20.2 Liquidity Preference Theory #Notebook

20.2 Liquidity Preference Theory #Notebook

The John Maynard Keynes developed the liquidity preference theory, the equation of exchange:

MV = PY = Nominal GDP = Price Level x Real GDP

M = money supply 

V = velocity

P = price level

Y = output

Money Supply x Velocity = Price Level x Output

Classical quantity theorists used the equation of exchange as the causal statement, the increases in the money supply lead to proportional increases in the price level. 

Although a good approximation of reality, the classical quantity theory could not explain why velocity was pro-cyclical and why it increased during business expansions and decreased during recessions.

Therefore Keynes searched for a better theory to explain these situations.

So, why do economic agents hold money?

Transactions: To make payments. As their incomes rise, do the number and value of those payments, so this part of money demand is proportional to income. Transaction demand for money is negatively related to interest rates. When interest rates are high, people will hold as little money for transaction purposes because people tend to only liquidate them when needed. 

When rates are low, people will hold more money for transaction purposes because it isn’t worth the brokerage fees to play with bonds very often. 

Precautions: To keep some spare cash lying around as a precaution. It is directly proportional to income. The lure of high-interest rates offsets the fear of the devil. When rates are low, it's better to play it safe. So the precautionary demand for money is also negatively related to interest rates.

Speculations: People hold larger money balances when rates are low. Money demand and interest rates are inversely related.

Keynes’s ideas can be stated as Md / P = f ( i <−>, Y <+> )

Md/P = demand for real money balances

f means “function of” (this simplifies the mathematics) 

i = interest rate

Y = output (income)

<+> = varies directly with

<−> = varies indirectly with

Keynes’s view was superior to the classical quantity theory of money because he showed that velocity is not constant.

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. 

20.1 The Quantity Theory #Notebook

20.1 The Quantity Theory #Notebook

If inflation erodes the purchasing power of the unit of account, economic agents will want to hold higher nominal balances to compensate.

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

Md / P = demand for real money balances

Md = money demand

Plv = price level

f means “function of” (not equal to)

Pi = Permanent income

ERoB – ERoM = the expected return on bonds - the expected return on money

ERoS – ERoM = the expected return on stocks (equities) minus the expected return on money

EIf – ERoM = expected inflation minus the expected return on money

According to Friedman's theory, the demand for real money balances increases when permanent income increases and declines when the expected returns on bonds, stocks, or goods increases versus the expected returns on money, which includes both the interest paid on deposits and the services banks provide to depositors.

Money demand is where the action is, because the central bank determines what the money supply will be, so we model it as a vertical line. 

Before the rise of modern central banking in the 20th century, the supply curve was sloped upward. Early monetary theorists did not discuss much of the nature of money demand since they also had to worry about the nature of the money supply. Under a specie standard, money was supplied exogenously. 

Consider the interest rate as the price of money on the vertical line, so when interest is high, more people want to supply money to the system because seigniorage is higher. And then, more people want to form banks, find ways of issuing money, and extant bankers want to issue more money (notes, and deposits).

Just like the price of gold or oil. When its price is low, there is less incentive to find more. But, when the price is high enough, more people want to go out to find more new gold veins or oilfields, or even more crimes associated with it.

If the return on financial investments decreases, they will want to hold more money because its opportunity cost is lower. 

If inflation expectations increase, but the return on money doesn’t, people will want to hold less money because the relative return on goods (land, gold, turnips) will increase.

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. 

19.1 The Trilemma, or Impossible Trinity #Notebook

19.1 The Trilemma, or Impossible Trinity #Notebook

The Free Floating Regime

The foreign exchange market that monetary authorities allow world markets to determine the prices of different currencies in terms of one another. The free float was characterized by tremendous exchange rate volatility and unfettered international capital mobility. 

Between World War II and the early 1970s, much of the world was on a managed, fixed-FX regime called the Bretton Woods System. Before that, many nations were on the gold standard.

It's the prevailing regimes when nations determine their monetary relationship with the rest of the world individually.

In the 19th century, there are silver standard, gold standard, floating in wartime, maintain fixed exchange rates (usually against USD). But just as no country can do away with scarcity or asymmetric information, none can escape the trilemma, also known as the impossible trinity.

