Econ 310 W2008 Class16

Econ 310 W2008 Class16 - Money and Banking Econ 310...

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Unformatted text preview: Money and Banking Econ 310 Announcements Reading: Today: Mishkin, Chapter 19 Tuesday: Mishkin, Chapter 20 Assignment Due next Tuesday, 5:00 pm 2 Money Demand Quantity Theory of Money M/P = Y/v Demand for real money balances dependent only on national income Links money supply growth to changes in the aggregate price level Criticisms Depends on a relatively stable velocity of money Velocity of money appears strongly procyclical 3 Keynes' Liquidity Preference framework The speculative demand for money is sensitive to interest rates (i.e. returns on the alternative asset) so Md/P = f(y, i) + 4 Money Market Equilibrium i ms ms(i) i md = f(i, y0) M/P M/P 5 Effect of increasing national income in money market i i1 ms i0 f(i, y1) f(i, y0) M/P M/P 6 Keynes' Liquidity Preference framework Think about velocity again: v = (P * Y)/M = Y/f(i, Y) So, if Y is high (boom period), what does this do to velocity? Model predicts that i rises Procyclical velocity is observed in the data Tendency for v to rise Gives some credibility to the model 7 Criticism of Keynes' model Model seems to fit some of the data Hard to reconcile other elements of the theory E.g. velocity is procyclical Individual chooses between money or bonds to satisfy her "speculative demand" Will only hold money to satisfy "speculative demand" if interest rates are low enough to generate expected negative returns on bonds Demand for money should be very responsive to interest rate changes Don't observe individuals divesting themselves of bond holdings in favor of money with small changes in the interest rate 8 The Inventory Approach Proposed in the work from Baumol and Tobin Explained that transactions demand alone would create money demand that was sensitive to interest rates Avoids the criticisms of the liquidity preference model 9 The Inventory Approach Economic agents receive periodic payments If those payments are held as money, then real money balances adjust over the period as the agent uses the balances to complete transactions 10 Money holdings Average daily money hldngs months 11 The Inventory Approach Could use half of the income to buy bonds, while holding half as money When the money runs out half way through the period, cash in the bond Replicates consumption pattern, AND provides extra interest income Downside: transactions costs 12 Money holdings Average daily money hldngs Average daily money hldngs months 13 Agent would prefer to convert as much cash as possible to bonds, and redeem the bonds slowly as transactions accrue The Inventory Approach But this is costly: Benefit: interest earned on bonds Transactions costs associated with redeeming/selling bonds Brokerage fees Delay costs 14 The Inventory Approach Optimal level of money held, which balances the forgone interest with the additional transactions costs on the marginal dollar of money held. Transactions motivated money demand function that depends on the interest rate on bonds: When the interest rate on bonds is high, there is incentive to hold more bonds, and bear additional transactions costs to accommodate purchases Real money demand is negatively related to the interest rate. 15 Friedman's New Quantity Theory Based on theory of asset demand Money is seen as one of a series of different assets: Demand for money depends on Bonds Equities Real assets Human capital the returns offered on money relative to those available on the alternative assets Permanent income (i.e. average, longrun expected income, rather than current income that is extremely variable) 16 Friedman's New Quantity Theory Md/P = f(Yp, rbrm, rerm, erm) + rm = return on money r = return on bonds b r = return on equity e e = expected inflation (implicit return on assets) Y = real permanent income p Md/P = demand for real money balances real 17 Yp: Permanent Income Effectively average longterm income Doesn't fluctuate with expected changes in income Fluctuates relatively little even with unexpected variations in income Business cycle effects on permanent income will be small Money demand is relatively insensitive to income variations (especially the business cycle) 18 rm: return on money Usually think the return on money is zero Here rm is potentially positive Highly liquid accounts may well offer interest Banks and financial institutions can offer services attached to their accounts that effectively offer a return to the account holder without the account holder receiving explicit interest payments 19 Returns on Assets Relative to Returns on Money rb rm: returns on bonds relative to money re rm: returns on equities relative to money e rm: returns to real assets relative to money All are negatively related to demand for money 20 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 21 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 22 Implications of Friedman's Model Money demand is not sensitive to return on bonds, equities or real assets, but to the returns on these assets relative to the return on money Money can receive a return, and there exist real incentives for the banking system to offer returns 23 Implications of 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 Offer returns (whether direct interest payments or nonpecuniary returns) to attract deposits Relative returns tend to be quite stable 24 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 25 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) 26 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 27 Keynesian Money Demand i M/P iH i* iL f(i, Y) M/P 28 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 29 Friedman's Money Demand i M/P i* f(i, Yp) M/P 30 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 31 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) 32 ...
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