Notes_ECO202_03 - Macroeconomics Theory and Policy...

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Unformatted text preview: Macroeconomics Theory and Policy Financial Market: LM Curve Masoud Anjomshoa 1 Economy circular flow Income Private Saving Households Taxes Budget Deficit Government Factor Payments Factor Market Financial Market Firms Capital Flow Borrowing Investors Foreigners Investment Export-Import Government Spending Consumption Goods Market Firms Revenue Inventories 2 Masoud Anjomshoa 1 Macroeconomics Theory and Policy Financial Market in Short Run: . In financial market LENDERS and BORROWERS meet. Sellers of assets Financial market is the market to buy/sell assets. Assets are used to accumulate Wealth. Wealth is used to transfer consumption over time, i.e. to smooth out the consumption, because income generally fluctuates. Short Run Assumption: Wealth is fixed. Two types 1- Money: needed for transactions, no return. of assets 2- Bonds: not good for transactions, have return. Masoud Anjomshoa 3 Financial Market in Short Run: . Money vs. Bonds: Liquidity vs. Return M B oney onds W ealth People decide what share of their wealth should be in form of money, and what share in form of bonds. (Asset Portfolio) Masoud Anjomshoa Masoud Anjomshoa 4 2 Macroeconomics Theory and Policy Financial Market in Short Run, Bonds: . Assumption: There are only one-year bonds, i.e. if someone buys them and keep them for one year, the face value will be paid. The interest rate, i, is defined as the rate return on the one-year bonds ( it can be imagined as prime rate). Face Value i Pr ice of bond 1 100 $1000 i P 1 100 b Important: Price of bonds, Pb, and the interest rate, i, have inverse relationship with each other. Masoud Anjomshoa 5 Bonds, an example: $1000 i P 1 100 b If i 10% If i 12% If i 8% Pb . Pb $1000 $909.09 1.10 $1000 $892.86 i Pb 1.12 $1000 Pb $925.93 i Pb 1.08 Pb Masoud Anjomshoa Masoud Anjomshoa $1000 (1 i) 6 3 Macroeconomics Theory and Policy Financial Market, Money: . What is money? There is no unique definition of money. M1 = Currency in circulation + Personal chequeing accounts at chartered banks + Current accounts at chartered banks (Demand deposits) (Aug 2000) $104.9 B M1 Masoud Anjomshoa 7 Financial Market, Money: . M2 = M1 + Personal saving accounts at chartered banks (GIC’s) + Non personal notice deposits at chartered banks $487.6B (Aug 2000) M2 M1 $104.9B Masoud Anjomshoa Masoud Anjomshoa 8 4 Macroeconomics Theory and Policy Financial Market, Money: . M3 = M2 + Non personal fixed term deposits of firms at chartered banks $670.4B + Foreign currency deposits (booked in Canada) at chartered banks $487.6B (Aug 2000) M3 M2 M1 $104.9B Masoud Anjomshoa Financial Market, Money: 9 . M2+ = M2 + all deposits and shares at: - Trust funds - Mortgage loan companies - Credit union - Government financial institutions - Individual annuities at life insurance companies - Money market mutual funds -… Masoud Anjomshoa Masoud Anjomshoa 10 5 Macroeconomics Theory and Policy Demand for Money: M . B oney onds W ealth Demand for bonds is calculated as the residual. Transaction demand for money: positively related to income. Md = L($Y , i ) + – Speculative demand for money: negatively related to interest rate. Md = $Y L(i) – 11 Demand for Money: . i i’ Md = $Y L(i) Given $Y B i – Inversely related to the interest