What Is a Trilemma / Impossible Trinity? 

It is an economic decision-making theory. Unlike a dilemma, two options, a trilemma offers three solutions to a complex problem. A trilemma suggests that countries have three options to choose from when making monetary policy decisions, the free flow of capital, fixed exchange rate, and independent monetary policy.

However, the options of the trilemma are conflictual because of mutual exclusivity that makes only one option of the trilemma achievable in one shot. The theory highlights the instability inherent in using the three primary options available to a country.

Image by Julie Bang © Investopedia 2019

A: If a country can choose to fix exchange rates with one or more countries and have a free flow of capital with others, then the independent monetary policy is not achievable. The interest rate fluctuations would create currency arbitrage stressing.

B: Fixed exchange rates among all nations and the free flow of capital are mutually exclusive. Only one can be chosen at a time. If there is a free flow of capital, there cannot be fixed exchange rates. 

C: If a country chooses fixed exchange rates and independent monetary policy it cannot have a free flow of capital. Because fixed exchange rates and the free flow of capital are mutually exclusive.

Briefly summarize, only two of the three holy grails of international monetary policy, fixed exchanged rates, international financial capital mobility, and domestic monetary policy discretion can be satisfied at once. 

In history, the United States and Great Britain abandoned the specie standard and allowed their currencies to float quite freely during wartime since they found the specie standard costly and preferred instead to float with free mobility of financial capital and also allowed them to borrow abroad while simultaneously gaining discretion over domestic monetary policy.

Reference

Majaski, C. (2020, August 28). Trilemma Presents Three Equal Options but Only One is Possible at a Given Time. Retrieved October 15, 2020, from https://www.investopedia.com/terms/t/trilemma.asp

19.4 The Choice of International Policy Regime #Notebook

19.4 The Choice of International Policy Regime #Notebook

Problems are often exposed when the central bank runs out of reserves, like in Thailand did in 1997. 

The International Monetary Fund (IMF) often provides loans to countries attempting to defend the value of their currencies. 

However, the IMF often forces borrowers to undergo fiscal austerity programs and even created a major moral hazard problem, such as repeatedly lending to the same few countries.

In China’s defense, many developing countries find it advantageous to peg their exchange rates to the dollar, the yen, the euro, the pound sterling, or a basket of such important currencies. 

The peg, as a monetary policy target similar to an inflation or money supply target, allows the developing nation’s central bank to figure out whether to increase or decrease MB and by how much.

Fixed exchange rates not based on commodities like gold or silver are notoriously fragile. Relative macroeconomic changes in interest rates, trade, and productivity can create persistent imbalances over time between the developing and the anchor currencies. 

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. 

19.3 The Managed or Dirty Float #Notebook

19.3 The Managed or Dirty Float #Notebook

Under a managed float, the central bank allows market forces to determine second-to-second (day-to-day) fluctuations in exchange rates, but intervenes if the currency grows too weak or too strong, keeping the exchange rate range bound. 

Central banks intervene in the foreign exchange markets by exchanging international reserves, assets denominated in foreign currencies, gold, and special drawing rights, SDRs.

If a central bank selling $10 billion of international reserves, thereby soaking up $10 billion of the monetary base.

The Assets = International reserves −$10 billion

The Liabilities = Currency in circulation or reserves −$10 billion

*The money is going back to their source.

If a central bank buys $100 million of international reserves, both MB and its holdings of foreign assets would increase.

Its Assets = International reserves +$100 million

Its Liabilities = Monetary base +$100 million

*The money is flowing out of their source.

Such transactions are influencing the foreign exchange rate via changes in MB through the money supply (MS).

Central banks also engage in sterilized foreign exchange interventions when they offset the purchase or sale of international reserves with a domestic sale or purchase. 

A central bank might offset or sterilize the purchase of $100 million of international reserves by selling $100 million of domestic government bonds.

Its Assets = International reserves +$100 million, Monetary base +$100 million

Its Liabilities = Government bonds −$100 million, Monetary base −$100 million

*Here I have a question to ask, why the Government bonds are on the liabilities side if it is originally one of the assets holdings?

