Download Section 1.3: Advantages of monetary economy over

Part I: Review of basic economic concepts and relations
Chapter 1: Basic economic concepts of prices and money
Section 1.1: Two types of economy
Historically, there are two types of economy:
(1)
Barter economy is an economy where goods and services are
exchanged for goods and service.
(2)
Monetary economy is an economy where goods and services are
exchanged for money.
All modern day economies are organized as monetary economies.
Typically the government of a monetary economy controls its money
supply.
Section 1.2: Two kinds of price
Theoretically there are two kinds of price in economies:
(1)
Relative price is the exchange rate of goods and services for
goods and services.
(2)
Absolute price is the exchange rate of goods and services for
money.
All the prices we see on the price tags of products in the
stores are absolute prices. By taking the ratio of a pair of
absolute prices we can recover a relative price. For example, the
absolute price of orange is thirty cents an orange, and the
absolute price of apple is fifty cents an apple. By taking
the ratio of this pair of absolute prices, we get the relative
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price of oranges for apples of the amount of five oranges for
three apples.
In microeconomics the interest is to determine the level of
relative prices. In macroeconomics the interest is to determine the
level of a value weighted average of the absolute prices of some
defined basket of goods.
Section 1.3: Advantages of monetary economy over barter economy
The three advantages of monetary economies over barter economies
are:
(1)
Money removes double coincidence of wants, which is a
situation in a barter economy where one person exchanges a
product with another person only if each person likes what the
other person has. In a barter economy, transaction cost is so
high that a lot of multilateral trades are foregone. In a
monetary economy, all multilateral trades of goods and
services for goods and services are broken down to bilateral
trades of goods and services for money so that more trades
take place. Since voluntary trades are mutually beneficial,
more trades are preferred to less trades.
(2)
Money allows specialization. In a barter economy, a lot of
mutually beneficial multilateral trades are forgone due to
high transaction cost. Since one cannot trade for the many
goods and services that one wants, one has to be able to
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produce many different goods and services. One becomes a Jackof-all-trade. Specialization will not be feasible. In a
monetary economy, each member of an economy can do what one is
best at. One can exchange one’s good or service that one
produced for money from one person and with the money one can
exchange for goods and services one wants from another person.
Since everyone in a monetary economy produces what everyone is
best at producing, a lot more goods and services are produced
for consumption. This makes a monetary economy superior to a
barter economy. In fact one can conceive money as the greatest
invention of the human race.
(3)
Money helps to economize on information. In a barter economy
with n products, we need to establish n(n-1)/2 relative
prices. In a monetary economy of n products, we need only to
establish n absolute prices. When n is a large number,
n(n-1)/2 is so much larger than n. Yet one can always
recover relative prices by taking the ratio of a pair of
absolute prices. Hence there is no loss of information in
using absolute prices in a monetary economy and yet there
are fewer prices that need to be established. Consider a
barter economy. How many relative price tags of a product do
we need to attach to the product? In a monetary economy, each
product has one absolute price tag attached to it.
Section 1.4: Functions of money
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There are four functions of money:
(1)
Medium of exchange facilitates transactions. People
exchange goods and services for money.
(2)
Unit of account sets absolute prices to account for the
value of the last unit of a product or service to
consumers.
(3)
Store of value is to defer current consumption to future
consumption to prepare for retirement.
(4)
Standard of deferred payments facilitates lending and
borrowing. One borrows a lump sum of money now in exchange
for repaying small amount of money by installments over a
period of time.
Hence money is commonly defined as anything that can perform the
four functions of money. It is a matter of degree how well a
financial asset satisfies the four functions of money and whether
it should be added to a measure of money supply. This means that it
is very hard to measure money supply accurately. Any measure of
money is only an approximation of what economists call money.
Sections 1.5: Characteristics of money
For one to recognize something as money, there are eight
characteristics of money:
(1)
General acceptance: people are willing to accept money in
exchange for goods and services. For example, tourism is a
major industry in Singapore. Singapore businessmen are
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eager to accept major foreign currencies in exchange for
their merchandises. Singapore dollars and major foreign
currencies become money supply in Singapore.
(2)
Portable: money must be easy to carry around. This explains
why elephants are never used as money.
(3)
Divisible: US currency is divided into small denominations,
practically speaking, down to the pennies. A pair of Levi
jeans carries the price tag of thirty five dollars and
ninety nine cents. When it gets down to the penny, little
kids don’t even pick it up from the floor. They know a
penny practically cannot be used to buy anything this days.
However, they would pick up a quarter, because that would
yield a piece of bubble gum from a bubble gum machine.
(4)
Identifiable: money must be easy to identify as genuine and
not counterfeit. This is why governments have to be ahead
of counterfeiters in printing technology. The distinguish
features of the U.S. currency are the inserted magnetic
strip to the left that reads USA, the water mark to the
right, the never dry ink, and the red and blue threads on
the service.
(5)
Durable: money must not be easily destroyed in the process
of transaction or in storage otherwise it cannot perform
the functions of medium of exchange and store of value.
This explains why water is never used as money.
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(6)
Liquidity: there are two properties of liquidity.
(a) Marketability means that there are always buyers and
sellers of the asset ready to do transactions with you
in case you want to sell or buy the asset for cash.
Cash is the most liquid of all assets. Marketability of
an asset can vary over time. An example is houses. In
the 1980s, a house could be sold within days of
listing. Normally it takes four to six months to sell a
house.
(b) Reversibility means that the price of the asset does
not change rapidly over time. A new car is not
reversible in value. Once you buy a car and drive it
out of the dealer’s parking lot, its resale value
normally drops ten percent.
(7a) Optimal scarcity: if we use a natural resource as money it
must be hard to find in the real world. This explains why
sand is never used as money. It is easy to scoop up tons
of sand from a beach.
(7b) Relative stability of supply: if we use a man-made resource
as money the producer of money must have self discipline
in controlling a steady growth of money supply. Under the
U.S Constitution, only Congress has the power to create and
destroy money, and that power is relegated to the Federal
Reserve Bank.
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Section 1.6: Types of money
There are two types of money:
(1)
Commodity money is money with high intrinsic value. For
example, the gold contents of gold coins are more valuable
than their face value. Hence gold coins are commodity
money.
(2)
Fiat money is money with low intrinsic value. For example,
the paper money we use everyday is fiat money because the
material of paper money is worth less than its face value.
Since the main function of money is medium of exchange, we
should always use the least valuable resource as money for
circulation. Hence we should use fiat money. In the modern day
world most of our money is not currency but bank deposits. We have
electrons stored in the memory disc of our bank computers to
register the balance in our checkable deposit accounts and hence as
money. We have practically unlimited supply of electrons in the
universe. If one day every deposit transaction is done
electronically, we will have the cheapest resource as money, namely
electrons stored in bank computers to register the balance of bank
deposits.
Section 1.7: Gresham Law
Gresham Law states that bad money drives good money out of
circulation. An example of Gresham Law is as follows. The silver
quarter minted prior to the sixties are good money because the
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silver content of those quarters are worth more than the face
value of twenty five cents. The modern day cheap copper-nickel
alloy quarters are bad money because the metal alloy is worth
less than the face value of twenty five cents. We rarely see
silver quarters in circulation. If you see one, you will pull it
out of circulation for the reason that the silver content of the
silver quarter is worth more than the face value of a quarter.
You will put it in your safety box. The cheap copper-nickel alloy
quarters remain in circulation.
