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					Chapter VII: Money, assets,
and interest rates
   A.   What is money?
   B.   Monetary aggregates
   C.   Demand for financial assets
   D.   Asset market equilibrium
   E.   Liquidity preference theory
   F.   Interest rates and interest rate spreads

                                              Goethe Business School
What is money ?

    “Money is what money does.
  Money is defined by its functions”
           (John Hicks).
      Money is an information
 processing technology that aims at
              reducing
 uncertainty and establishing trust.     John Hicks
                                           1904-89


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                                       Goethe Business School
What is money ?
   Money is typically defined by describing its
    functions
   Important functions are:
     unit of account
     medium of exchange
      (the easing of transactions of goods and services)
     the store and transfer of value (wealth)
   The functions of money are embedded
    into a historical process
   The definition of money is thus evolving
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                                                Goethe Business School
Stone “money”
of the island of Yap




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                       Goethe Business School
Evolution
of the payment system

   Commodity money
   Fiat money
   Electronic money
     Debit cards (EC card, ATM card)
     Stored-value card (“money card”)
     Electronic cash/checks
   Are we moving to a cashless society?

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                                           Goethe Business School
Unit of account
   In microeconomic theory any good can function
    as a unit of account
   It is more convenient to use “money” as a single,
    uniform unit of account because goods may be
    subject to relative price changes
   At the global level it is questionable what should
    be the unit of account
   The U.S. dollar and the euro play an important
    role, but there are also proposals to revert to
    commodity money (gold, petroleum)

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                                            Goethe Business School
Medium of exchange
   The decomposition of exchange acts renders
    a modern economy based on labor sharing
    possible
   But this requires the existence of a social
    consensus, according to which money is
    accepted as a general medium of exchange
   A legal provision can facilitate such
    acceptance, but it cannot necessarily be
    enforced
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                                        Goethe Business School
Medium of exchange:
Lack of confidence
   Where there is lack of confidence in a legal
    tender, there could be escape into
    “substitute currencies”
    (= “hard” currencies or commodity money
    --> such as cigarettes, butter)
   Such “monies” circulate forcibly as media of
    exchange, but they are unsuitable as a
    store of value (Gresham’s “Law”):
             Bad money replaces good money!
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                                         Goethe Business School
Payment function

    This function permits the granting of
     credit, the transfer of credits and
     liabilities, and the redemption of
     debentures
    The prerequisite is that credit money will
     be provided and is universally accepted
     within a society

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                                      Goethe Business School
Store of value
    To the extent that assets may have
     monetary characteristics, money can
     produce returns (interest income)
    Normally, money is held interest-free
    The question is: Why do individuals hold
     money without interest?
    This brings us to the notion of
          Ability to pay or “liquidity”
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                                          Goethe Business School
“Quasi-money”

   Close substitutes to money (such as
    short-term financial assets) can function
    as a store of value, hence bear interest,
    and still be “liquid”
   Such “quasi-money” can be converted
    into money without high transactions
    costs

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                                      Goethe Business School
Liquidity as a
technology of exchange
    Liquidity depends on social conventions
     which establish confidence among
     potential trading partners and facilitate
     exchange
    Disobeying to the rules is costly, so
     money reduces transactions costs and
     gets an own “intrinsic” value or price

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Liquidity
   The question is,
    how to define “liquidity”.
   Milton Friedman proposes
    an “ideal” definition:
   Liquity =
             i Ai * wi,
                                         Milton Friedman
    where wi is the                           1912-
    “degree of moneyness” of asset Ai.   Nobel Prize 1976


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                                         Goethe Business School
Empirical definition of money
   Friedman’s approach had an important
    influence on the empirical and operational
    definition of money
   The definition of “quasi-money” includes
    not only central bank money and demand
    deposits, but also time deposits and
    savings according to their “degree of
    moneyness”

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                                      Goethe Business School
    Measuring money demand

   M1=
    “narrow money”
   M2=
    “intermediate”
    money
   M3=
    “broad money”




