Financial Shocks

Financial shocks, alone or in combination, have a strong propensity to initiate financial crises. Here are the five reasons we know for now.

Increases in uncertainty. When companies and investors concern about the future, they tend to use their money safely. 

Increases in interest rates. Higher interest rates make business projects less profitable, lower the gross domestic product (as we know it's GDP), and also tend to discourage good borrowers. Higher interest rates even hurt cash flow, rendering firms more likely to default.

Government fiscal problems are also crucial since it connects to the value of currencies and the value of relative securities.

Balance sheet deterioration. Whenever a firm’s balance sheet deteriorates, the asymmetric information rears its trio of ugly, fang-infested faces. 

Banking panics. If anything hurts banks’ balance sheets, banks will reduce their lending to avoid going bankrupt and incurring the wrath of regulators, negatively affect the economy by reducing the flow of funds between investors and entrepreneurs. 

A Financial Shock from Recent History

A financial shock that happening recently, is the shocks caused by COVID-19. Obviously, it has already spread worldwide. Before the vaccine actually come out, everything about the economic rebound is all uncertain. Many physical stores are closed because of uncertainty, business owners feel concerned about the future, they tend to reduce their business and run it safely. 

During the hard period, governments are trying to do something to win their supports. However, money does not grow on trees, there are always costs. Financial stimulus policies have become more and more frequent recently and the US government even consider the second stimulus check. But do you really think we have infinite money to spend? Where does this money come from? Of course, from taxes mostly. 

The Federal Reserve also takes actions on this, lower the interest rate during the difficult time. Lowering the interest rate may induce business expansion and so do the GDP, but it is still be blocked by the certainty. Moreover, it also affecting the money demand and gross investment. 

Reference

Gittins, W. (2020, October 24). Second stimulus check update: US coronavirus relief bill. Retrieved October 26, 2020, from https://en.as.com/en/2020/10/24/latest_news/1603567807_242410.html

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

Principle of Finance Aggregate Demand & Aggregate Supply #Notebook

Principle of Finance Aggregate Demand & Aggregate Supply #Notebook

As we have learned from the Macroeconomics, the aggregate demand, and supply, that relates the price level to the total final goods and services demanded (aggregate demand) and the aggregate supply was a new theory developed by economists.

The aggregate demand and supply model can be used to examine both the short and the long run, it's similar to the price theory model of supply and demand, and it gives policymakers the grounds for implementing policies. 

The aggregate supply curve, in the long run, is thought to be vertical at the natural level of output. In the long run, the economy can produce only so much given the state of technology, the natural rate of unemployment, and the amount of physical capital devoted to productive uses.

However, in the short run, prices of final goods and services generally adjust faster than the cost of inputs are often sticky due to long-term contracts fixing their price. 

23.3 Equilibrium Analysis #Notebook

If we start with the AD, AS, and the long term AS curve, their intersection indicates both the price level P* and the output Y*.

At any price > the equilibrium price level, there will be excess supply, so prices will fall toward the equilibrium point.

At any price < the equilibrium price level, there will be excess demand, so prices bid up to the equilibrium point.

The self-correcting mechanism makes many policymakers hard to choose their plans. However, In the long run, we probably are all dead. 

Policymakers often try to discover how to shift Ynrl to the right because, if they can do that, it doesn’t matter how short the long term is. 

People often believe that wars induce long-term economic growth, but they are quite wrong. Empirically, wars are indeed often followed by recessions and deflation. Although wars do indeed speed research and development, it is not worth the wartime destruction of great masses of human and physical capital.

During the war, the output increase because of increases in G (war products, tanks, guns.) and I (new or improved factories to produce war gears.). Due to the right shift in AD, the price level also rises, it's the illusion of wealth. After the war, both lower output and the AD leftward shift decreases the price level. 

23.4 The Growth Diamond #Notebook

By reducing asymmetric information and tapping economies of scale, the financial system efficiently links investors to entrepreneurs, ensuring that society’s scarce resources are allocated to the highest valued uses and that innovative ideas get a fair trial.

In the growth diamond, the home plate is represented by government, first base by the financial system, second base by entrepreneurs, and third base by management. 

To succeed economically, a country must first possess a solid home plate, a government that protects the lives, liberty, and property of its citizens. 

Next, it must develop an efficient financial system capable of linking savers and investors to people with good business ideas, and entrepreneurs.

The managers at third take over after a product has emerged and matured.

The growth diamond is powerful and can be applied to almost every country on earth. 

23.5 Financial Shocks #Notebook

Financial shocks, alone or in combination, have a strong propensity to initiate financial crises:

Increases in uncertainty. When companies and investors concern about the future, they tend to use their money safely. 

