Download Monetary Economics and the European Union Lecture: Week 1

Course Outline
320.326 (KS) WS 2014-15
Monetary Economics and the European Union
Instructor: Professor Robert J. Hill
Office: 04-F-28
Telephone: 380-3442
E-mail address: [email protected]
Consultation times for summer semester 2014: Mondays 10:00-12:00
Textbooks:
Mishkin F. S. (2006), The Economics of Money, Banking and Financial
Markets, Pearson: Addison-Wesley, Eighth Edition (MK)
De Grauwe P. (2012), Economics of Monetary Union, Oxford University
Press, Ninth Edition (DG)
Assessment:
Class participation
Midterm exam
Final exam
5 percent
40 percent
55 percent
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Provisional Lecture Schedule
Week 1 – (28 October 2014) – Uses of money, commodity and fiat money,
and the quantity theory of money
MK – Chapters 3, 18, 19
Week 2 – (4 November 2014) – Keynes theory of liquidity preference, Hicks
and ISLM
MK – Chapters 19, 20, 21
Week 3 – (11 November 2014) – Friedman and monetarism
MK – Chapters 19, 23
Week 4 – (18 November 2014) – Rational expectations and optimal policy
design
MK – Chapter 25 (supplemented by additional readings)
Week 5 – (25 November 2014) – Tutorial covering material from Weeks 1-4
Week 6 – (2 December 2014) – Midterm exam
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Week 7 – (9 December 2014) – Inflation targeting
MK – Chapter 16, 23 (supplemented by additional readings)
Week 8 – (16 December 2014) – Lessons from the global financial crisis
(assigned readings)
Week 9 – (12 January 2015) – Optimum currency areas and the costs and
benefits of monetary union (including lessons learned from the Eurozone crisis)
DG – Chapters 1-5
Week 10 – (13 January 2015) – The transition to monetary union in the
European Union and the European Central Bank – DG – Chapters 6-8
Week 11 – (19 January 2015) – Monetary and fiscal policy in the European
Union – DG – Chapters 9-11
Week 12 – (20 January 2015) – Tutorial covering material from Weeks 7-10
Week 13 – (27 January 2014) – Final exam
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The lecture overheads and tutorial questions will be posted
on the institute website.
Click on http://volkswirtschaftslehre.uni-graz.at/
Then select "Lehren".
Then scroll down until you find my name and select it.
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320.326: Monetary Economics and the European Union
Lecture: Week 1
Instructor: Prof Robert Hill
Uses of Money, Commodity and Fiat Money,
and the Quantity Theory of Money
Mishkin – Chapters 3, 18 and 19
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1. What Is Money?
(i) A unit of account
Consider an economy consisting of N commodities. Money reduces a
matrix of N(N-1)/2 relative prices (see next slide) to a vector of N-1
prices that market participants need to keep track of. (Note PAB = 1/PBA)
The prices should be transitive, i.e., PAB × PBC = PAC
For example: suppose 1 apple trades for 2 bananas, and 1 banana
trades for 3 carrots. Then one apple should trade for 6 carrots.
Otherwise there will be arbitrage opportunities.
If the no-arbitrage condition holds, then it follows that
PBC = PAC/PAB = 6/2 = 3
That is, all the relative prices in the matrix (next slide) can be derived
by taking ratios of pairs of prices from the first row (i.e., PAB, PAC, PAD
and PAE).
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Apples
Bananas
Carrots
Doughnuts
Eggs
Apples
1
pAB
pAC
pAD
pAE
Bananas
pBA
1
pBC
pBD
pBE
Carrots
pCA
pCB
1
pCD
pCE
Doughnuts
pDA
pDB
pDC
1
pDE
Eggs
pEA
pEB
pEC
pED
1
where pAB is the price of one apple measured in units of bananas.
When apples are the unit of account, all we need to consider are the prices
pBA, pCA, pDA, and pEA (i.e., the first column of the matrix).
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(ii) A means of payment (medium of exchange)
A medium of exchange eliminates the need for a double
coincidence of wants or complicated sequences of transactions.
By dramatically reducing the transaction costs of trading, the
existence of money encourages the division of labour. Everyone
can then focus on producing whichever good or service they have
a comparative advantage in and then trade. This increases total
output as compared with a situation where everyone tries to be
self sufficient.
