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Transcript
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 1 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 2 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 3 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 4 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. 5 (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. 6 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 7 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. 8 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 9 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 10 (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 11 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. 12 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. 13 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 14 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 15 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 16 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. 17 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 18 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. 19 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 20 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 21 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. 22 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, 23 -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. 24 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 25 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 26 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 60 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 61 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. 62 Chapter 25: Fourth generation Keynesian model Assumptions of -flexible interest rates the 4th generation -flexible product prices Keynesian Model -flexible wages -uncertainty 63 -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 64 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 65 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 66 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. 67 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 68 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 69