Section 1.8: Measures of money supply
There are three official measures of money supply, namely, M1,
M2, and M3:
(1)
M1 is the sum of currency in the general public’s hand,
demand deposit, checkable deposits and travelers' check.
(2)
M2 is the sum of M1 and saving deposit, small denomination
time deposits, retail MMMF and MMDA.
(3)
M3 is the sum of M2 and Eurodollars, RP, large
denomination time deposits and institutional MMMF.
M1 serves the functions of medium of exchange, unit of account,
and standard of deferred payments. M2 and M3 include other assets
that serve the additional function of store of value. As we move
from M1 to M3 as a measure of money supply, we add less and less
liquid assets to the measure of money supply.
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Section 1.9: Components of M1
Currency consists of coins minted by the U.S. Treasury and
federal reserve notes printed by the Federal Reserve Bank, the
central bank of the United States of America. A central bank of a
country is a bank for the government of that country. It creates
and destroys money, and regulates the value of money.
Demand deposits are deposits which earns no interest on the
Balance. This is due to Regulation Q of the Federal Reserve Bank,
which prohibits payment of interest on demand deposits. Depositors
can write checks to draw on the balance of the deposit of the
account. One reason for the existence of demand deposits is that
they are created when banks make loans to the general public. When
a bank makes a loan to a borrower, it does not give cash to the
borrower. Instead, it gives a demand deposit check book to the
borrower with the amount of loan the borrower applied for as the
balance in that checking account. There is no reason for a bank
to charge interest on a loan to a borrower and then pays the
borrower interest on the balance of the demand deposit created by
the loan.
Checkable deposits are deposits which earn interest on the
Balances. Depositors can write checks to draw on the balance of
the deposit of the account.
Travelers' checks are purchased from banks. Buyers are required
to sign the checks at the time of purchase. They have to sign
the checks again in front of the merchant selling the goods to the
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buyers of the travelers' check when they use them. If you have
cash in a lost wallet, it is gone. If you have travelers' checks in
a lost wallet, you can call the bank that issued the travelers'
checks to stop payment and reissue the travelers' checks to you.
This is why people carry travelers’ check instead of cash when they
travel overseas.
Section 1.10: Components of M2
Savings deposits are deposits that you earn daily interest and
can withdraw any time you want but you have no checking facility.
Time deposits are deposits that you agree with a bank to leave
the sum of money for a specified period of time with interest
penalty for early withdrawal. Nowadays there are both fixed and
variable rate time deposits. Time deposits are more popular in
the form of certificate of deposit (CD).
Small denomination time deposits have balance in an amount less
than a hundred thousand dollars. They are typically non-negotiable
meaning that the CD has a bearer's name on it and only the bearer
can collect the principal and interest when the CD matures.
MMMF stands for money market mutual funds. A mutual fund is an
investment cooperative whereby small investors pool their
investment dollars together to allow a mutual fund manager to
diversify their investment dollars to a variety of assets.
MMMF is a mutual fund that the mutual fund manager is required to
invest only in money market instruments which means short-term
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(maturity within a year), highly liquid (marketable and reversible
in value) financial assets.
Typically investors with MMMF accounts can write checks to use
the balance in their MMMF accounts.
MMMF are offered by financial
brokerage firms and mutual fund companies. The federal government
does not insure balances in MMMF.
Retail MMMF refers to MMMF whose account holders are individual
investors. Typical retail MMMF account balances go up on pay day
and then go down over the month due to mortgage payment, car
payment and other payments. Since the balances are not stable, it
means they are liquid. That is why we classify retail MMMF under
M2.
Merrill Lynch was the first financial brokerage firm that
offered MMMF starting in 1970. Due to its tremendous popularity
over time, other forms of mutual funds flourish. Today we have
bond, equity, balanced (with fixed proportions in money market,
bond market and stock market), asset allocation (with variable
proportions in money market, bond market, and stock market),
precious metal, industry-specific, country-specific, foreign (with
funds invested only in foreign countries) and global (with funds
invested in domestic and foreign countries) mutual funds. Listings
in the Wall Street Journal covers three pages of mutual fund
listing and the number of pages are growing.
MMDA stands for money market deposit accounts. They are similar
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to MMMF but are offered by banks and are insured by the Federal
Deposit Insurance Corporation (FDIC). They yield a lower return
than MMMF according to the principle of high risk high return.
Banks introduce MMDA in the eighties to lure depositors to take
some of their cash from MMMF back to banks.
Section 1.11: Components of M3
Eurodollars in general mean U.S. dollars deposited in banks
outside of the United States of America. After the end of the
Second World War, Russia and the United States of America entered
the Cold War. The Russian government did not want to deposit its
U.S. dollars in the United States of American to avoid having
its financial assets frozen by the United State government. It
turned out that a bank in London was willing to depart from
traditional bank practice of accepting only that country's currency
in that country's banks. The London bank found it profitable to
accept U.S. dollar deposits and to pay principal and interest in US
dollars because, after the Second World War, there was an immense
demand for U.S. dollars loans by European governments and
corporations to buy U.S. products and capital goods to rebuild the
European economies. The United States of America was the only large
industrialized country whose industrial base remained intact after
the Second World War. Since then, other European countries also
offer Eurodollar accounts. They are willing to accept other foreign
currency as well such as Japanese yen. Hence we speak of Euroyens.
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The markets are then generically known as Eurocurrency markets.
Eurodollars in M3 stands for that amount of the Eurodollars as
defined above that are loaned back to the United States of
American through banks overseas.
RP or repo stands for repurchase agreement in which one sells
Treasury bills to another with the promise to buy them back
later in time at a higher price. It is similar to a secured loan
with the Treasury bills as collateral.
Large denomination time deposits refer to time deposits with
balances in excess of one hundred thousand dollars. They are
negotiable if the amount is at least one million dollars.
Negotiable means that whoever presents the bank CD on the date of
maturity will be entitled to the principal and interest.
This
makes negotiable bank CD marketable.
Citibank is the first bank to introduce negotiable bank CD. It
is very popular among large corporations. If a large corporation
needs cash, it can easily sell its negotiable bank CD to any
corporation for cash.
For large denomination time deposits with amount less than one
million, they are not negotiable. This means the owner of such bank
CD stands to lose a large sum of money for early withdrawal. This
makes them less liquid, because the owner would hesitate on early
withdrawal.
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Chapter 2: Economic relations of money supply growth rate and
inflation rate, nominal interest rate, business cycle,
and federal government budget deficit
Section 2.1: Inflation and its measures
Inflation rate is the rate of change of general price level.
There are many different measures of general price level. The most
common ones are consumer price index (CPI), producer
price index (PPI), and GDP deflator. They differ by the
composition of the baskets of goods and services from which
they are constructed. Consumer price index is based on the
basket of consumer goods and services that a typical middle age
American living in a large metropolitan area would buy. Producer
price index is based on the basket of raw material, labor
and intermediate goods that a typical business firm would buy.
GDP Deflator is based on the most comprehensive basket of
all final goods and services that the households, the firms, and
the government would buy.
Consumer price index and producer price index are
available on a monthly basis. In contrast, GDP deflator is
available on a quarterly basis, because it is very costly to
collect data on the basket of all final goods and services.
Consumer price index and producer price index are calculated
by the Laspeyres price index formula, which looks at a base year
basket of goods at today’s prices relative to the base year basket
of goods at the base year prices. In contrast, GDP deflator is
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calculated by the Paasche price index formula, which looks at the
current year basket of goods at the current year prices relative to
the current year basket of goods at previous year prices.