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                             Goethe Business School
Components of M3
   Repurchase agreement: it is an arrangement
    whereby an asset is sold but the seller has a
    right and an obligation to repurchase it at a
    specific price on a future date or on demand.
   Such an agreement is similar to collateralized
    borrowing, but differs in that ownership of the
    securities is not retained by the seller.
   Repurchase transactions are included in M3 in
    cases where the seller is a Monetary Financial
    Institution (MFI) and the counterparty is a non-
    MFI resident in the euro area.
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                                            Goethe Business School
Components of M3
   Money market funds:
    they are collective investments
     which are close substitutes for deposits
     and which primarily invest in money market
      instruments and other transferable debt
      instruments with a residual maturity up to one
      year,
     or in bank deposits which pursue a rate of
      return that approaches the interest rates on
      money market instruments.
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                                           Goethe Business School
Money demand in the
Euro-area (end of 2007)
                  Billion euros   In pc of currency
                                    in circulation

 Currency in          675               100
 circulation
 M1 = “narrow        3,835              569
 money”
 M2 = “inter-        7,339              1088
 mediate” money
 M3 = “broad         8,650              1282
 money”
                                                             18

                                          Goethe Business School
Development of M3
in the Euro area 1999-2008




                                                19

                             Goethe Business School
Relationship between M3 and
the inflation rate (HIPC)




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                              Goethe Business School
Quantity of money
   The central bank creates “base money”,
    but this is not the only money in circulation
   Commercial banks also create money through
    credits to their customers
   However as the liquidity of commercial banks
    hinges on base money, it is reasonable to
    assume some relationship between total money
    and base money
   It is often assumed
         M = m  B = multiplier  base money

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                                         Goethe Business School
Keynes’ attitude
toward money
   Money is part of a portfolio of assets and
    competes with real assets, other financial
    assets (such as bonds, commercial
    papers), and human capital
   Any change in the stock of money will
    have to lead to a portfolio adjustment
    which affects the price structure of the
    portfolio

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                                       Goethe Business School
Focus on demand for
financial assets
   We shall look into the money supply
    process and central banking in the next
    chapter
   We now focus on the demand for financial
    assets, of which money is part of the
    portfolio, and on interest rates


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                                    Goethe Business School
The demand for financial
assets
   What determines the quantity demanded
    of an asset?
     Wealth (total resources owned)
     Expected return of one asset relative to
      alternative assets
     Risk (the degree of uncertainty associated
      with the return)
     Liquidity (the ease and speed with which
      an asset can be turned into cash)

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                                          Goethe Business School
The demand for bonds
   We consider a one-year discount bond, paying
    the owner the face value of €1,000
    in one year
   If the holding period is one year, the return
    on the bond is equal the interest rate i
   It means: i = r = (F-P)/P
   If the bond price is €950, r = 5.3%
   We assume a quantity demanded at that price of
    €100 million

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                                         Goethe Business School
The demand for bonds

   If the price falls, say to €900, the interest
    rate increases (to 11.1%)
   Because the return on the bond is higher,
    the demand for the asset will rise, say to
    €200 million, etc



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                                         Goethe Business School
The demand for bonds

 Price of bond (€)                        Interest rate (%)

 950                                            5.3
 900                                           11.1
 850                                           17.6
 800                                           25.0
 750                                           33.0




            100   200   300   400   500
                                                                 27

                                              Goethe Business School
The supply for bonds

 Price of bond (€)                        Interest rate (%)

  950                                           5.3
  900                                          11.1
  850                                          17.6
  800                                          25.0
  750                                          33.0




            100   200   300   400   500                          28

                                              Goethe Business School
 Market equilibrium
 (asset market approach)
     Price of bond (€)                        Interest rate (%)

     950                                            5.3
     900                    C                      11.1
P*   850                                           17.6       i*
     800                                           25.0
     750                                           33.0