rate, i. A Md M’ M Money, M Higher interest rate: Higher opportunity cost of holding money Masoud Anjomshoa Masoud Anjomshoa 12 6 Macroeconomics Theory and Policy Demand for Money: . $Y’ > $Y Md = $Y L(i) – i Positively related to the nominal income, $Y. i1 Higher income: i2 Md Money, M Higher (transaction) demand for money at any level of interest rate Masoud Anjomshoa Demand for Money: Given $Y 13 . Md = $Y L(i) – i Functional shift: Technological progress in financial sector. i1 i2 Introduction of: M d’ Md Money, M - Shift the whole curve. Masoud Anjomshoa Masoud Anjomshoa 14 7 Macroeconomics Theory and Policy Supply of Money: i Ms . Ms ’ Ms M Money supply is a policy variable set by the Central Bank. Expansionary monetary policy: When the Central Bank expands the money supply. M M M' The Central Bank buys government bonds. Masoud Anjomshoa Supply of Money: i Ms ’ 15 . Ms M Ms Contractionary monetary policy: When the Central Bank reduces the money supply. The Central Bank sells government bonds. M' M M Masoud Anjomshoa Masoud Anjomshoa 16 8 Macroeconomics Theory and Policy Equilibrium in Financial Market: M d $Y L(i) s M M $Y PY i . s M M P P Given Y M d i Y L( ) P s M M P P E i d M i Y L( ) P M/P M P Real Money: M/P Masoud Anjomshoa 17 Equilibrium in Financial Market: M i Y L( ) P s M M P P Given Y i i s M M P P s M M1 P P 1 Expansionary Monetary policy: M CB buys bonds A B i1 M/P M1 / P d M i Y L( ) P M/P Masoud Anjomshoa Masoud Anjomshoa . d 18 9 Macroeconomics Theory and Policy Equilibrium in Financial Market: d s M Y L( i ) P i M M P P s M M P P i1 B i . Increase in output/income, Y: At any level of interest rate, the (transaction) demand for money increases A d M Y1 L( i ) P 1 d M Y L( i ) P M/P M/P Masoud Anjomshoa 19 Equilibrium in Financial Market (LM Curve):. d M Y L( i ) P s M M P P LM curve is the geometric location of all (i , Y) that bring the financial market to equilibrium. i i LM E2 i2 i1 i2 E1 s M M P P E2 d M i Y2 L( ) P 2 i1 d E1 Y1 Y2 Y Masoud Anjomshoa Masoud Anjomshoa M/P M Y1 L( i ) P 1 M/P 20 10 Macroeconomics Theory and Policy Equilibrium in Financial Market (LM Curve): d s M i Y L( ) P d M M P P M M P P s LM Curve M Y L( i ) P At any level of interest rate, the (transaction) demand for money increases LM i i2 i1 Increase in output/income, Y: E2 E1 Y1 Y2 Y Masoud Anjomshoa 21 Equilibrium in Financial Market (LM):. If money supply increases (expansionary monetary policy): the LM curve shifts down. s i M M P P i2 E2 i LM LM’ E2 i2 i’2 i1 i’1 E1 i1 i’1 E’1 Y1 E1 Y d M i Y2 L( ) P 2 d E’1 Y2 Masoud Anjomshoa Masoud Anjomshoa E’2 i’2 E’2 's M' M P P M/P M' / P M Y1 L( i ) P 1 M/P 22 11 Macroeconomics Theory and Policy Equilibrium in Financial Market (LM):. Technological progress in financial market leads to a downward shift in LM curve. s i M M P P i2 E2 i’2 E’2 i1 i’1 E1 i LM LM’ E2 i2 i’2 i1 E1 i’1 E’2 E’1 Y1 Y2 Y d M i Y2 L( ) P 2 d M Y1 L( i ) P 1 E’1 M/P M/P M' / P Masoud Anjomshoa 23 Equilibrium in Financial Market (LM):. If price level falls, it leads to a downward shift in the LM curve s i M M P P i2 E2 i LM LM’ E2 i2 i’2 i1 i’1 E1 i1 i’1 E’1 Y1 E1 Y2 Y d M i Y2 L( ) P 2 d E’1 Masoud Anjomshoa Masoud Anjomshoa E’2 i’2 E’2 's M M P' P M/P M / P' M Y1 L( i ) P 1 M/P 24 12 Macroeconomics Theory and Policy Equilibrium in Both Markets:. IS : Y c o c1 (Y T ) I(Y, i ) G M Y L( i ) LM : P