Section 2.2: Money supply growth rate and inflations rate
Inflation rate is positively related to money supply growth
rate. The empirical fact to support this conjecture is that, in the
1960s and since 1985, we have single digit money supply growth
rate as well as single digit inflation rate. In the 1970s and
the first half of 1980s, we have occasions of double digit money
supply growth rate as well as occasions of double digit
inflation rate. However, this only shows correlation and not
causality. The following theory will give us causality.
Friedman’s Theory of Inflation: too much money chases after too
few goods will lead to inflation.
A buyer who has money and cannot get hold of a product will
offer a higher price to a seller to secure the sale of that product
to him from other buyers. If everyone in an economy suddenly has a
lot more money, everyone will offer a higher price for the product
that person wants and cannot get hold of. If everyone in the
economy does that, product prices will go up, leading to inflation.
Section 2.3: Money supply growth rate and nominal interest rate
Nominal interest rate is positively related to money supply
growth rate. The empirical fact to support this observation is that
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we have single digit money supply growth rate as well as single
digit nominal interest rate in the 1960s and since 1985. In the
1970s and the first half of the 1980s, we have occasions of
double digit money supply growth rate as well as occasions of
double digit nominal interest rate. Again this only shows
correlation and not causality. The following theory will give us
causality.
Fisherian Theory of Interest Rate: 1 + nominal interest rate =
(1 + real interest rate) x (1 + expected inflation rate)
Fisherian theory of interest rate tells us that money lenders
need to be compensated for three reasons. First, lenders need to
be compensated for the erosion of the real purchasing power of
the dollars due to inflation over the loan period. This is
represented by the expected inflation rate in the Fisherian
theory of interest rate. Secondly, even in a world with no
inflation, lenders need to be compensated for foregoing their
current consumption. Thirdly, lenders need to be compensated for
taking the risk of default. The last two reasons is represented
by the real interest rate in the Fisherian theory of interest
rate. Combining real interest rate and the expected inflation
rate over the loan period helps lenders to determine the nominal
interest rate for a loan over that period.
As money supply growth rate increases without comparable rise in
real output, Friedman's theory predicts a higher inflation rate.
Then lenders will revise their expected inflation rate up and
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through the Fisherian theory of interest rate the nominal
interest will go up.
Section 2.4: Money supply growth rate and business cycle
A business cycle is usually tracked by real GDP. It consists of
the peak of the real GDP, followed by a recession of an economy,
that is a downturn of real GDP. The trough of a business cycle is
when real GDP bottoms off, and is followed by a recovery of the
economy, that is an upturn of real GDP until another peak occurs.
The official definition of a recession is two quarters of real GDP
downturn.
There are two empirical facts about the relation of money supply
growth rate and business cycles, First, for the last eight
recessions in the USA since the Second World War, months before the
downturn of the business cycle money supply growth rate dropped.
Secondly, there were occasions when there were no downturn of the
business cycle after money supply growth rate dropped. The first
fact supports the argument that money supply is an important
determinant of business cycle; and the second fact supports the
argument that money supply is only one of many important
determinants of business cycle. Other determinants of business
cycle includes energy price hikes and drastic and unexpected
government fiscal or monetary policy changes.
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Section 2.5: Federal government budget constraint
Federal government budget constraint says that every dollar of
the federal government expenditures has to be financed by one of
three ways: tax financing, debt financing and inflation
financing. Under the U.S. Constitution only the federal
government has the option of inflation financing, namely printing
money to pay its bills which causes inflation. State and local
government are not allowed to print money to finance their
expenditures. If we subtract taxes from government expenditures
and if the difference is positive, we have budget deficit. If
the difference is zero, we have balanced budget. If the
difference is negative, we have budget surplus.
Section 2.6: Money supply and federal government budget deficit
If a country borrows so much to the extent it cannot borrow
any more, then every dollar of budget deficit has to be financed
by a dollar change in high power money leading to inflation.
This is stereotypical of developing countries. Developing
countries, by definition, do not have a fully developed tax
system and they tend to rely on heavy military spending to gain
and maintain military support for their government. This
explains why developing countries have budget deficit and why on
the average they have higher inflation rate than developed
countries. This also limits the independence of fiscal and monetary
policies. Fiscal policies are government policies that try to
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change government expenditure and/or taxes to affect real GDP of an
economy. Monetary policies are government policies that try to
change money supply to affect real GDP of an economy. In fact in
the absence of debt financing, every dollar of budget deficit leads
to a dollar change in high powered money, which is the sum of
currency in the general public’s hand and bank reserves.
Chapter 3: Circular flow of a monetary economy
Section 3.1: Closed versus open economy
Circular flow of a three-sector three-market economy helps us to
conceptualize any closed economy, namely an economy with no
international trade. Once we understand a closed economy we can
easily add net export, namely export minus import, to make it a
four sector open economy.
Section 3.2: The three sectors of a monetary economy
The three decision making sectors are government, households and
firms.
We include federal, state, county, city, township, and quasigovernment under the government sector. Quasi-government agencies
are government agencies that do not belong to neither the
executive, legislative nor judiciary branches of the government.
Federal Reserve Bank is an example of quasi-government agency.
We include over a hundred million households in the United
States of America under the household sector.
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We include the tens of thousands of firms in diverse number of
industries under the firm sector.
Section 3.3: The three markets of a monetary economy
The three markets of a monetary economy are product, asset &
resource market. We include under product market all final goods
and services sold to the consumers, all military goods and services
sold to the government and all newly produced capital goods sold to
firms.
We include all financial markets under asset market, such as
stock market, bond market, money market and foreign exchange
market, and all financial intermediaries such as commercial bank,
savings and loans associations, mutual savings banks, and credit
unions under asset market.
Foreign exchange market is the largest
financial market in terms of daily volume of transaction.
We include labor market and raw material market, such as
crude oil market, under resource market.
We study the three markets in the circular flow diagram to
understand how the three decision making sectors interact with
one another through the supply side and the demand side of each
market.
Section 3.4: Two national income identities
We also make use of the circular flow diagram to help us to
identify two national income identities to measure gross
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domestic product(GDP) of an economy.
Gross domestic product is defined as the market value of all
final goods and services produced by residents of an economy within
one year.
With respect to the demand side of the product market, we can
measure GDP by asking who is buying up the final goods and
services through the product market. Households buy part of them
up as consumption expenditures, C. Firms buy part of them up as
investment expenditures, I. Note that investment here refers to
capital investment, that is the purchase of newly produced capital
goods. Government buys part of them up as government expenditures,
G. Hence real GDP, y = C + I + G. This is the flow of product
(expenditures) approach to measure real GDP.
With respect to the supply side of the product market, we can
measure real GDP by noting that every dollar of real GDP generates
a dollar of sale revenue to the firms. Through different channels
the sale revenue becomes real income to the
households. We then
ask how the households would spend their real income. They spend it
as consumption expenditures, C, as private savings, S, or as tax
payments, T. Hence real income, y = C + S + T. This is the disposal
of income approach to measure real GDP.
Section 3.5: Use of the circular flow of a monetary economy
A circular flow diagram is a simple way to conceptualize an
economy. Economies differ from each other only in terms of which
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decision making sector commands how much of the resources of the
economy. For example, in socialist countries the government sector
commands most of the resources of an economy but in a capitalist
economy the household sector commands most of the resources. In
addition some countries, such as Singapore, rely heavily on the
product market because they have practically no natural resources
while other countries such as Saudi Arabia rely heavily on the
resource market because they lack manufacturing industries but
are rich in natural resources.