                100   200   300   400   500
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                                                  Goethe Business School
Market equilibrium
   Equilibrium occurs at point C, where
    demand and supply curves intersect
   P* is the market-clearing price, and i* is
    the market-clearing interest rate
   If the P  P*, there is “excess supply” or
    “excess demand” of bonds
   The supply and demand curves can be
    brought into a more conventional form:

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                                        Goethe Business School
A reinterpretation
of the bond market
 Interest rate (%)                             Demand for bonds, Bd =
                                             Supply of loanable funds, Ls
  33.0
  25.0
  17.6
  11.1
  5.3



                                                Supply of bonds, Bs =
                                             Demand for loanable funds, Ld


             100     200   300   400   500
                                                                              31

                                                           Goethe Business School
Why do
interest rates change?
   If there is a shift in either the supply or
    demand curve, the equilibrium interest rate
    must change.
   What can cause the curves to shift?
       Wealth
       Expected return
       Risk
       Liquidity

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                                      Goethe Business School
Example: Increase in risk,
and demand for bonds
   If the risk of a bond increases, the demand
    for bonds will fall for any level of interest
    rates
   It means that the supply of loanable funds
    is reduced
   It is equivalent to a leftward shift of the
    supply curve


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                                        Goethe Business School
A shift of the
supply curve of funds
 Interest rate (%)                             Demand for bonds, Bd =
                                             Supply of loanable funds, Ls
 33.0                D
 25.0                      C
 17.6
 11.1
  5.3



                                                Supply of bonds, Bs =
                                             Demand for loanable funds, Ld


             100     200   300   400   500
                                                                              34

                                                           Goethe Business School
Effects on the supply
of funds for bonds
                                       Shift in
               Change in   Change in               Change in
                                       supply
                variable    quantity              interest rate
                                        curve


   Wealth                              right

   Expected
                                        left
   interest
   Expected
                                        left
   inflation

   Risk                                 left

   Liquidity                           right
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                                                     Goethe Business School
The supply of bonds

   Some factors can cause the supply curve
    for bonds to shift, among them
     The expected profitability of investment
      opportunities
     Expected inflation
     Government activities


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                                           Goethe Business School
Example:
Higher profitability and supply of bonds


   If the profitability of a firm increases,
    the supply for corporate bonds will
    increase for any level of interest rates
   It means that the demand of loanable
    funds increases
   It is equivalent to a rightward shift of the
    demand curve
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                                           Goethe Business School
A shift of the
demand curve for funds
 Interest rate (%)                             Demand for bonds, Bd =
                                             Supply of loanable funds, Ls
                                  D
 33.0
 25.0                      C
 17.6
 11.1
  5.3



                                                Supply of bonds, Bs =
                                             Demand for loanable funds, Ld


             100     200   300   400   500                                    38

                                                           Goethe Business School
Effects on the demand
of funds for bonds
                                        Shift in
                Change in   Change in               Change in
                                        demand
                 variable    quantity              interest rate
                                         curve


Profitability                           right

Expected
                                        right
inflation
Government
                                        right
activities

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                                                      Goethe Business School
Equilibrium
in the market for money
 Interest rate (%)
                           Supply of money, Ms

  33.0
  25.0
  17.6
  11.1
                           C
  5.3



                                                 Demand for money, Md



             100     200   300   400   500
                                                                            40

                                                         Goethe Business School
Shifts in the demand
for money curve
   Keynes considers two reasons why the
    demand for money curve could shift:
     income;
     and the price level
   As income rises
     wealth increases and people want to hold
      more money as a store of value
     people want to carry out more transactions
      using money
                                                             41

                                          Goethe Business School
Response to a change in income
 Interest rate (%)
                               Supply of money, Ms

 33.0
 25.0
                           D
 17.6
 11.1
                           C
  5.3



                                                     Demand for money, Md



             100     200       300   400   500
                                                                                42

                                                             Goethe Business School
Response to a change
in the money supply
   It is assumed that the central bank
    controls the total amount of money
    available
   The supply of money is “totally inelastic”.
   However the central bank can gear the
    money supply by political intervention
   If the money supply increases,
    the interest rate will fall (liquidity effect)