i LM Y Equilibrium in Equilibrium in Equilibrium in E i IS Y Y Output Capacity Masoud Anjomshoa 25 Impact of Fiscal Policies:. If government spending, G, IS : Y c o c1 (Y T ) I(Y, i ) G M Y L( i ) LM : P i LM i1 i A O Y Y1 Masoud Anjomshoa increases Point A is a short run equilibrium. Economy is in boom. Y ↑ Consumption increases, but how about investment? IS1 Y ↑ and i↑ IS Y Masoud Anjomshoa 26 13 Macroeconomics Theory and Policy Impact of Monetary Policies:. IS : Y c o c1 (Y T ) I(Y, i ) G M Y L( i ) LM : P i LM LM1 If the Central Bank increases money supply, M : The CB buys bonds Point A is a short run equilibrium. Economy is in boom. O i i1 A IS Y Y Y1 Masoud Anjomshoa 27 Dynamics of Changes:. IS : Y c o c1 (Y T) I(Y, i ) G M Y L( i ) LM : P i LM If the Central Bank increases money supply, economy goes from O to B. But what is the exact path that the economy covers? LM’ i i1 O B IS Y Masoud Anjomshoa Y1 Y Masoud Anjomshoa 28 14 Macroeconomics Theory and Policy s i O i i1 i’ B A Y Z IS Y Y1 B Z Y1 B d M Y1L(i) P d M YL(i) P M' / P M/P - Financial market achieves equilibrium fast. - Goods market reached to equilibrium gradually. - Interest rate adjusts instantly, while output adjusts slowly. Z O Y s M M' P P A M/P Z’ A O i i1 i’ Z=Y Z1 M M P P i LM LM’ Monetary policies lead to an overshoot in interest rate. Y Masoud Anjomshoa 29 Shocks and Stabilization Policies:. IS : Y c o c1 (Y T) I(Y, i ) G M Y L( i ) LM : P LM i If consumers become pessimistic O i i1 A: Short run equilibrium. A IS1 Y1 Y IS Y Masoud Anjomshoa Masoud Anjomshoa Economy goes to recession. Self-fulfilling Prophecy 30 15 Macroeconomics Theory and Policy Shocks and Stabilization Policies:. The Central Bank can stabilize the economy by expansionary monetary policy. Stabilization Policies LM i B: New equilibrium after the stabilization policy. LM1 Compare points O and B: i Y=C+I+G O A i1 B i2 IS1 Y1 IS Y Y Higher investment, and lower consumption Masoud Anjomshoa 31 Shocks and Stabilization Policies:. Stabilization Policies LM i Government can stabilize the economy by expansionary fiscal policies. C: New equilibrium after the stabilization policy. Compare points O and C: i2=i i1 G↑ A IS IS1 Y1 Masoud Anjomshoa Y Y=C+I+G T↓ C O Y=C+I+G Y Masoud Anjomshoa In both cases government budget deficit increases 32 16 Macroeconomics Theory and Policy Supply of Money Masoud Anjomshoa 33 Supply of Money: Reserves (R ): The portion of deposits that banks have not lent. A bank liabilities include deposits. A bank assets include reserves and outstanding loans. 100-percent-reserve banking: A system in which banks hold all deposits as reserves. Fractional-reserve banking: A system in which banks hold a fraction of their deposits as reserves. In fractional-reserve banking systems, banks create money, but they don’t create wealth: Bank loans give borrowers some new money and an equal amount of new debt. Masoud Anjomshoa Masoud Anjomshoa 34 17 Macroeconomics Theory and Policy Supply of Money: Commercial Banks Balance Sheet Assets | Liabilities Reserves $200 | Deposits $1000 Loans $800 | | Reserves $160 | Deposits $800 Loans $640 | | Reserves $128 | Deposits $640 Loans $512 | … | … Open Market Operation: Central Bank buys $1000 bonds from a person . People don’t keep cash Required Reserves Ratio is 20%: rr = 0.2 0.8=(1-rr) . Reserves Loans $1000 | Deposits $4000 | $5000 Masoud Anjomshoa 35 Supply of Money: . . Commercial Banks Balance Sheet Assets | Liabilities Reserves $1000 | Deposits $5000 Loans $4000 | Central Bank Balance Sheet Assets | Liabilities Bonds $1000 | Reserves $1000 . . High Powered Money = Reserves H = R = 1000 Money = Cash + Demand Deposits M = C + D = 0 + 5000 = 5000 Money Multiplier = m = M/H M=mH m = M/H m = 5000/1000 = 5 m = D/R Masoud Anjomshoa Masoud Anjomshoa m = 1/rr 36 18 Macroeconomics Theory and Policy Open Market Operation: Central Bank buys $1000 bonds from a person Required Reserves Ratio is 20%: rr = 0.2 Commercial Banks Balance Sheet Assets | Liabilities Reserves $150 | Deposits $750 Loans $600 | | Reserves $ 90 | Deposits $450 Loans $360 | | Reserves $ 54 | Deposits $270 Loans $216 | … | … . People keep cash: cr = cash/deposit =1/3 Cash $250 0.6 $150 1 rr 1 cr $ 90 . Reserves Loans $ 375 | Deposits $1500 | $1875 $625 Masoud Anjomshoa . . Commercial Banks Balance Sheet Assets | Liabilities Reserves $ 375 | Deposits $ 1875 Loans $1500 | Central Bank Balance Sheet Assets | Liabilities Bonds $1000 | Reserves $ 375 | Cash $ 625 37 . Cash $ 625 . High Powered Money = Cash + Reserves H = C + R = 1000 Money= Cash +Demand Deposits M = C + D = 625 + 1875 = 2500 Money Multiplier = m = M/H m = 2500/1000 = 2.5 M = m H m = M/H m = (C+D)/(C+R) m = (C/D+1)/(C/D+R/D) m = (1+cr)/(rr+cr) Masoud Anjomshoa Masoud Anjomshoa 38 19 Macroeconomics Theory and Policy Central Bank buys $1000 bonds from a person Required Reserves Ratio is 20%: rr = 0.2 Banks keep 20% excess reserves: e = 0.2 Commercial Banks Balance Sheet . Assets | Liabilities Reserves $150 | Deposits $750 Excess Reserves $150 | Loans $450 | | Reserves $67.5 | Deposits $337.5 Excess Reserves $67.5 | Loans $202.5 | … | … Reserves $272.7 | Deposits $1363.6 Excess Reserves $272.7 | Loan $818.2 | People keep cash: cr = cash/deposit =1/3 Cash $250 0.45 1 e rr 1 cr $112.5 . $454.6 Masoud Anjomshoa 39 Commercial Banks Balance Sheet Assets | Liabilities . Cash Reserves $272.7 | Deposits $1363.6 $454.6 Excess Reserves $272.7 | Loan $818.2 | Central Bank Balance Sheet Assets | Liabilities . . Bonds $1000 | Reserves $272.7 | Excess Reserves $272.7 | Cash $454.6 High Powered Money = Cash + Reserves +Excess Reserves H = C + R + E = 1000 Money = Cash + Demand Deposits M = C + D = 1363. 6 + 454.6 = 1818 Money Multiplier = m = M/H m = 1818/1000 = 1.818 Masoud Anjomshoa Masoud Anjomshoa 40 20 Macroeconomics Theory and Policy m = M/H m = (C+D)/(C+R+E) m = (C/D+1)/(C/D+R/D+E/D) m = (1+cr)/(rr+cr+e) 1 cr M H cr e rr People Central Bank: - Require reserve ratio, rr Commercial Banks - Open market operation, H - Overnight rate For Canada Required Reserve Ratio is 0: rr =0 - Deposit switching Masoud Anjomshoa 41 Bank Rate: The interest rate that the Central Bank charges the commercial banks for overnight loans, ib. Overnight Rate: The interest rate that the commercial banks charge each other for overnight loans, iov. Operating Band: A 0.5% range below the Bank Rate. 4.50% 4.25% Operating Band 4.00% 3.75% 3.50% Bank rate, ib: The interest rate that the Central bank charges the other banks for overnight loans. Targeted Overnight Rate, iov. The interest rate that the Central bank pays to the other banks for their excess reserves. Masoud Anjomshoa Masoud Anjomshoa 42 21 ...
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