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Chapter 4: The importance of financial intermediation
Financial intermediation is the process whereby small amounts
Of savings funds are collected from the households and transformed
into the hands of firms and government for investment
Funds flow from savings-surplus units, namely households to
savings-deficit units, namely firms and government.
Investment opportunity frontier is the income today and
Tomorrow that can be achieved when one invests efficiently.
Indifference curve is the combinations of consumption today and
tomorrow that give a consumer the same level of satisfaction .
Capital market & discounting: present value versus future value
Optimal investment point is the maximum present value income point
on the investment opportunity frontier.
Intertemporal budget constraint states that the present value
of one’s lifetime consumption spending has to be equal to one’s
present value lifetime income.
Intertemporal consumer budget line is the combinations of
consumption today and consumption a year from today that a
consumer can afford when she uses up all her maximum present value
income. It is the graph of the intertemporal budget constraint.
Utility maximization and optimal consumption point
Functions of financial intermediaries
-facilitate intertemporal consumption choice & equalize marginal
investment returns,
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-reduce transaction costs,
-produce information,
-pool resources to provide divisibility & flexibility,
-diversification of risk,
-participate in money supply creation process,
-provide expertise & convenience such as ATM counters.
Diversification is the holding of assets with less than positively
perfectly correlated returns.
A portfolio is a collection of assets.
The Insurance Principle states that diversification provides risk
reduction, and if sufficient number of assets with uncorrelated
returns are included in a diversified portfolio, then the risk
of the portfolio can be practically reduced to zero.
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Part II: Institutional facts of financial institutions and
financial markets
Chapter 5: Facts of financial institutions
There are three different types of financial institution:
(1)
Depository institutions are financial institutions that
accept deposits from customers. There are four kinds of
depository institution.
(a)
Commercial banks are depository institutions that
serve both households and business in making a variety
of consumer and business loans.
(b)
Savings and loans associations in the good old days
provide only mortgage loans, but since the 1980s they
act like commercial banks and make a variety of
consumer and business loans. Commercial banks and
savings and loans associations have a separate class
of shareholders.
(c)
Mutual savings banks are similar to commercial banks
but there is no separate class of shareholders. The
depositors are de facto the shareholders.
(d)
Credit unions are similar to mutual savings banks
except that they are nonprofit organizations. Members
of a credit union have to have some common linkage,
such as the members of some organization.
(2)
Contractual savings institutions are financial institutions
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through which participants agreed by contract to set aside
a certain amount of savings on a periodic basis. There are
three kinds of contractual savings institution.
(a)
Life insurance companies provide a lump sum of money
to the beneficiaries of a policyholder in the event
that the policyholder dies. While subscribing to a
life insurance, the policyholder pays an annual
premium to the life insurance company.
(b)
Pension funds are retirement funds set up by
employers for their employees to reward employees for
devoting so many years of their lives for the
employers. Each month an employer contributes to the
pension funds on behalf of an employee. After working
for five years for an employee, the contributions of
the employer is vested in the employee’s name. Before
the five years vesting period, an employee loses the
retirement if he/she resigns from the employer. Once
the pension is vested, even the employee changes job,
he/she at the retirement age will be able to withdraw
a pension from his/her pension account. Hence the
longer an employee works for an employer, the larger
is the amount of pension check he/she receives. Upon
retirement an employee will be entitled to the monthly
pension payment until the employee dies. A surviving
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spouse will not be entitled to the pension payment
unless while the employee was working for the employer
decides to set up an employee contribution which will
then allows a surviving spouse to half of the pension
payment upon the death of the employee. During the
1990s it was discovered that even though on the book
money is transferred from an employer to an employee’s
pension account, in reality only partial contributions
have been transferred. For example, General Motors
pension funds are only sixty percent funded. During
the Clinton administration the federal government put
a lot of pressure for corporations to raise their
pension funding. The corporations excuse is that the
money transferred to a pension fund might be invested
in securities of the rival corporations. The more
convincing reason is that in the Department of Labor
there is an agency called Pension Benefit Guarantee
Corporation, which will pick up the tab of pension
payments to current retired employees in the event
their former employer declares bankruptcy. This
generates what economists call moral hazard, meaning
that if it is costly to avoid mishap, once there is
insurance, people will shirk the cost to avoid mishap
so that mishap happens more often. From the manager of
a pension fund, the source of funding is from the
27
employer and employee monthly contributions. The
pension fund manager in turn invests the money in
stocks, bonds and money market instruments.
(c)
Fire and casualty insurance companies are companies
that sells auto insurance, disability insurance, and
home owners policies etc. Their source of funds is
from insurance premium. The use of funds is to
diversify in a wide spectrum of markets as the pension
funds do.
Investment intermediaries:
(a)
Mutual funds are investment cooperatives in which
small sums of money are collected from many investors
into a large pot of money for a fund manager to
diversify into many different financial assets. If a
fund manager is restricted to invest in corporate
stocks, the fund is equity mutual fund. If he is
restricted to invest in long term government or
corporate debt instruments, the fund is a bond mutual
fund. If he is restricted to invest in a fixed
proportion of short-term debt, long-term debt, and
corporate stock, the fund is balanced fund. If he is
allowed to invest in whatever proportion of short-term
debt, long-term debt, and corporate stock, the fund is
an asset allocation fund.
28
(b)
Money market mutual funds are mutual funds where the
fund manager is restricted to invest in short-term,
highly liquid assets. Short-term assets mean assets
with maturity of one year or less. Highly liquid
assets mean assets where there are many buyers and
sellers of the assets and the values of the assets do
not change drastically over time.
(c)
Finance companies provide consumer loans to
individuals who have bad credit risk to the extent
that banks and savings and loans associations would
not provide them credit. These companies sell bonds
and stocks to raise funds for the financing of their
consumer loans.
29
Chapter 6: Four major financial markets and four major forms of
a financial market
Section 6.1: Major types of financial market
There are four major types of financial market in the financial
world:
(1)
Money market is the market for short term (with maturity
within a year), highly liquid (marketable and reversible
in value) asset.
(2)
Bond market is the market for long term debt instruments
of corporations.
(3)
Stock market is the market for ownership rights of
corporations.
(4) Foreign exchange market is the market for national
currencies.
Of the four major markets, the foreign exchange market is the
largest in terms of daily volume transactions.
Section 6.2: Sub-markets of a financial market
Within each financial market, we can further divide it into
four sub-markets:
(1)
Spot market is a market where transactions are completed
with forty eight hours.
(2)
Forward market is a market for forward contracts. A
forward contract is an agreement today on the price of
an asset to be used sometime in the future for a
30
specified quantity of the asset. That sometime in the
future is in excess of forty eight hours.
(3)
Futures market is a market for futures contracts. A
Futures contract is also an agreement today on the price
of an asset to be used sometime in the future for a
specified quantity of the asset. The differences of
futures and forward contracts will be explored shortly.
(4)
Options market is a market for option contracts. An
option gives the owner of the option the right to
exercise another contract within a limited time period.
Section
6.3:
Differences
between
contract markets
forward
versus
futures
Forward contracts and futures contracts differ in four respects:
(1)
Forward contracts are traded through over-the-counter
markets. Over-the-counter markets are done through a
dealership system, where each dealer holds an inventory of
the asset for investors to buy from or to sell to. The
dealers are to maximize profits. They buy low from and sell
high to investors. The profits made by a dealer are limited
by competition among dealers, the market interest rate and
the volatility of the asset prices.
