5.9 financial markets and central bank online test
duty13
Week16lecture.pptxMoney Growth, Money Demand, and Modern Monetary Policy
Chapter 20
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Learning Objectives
Describe the transactions demand and the portfolio demand for money.
Explain why key central banks have shifted away from targeting money growth.
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20-2
The Transactions Demand for Money
The quantity of money people hold for transactions purposes depends on their
Nominal income,
The cost of holding money
The availability of substitutes
The higher people’s nominal income, the more they will spend, needing more money.
The higher nominal income is, the higher nominal money demand will be.
20-3
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3
The Transactions Demand for Money
Deciding how much money to hold depends on the costs and benefits.
Benefits: Holding money allows people to make payments.
The cost is based on opportunity cost.
The interest that people lose in not buying an interest-bearing bond is the opportunity cost of holding money.
The decision to hold money depends on how high the bond yield is and how costly it is to switch bank and forth.
20-4
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4
The Transactions Demand for Money
For a given cost of switching, as the nominal interest rate rises, people reduce their checking account balance, shifting funds into and out of higher-yield investments.
The higher the nominal interest rate, the higher the opportunity cost of holding money, the less money individuals will hold for a given level of transactions, and the higher the velocity of money.
20-5
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The Transactions Demand for Money
This relationship explains why inflation tends to exceed money growth in high-inflation countries
At high levels of inflation, money is losing value very quickly.
People respond to the high cost of holding money by keeping as little of it as possible.
They purchase durable goods that have zero real return - better than negative return on currency.
20-6
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The Transactions Demand for Money
The frantic spending drives up the velocity of money.
Because high inflation brings an increase in velocity, inflation must be higher than money growth in those countries.
20-7
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The Transactions Demand for Money
The transactions demand for money is affected by technology.
Financial innovation allows people to limit the amount of money they hold.
It reduces the cost of shifting funds from an interest-bearing bond to a checking account.
This lowers the money holdings at a given level of income.
This increases the velocity of your money.
20-8
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The Transactions Demand for Money
We all hold money to insure ourselves against unexpected expenses.
We call this the precautionary demand for money
This rises with risk.
The higher the level of uncertainty about the future, the higher the demand for money and the lower the velocity of money will be.
20-9
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The Portfolio Demand for Money
As a store of value, money provides diversification when held along with a wide variety of other assets.
The demand for bonds depends on several factors including:
Wealth
The return relative to alternative investments
Expected future interest rates on bonds
Risk relative to alternative investments
Liquidity relative to alternative investments
20-10
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10
The Portfolio Demand for Money
As wealth rises, the quantity of all these investments, including money, rises with it.
A decline in bond yields will increase the portfolio demand for money.
When interest rates rise, bond prices drop and bondholders suffer a capital loss.
If you think interest rates are likely to rise, bonds will become less attractive than money to you.
When interest rates are expected to rise, money demand goes up.
20-11
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The Portfolio Demand for Money
If a sudden decrease in the liquidity of stocks, bonds, or other assets occurred, we would expect to see an increase in the demand for money.
20-12
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The Demand for Money
20-13
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13
Targeting Money Growth in a Low-Inflation Environment
The only solution to high inflation is to reduce money growth.
In a low-inflation environment, controlling inflation is not so simple.
The quantity theory of money tells us that our ability to use money growth as a policy guide depends on the stability of the velocity of money.
Velocity is stable in the long-run but not in the short-run.
20-14
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Targeting Money Growth in a Low-Inflation Environment
There are two criteria for the use of money growth as a direct monetary policy target:
A stable link between the monetary base and the quantity of money and
A predictable relationship between the quantity of money and inflation.
The first of these allows policymakers to predict the impact of change in the central bank’s balance sheet on the quantity of money.
20-15
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15
Targeting Money Growth in a Low-Inflation Environment
The second allows them to translate changes in money growth into changes in inflation.
Central bankers need numerical estimates of these relationships.
The relationship between money demand and its determinants must be stable and predictable -- a problem for U.S. policymakers.
20-16
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16
The Instability of U.S. Money Demand
Nominal income is roughly proportional to money demand.
Doubling nominal income means doubling the dollar value of the transactions they engage in, which require double the original amount of money.
