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Econ 310 W2008 Class17

Econ 310 W2008 Class17 - Money and Banking Econ 310...

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Unformatted text preview: Money and Banking Econ 310 Announcements Reading: This week: Mishkin, Chapters 19 & 20 Assignment Due today, 5:00 pm New assignment available later this week Second Exam During class time, March 27 2 Friedman's New Quantity Theory Md/P = f(Yp, rbrm, rerm, erm) + Md/P = demand for real money balances Y = real permanent income p r = return on money m r = return on bonds b r = return on equity e e = expected inflation (implicit return on assets) real 3 rm: nominal return to holding money Usually think the return on money is zero Certainly, the nominal return to holding currency is zero Friedman proposes that rm is potentially positive. Why? Some highly liquid accounts bear interest Banks offer services attached to their accounts that represent a (non pecuniary) return to the account holder These nonpecuniary benefits are likely to be sensitive to interest rates on other assets Direct deposit facilities Lower rates on loans Financial advice "Rewards" programs Free tshirts Attractive/courteous tellers If loans can gather high interest rates, bank compete for deposits 4 Friedman's Model Money demand is not sensitive to the absolute level of return on bonds, equities or real assets Money is sensitive to returns on these assets relative to the return on money Must ask not only how returns on bonds/equities/real assets change Must also ask how return on money changes Money can receive a return There exist incentives for banks to offer returns on money Returns on money are likely to change for the same reasons that returns on other assets will change 5 Friedman's Model Suppose rb rises Banks realize that they can lend at higher rates To facilitate this lending, banks wish to attract more deposits Increase returns to money (whether direct interest payments or nonpecuniary returns) to attract deposits When rb is high, rm tends to be high as well Relative returns tend to be quite stable Changes in rb tend not to affect demand for real money balances (as rb rm) tends not to change 6 Implications of Friedman's Model This interpretation yields: Reminiscent of the quantity theory Low sensitivity to expected changes in income or transitory, unexpected changes Insensitive to returns on other assets, as changes in these returns tend to be mimicked by the return to money Monetary changes are translated to changes in the price level, and so to nominal income 7 Md/P = f(Yp) Implications of Friedman's Model Velocity: Does Friedman's model generate a procyclical velocity? v = PY = Y . Suppose we are in a boom, so that Y is rising quickly: M f(Yp) Permanent income doesn't rise nearly as quickly Therefore the numerator rises quickly while the denominator rises slowly Velocity increases (as required) 8 Keynes v. Friedman Are these truly different models? Suppose Friedman's model Models would be qualitatively the same Had only one alternative asset (bonds) Had the return on money fixed at 0 Depended on national income rather than permanent income 9 Keynes v. Friedman Differences come in the specific empirical predictions made: Friedman asserts low sensitivity to current national income Keynes asserts no sensitivity to return on money (as he assumes money receives no return) Keynes asserts that returns on a wide range of assets, financial and real, tend to move together, so can proxy for these with a single return: the return on bonds 10 Competing Predictions Keynes: Money demand is sensitive to interest rates We need to be concerned about the liquidity trap Velocity is procyclical Velocity is hard to predict as money demand tends to change when expectations about the longrun average interest rates change Interest rates are so low that nobody wants to hold bonds: all wealth is trapped in liquid form E.g. When cyclical changes in output are observed, the money demand function shifts Extent of the shift depends on how expectations of long term average interest rates change Variability in the money demand is hard to pin down 11 Keynesian Money Demand i M/P iH i* iL f(i, Y) M/P 12 Competing Predictions Friedman: Money demand is insensitive to interest rates Velocity is procyclical Velocity is easy to predict as the money demand equation is relatively stable, and the relationship between permanent income and current income are reasonably well understood Money supply changes will be translated almost wholly into changes in the price level, and therefore into nominal expenditures 13 Friedman's Money Demand i M/P i* f(i, Yp) M/P 14 Empirical Evidence Interest Sensitivity of Money Demand Stability of Money Demand No evidence of liquidity trap Significant evidence of sensitivity to the interest rate Prior to the stagflationary period in the early seventies, money demand seemed quite stable Now, money demand seems significantly less stable Instability is likely caused by rapid development of the financial sector 15 The Bottom Line Money demand: We will want to be aware of, and contrast, the distinct predictions associated with the extreme cases: Money demand is highly inelastic (i.e. insensitive to interest rates, as predicted by Friedman); or Money demand is highly elastic (i.e very sensitive to the interest rate, as predicted in Keynes' "liquidity trap"). Md = f(Y, i) 16 The IS-LM model Simple Static model Designed to give insight into simultaneous determination of interest rates and national income Relies on equilibrium in two markets Goods market Money market When the money market clears, so does the bond market, which lurks at all times in the background 17 Money Market equilibrium i1 i 0 f(i, y1) f(i, y0) M/P When y rises from y0 to y1 Equilibrium interest rate, i, goes up too To ensure money market is always in equilibrium, i and Y must be positively related M/P 18 The LM curve Liquidity demand = Money supply L = M (i.e. LM) i i1 LM i0 Y0 Y1 Y 19 The LM Curve Captures the relationship between interest rates and national income required to ensure money market equilibrium Inverse relationship Implies equilibrium in the bond market as well Also must depend on other influences on liquidity demand or money supply 20 If national income rises, creates excess demand for money People sell bonds Bond prices fall, interest rates rise Find equilibrium at higher i. The LM curve What doesn't shift the LM curve? Changes in national income and their associated change in interest rates Movements along the curve What does shift the LM curve? Changes in nominal money supply Changes in the price level Changes in expected interest rates Other exogenous changes in money demand 21 Example: increase in the real money supply (i.e. M or P) i M0/P M1/P i LM0 LM1 i0 i1 f(i, Y0) M /P 0 M /P 1 M/P Y0 The LM curve Y Money Market 22 Example: decrease in the expected future interest rates i M0/P i LM0 LM1 i0 i1 f(i, Y0, ie0) f(i, Y0, ie1) M /P 0 M/P Y0 The LM curve Y Money Market 23 Friedman v Keynes Competing theories of money demand Has implications for the relationship between i and Y Different sensitivity of money demand to changes in the interest rate Implies differences in the LM curves generated 24 Keynes' money demand and LM i M/P i LM i1 i0 f(i, Y0) f(i, Y1) M/P Money Market Y0 Y1 Y 25 LM Curve Friedman's money demand and LM i i1 M/P i LM f(i, Y1) i0 f(i, Y0) M/P Money Market Y0 Y1 Y 26 LM Curve ...
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