Why not like this?

Its Assets = International reserves +$100 million, Government bonds −$100 million

Its Liabilities = Monetary base +$100 million, Monetary base −$100 million

Since there is no net change in MB, a sterilized intervention should have no long-term impact on the exchange rate. It is for the short-term or for the signal of desire.

Central banks can use international reserves in a fruitless attempt to prevent a depreciation, or maintenance of the peg might require increasing or decreasing the MB counter to the needs of the domestic economy.

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. 

19.2 Two Systems of Fixed Exchange Rates #Notebook

19.2 Two Systems of Fixed Exchange Rates #Notebook

Because of arbitrageurs, a type of investor who attempts to profit from market inefficiencies, the spot exchange rate, the market price of bills of exchange, could not stray very far.

The gold standard system was self-equilibrating, functioning without government intervention. But, its weakness was that the governments had so little control of its domestic monetary policy, even did not need a central bank. 

The Bretton Woods System was designed to overcome the flaws of the gold standard while maintaining the stability of fixed exchange rates. By making the dollar the free world’s reserve currency, more elastic supply of international reserves, and also allowed the United States to earn seigniorage. 

However, The Bretton Woods System had to restrict international capital flows and witnessed a massive shrinkage of the international financial system.

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. 

Why The Simultaneous Targeting of The Money Supply and Interest Rates Is Sometimes Impossible to Achieve?

Why The Simultaneous Targeting of The Money Supply and Interest Rates Is Sometimes Impossible to Achieve?

Because the variables are many during the process. According to the model of demand and supply, the equilibrium price is determined by demand and supply. Although we can control the supply and the interest rates, the demand is still out of control. The demand can be affected by any natural events, expectations, and even just emotions. We just cannot control everything in every moment.

Theoretically, demand and supply cross at an equilibrium price point. But, in the real world, it's not always that simple. Mostly, the prices are like waves on the sea. Not to mention we are just able to partly control the supply and the interest rates, but not totally control everyone's brain. Can central banks control your demand in food, water, safety, and investment? Of course not.

How Central Banks Intervene in Foreign Exchange Markets?

Central banks sometimes try to achieve their goals by intervening in foreign exchange markets. It's a monetary policy tool used by central banks, mostly to stabilize the exchange rate, also to build reserves, or provide them to the country's banks. Central banks can buy or sell foreign currency in foreign exchange markets. But, it must be careful to minimize unintended effects. There is no guarantee that traders can look for the new trend to emerge before placing a trade.

The most difficult parts of doing this were the timing and the amounts. Act too early or too late, too much or not enough, all have their pros and cons. However, currency stabilization still requires short-term or long-term interventions. Countries that are heavily reliant on exports may do not want to see that their currency is too strong for other countries to afford the goods they produce. So, they intervene to keep the currency at a lower level. 

For example, in 2015, the Swiss National Bank set a minimum exchange rate between the Swiss Franc and the Euro to keep the Swiss Franc from strengthening beyond an acceptable level for other European importers of Swiss goods. Nevertheless, foreign exchange interventions can be risky in that they can undermine a central bank's credibility if it fails to maintain stability. 

The Bretton Woods Agreement

The Bretton Woods agreement of 1944 replaced the gold standard with the U.S. dollar as the global currency, and established America as the dominant power in the world economy. The agreement also created the World Bank and the International Monetary Fund (IMF) to monitor the new system.

Under the agreement, these participated countries promised that their central banks would maintain fixed exchange rates with the US dollar. That means these central banks would have to actively buy up or sell short their currency in foreign exchange markets. Purchasing or selling a currency would lower or higher the supply of the currency, and then raise or reduce its price. This is a monetary policy often used by central banks to control inflation.

Obviously, the agreement created more demand for dollars, even though its value remained the same. But, why did they do that? Until World War I, most countries were on the gold standard, a standard built on the supply of gold and the ratio to exchange it. That generates an obvious issue. How can we control the supply of gold? This basically gives up an effective monetary policy tool. Therefore, they cut the tie to gold so they could print the currency needed to pay for their war costs. However, money does not grow on trees. This quick inflow of currency caused hyperinflation, so returned to hug the gold after the war, until the Great Depression. 

