6. How much money has an economy? Money • Money is everything considered money. Money is recognized by its three main functions. • Medium of exchange. Goods can be generally obtained in exchange for money, that is, money must can be used to make purchases of goods. • Store of value. Money has the ability to preserve (at least part) of its purchasing power in time: it is a way of accumulating purchasing power. • Unit of account. The value of goods is expressed in
http://stephenlaughlin.posterous.com/buy‐an‐100‐trillion‐zimbabwe‐dollar‐bank‐note terms of money (this was the € from 1999 to 2002). http://en.wikipedia.org/wiki/Zimbabwean_dollar II 1 II 2
Fiat money Our currency: the euro
• Essentially, money is anything which is generally • The euro (sign: €; code: EUR) is the official accepted as a payment for goods. currency (= physical money) of the 17 members of the eurozone (officially called euro area): A, B, C, E, • But money is accepted in exchange for goods FI,FR,GE,GR,IR,IT,L,M,N,P,SLA,SLE,&SP. because of the belief that it will be subsequently accepted in exchange for goods. • The euro was born in Jan. 1999 as a unit of account and became currency on 1 Jan. 2002. It is managed • To reinforce that belief, originally money had to by the Eurosystem: the European Central Bank have intrinsic value: money itself was a good (like plus the central banks of the eurozone members. cattle or silver: commodity money). With time, it became unnecessary for money to have intrinsic • It is the 2nd most traded currency in the world, value. Money is now fiat money: intrinsically after the $. By mid‐2010, it surpassed the $ as the worthless pieces of paper and metal. currency with highest value in circulation (€800 b.). II 3 II 4
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Eurozone / European Union Euro coins in circulation (value) million € http://aviagemdosargonautas.blogs.sapo.pt/437873.html 10000 2€ 9500 9000 8500 8000 7500 7000 1€ 6500 6000 5500
5000 4500 4000 3500 50 c 3000 2500 20 c 2000 10 c 1500 1000 5 c 2 c 500 1 c 0 2002Feb 2003Feb 2004Feb 2005Feb 2006Feb 2007Feb 2008Feb 2009Feb 2010Feb 2011Feb 2012Feb II 5 2002Aug 2002Nov 2003Aug 2003Nov 2004Aug 2004Nov 2005Aug 2005Nov 2006Aug 2006Nov 2007Aug 2007Nov 2008Aug 2008Nov 2009Aug 2009Nov 2010Aug 2010Nov 2011Aug 2011Nov 2012Aug 2012Nov 2002May 2003May 2004May 2005May 2006May 2007May 2008May 2009May 2010May 2011May 2012May
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 1 II 7 II 8 Euro coins in circulation (% of value) € banknotes in circulation (quantity) 42 millions 2€ 6200 40 6000 http://www.ecb.int/stats/euro/circulation/html/index.en.html 38 5800 5600 50 € 36 http://sdw.ecb.europa.eu/browse.do?node=5274891 5400 34 5200 5000 32 4800 30 4600 1€ 4400 28 4200 26 4000 3800 24 3600 22 3400 3200 20 3000 20 € 18 2800 2600 16 2400 14 2200 10 € 50 c 2000 12 1800 10 20 c 1600 8 1400 1200 10 c 6 1000 5€ 800 100 € 5 c 4 500 € 600 2 c 2 400 200 € 1 c 0 200 0 2002Feb 2003Feb 2004Feb 2005Feb 2006Feb 2007Feb 2008Feb 2009Feb 2010Feb 2011Feb 2012Feb 2002Aug 2002Nov 2003Aug 2003Nov 2004Aug 2004Nov 2005Aug 2005Nov 2006Aug 2006Nov 2007Aug 2007Nov 2008Aug 2008Nov 2009Aug 2009Nov 2010Aug 2010Nov 2011Aug 2011Nov 2012Aug 2012Nov 2002May 2003May 2004May 2005May 2006May 2007May 2008May 2009May 2010May 2011May 2012May 2002Jul 2003Jul 2004Jul 2005Jul 2006Jul 2007Jul 2008Jul 2009Jul 2010Jul 2011Jul 2012Jul 2002Apr 2002Oct 2003Apr 2003Oct 2004Apr 2004Oct 2005Apr 2005Oct 2006Apr 2006Oct 2007Apr 2007Oct 2008Apr 2008Oct 2009Apr 2009Oct 2010Apr 2010Oct 2011Apr 2011Oct 2012Apr 2012Oct 2002Jan 2003Jan 2004Jan 2005Jan 2006Jan 2007Jan 2008Jan 2010Jan 2011Jan 2012Jan 2009Jan
II 9 € banknotes in circulation (% quantity) II 10
42 40 http://www.ecb.int/stats/euro/circulation/html/index.en.html 38 36 34 50 € 32 30 28 26 24 22 20 € 20 18 https://stats.ecb.europa.eu/stats/download/bkn_coins_quant/bkn_coins_quant/bkn_coins_quant.pdf 16 10 € 14 5€ 12 10 8 100 € 6 500 € 4 2 200 € 0 2002Jul 2003Jul 2004Jul 2005Jul 2006Jul 2007Jul 2008Jul 2009Jul 2010Jul 2011Jul 2012Jul 2002Apr 2002Oct 2003Apr 2003Oct 2004Apr 2004Oct 2005Apr 2005Oct 2006Apr 2006Oct 2007Apr 2007Oct 2008Apr 2008Oct 2009Apr 2009Oct 2010Apr 2010Oct 2011Apr 2011Oct 2012Apr 2012Oct 2002Jan 2003Jan 2004Jan 2005Jan 2006Jan 2007Jan 2008Jan 2010Jan 2011Jan 2012Jan 2009Jan
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https://stats.ecb.europa.eu/stats/download/bkn_notes_quant/bkn_notes_quant/bkn_notes_quant.pdf https://stats.ecb.europa.eu/stats/download/bkn_notes_val/bkn_notes_val/bkn_notes_val.pdf