Increases in interest rates. Higher interest rates make business projects less profitable, lower the gross domestic product (GDP), and also tend to discourage good borrowers. Higher interest rates even hurt cash flow, rendering firms more likely to default.

Government fiscal problems are also crucial since it connects to the value of currencies and the value of relative securities.

Balance sheet deterioration. Whenever a firm’s balance sheet deteriorates, the asymmetric information rears its trio of ugly, fang-infested faces. 

Banking panics. If anything hurts banks’ balance sheets, banks will reduce their lending to avoid going bankrupt and incurring the wrath of regulators, negatively affect the economy by reducing the flow of funds between investors and entrepreneurs. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

22.3 Aggregate Demand Curve #Notebook

 22.3 Aggregate Demand Curve #Notebook

The AD curve is essentially just another way of stating the IS-LM model, anything that would change the IS or LM curves will also shift the AD curve. 

The AD curve shifts in the same direction as the IS curve and the AD curve also shifts in the same direction as the LM curve.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

22.2 Implications for Monetary Policy #Notebook

22.2 Implications for Monetary Policy #Notebook

The IS-LM model has a major implication for monetary policy. When the IS curve is unstable, a money supply target will lead to greater output stability, and when the LM curve is unstable, an interest rate target will produce greater macro stability.

The policy power of the IS-LM is severely limited by its short-run assumption that the price level doesn’t change. 

The key is the addition of a new concept, called the natural rate level of output, Ynrl, the rate of output at which the price level is stable in the long run. 

When actual output (Y*) is below the natural rate, prices will fall; when it is above the natural rate, prices will rise.

The IS curve is stated in real terms because it represents equilibrium in the goods market, therefore changes in the price level do not affect consumption expenditures, investment, government spending, Taxes, or net exports or the IS curve.

However, the LM curve is affected by changes in the price level, shifting to the left when prices rise and to the right when they fall. 

Holding the nominal MS constant, rising prices decrease real money balances, shifts the LM curve to the left.

Suppose an economy is in equilibrium at the natural rate level of output (Ynrl), when the monetary stimulus increase the MS shifts the LM curve to the right. In the short term, interest rates will come down and output will increase. But because actual output Y* is greater than Ynrl, prices will rise, shifting the LM curve back. As a result, the output and the interest rate are the same but prices are higher. Economists call this long-run monetary neutrality.

Fiscal stimulus shifts the IS curve to the right, increasing output but also the interest rate. Because Y* is greater than Ynrl, prices will rise and the LM curve will shift left, reducing output, increasing the interest rate higher still, and raising the price level.

Under the IS-LM Model, looks like policymakers just can’t win in the long run, since policymakers cannot make Y* exceed Ynrl. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

21.1 Aggregate Output and Keynesian Cross Diagrams #Notebook

21.1 Aggregate Output and Keynesian Cross Diagrams #Notebook

Developed in 1937 by economist and Keynes disciple John Hicks, the IS-LM model is still used today to model aggregate output (GDP, or GNP) and interest rates in the short run. It begins with John Maynard Keynes’s recognition that

AoS = AD = Cs + Inv + Gs + NExpo

Aggregate output (Supply) = Aggregate demand = Consumer expenditure + Investment + Governemnt spending + Net exports

Keynes further explained that Consumer expenditure can be calculated by:

Consumer expenditure = Autonomous consumer expenditure (food, clothing, shelter, and necessaries) + ( Marginal propensity to consume X Disposable income )

For example, during the Great Depression, the investment fell from $232 billion to $38 billion (in 2000 USD), so the aggregate output fell by more than $232 billion − $38 billion = $194 billion. 

We know that because investment fell and the marginal propensity to consume was > 0, so, the fall was more than $194 billion.

An increase in exports over imports will increase aggregate output by the increase in NExpo times the expenditure multiplier. Likewise, a decrease in NExpo will decrease aggregate output by the decrease in NExpo times the multiplier.

Government spending (Gs) also increases aggregate output. However, some government spending comes from taxes, which consumers view as a reduction in income. With taxation, the consumption must to minus the taxations.

Many governments, including that of the United States, responded to the Great Depression by increasing tariffs. Today we know that such policies beggared everyone. What were policymakers thinking?

They were thinking that tariffs would decrease imports and thereby increase NExpo and aggregate output. That would make their trading partner’s NExpo decrease, thus beggaring them by decreasing their aggregate output.

But, in reality, it was dead wrong. Other countries retaliated with tariffs of their own. Even if they did not do it, it was a losing strategy because by making trading partners poorer.