Interest rates, or more precisely, the opportunity cost of holding money
20-17
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17
The Instability of U.S. Money Demand
The opportunity cost of M2 is defined as the yield on three-month U.S. Treasury bill minus the return on holding M2.
The opportunity cost is a measure of the real return that individuals give up when they decide to hold M2 rather than a three-month Treasury bill.
20-18
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18
The Instability of U.S. Money Demand
20-19
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19
The Instability of U.S. Money Demand
There is a relationship between the velocity of money and the opportunity cost of holding money.
But the relationship shifted quite a bit between the two decades.
Using the relationship from the 1980s as a basis for policymaking in the 1990s and thereafter would not have produced the desired result.
20-20
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The Instability of U.S. Money Demand
What caused the instability of money demand over these three decades?
One reason has to do with the introduction of financial instruments that paid higher returns than money, but could still be used as a means of payment.
While officials have tried to account for the new instruments by changing the composition of the monetary aggregates, money demand continues to appear unstable.
20-21
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The Instability of U.S. Money Demand
A second explanation has to do with changes in mortgage refinancing rates.
As long-term interest rates fell throughout the 1900s and into the 21st century, they spurred periods of intense activity in the mortgage market.
When mortgage interest rates fall dramatically, large numbers of people pay off their old, high-interest rate mortgages and replace them with new, low-interest mortgages.
20-22
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22
The Instability of U.S. Money Demand
When a mortgage is refinanced, it creates demand for money in several ways.
Some of the equity in the home is removed ,the proceeds of which go into liquid deposit accounts.
Funds for the new mortgage must be collected from investors and transferred to holders of the old mortgage.
They flow through an account that is part of M2.
Once interest rates stabilize M2 settles down, but in the meantime velocity fluctuates.
20-23
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Making policy is about numbers.
This means using statistical models.
The problem is that when policymakers change the way they make policy, everyone changes the way they act: the Lucas critique.
Following changes in policy regime, old models may be a poor guide for future policy.
20-24
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24
Targeting Money Growth: The Fed and the ECB
Though today virtually no central bank targets money growth, the practice was common in the 1970s.
In the U.S., the Federal Reserve Board had to make quarterly appearances to testify to the Fed’s money growth targets for the coming year.
But announcing an objective is one thing; achieving it is something else.
The FOMC rarely hit its money growth targets.
20-25
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25
Targeting Money Growth: The Fed and the ECB
In July 2000, the committee stopped publishing them.
Policymakers could have hit their money growth targets, but doing so would have meant adjusting the federal funds rate target frequently, and by large amounts.
This is something policymakers are unwilling to do.
20-26
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Targeting Money Growth: The Fed and the ECB
The ECB’s Governing Council periodically announces a money growth rate that is intended to serve as a long-run reference value.
The difference of opinion between the Fed and the ECB on this matter can be traced to their divergent views on the stability of money demand.
Researchers who study the demand for money in the euro-area have concluded that it is stable, which implies that changes in velocity are predictable.
20-27
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Targeting Money Growth: The Fed and the ECB
20-28
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Targeting Money Growth: The Fed and the ECB
While short-run fluctuations in velocity were significant, European policymakers point to the tendency of velocity to return to its long-run downward trend over periods of a few years.
The ECB and the Fed have both chosen interest rates as their conventional operating target.
Interest rates are the link between the financial system and the real economy.
20-29
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Targeting Money Growth: The Fed and the ECB
By keeping interest rates stable, policymakers can insulate the real economy from disturbances that arise in the financial system.
While inflation is tied to money growth in the long run, interest rates are the tool policymakers use to stabilize inflation in the short-run.
20-30
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Targeting Money Growth: The Fed and the ECB
20-31
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31
Boskin Commission concluded that the U.S. CPI systematically overstated inflation by 0.8 to 1.6 percentage points each year.
The BLS worked to reduce this
Recently overinflation concerns have resurfaced
We (mis)measure changes in the quality of information technology, digital content, and health care
Reasons why the CPI tends to overstate inflation:
Consumers are continually shifting their consumption basket
New welfare-enhancing goods are included in the CPI only with a significant lag and are difficult to estimate
CPI has long overstated inflation, so the rise of living standards has been understated for decades
20-32
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