banks have to hold a share of deposits, θ, as reserves R = θd d (5) R = θ(1-c)m d (6) 02/10/2015 21

Model of money demand and supply Demand for central bank money by the public and banks: H d = CU d + R (7) Substitute using equations 2, 3, 6 H d = [c+ θ(1-c)] f(yp, i) (8) Supply of central bank money = demand for it H = H d = [c+ θ(1-c)] f(yp, i) (9) Rearrange equation 9 so that the supply of money equals the demand 1 H = f(yp, i) (10) [c+θ 1 c ] 1 >1 this constant is referred to as the money multiplier [c+θ 1 c ] Central bank money has a larger effect when there are banks 02/10/2015 22

Money demand and supply Example of the money multiplier Central bank buys a bond for 100 increases H by 100 Seller of bond deposits cash in a bank deposits D rise by 100 Bank needs to retain θ, say 10%, of the cash against the deposit The bank buys bonds for 90. The seller deposits it in the bank Bank needs to retain θ, say 10%, of the cash ( 9) against the deposit The bank buys bonds for 81. The seller deposits it in the bank Etc. etc. Eventual change in M= 100(1+.9+.9 2 + )= 100 1 (1.9) = 1000 02/10/2015 23

Money demand and supply What can change is outside control of Central Bank? f(yp, i) the demand for money (e.g. a rush to liquidity) c share of currency in money demand (e.g. a bank run could change it) Monetary policy is implemented through changes in H, Cash Through open market operations buying and selling assets in return for cash H Effects of monetary policy affected by θ? This may be regulated or could be chosen by banks to maximise expected profits In crisis θ changed as banks wanted to hold more cash and did not trust each other. Central Banks could have imposed a minimum θ but not a maximum Changed effects of Central Bank open market operations 02/10/2015 24

Demand and Supply of Money i S D 1 D 2 M 02/10/2015 25

Implications for monetary policy The demand for money and the supply of money determine the short term interest rate the price of money Given the demand for money the ECB can control EITHER the supply of money or the price (interest rate) but not both If there is an unstable demand for money Targeting a particular supply of money may have unpredictable consequences If D1 represents true demand for money changes in supply may have unpredictable consequences, reflected in uncertain interest rates If D2 then more predictable more stable interest rates if choose the supply Interest rate stability (predictability) can insulate real economy from financial shocks 02/10/2015 26

Implementing Monetary Policy Need research to tell you what drives the demand for money Need to understand is this model stable Shocks to the system may cause a change in behaviour Need to understand what determines supply Not determined directly by the Central Bank Changes in supply behaviour may restrict scope for Central Bank action Need model a demand curve and a supply curve to know how interest rates are determined OR how interest rates may affect demand for money Ultimately need to know how monetary policy affects the real economy, including the rate of inflation The next lecture 02/10/2015 27

The Lucas Critique Models used for monetary policy making are based on historical data Can we learn from history? Will history repeat itself? Changes in policy may change people s behaviour Also, the public can read the models too. Economic and financial decisions are based on expectations about the future Policy may change expectations and, hence, behaviour. Can make models invalid Models, to be robust, must take account of this learning behaviour Very important in financial sector because behaviour is based on expectations Argues for predictable policy making 02/10/2015 28

Rational expectations Lucas critique assumes rational expectations The formation of expectations based on rational forecasts Makes for more complex models People s behaviour today depends, not only on a range of variables today, but also on the forecasts of those variables for the future Have to solve models, not just for today, but well into the future in order to predict what people will do today. 02/10/2015 29

Rational expectations - examples Rational expectations results in sudden jumps with new information Draghi announced quantitative easing in December 2015 Everyone new that in buying bonds over two years many of them would come from foreigners. This would reduce the value of the. The did not change gradually as the bonds were bought. Instead the jumped to a new equilibrium value and has stayed there. Investment and interest rates Investors decide based on expected future profits. Interest rates are crucial in the decision to invest. However, if there is an economy-wide boom in investment the demand for money will rise and there may be inflationary pressures. In turn this may cause interest rates to rise. Could result in a decision not to invest because of expectations of monetary policy consequences of the investment boom. 02/10/2015 30

Quantitative Easing Liquidity trap Central Bank traditional open market operations: buy short term securities change short-term interest rate Short-term interest fell to zero Banks don t want central bank money lodge it back with ECB Banks cannot make profitable use of Central Bank money. 02/10/2015 31

Interest rate, i The Liquidity Trap M d M s 1 M s 2 M s 3 Money, M 02/10/2015 32

Quantitative Easing Liquidity trap Central Bank traditional open market operations: buy short term securities change short-term interest rate Short-term interest fell to zero Banks don t want central bank money lodge it back with ECB Banks cannot make profitable use of Central Bank money. Quantitative easing Buy other assets government bonds Reduces long-term interest rates Hope that sellers of long bonds buy other assets equities or invest. Reduces cost of capital for those who are not over-leveraged 02/10/2015 33

Quantitative Easing Buying bonds on the market don t care about sellers However, foreign holders of Euro government bonds face a choice The interest rate on Euro area assets has fallen relative to foreign assets sell? ECB buying assets held by foreigners will raise value of foreign currency Fall in value of Euro will make Euro assets less attractive sell? Affects exchange rate Rational expectations: When QE announced foreign holders of Euro bonds knew it would weaken They try to bail out en masse, triggering big change in exchange rate Change in exchange rate makes imports into Euro area more expensive Raises rate of inflation directly http://www.irishtimes.com/business/economy/john-fitzgerald-what-europe-could-do-about-low-inflation-1.2055497 02/10/2015 34

Policy making under uncertainty Central Banks are not infallible How long does it take for monetary policy to work? The longer it takes the more reliance on theory and models Models are not perfect and people can change behaviour Are the risks higher as a result of an undershoot in the inflation rate or an overshoot in the inflation rate? Plot a stable path or adjust in the face of new information? 02/10/2015 35

Questions Why does an independent central bank reduce occurrences of extremely high inflation, especially in developing economies? Why was there a fall in velocity during the recent crisis? Look at papers on demand for money in Ireland 02/10/2015 36

References Cecchetti and Schoenholtz, Money, Banking, and Financial Markets, Chapter 20 Blanchard, Amighini and Giavazzi, Macro-Economics a European Perspective, Chapter 4. Demand for Money QE http://www.tara.tcd.ie/bitstream/handle/2262/64176/21%20oct%2089%20hurley.pdf?sequence=1&isallowed=y http://www.tara.tcd.ie/bitstream/handle/2262/64458/21%20jul%2090%20hurley.pdf?sequence=1&isallowed=y http://www.tara.tcd.ie/bitstream/handle/2262/60367/vol%2035_3frain.pdf?sequence=1&isallowed=y http://www.irishtimes.com/business/economy/john-fitzgerald-what-europe-could-do-about-low-inflation-1.2055497 Somalia and Zimbabwe http://jae.oxfordjournals.org/content/11/3/309.full.pdf+html https://www.tcd.ie/iiis/documents/discussion/pdfs/iiisdp293.pdf 02/10/2015 37