In short, the policy limited their own ability to import and led to no long-term change in NExpo.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

Build The IS-LM Model

Assume that we have the following data:

C=100+0.50Y 

Ip=100-20r 

Mt=0.10Y 

Ms=100-10r 

M=80

a. Build the IS-LM function

Suppose the government spending, and the net export(NExpo) is o, then the model will be:

IS Model:

Y = Aggregate demand = Consumer and household consumption expenditures + Investment + Government spending + NExpo

Y = (100 + 0.5Y) + (100 - 20r) = 200 +0.5Y -20r

0.5Y = 200 - 20r

Y = 400 - 40r (The IS Equation)

The LM Model:

Money demand (speculative, transaction demand) is equal to the Money supply.

Money demand = Money supply

100 - 10r + 0.1Y = 80

0.1Y = 10r - 20

Y = 100r - 200 (The LM Equation)

The IS & LM intersection

400 - 40r = 100r - 200

140r = 600

r = 4.29

Y = 100r - 200

Y = (100 * 4.29) - 200

Y = 429 - 200

Y = 229

The intersection is (229, 4.29), which means the equilibrium interest rate 4.29% and the eqiilibrium output 229.

b. If we assume an increase in Investments by 100 units, please calculate again the IS-LM functions.

Assume an increase in Investments by 100 units, then....

The original IS Equation = Y = 400 - 40r

The new IS Equation = Y = 400 - 40r +100 = 500 - 40r

Y = 500 - 40r 

For every given data, the IS Equation will shift rightward (+100), and cause the equilibrium to have a larger aggregate output and larger interest rate which will also increase the supply of goods. 

c. The intersection of IS-LM functions defines four areas. Please analyze the behavior of the markets for goods and money for each area. 

Normally, there are four areas on the graph, separate by the equilibrium point of the intersection of the LM Equation line and the IS Equation line.

Region AB represents the pressure on the interest rate to fall down since it's higher than the theoretical equilibrium interest rate. As the interest rate goes down, the IS or LM curve respectively moving by their causes.

Region CD represents the pressure on the interest rate to increase since it's lower than the theoretical equilibrium interest rate. As the interest rate goes up, the IS or LM curve respectively moving by their causes.

Region BC represents the pressure on the output and supply to fall down since it's higher or lower than the theoretical equilibrium output and demand. 

Region AD represents the pressure on the output and supply to increase since it's lower than the theoretical equilibrium output and demand. 

Reference

Wright, R. E., & Quadrini, V. (2009).Money and Banking. Flat World Knowledge Inc.

22.1 Shifting The IS-LM Curves #Notebook

22.1 Shifting The IS-LM Curves #Notebook

The IS-LM model can help policymakers to decide between two major types of policies such as government expenditure and tax, or monetary (interest rates and money supply). 

An autonomous expenditure describes the components of an economy's aggregate expenditure that are not impacted by the level of income. This type of spending is considered automatic and necessary.

The classical economic theory states that any rise in autonomous expenditures will create at least an equivalent rise in aggregate output, such as GDP, if not a greater increase.

The LM curve, the equilibrium points in the market for money, shifts for two reasons: changes in money demand, and changes in the money supply. 

If the money supply increases (decreases), ceteris paribus, the interest rate is lower (higher) at each level of aggregate output.

The LM curve shifts right (left), means at any given level of output Y, more money (less money) means a lower (higher) interest rate. 

An autonomous change in money demand (not related to the price level, aggregate output, or i) will also affect the LM curve such as stocks get riskier or the transaction costs of trading bonds increases. 

The theory of asset demand tells us that the demand for money will increase (shift right), thus increasing interest rates.

Interest rates could also decrease if money demand shifted left because stock returns increased or bonds became less risky.

An increase in autonomous money demand will shift the LM curve left, with higher interest rates at each Y; a decrease will shift it right, with lower interest rates at each Y.

The IS curve shifts whenever an autonomous change occurs in Consumer spending, Investment, Government spending, Net exports. 

The IS curve shifts right (left). When taxes increases (decreases), all else constant, the IS curve shifts left (right) because taxes effectively decrease consumption. 

These are changes that are not related to output or interest rates, which merely indicate movements along the IS curve. 

Changes in consumer preferences will change the output at each interest rate and shift the entire IS curve.

How Government Policies Can Affect Output?

In the short run, an increase in the money supply will shift the LM curve to the right, thereby lowering interest rates and increasing output. Decreasing the MS would have precisely the opposite effect. 

Fiscal stimulus such as decreasing taxes or increasing government expenditures will also increase output but, unlike monetary stimulus (increasing MS), will increase the interest rate. This way, it works by shifting the IS curve upward rather than shifting the LM curve. 

Since Y = Aggregate demand = Consumer and household consumption expenditures + Investment + Government spending + NExpo -Taxes. If taxes increases, the IS curve will shift left, decreasing interest rates but also aggregate output. 

During financial panics, people often complain of high interest rates and declining economic output. Use the IS-LM model to describe why panics have those effects?