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 2 Monetary aggregates Technical definitions of money (ECB) • Narrow money (M1) includes currency, i.e. banknotes and • Monetary aggregates are technical ways of defining coins, as well as balances which can immediately be (measuring the amount of) money. converted into currency or used for cashless payments. • M0 = monetary base = high‐poweredmoney=E+R • ʺIntermediateʺ money (M2) comprises narrow money (M1) and, in addition, deposits with a maturity of up to two . E = currency held by the public (cash) years and deposits redeemable at a period of notice of up to . R = bank reserves = currency in bank vaults + the three months. Depending on their degree of moneyness, such banks’ deposits at the central bank deposits can be converted into components of narrow money. • Broad money (M3) comprises M2 and marketable instru‐ •M1=E+D(money stock, money supply, monetary mass) ments issued by the MFI (Monetary Financial Institutions) . D = deposits = non‐interest‐bearing accounts at banks sector. Certain money market instruments (money market • M2 = M1 + savings deposits fund shares/units and repurchase agreements) are included in this aggregate. A high degree of liquidity and price cer‐ • M3 = M2 + time deposits + others tainty make these instruments close substitutes for deposits. II 13 II 14
II 15 II 16 Monetary aggregates, levels, eurozone Monetary aggregates, growth, eurozone
15 5200 14,5 M1 5000 http://www.ecb.int/stats/money/aggregates/series/html/index.en.html M1 14 4800 13,5 4600 13 M3 4400 12,5 12 4200 11,5 4000 11 3800 10,5 3600 10 3400 M2M1 9,5 9 3200 8,5 3000 8 2800 7,5 2600 7 2400 6,5 2200 6 5,5 2000 5 M2 1800 4,5 1600 4 1400 3,5 1200 3 2,5 1000 2 800 1,5 600 M3M2 1 400 0,5 http://www.ecb.int/stats/money/aggregates/series/html/index.en.html 200 0 -0,5 0 JAN-1980 JAN-1981 JAN-1982 JAN-1983 JAN-1984 JAN-1985 JAN-1986 JAN-1987 JAN-1988 JAN-1989 JAN-1990 JAN-1991 JAN-1992 JAN-1993 JAN-1994 JAN-1995 JAN-1996 JAN-1997 JAN-1998 JAN-1999 JAN-2000 JAN-2001 JAN-2002 JAN-2003 JAN-2004 JAN-2005 JAN-2006 JAN-2007 JAN-2008 JAN-2009 JAN-2010 JAN-2011 JAN-1980 JAN-1981 JAN-1982 JAN-1983 JAN-1984 JAN-1985 JAN-1986 JAN-1987 JAN-1988 JAN-1989 JAN-1990 JAN-1991 JAN-1992 JAN-1993 JAN-1994 JAN-1995 JAN-1996 JAN-1997 JAN-1998 JAN-1999 JAN-2000 JAN-2001 JAN-2002 JAN-2003 JAN-2004 JAN-2005 JAN-2006 JAN-2007 JAN-2008 JAN-2009 JAN-2010 JAN-2011 JAN-2012
7. Why do financial assets exist? The business of making money
• Every activity taking place in an economy can be • In a (modern) monetary economy, goods are typi‐ assigned to one of two sides. cally not exchanged for goods but for (fiat) money. • In the real side of the economy, goods (= goods & • Therefore, the first activity in which people must services) are exchanged for money. Wealth (goods) engage in a monetary economy is raising money. is generated in the real side. • One way of raising money consists of selling goods • In the financial side, financial assets (which in others want. Thus, one may sell his/her time for a essence are promissory notes or money substitutes) wage or a good he/she can produce for a price. are exchanged for money (or other financial assets). • Though each side has a life of its own, most of • What if one has no good others may want? Then what happens in an economy is the result of the one can raise money by issuing a financial asset, interaction between these two sides. which is little more than a promise of payment. II 17 II 18
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 3 Financial assets Enter interest rates
• A financial asset is basically an IOU: a paper where • Suppose you know you will get 1,000 € in a month someone acknowledges a debt (“I owe you”). and need (or want) them today. You then issue a financial asset stating that you will pay 1,000 € in a • A financial asset is a substitute for money, as it month to the bearer (owner) of the asset. represents a promise today to pay money in the future. It is a way of capitalizing future revenues. • But it will illusory to expect to sell that asset for • Suppose you do not have money today, but expect 1,000 €, for the buyer gives 1,000 € and receives you will have in the future. A financial asset is like 1,000 € in a month: the buyer losses the possession a time machine allowing you to take your money of 1,000 € for a month in exchange for nothing. back from the future: you issue an IOU and sell it • So the asset must be sold for less than 1,000 €. The today for money. Problem: part of your future interest rate of the asset is its implicit rate of return. money is lost when reaching the present. II 19 II 20