Example: suppose you want to sell apples and buy eggs.
You could try and find someone who wants to do the reverse
transaction (i.e., sell eggs and buy apples). This is called a double
coincidence of wants.
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Such a person may not exist.
The alternative, in the absence of money is to find a path from apples
to eggs.
For example, suppose you find someone who is willing to swap eggs for
carrots. Now if you can find someone who is willing to swap carrots for
apples, you can get to your desired outcome in two steps. Or perhaps
you find someone willing to trade carrots for bananas. Now you seek
someone willing to trade bananas for apples, etc.
Clearly, without money, trading is a complicated, time consuming and
‘hit and miss’ process.
With money, all you need is to find a person X who wants to buy apples
and another person Y who wants to sell eggs. It does not matter what
person X wants to sell or what person Y wants to buy.
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(iii) A store of value
The store of value function of money allows a temporal separation of
selling and buying.
Other assets are also stores of value (e.g., houses, cows, shares,
works of art).
Money is the most liquid asset. Liquidity is defined as the relative
ease and speed with which an asset can be converted into a
medium of exchange.
Example: If you want to sell your house quickly, you may have to
settle for a lower price.
How good a store of value money is depends on the rate of inflation.
A doubling of the price level implies a halving of the value of money.
Under high inflation, people no longer want to hold much money
since then it is no longer a good store of value.
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2. Commodity Money
A commodity (e.g., cattle, salt, seashells, beads, cigarettes,
gold, silver) is used as money.
A suitable candidate should have the following properties:
(i) easy to standardize
(ii) easy to transport
(iii) widely accepted (it must be perceived to have some intrinsic
value and be sufficiently scarce)
(iv) durable
(v) divisible
(vi) easy to store
Most commodities are difficult to carry around in large amounts.
Hence there is a role for banks that issue banknotes (or IOUs)
linked to the commodity money. In most countries, the issue of
banknotes eventually became the preserve of the central bank.
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The money supply in such cases consists of the banknotes in
circulation and deposits at banks rather than the commodity itself.
A commodity standard exists when a country maintains an equality
between the value of a domestic monetary unit and a specified amount
of the commodity.
In 1816, the value of a pound sterling was set equal to 113 fine grains
of pure gold.
There are two main problems with a commodity standard:
(i) An otherwise useful commodity is diverted for monetary use.
The use of banknotes convertible into the commodity partially
alleviates this problem.
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(ii) The money supply will vary over time in response to changes in
the availability of the commodity.
Example: Under a gold standard, the discovery of a new gold mine
causes a loosening of monetary policy.
This is because the new discovery increases the supply of gold, and
hence pushes down its price. This means that the price of everything
else expressed in units of gold (and the currency) rises. In other words,
the discovery generates inflation.
It would be better if changes in the money supply were deliberate
acts of a central bank rather than somewhat random events.
From 1816 to 1851, prices fell in Britain, after which they rose until
1873, before falling again until the end of the century.
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These inflations and deflations can be explained as follows:
1816-1851: the increase in the supply of gold did not match the rate
of economic growth
1851-1873: large increase in the supply of gold from California
1873-1895: In 1850 only Britain and Portugal were on the gold
Standard. By 1880 America and almost all of Western Europe had
also adopted it. This increase in demand for gold pushed up its price.
1895-1913: New discoveries of gold in the Transvaal and the
Klondike and new mining technologies saw gold production rise.
Falling prices caused real interest rates to rise imposing considerable
hardship on borrowers (the nominal interest rate cannot become
negative). This encourages households and firms to delay purchases
and discourages investment. Together these effects could push the
economy into recession.
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3. Bretton Woods
The Bretton-Woods system was adopted in 1945. It was an attempt
to get back to the stability of the gold standard system of fixed
exchange rates that existed prior to 1914.
All currencies were fixed against the dollar (within 1 percent bands).
Only the US dollar was convertible into gold (at $35 per ounce).
Only central banks could trade dollars for gold.
Periodically, rates could be adjusted (e.g., the pound sterling in 1949
was devalued from $4.03 to $2.80. In 1967 it was again devalued
from $2.80 to $2.40).
Bretton Woods collapsed in 1971 and was replaced by a system of
floating exchange rates.
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Why did Brettons-Woods collapse?