                                                             43

                                          Goethe Business School
Response to a change
in money supply
 Interest rate (%)
                           Supply of money, Ms

 33.0
 25.0
 17.6
 11.1
                           C           D
 5.3



                                                 Demand for money, Md



             100     200   300   400       500
                                                                             44

                                                          Goethe Business School
Secondary effects
of increased money supply
   If the money supply increases this has a
    secondary effect on money demand
   As we have seen:
     it has an expansionary effect on the economy
      and raises income and wealth
      -> interest rates increase (income effect).
     it causes the overall price level to increase
      -> interest rates increase (price effect)
     it affects the expected inflation rate
      -> interest rates increase (Fisher-effect)
                                                             45

                                          Goethe Business School
Should the ECB
lower interest rates?
   Politicians often ask the ECB to expand the
    money supply in order to promote a cyclical
    upturn (to combat unemployment)
   The liquidity effect does in fact
    reduce the level of interest rates!
   But the induced effects on money demand,
     the income effect,
     the price-level effect, and
     the expected inflation effect
    all increase the level of interest rates
                                                                  46

                                               Goethe Business School
Increase of money supply
plus demand shift
Interest rate (%)
                          Supply of money, Ms

33.0
25.0
                                      E
17.6
11.1
                          C           D
 5.3



                                                Demand for money, Md



            100     200   300   400       500                                47

                                                          Goethe Business School
Readings


   Reading 7-1: “The mandarins of money”,
    The Economist, August 9, 2007
   Reading 7-2: “Oceans apart”, The
    Economist, February 28, 2008
   Reading 7-3: “Asset Management:
    European disunion”, The Economist, May
    22, 2003 (optional)
                                                      48

                                   Goethe Business School
Can short term interest rates
fall below zero?
   Not really if we talk about nominal interest
    rates
   Perfectly possible when we look at real
    interest rates
   Negative real interest rates may occur
    where price inflation was not perfectly
    anticipated in the loan (debt) contract


                                                           49

                                        Goethe Business School
“Liquidity trap”
   A situation in which prevailing interest
    rates are low and cash holdings are high
   In a liquidity trap, consumers choose to
    avoid bonds and keep their funds in cash
    because of the prevailing belief that
    interest rates will soon rise
   Since bonds have an inverse relationship
    to interest rates, many consumers do not
    want to hold an asset whose price is
    expected to decline
   As a result, monetary policy is ineffective
                                                          50

                                       Goethe Business School
Liquidity trap and money
supply
     Nominal
 Interest rate (%)         Supply of money, Ms

 33.0
 25.0
 17.6
 11.1
 5.3



                                                 Demand for money, Md
                           C           D
             100     200   300   400       500
                                                                             51

                                                          Goethe Business School
Real interest rates
in the United States

   During the 1970
    real interest rates
    were significantly
    below 0% in the
    United States
    (and worldwide)



                                             52

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And again now in the USA ….




                                                 53

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Liquidity trap and Japan
   During the 1990 Japan experienced a period of
    economic stagnation, which the central bank
    attempted to counter through expansionary
    monetary policy
   The BoJ reduced its interest rates from 6% in
    July 1991 to 0,5% in September 1995
   From February on, she started her zero interest
    rate policy (ZIRP)
   Despite 0% nominal interests, the real rate of
    interest was positive due to falling prices

                                                             54

                                          Goethe Business School
Real interest and Deflation

   12                             Japan«s Real Interest Rates

   10

    8

    6

    4

    2

    0
     85

            87

                   89

                          91

                                 93

                                        95

                                               97

                                                      99
   19

          19

                 19

                        19

                               19

                                      19

                                             19

                                                    19                        55

                                                           Goethe Business School
Discussion 7:
Money, inflation, and interest rates

   What determines the demand for money?
   How are money markets linked to bond
    markets?
   What factors influence the real interest
    rate in the short and the long run?



                                                          56

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