Futures contracts are traded through organized exchanges.
Organized exchanges are done through a broker-specialist
system, where brokers take buy and sell orders from
investors around the world, and pass on to a specialist at
31
the organized exchange. The specialist then matches as
quickly as possible the buy and sell orders so that trades
are continuous. A specialist holds a small inventory of the
asset to facilitate trade by selling out of the specialist
inventory when there are too many buy orders, or by buying
to accumulate inventory when there are too many sell
orders. The organized exchange allows a specialist to earn
to fair rate of return on the inventory holding. The
specialist is not supposed to maximize profit.
(2)
Forward contracts are negotiable in size and maturity date.
A forward contract is a tailor made contract.
Futures contracts are standardized in size and maturity
date. Typical maturity dates are on the third Friday of the
month at the end of a quarter of a year. An organized
exchange sets the size and maturity of a futures contract.
You can buy one or multiple of a contract but not fractions
of the contract.
(3)
Forward contracts are nontransferable once the contracts
are agreed and hence not liquid. Once you sign a forward
contract, it remains legally binding until the contract is
fulfilled at maturity.
Futures contracts are marketable and hence liquid. If you
buy a futures contract at one moment of time, you can sell
it back to the market at the next moment of time.
32
(4)
Forward contracts involve no exchange of cash until the
contracts mature and hence create no interim cash flow
problem.
Futures contract has mark-to-market arrangement causing
possible interim cash flow problem. Mark-to-market
arrangement works as follows. Buyers and sellers of futures
contracts have to set up a cash account with a broker with
a specified minimum balance. At the end of each trading
day, the broker will calculate the net change in market
value of the futures contracts from the previous trading
day. If the futures contract values have gone up, cash will
be deducted from the sellers’ cash account and transferred
to the cash account of the buyers. When the cash balance of
an investor’s account drops to the minimum amount, the
broker will call the investor. Within twenty four hours,
the investors will need to add more cash to the account. If
an investor fails to do so, the broker will nullify the
position of the investor, namely if an investor has bought
a futures contract, the broker will sell the contract back
to the market, and if an investor has sold a futures
contract, the broker to buy the contract back from the
market. An investor will not be able to recover the losses
if the market later moves in favor of the investor. All
losses will be capitalized.
33
Section 6.4: Basic types of option contract
Options market is a market for rights to exercise another
contract within a limited time period. There are two major forms of
options:
(1)
A call option allows a buyer of the option to buy an asset
at an exercise price within a limited time period. One buys
a call option in anticipation of rising future price of the
underlying asset.
(2)
A put option allows a buyer of the option to sell an asset
at an exercise price within a limited time period. One buys
a put option in anticipation of falling future price of the
underlying asset.
Section 6.5: Derivative markets
Futures and options are examples of derivatives because they
derive their value from some underlying asset values. Derivatives
are high risk. For example, it costs you a small sum of money to
buy a call option. If within the specified time period, the
underlying asset price does not go up, then you suffer a hundred
per cent loss of your investment. Any investment that can yield a
hundred per cent loss is high risk. A notorious example is the
Orange County fiasco, where the county investor lost billions of
dollars in investing in derivatives.
34
Chapter
7:
Money
market
instruments
instruments
and
capital
market
Money market instruments -U.S. Treasury bills
-Negotiable bank CD
-Commercial papers
-Bankers' acceptance
-Repurchase agreements
-Federal funds
-Eurodollars
Capital market instruments -Stocks
-Corporate bonds and notes
-Mortgages
-U.S. Treasury bonds & notes
-State and local government bonds
-U.S. government agency securities
-Consumer loans & Commercial loans
Foreign bonds are bonds sold in a country and the principal and
interest are denominated in that country's currency but the
issuers of the bonds are from another country.
Eurobonds are bonds sold in a country but the principal and
interest are denominated in another country's currency.
Euroequities are shares of a corporation registered in a country
which are traded in another country.
35
Part III: Theories of interest rate
Chapter 8: Types of loan and concepts of investment returns
Types of loans:
A simple loan is a loan where the lender lends out a lump sum of
money today, called the principal, in return for a larger lump sum
of money in the future, called the principal and interest.
A fixed payment loan is a loan where the lender lends out a lump
sum of money today in exchange for a fixed lump sum of money over
several months or years in the future. A good example is a fixed
rate mortgage loan.
A coupon bond is an IOU issued by government or corporation for a
price with the name of the issuer, a face value, a coupon rate and
a maturity date. The investor in return is entitled to annual
coupon payments, calculated by taking the product of the coupon
rate and the face value, until the bond matures, and on the date of
maturity, the investor is entitled to the payment of the amount of
the face value.
A discount bond is an IOU issued by government or corporation for a
price with the name of the issuer, a face value and a maturity
date. The investor is entitled to the payment of the amount of the
face value on the date of maturity. There is no interim payment
between the date of issuance and the date of maturity.
A consol is an IOU issued by the British government for a price
with no maturity date. The investor is entitled a fixed consol
payment per year indefinitely.
Yield to maturity is the discount rate that equates the present
value of future stream of cash inflows to current cash outflows.
Bonds prices are inversely related to market interest rate.
Current yield is coupon payment per the price of the coupon bond.
Yield on a discount basis is the product of two terms. The first
term is the ratio of the difference of the face value and the price
of a discount bond to the face value of the discount bond. The
second term is the ratio of three hundred and sixty days and the
number of days to maturity of the discount bond. This formula for
estimating the yield of a discount bond understates the true yield
of a discount bond. The formula was developed before the
availability of slide rule. It simplified the multiplication and
division in the hand calculation.
36
One-year holding yield = current yield + rate of capital gains
The bid price of a bond is the price investors can sell a bond
through a bond dealer.
The asked price of a bond is the price investors have to pay to buy
a bond through a bond dealer.
The Moody’s bond rating is as follows:
The highest “blue chip” bonds are rated as AAA bonds. From there it
drops to AA, A and Baa. Any rating below Baa, such as Ba, B , C and
D, are considered as junk bonds, because the risk of default is so
high that those bonds can become practically junk. In fact a bond
that has a D rating is a bond that since its issuance has defaulted
for at least one coupon payment.
Risk premium is the difference between the yield to maturity of a
risk assets and the yield to maturity of a riskless asset with
the same time to maturity.
37
Chapter 9: Mirror image of bond market and loanable funds market
Supply of bonds, demand of bonds & the bond market equilibrium
Determinants of the demand for bonds -wealth
-expected returns
-expected inflation
-risk
-liquidity of investors
-liquidity of the bond
Determinants of the supply of bonds -profitability of investment
-expected inflation
-government budget deficits
Loanable funds market: supply, demand & equilibrium interest rate
38
Chapter 10: Why are there so many market interest rates?
Why do interest rates differ -differences in time to maturity
-differences in risk
-differences in tax treatment
-differences in administration costs
-difference in bond features
A municipal bond is issued by state and local government and the
interest earnings are federal and that state income tax free.
A callable bond is a bond that the issuer can prepay the principal
before the time to maturity of the bond.
A convertible bond a bond that the holder of the bond can
exchange the bond for some specify number of corporate shares
some time within the time to maturity.
39
Chapter 11: The term structure of interest rate
Section 11.1: Characteristics of a yield curve
The term structure of interest rate is the relation between
yield to maturity & time to maturity. The yield curve is the graph
for the term structure of interest rate. The typical shape of a
yield curve is upward sloping. Occasionally it can be downward
sloping, U-shaped, and hump-shaped. In any case the yield curve is
a smooth curve.