(i) Governments were supposed to intervene in the foreign exchange
markets (with the assistance of the IMF if necessary) to maintain
their exchange rate within the allowed range. This could be difficult
because of:
(a) Imbalances in the purchasing power of currencies:
Countries with higher inflation rates end up with overvalued
currencies and current account deficits (since imports become
cheaper and exports more expensive).
(b) Balance of payments crises:
A country running a current account deficit must sell foreign
exchange reserves if it wishes to maintain the peg. Britain had to
devalue in 1949 and 1967 as it was running out of foreign
exchange/gold reserves.
(ii) Revaluations could create arbitrage opportunities – although only
central banks could really exploit these opportunities.
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(iii) Rising inflation in the US in the late 1960s (partly due to the Vietnam
war) caused the price of gold on the open market to rise significantly
above $35 per ounce. Central banks therefore had an incentive to buy
gold at the Brettons-Woods price from the US Federal Reserve and
then sell on the open market (another arbitrage opportunity).
4. Fiat Money
The abandonment of Bretton Woods led to the emergence of fiat
money.
Fiat money is not backed by any commodity. Its intrinsic value
depends on the reputation of the central bank.
5. Can Fixed Exchange Rates Still Work – the Case of the ERM?
The European Exchange Rate Mechanism (ERM) was supposed to
maintain exchange rate fluctuations for European currencies within 6
percent bands.
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Britain joined the ERM in 1990. The joining rate of 2.95DM soon
came to be seen as overvalued (largely due to relatively high inflation
in the UK). Speculators started betting on a depreciation of the pound
by converting pounds into DM.
Note: unlike under Bretton-Woods, capital controls no longer existed.
To maintain the exchange rate, the British government had to sell its
foreign exchange reserves. When it became clear this strategy was
not sustainable, British abandoned the ERM in 1992. George Soros
made over $1 billion from betting on a depreciation of the pound.
Soros borrowed in pounds and converted them into DM. After the
depreciation he converted back into pounds, paid off the loan and
had more than $1 billion left over.
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6. What Are the Alternatives to the ERM?
Even with draconian capital controls it might not be possible to
maintain a fixed exchange rate (due to balance of payment
imbalances and differing inflation rates).
Capital controls usually take the form of taxes on foreign exchange
transactions and/or restrictions on the amount of domestic currency
that can be taken out of the country.
Such capital controls are no longer an option given the extent of
globalization.
This leaves the international community with two alternatives:
(i) Monetary union
(ii) Floating exchange rates
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7. The Demand for Money
Equilibrium in the money market depends on the demand and supply
of money. What determines the demand for money?
The first answer to this question was provided by the Classical
Quantity Theory of Money.
The quantity theory of money is particularly associated with Irving
Fisher and his 1911 book entitled “The Purchasing Power of Money”.
It starts from the following equation of exchange:
MV = PY
M = money supply
V = velocity of circulation of money (spent on final goods)
P = price level
Y = real income (or output)
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As stated, this equation is an identity (i.e., it is true by definition).
Assuming that V and Y are constant in the short-run, it explains why P
falls when M falls and P rises when M rises. This is consistent with
Britain’s inflation/deflation experience in the 19th century under the
gold standard.
The quantity theory of money transforms from an identity to a theory
of the demand for money with two assumptions:
(i) Velocity is constant
(ii) The money market is in equilibrium (i.e., Ms = Md)
Irving Fisher argued that velocity is determined by the institutional and
technological features of an economy which are reasonably constant
in the short run.
Example: increased use of credit cards will act to increase velocity.
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Taking velocity over to the right hand side
M = (1/V) PY
When the money market is in equilibrium, M = Md. Now setting
(1/ V) = k, we obtain that
Md = k PY
The nominal demand for money is a linear function of nominal
income.
or
Md/P = k Y
Real money demand is a linear function of real income.
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Is velocity constant?
See Figure 1 in Mishkin (2006), chapter 19, p.496.
Velocity fluctuates quite a bit in the short run. Furthermore, it
tends to rise systematically in booms and fall in recessions.
The classical economists did not know this, since they did not
have access to the required data. National accounts (which
measure P and Y) had not yet been invented.
Hence the premise on which the quantity theory of money is
based (i.e., that V is constant) seems suspect.
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