Nonetheless, the agreement collapses. In 1971, the United States suffered from massive unemployment and low economic growth. President Nixon started to deflate the dollar's value in gold since the dollar was pegged to the price of gold. By 1973, the Bretton Woods system was replaced de facto by the current regime based on freely floating fiat currencies.

Reference

Amadeo, K. (2020, September 03). How a 1944 Agreement Created a New World Order. Retrieved October 12, 2020, from https://www.thebalance.com/bretton-woods-system-and-1944-agreement-3306133

Chen, J. (2020, September 16). Foreign Exchange Intervention Defintion. Retrieved October 12, 2020, from https://www.investopedia.com/terms/f/foreign-exchange-intervention.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. 

17.4 The Taylor Rule #Notebook

17.4 The Taylor Rule #Notebook

fft = π + ff*r + 1 ⁄ 2(π gap) + 1 ⁄ 2(Y gap)

Federal funds target = inflation + the real equilibrium fed funds rate + 1/2 inflation gap +1/2 output gap

fft = federal funds target

π = inflation

ff*r = the real equilibrium fed funds rate

π gap = inflation gap (π – π target)

Y gap = output gap (actual output, GDP − output potential)

Globalization makes it increasingly important for the Fed and other central banks to look at world inflation and output levels to get domestic monetary policy right.

Foreign exchange rates can also flummox central bankers and their policies. Increasing or decreasing interest rates will cause a currency to appreciate or depreciate in currency markets. 

Because the value of a currency directly affects foreign trade, when a currency is strong or weak relative to other currencies, imports will be stimulated or contracted because foreign goods will be cheap or expensive.

Some countries with economies heavily dependent on foreign trade have to be extremely careful about the value of their currencies.

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.

17.3 Central Bank Targets #Notebook

17.3 Central Bank Targets #Notebook

TOOLS → SET TARGET → SET GOAL

Time inconsistency problem, The inability over time to follow a good plan consistently. Like a wayward dieter or a lazy student, they overshot their targets time and time again. 

Monetary targets did not always equate to the goals. There are long lags between policy implementation and real-world effects. The situation is changing over time, and nearly impossible to predict. 

Central banks cannot control both an interest rate and a monetary aggregate at the same time. 

Central banks can control interest rate or MS, but not both

If the central bank leaves the supply of money fixed, changes in the demand for money will make the interest rate jiggle up and down. It can only keep interest rates fixed by changing the money supply. However, with the monetary supply moving round and round, up and down, it became difficult to hit monetary targets.

If central banks adopt explicit inflation targets, the result will be lower employment and output in the short run. As inflation expectations spread, an extended period begins, and then high employment.

Inflation targeting frees central bankers to do whatever it takes to keep prices in check, to do it with more useful information, not just monetary statistics. That makes the policies more sensible to the public because anyone can feel it.

However, if a country like New Zealand, its legislature can oust what central banker is doing by law, it makes the central bank less independent. But, if it legislature uses the punishment only to oust incompetent or corrupt central bankers, it should be salutary. 

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.

17.2 Central Bank Goal Trade-offs #Notebook

17.2 Central Bank Goal Trade-offs #Notebook

Central banks often get themselves in a dilemma, in which price stability, inflation control, economic growth, and employment. Although in the long run, the two goals are compatible, they sometimes are not in the short run.

Central banks have to make hard decisions.....

Raise interest rates or slow or even stop MS growth to stave off inflation? 

Or, decrease interest rates, speed up MS growth to induce companies and consumers to borrow to stoke employment and growth? 

When central banks act as a lender of last resort to restore stability to the financial system, they create a time inconsistency problem and moral hazard. Business owners and bankers take on extra risks since they think they will get free favors while difficult times.

However, a little frictional unemployment is a good thing because it allows the labor market to function more smoothly. Frictional unemployment naturally occurs, even in a growing, stable economy. Workers choosing to leave their jobs in search of new ones. 

Structural unemployment, when workers’ skills do not match job requirements, is not such a good thing, but is probably inevitable in a dynamic economy saddled with a weak educational system. 

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.