The are four theories of the term structure of interest rates
that help to explain the above empirical observation of yield
curves.
Section 11.2: Liquidity Preference Hypothesis
Liquidity Preference Hypothesis assumes that investors
prefer more liquid assets than less liquid assets. Cash is
the most liquid of all assets. The longer a lender makes a loan,
the longer the lender foregoes the use of the cash for the loan.
Hence the lender requires a higher yield to maturity to compensate
for the longer period of foregone cash use by the lender. The
difference between the higher yield to maturity on a long term loan
and the lower yield to maturity on a short term loan is known as
the liquidity premium. The liquidity premium should always be
positive. This means the Liquidity Preference Hypothesis can only
explain the typical case of an upward sloping yield curve, and
cannot explain
the exceptional cases of a yield curve. The next
40
three hypotheses can explain the exceptional cases of a yield
curve.
Section 11.3: Unbiased Expectations Hypothesis
Unbiased Expectations Hypothesis assumes investors form
rational expectations and are risk neutral. Rational
expectations assumes investors form expectations in two steps.
First, investors gather information before they form
expectations. They gather information until marginal benefit of
information equals marginal cost of information. The amount of
information gathered is then known as the optimal information.
Secondly, investors form expectation based on the optimal
information collected such that the expectation is unbiased, that
is, on average the expectation is correct but sometimes they may be
over or under estimates. It is only on the average they are
correct. An example of rational expectation is that an investor
cannot be forever jinxed. If you ever find an investor that is
always wrong in investing, you have found a best friend. You invest
the opposite of your new found best friend and you will be rich.
Unbiased Expectation Hypothesis relies on the knowledge of a
concept called forward interest rate. First a forward loan is a
loan with an interest rate agreed today but to be taken out some
time in the future for a specified period of time. The interest on
the forward loan is called the forward interest rate.
A corporation can create a forward loan using the financial markets
41
by selling a long term security with maturity date being the
maturity date of the forward loan, and at the same time investing
the proceed from the sale of the long term security in a short term
security with maturity date being the date the corporation needing
the forward loan.
Unbiased Expectations Hypothesis implies that short-term and longterm securities of perfect substitute of one another.
Section 11.4: Segmented Market Hypothesis
Segmented Market Hypothesis assumes the buyers and sellers of
short-term securities are separate groups of people to the buyers
and sellers of long-term securities. For example, younger investors
like long-term securities, but older investors like short-term
securities. It implies that short-term and long term securities are
not substitute of one another.
Section 11.5: Preferred Habitat Hypothesis
42
Part IV: Management of depository institutions
Chapter 12: Balance sheet of depository institutions
The balance sheet identity: Total assets = total liabilities
ASSETS
Reserves
Cash items in process of collection
Deposits with other banks
Securities
Loans
Other assets
LIABILITIES
Checkable deposits 22%
Nontransaction deposits 48%
Borrowings 23%
Bank capital 7%
Off balance sheet activities -foreign exchange transactions
-loan guarantees/bankers acceptance
-lines of credit
43
Chapter 13: Four problems of depository institution management
Four primary problems of depository institution management
- Liquidity management is to provide sufficient funds to meet
depository withdrawals,
-Asset management is to maximize returns of bank assets
subject to a level of risk tolerance,
-Liability management is to raise funds for a bank in a timely
manner,
-Interest rate risk management is to minimize risk exposure of
bank assets & liabilities due to interest rate fluctuations.
To solve liquidity problems, banks can engage in
-asset approach: call back loans
sell secondary reserves
sell loans
repurchase agreements
-liability approach: borrow from other banks
issue CD/commercial papers
borrow from the FED
attract more deposits
44
Chapter 14: Asset management and portfolio theory
Expected value of a random variable measures the central tendency
of the random variable.
Variance or standard deviation of a random variable measures the
dispersion of the random variable.
Covariance of two random variable measures whether the two random
variables tend to move in the same directions or tend to move in
opposite directions.
Minimum variance opportunity set is the combinations of expected
returns & risk that minimize risk subject to a required expected
return among the set of risky assets.
Efficient set is the combinations of expected returns and risk that
maximizes expected returns subject to risk among the set of
risky assets.
Risk-free asset & market portfolio
Capital market line is the combinations of expected returns and
risk that maximizes expected returns subject to risk among the
set of risky assets and the risk-free asset.
Indifference curve is the combinations of expected returns and risk
that yield the same level of satisfaction to an investor.
Optimal portfolio point is the point of tangency of an indifference
curve with the capital market line.
Price of risk is the marginal rate of substitution of expected
returns per unit of risk(= slope of the capital market line).
45
Risk premium = Price of risk x quantity of risk
Chapter 15: Interest rate risk management
Fixed rate versus interest-rate sensitive assets(liabilities)
Measure of interest rate risk
-gap analysis assumes horizontal yield curve and that short term
and long term interest rates have the same fluctuations.
-maturity bucket approach allows non horizontal yield curve and
different fluctuations of short term and long term interest
rates.
-standardized gap analysis recognizes different interest rate
elasticities of assets and liabilities.
-duration analysis(Macaulay's duration measures the weighted
average of the timing of cash flows)
Strategies of interest rate risk management
-matching maturity & amount of assets & liabilities using
discount bonds
-matching duration & present values of assets & liabilities
using discount bonds
-interest-rate swap
-hedge with futures & options on debt instruments
Interest immunization is that state when interest rate risk is
46
completely removed.
Interest immunization is not necessarily desirable because for a
high enough price of risk it may pay to take some interest rate
risk, a lesson from asset management and portfolio theory.
Part V: Financial regulatory agencies and money supply
Chapter 16: Financial regulatory agencies
Financial regulatory agencies
-Securities & Exchange Commission(SEC)
-Commodities Futures Trading Commission(CFTC)
-Office of the Comptroller of Currency(OCC)
-Federal Reserve Bank(FED)
-Federal Depository Insurance Corporation(FDIC)
-State Banking Commissions
-Office of Thrift Supervision(OTS)
-National Credit Union Administration(NCUA)
-National Credit Union Share Insurance Fund(NCUSIF)
Two primary methods for FDIC to handle failed banks
-payoff method is for FDIC to liquidate the failed bank and
payoff all depositors up to a hundred thousand dollars for
47
their deposit.
-purchase and assumption method is when FDIC buys all the bad
loans of the failed bank at face value thereby injects cash to
the failed bank and then invites a well managed bank to buy the
failed bank.
Chapter 17: Fractional reserve banking and money supply
Fractional reserve banking system is a banking system that legally
allow banks to hold less than 100% of their deposits as bank
reserves.
Bank reserve is the sum of the cash in the vault of the bank
and the bank's deposits at the FED.
Required reserve ratio is the percentage of bank deposits that has
48
to be held as required reserves.
Money creation(destruction) process is when a bank has
more(less) bank reserves it can make more(less) loans and hence
creates more(less) demand deposit and hence more(less) money.
In the modern day world money is created or destroyed through
electronic signal transfer to a bank computer by debiting or
crediting deposit account balances.
Potential money supply multiplier is the change in money supply
due to a dollar increase in reserve under the assumptions that
there is no excess reserves and coins & currency remains constant.
High-powered money(Monetary base) is the sum of coins & currency
in the public hand and bank reserves.
Excess reserve is bank reserves minus required reserves.