The LM curve will shift left during financial panics, raising interest rates and decreasing output, because the demand for money increases as economic agents scramble to get liquid.

During financial panics, the LM curve shifts left as people flee risky assets for money, thereby inducing the interest rate to climb and output to fall. Hamilton and Bagehot argued that monetary authorities should respond by increasing MS directly, shifting the LM curve back.

The LM curve shifts right (left) when the money supply, or demand (real money balances) increases (decreases).

The IS curve shifts right (left) when Consumption expenditures, Investment, Government, or Net exports increase (decrease), or Taxes decreases (increases). This relates directly to the Keynesian cross diagrams.

Reference

Wright, R. E., & Quadrini, V. (2009).Money and Banking. Flat World Knowledge Inc.

The Modern Quantity Theory and The Liquidity Preference Theory

The Modern Quantity Theory and The Liquidity Preference Theory 

Introduction

In every academic field, there are always better and better theories to help us better understand how the real world works. However, we can only close to be perfect, not actually perfect. The liquidity preference theory or the modern quantity theory all just trying to be perfect by thinking more and more deeply or more comprehensively. To figure out the pros and cons can help us learn from those mistakes and try to built a better world.

The Liquidity Preference Theory

The liquidity preference theory was developed by John Maynard Keynes, which assumes investors prefer cash or other highly liquid holdings while all other factors being equal. So, investors should demand a higher interest rate or higher return on securities that carry greater risk. 

According to this theory, cash is a commonly accepted and most liquid asset. The interest rates on short-term securities are lower because investors are sacrificing less liquidity for the opportunity cost of time. John Maynard Keynes also mentioned three motives that determine the demand for liquidity, the transactions motive, precautionary motive, and speculative motive.

The transactions motive is part of our day to day life, higher costs of living such as more expensive to feed your stomach mean a higher demand for cash and liquidity to meet those basic needs. More than that, if investors invest their funds in stocks or any other securities, may also have a high demand for liquidity to repay their obligations, paying rents, or mortgages.

The concept of precautionary motive is similar to insurance, a preference for additional liquidity in some unexpected events may require a substantial outflow of cash, such as car repairs or healthcare bills.

The speculative motive is a little similar to the precautionary motive since we all have some concerns about the future. But unlike the precautionary motive that sources from what we need, the speculative motive sources from what we want. For example, when interest rates are low, the demand for cash is high and they may prefer to hold other assets until interest rates rise. What we want is a better opportunity in the future.

If a 3-year IOU is expected to get 3% in return, then a 10-year IOU is less likely to get 2% in return. For the investor to sacrifice liquidity, they must receive a higher rate of return in exchange to have the cash tied up for a longer period.

In conclusion, the liquidity preference theory refers to money demand as measured through liquidity. In real-world terms, the more quickly an asset can be converted into currency, the more liquid it becomes.

The Modern Quantity Theory

Unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. Instead, the demand for money should depend not only on the risk and return offered by money but also on the various assets which the households can hold instead of money. 

In short, transfers of stock or public debt are there equivalent to payments in species. So, velocity rises when there are money substitutes, highly liquid assets that allow economic agents to earn interest. 

Why?

Because Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in the comparison of expected returns, such as the differences between bonds, stocks, or even inflations.

Reference

Chen, J. (2020, September 16). Liquidity Preference Theory Definition. Retrieved October 18, 2020, from https://www.investopedia.com/terms/l/liquiditypreference.asp

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

20.3 Friedman versus Keynes #Notebook

20.3 Friedman versus Keynes #Notebook

The modern quantity theory is superior to Keynes’s liquidity preference theory because it is more complex, specifying three types of assets (bonds, equities, goods) instead of just one (bonds). 

In Friedman’s theory, velocity is no longer a constant and does not assume that the return on money is zero. Instead, it is highly predictable.

Unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. 

Md / Plv: f (Pi varies directly with, ERoB – ERoM varies indirectly with, ERoS – ERoM varies indirectly with, EIf – ERoM varies indirectly with)

The reason for this is that Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in ERoB – ERoM, ERoS – ERoM, or EIf – ERoM because both sides would rise or fall about the same amount. 

Interest rates did not strongly affect the demand for money, so velocity was predictable and the quantity of money was closely linked to aggregate output. Except when nominal interest rates hit zero (as in Japan), the demand for money was somewhat sensitive to interest rates, it's a liquidity trap, where money demand is perfectly horizontal. Since the money demand became more sensitive to interest rate changes, velocity, output, and inflation became harder to predict.  

Transfers of stock or public debt are there equivalent to payments in species. So, velocity rises when there are money substitutes, highly liquid assets that allow economic agents to earn interest. 

Not as much money supply was needed to support the GDP and price level. Velocity can rise during the period that government debts are large. It then dropped as the government paid off the debt, requiring the use of more M1.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.