Currency demand-deposit ratio
Actual money supply multiplier is the change in money supply due
to a dollar increase in high-powered money under the assumptions
that there may be excess reserve, and currency demand-deposit
ratio is constant.
Bank credit is the amount of bank loans(=demand deposits-reserves).
Bank credit multiplier is the change in bank credit due to a
dollar change in high-powered money under the assumptions that
there may be excess reserve, and currency demand-deposit ratio is
constant.
49
Chapter 18: Financing of federal government spending
Financing of government spending: tax financing
debt financing
inflation financing
50
Monetizing the debt is when the FED buys government securities
from the general public converting government debt into money in
the general public's hand.
Chapter 19: The Federal Reserve Bank
51
The Federal Reserve Bank and the Federal Reserve Act of 1913
Consolidated balance sheet of the FED
ASSETS
LIABILITIES
S1 US gov't securities
U1 Federal Reserve notes
S2 Discount loans
U2 Bank deposits
S3 Gold & SDR certificates
S5 US Treasury deposits
U3 Coin
S6 Foreign & other deposits
S8 Cash items in process of
S9 Deferred availability cash
collection
items
S4 Other Federal Reserve assets
S7 Other Federal Reserve
liabilities & capital accounts
Uses of monetary base = U1+U2-U3+Treasury currency outstanding
-Cash held by the Treasury
Sources of monetary base = S1+S2+S3+S4-S5-S6-S7+(S8-S9)
+Treasury currency outstanding
-Cash held by the Treasury
Float = S8 - S9
A float is equivalent to an interest-free loan from the FED to the
depository institutions.
Goals of the FED -price stability
-economic growth
-full employment
-interest rate stability/affordability
-financial market stability
-foreign exchange mkt stability
Two types of targets of the FED
-intermediate targets: monetary aggregates(M1,M2,M3)
short or long term interest rate
-operating targets: reserve aggregates(reserve, monetary base)
daily interest rate(federal funds rate)
Criteria for choosing targets -measurability
-data availability
-controllability
-predictability of outcomes
Desirability of anticyclical monetary policy
Sources of procyclical monetary policy -targeting on free reserves
-targeting on interest rate
52
Chapter 20: Tools of the Federal Reserve Bank in controlling
money supply
Open market operation(OMO) is the buying and selling of federal
government securities by the FED to control money supply.
The Banking Act of 1933
Two types of OMO
Dynamic OMO is open market operation when the Federal Reserve Bank
wants to permanently change the volume of money supply.
Defensive OMO is open market operation when the Federal Reserve
Bank wants to temporarily change the volume of money supply.
Two means of OMO -purchase or sale of gov't securities
-repo & reverse repo
Advantages of OMO -complete control
-flexible
-reversible
-no administrative delay
Discount policy and the Federal Reserve Act of 1913
Three types of discount loans -adjustment credit loans
-seasonal loans
-extended credit loans
Four costs of discount loans -interest cost at the discount rate
-raise chances/frequency of audit
-reduces chances of future loans
-may not do reverse repo
Advantages of discount policy -lender of last resort
-signal FED intention
Disadvantages of discount policy -announcement effect
-spread of i vs d & money supply
-incomplete control
-not easily reversible
Reserve requirement and the Banking Act of 1935
The Depository Institutions Deregulation & Monetary Control Act
of 1980
Disadvantages of required reserve regulation -sensitivity
-liquidity of banks
Contemporaneous reserve requirements is the implementation of the
53
required reserve regulation through a seven-week cycle with
transaction deposit daily averages calculated over a reserve
computation periods (from Tuesday of week one to Monday of week
three) and reserve daily average calculated over a reserve
maintenance period (from Thursday of week five to Wednesday of week
seven).
54
Part VI: Macroeconomic theories of the effect of changes in
money supply on the economy
Chapter 21: Classical model and the neutrality of money
Velocity of money is the number of times money changes hand in
an economy in one year. In notation, it reads as V = Py/M.
Since there are different measures of money supply, M, there are
different measures of velocity of money. If we use M1 as our
measure of money supply, we have V1 as our velocity of money,
where V1 = Py/M1. Similarly, if we use M2 as our measure of
money supply, we have V2 as our measure of velocity of money,
where V2 = Py/M2.
If we take the definition of the velocity of money and multiply
both sides by money supply, we have the equation of exchange:
MV = Py. On the left hand side of the equation of exchange we
have dollar value of the flow of money and on the right hand
side of the equation of exchange we have the dollar value of the
flow of money.
The Simple Quantity Theory of Money assumes that velocity of
money is constant. This in turn means general price level is
55
directly proportionate to money supply but inversely related to
real income. In notation, we have P = MV/y.
Assumptions of the Classical Model
-flexible real interest rate means real interest rate is free to
move up or down.
-flexible product prices mean product prices are free to move up
or down.
-flexible real wages mean real wages are free to move up or
down.
-certainty means everyone knows everything, especially prices.
-competitive labor market means there is a supply curve of labor
and a demand curve for labor. Intersection point of the supply
of and the demand for labor curves will determine the
equilibrium real wages and the number of workers employed.
-production function is the mapping of input to output when
inputs are used efficiently.
-Say's Law: supply creates its own demand. This means that we
need only model supply of products and we don’t need to model
demand for product because supply will creates its own demand.
In this sense the Classical Model is the grandfather of supply
side economics. Unfortunate, modern understanding of economics
tells us that the Say’s Law is incorrect. Supply and demand
are independent because the decision makers behind the supply
curve and the decision makers behind the demand curve are
56
different groups of people.
-Simple Quantity Theory of Money
-Classical savings function: real saving is positively related
to real interest rate.
-investment function: real investment is inversely related to
real interest rate.
-competitive loanable funds market means there is a supply curve
of bank loans, which is given by the Classical savings
function, and there is a demand curve for bank loans, which is
given by the investment function plus government budget
deficits financed by borrowing. The
-7 endogenous variables: W/P, N, y, P, i, S & I
Neutrality is that changes in money supply have no effect on
equilibrium real income(GDP).
Dichotomy is that the determination of the equilibrium levels of
real variables is separated from the determination of the
equilibrium levels of nominal variables.
Crowding-out effect is that an increase in government expenditures
drives up interest rate & reduces investment.
Ricardian Equivalence Theorem states that government budget
deficit due to a tax cut financed by borrowings has no effect on
real interest rate and investment but increases savings.
57
Chapter 22: Second generation Keynesian model
Assumptions of the 2nd generation Keynesian Model
-flexible interest rates mean interest rates are free to move
up or down.
-fixed product prices and fixed wages mean product prices and
wages cannot be adjusted up or down in a short period of time.
-certainty means everyone knows everything, including prices.
-product market equilibrium means real product demand equals
real product supply. It also means intended real investment,
I, plus government expenditures, G, equals real savings, S,
plus taxes, T. In notation, it reads as I(i ) + G = S(y-T) + T.
-money market equilibrium means real money demand equals real
money supply.
58
-production function is the mapping of input to output when the
input is used efficiently.
-investment function is the inverse relation between real
investment and real interest rate.
-Keynesian savings function: real saving is positively related
to real income.
-the five endogenous variables are real interest rate, real
income, number of workers employed, real investment and real
savings.
IS curve is the combinations of real interest rate and real income
that yield an equilibrium in the product market.
The IS curve is downward sloping because as real interest rate goes
up, real investment goes down. Real investment is a component of
real product demand. The reduction in real product demand will
create an excess supply in the product market. To restore
equilibrium in the product market, real product supply must go
down. This means real savings plus taxes must go down, which in
turn means real income has to go down. In summary, higher real
interest rate corresponds to lower real income as we move from
one point of the IS curve to a new point further up to the left
of the IS curve.
Motives for money demand
-transactional demand for money is holding real money as a
medium of exchange for both regular and unexpected
expenditures. Transactional demand for money should be
59
positively related to real income.
-speculative demand for money is holding real money for the
purpose of unforeseeable great investment opportunities.
Speculative demand for money should be negatively related to
real interest rate. Real interest rate is the opportunity cost
of holding money. The higher the real interest rate the higher
is the opportunity cost of holding money and the less is
speculative demand for money.
LM curve is the combinations of real interest rate and real income
that yield an equilibrium in the money market.
The LM curve is upward sloping because as real income increases,
transactional demand for money increases. This creates excess
demand in the money market since there is no change in real
money supply. To restore equilibrium in the money market,
speculative demand for money must decrease and real interest
must increase to make room for the higher transactional demand
for money. In summary, higher real income corresponds to higher
real interest rate as we move from one point of the LM curve to
a new point further up to the right of the LM curve.
Simultaneous equilibrium in the product and the money market
determines the equilibrium real interest rate and real income.
Graphically this is given by the intersection point of the IS
curve and the LM curve. Once the equilibrium real income is
determined, we make use of the Keynesian savings function to
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to determine the equilibrium real savings and the production
function to determine the equilibrium number of workers
employed. Also with the equilibrium real interest rate
determined, we make use of the investment function to determine
the equilibrium real investment. In total this gives us the five
endogenous variables of the Second Generation Keynesian model.
Chapter 23: Monetary transmission mechanisms
Monetary Transmission Mechanism is the process through which
changes in money supply affect equilibrium real income in an
economy.
8 Monetary transmission mechanisms -Classical
-Keynesian
-Availability Hypothesis
-Tobin's q
-Consumer durable expenditures
-Wealth effect
-Liquidity effect
-Exchange rate effect
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Chapter 24: The debate on the effectiveness of monetary vs fiscal
policy among Keynesians vs monetarists
Keynesian(Monetarist) theory assumes inelastic(elastic) investment
& elastic(inelastic) speculative demand for money leading to
the conclusions that fiscal policy is effective(ineffective) but
monetary policy is ineffective(effective) in the short run.
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Chapter 25: Fourth generation Keynesian model
Assumptions of
-flexible interest rates
the 4th generation -flexible product prices
Keynesian Model
-flexible wages
-uncertainty
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-adaptive expectations
-product market equilibrium
-money market equilibrium
-investment function
-Keynesian savings function
-labor market equilibrium
-production function
-7 endogenous variables: P, y, i, I, S, N & W
Aggregate demand is the combinations of general price level &
real income that yield simultaneous equilibrium in the product
and money market.
Why is the aggregate demand curve downward sloping?
Determinants of aggregate demand
-investment
-government expenditures
-savings
-taxes
-money supply
-transactional demand for money
-speculative demand for money
Aggregate demand management policies are gov't policies that try
to shift the AD curve to affect equilibrium real income,
e.g. fiscal & monetary policies
Aggregate supply is the combinations of general price level &
real income that yield an equilibrium in the labor market.
Why is the aggregate supply curve upward sloping?
Determinants of aggregate supply -labor demand
-labor supply
-price expectations
-production function
Aggregate supply management policies are gov't policies that
try to shift the AS curve to affect equilibrium real income.
e.g. labor market policy and research & development policy.
Short-run vs long-run aggregate-supply curve
Supply side shocks, stagflation vs deflationary growth
Demand side shocks, recession vs inflationary growth
Anticipated vs unanticipated policies
Part VII: Determinants of foreign exchange rates
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Chapter 26: Long run determinants of foreign exchange rate
Foreign exchange rate is the rate of conversion of one national
currency for another national currency. There are two ways to
express foreign exchange rates. First, we can express it as number
of units of a foreign currency per unit of the domestic currency.
This is the most common way to quote foreign exchange rate.
Secondly, we can express it as number of units of the domestic
currency per unit of a foreign currency. The British pound is
commonly quoted on the basis.
Appreciation vs depreciation
Price of gold
Devaluation vs up-valuation(revaluation)
The Law of One Price is based on four assumptions:
1) Homogeneous product.
2) Perfect information.
3) Competitive markets.
4) No transaction cost.
Purchasing Power Parity is a generalization of the Law of One
Price. It is based on five assumptions:
1) Homogeneous products.
2) Perfect information.
3) Competitive markets.
4) No trnsaction cost.
5) All goods are tradable.
Absolute vs Relative
There are four long run determinants of foreign exchange rates
-domestic vs foreign prices
-tariffs & quotas
-preferences of domestic vs foreign goods & services
-domestic vs foreign productivity growth rates
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Chapter 27: Short run determinants of foreign exchange rates
Covered Interest Rate Parity assumes that investors cover their
foreign exchange rate risk by a forward contract. Hence the
principal and interest from a dollar invested for a year at the
domestic interest rate must be equal to the current foreign
exchange rate times the principal and interest invested for a year
at a foreign interest rate divided by the forward foreign exchange
rate.
Open Interest Rate Parity assumes investors do not cover their
foreign exchange rate risk. Instead it assumes investors are risk
neutral and form
rational expectations
There are three short run determinants of foreign exchange rates
-domestic vs foreign interest rates
-expected future foreign exchange rate
-gov't intervention
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Chapter 28: Current accounts and capital accounts
Trade balance is the sum of net export of merchandise and net
export of services.
Current account balance is the sum of trade balance, net investment
income and net unilateral transfer.
Capital account balance is the sum of capital inflows and capital
outflows.
Official reserve transaction balance(balance of payment) is the
sum of current account balance and capital account balance.
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Chapter 29: Equilibrium foreign exchange rate
Export is inversely related to foreign exchange rate. Import is
positively related to foreign exchange rate. Trade balance foreign
exchange rate is that foreign exchange rate where export equals
imports.
Capital inflows are financial investment in the domestic country
by foreign investors. They are positively related to the domestic
interest rate and negatively related to foreign exchange rate.
Capital outflows are financial investment overseas by domestic
investors. They are negatively related to domestic interest rate
and positively related to foreign interest rate.
The determinants of the demand for US dollars in the foreign
exchange market are US export and capital inflows. The determinants
of the supply of US dollars in the foreign exchange market are
imports and capital outflows. Equilibrium foreign exchange rate is
that foreign exchange rate where demand for US dollars equals
supply of US dollars in the foreign exchange market.
From 1946 to 1970, every year in United States of America we
have trade surplus. Even with the two energy crises of skyrocketing
oil prices in the 1970s, the trade deficit in the United States of
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America was in the tens of billion of dollar. The hundreds of
billion of dollar of trade deficit began in 1983 after the Reagan
tax took full force. The Reagan tax cut generated hundreds of
billion of dollar in federal government budget deficit. Reagan did
not like inflation. With inflation financing ruled out, the
hundreds of billion of dollar of
budget deficit were financed by
debt. Annually the US Treasury had to borrow hundreds of billion of
dollar driving up the US interest rate. The high US interest rate
encouraged capital inflows but discouraged capital outflows. The
imbalance drove the equilibrium foreign exchange rate above the
trade balance foreign exchange rate, leading to import greater than
export, hence the hundreds of billion of dollars of trade deficit.
National income identities of a four-sector economy
-Flow of product (expenditures) approach
-Disposal of income approach
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