Rate of return of an asset Functions of financial assets
•LetV the nominal (face) value of the asset: how • From the perspective of the purchaser, the financial much it promises to pay in the future. assetisawayofsavingpurchasingpower(away of sending it from the present to the future). •LetP be the price at which the asset is sold. • From the perspective of the issuer (or the seller, if • Then the (implicit) rate of return iA (or rate of profit) of the asset is the profit V P obtained from the buyer becomes a seller), the financial asset is a buying the asset per monetary unit invested in the way of acquiring purchasing power (a way of purchase. The formula is (multiply the right‐hand bringing it from the future to the present). by 100 to get a percentage): V P • A financial asset is an instrument to get money if • For instance, if V = 1000 and iA = . you need it from someone not needing it now. Put P it briefly, a financial asset is a loan of money. P = 800, then iA = 25%. II 21 II 22
Properties of financial assets A selection of financial assets /1
• Liquidity. Ease and rapidity with which the asset • Currency. It is an extreme case of financial asset: can be turned into money (can be sold). instant maturity (1€ pays 1€ now), no return, no risk, and maximum liquidity. • Risk. The likelihood that the compromise of repayment will not be respected. • Bank deposit. By depositing money in a bank, the depositor is purchasing an asset issued by the • Rate of return. Ratio of the profit to the cost of bank: the deposit. This asset is riskier than cur‐ obtaining that profit. rency: if the bank goes bankrupt, the money is lost. • Maturity. The date at which the issuer must pay • Loan. The loan is the reverse of the deposit: it is as the face value to the holder of the asset. if the bank deposited money on you in exchange for a premium and the repayment of the deposit.
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Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 4 A selection of financial assets /2 A selection of financial assets /3
• Bonds. A bond is a debt security that, in exchange • Commercial paper. They are promissory notes for the face value V, pays a certain amount (the issued by firms to fund operational expenses. coupon) at fixed periods before maturity and repays V at maturity. A 4‐year 100 € bond offering • Shares. The share of a firm is an indivisible unit of an annual 5% pays 5 € at the end of years 1, 2, 3, the firm’s capital. Shares are equity security. A and 4, and repays the 100 € at the end of year 4. security is a fungible, negociable instrument representing financial value. • Variations: perpetuities (bonds with no maturity), floating‐rates bonds, inflation‐linked bonds… • Securities are divided into debt securities (like bonds) and equity. Having an equity means •Zero‐coupon bonds. Bonds issued at a discount , owning part of a firm; having a bond issued by the that is, sold for less than the face value. Example: firm means being a creditor of the firm. Treasure bills (or, for short, T‐bills). II 25 II 26
Are shares financial assets? Goods turned to financial assets
• In a strict sense, shares of a firm are not financial • Buying shares is a form of saving, and selling them assets, since they represent parts of a firm: the is a form of raising money. Thus, shares become owner of shares is a shareholder (owns the firm). indistinguishable from financial assets. • Unlike debt securities, shares do not entitle to a • Any good sold and bought according to the regular payment: the payment of dividends is expected evolution of its price behaves like a discretional. financial asset: it is not sold or bought due to intrinsic qualities, but as a tool for making money • But shares typically represent such a small part of by exploiting price changes. the value of a firm that they are bought and sold not because of their intrinsic value, but because of • This may generate “speculative bubbles”. Known the expected evolution of their price. cases: oil, real estate, raw materials, stamps… I 74 II 28
II 29 II 30 IBEX‐35, 05 Jan 198717 Jan 2013 IBEX‐35, volume, Jul 2000 ‐ Jan 2013 million € 16000 1800 15000 http://stooq.com/q/d/?s=^ibex&c=0 1700 http://stooq.com/q/d/?s=^ibex&c=0 14000 1600 13000 1500
12000 1400
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4000 500 400 3000 300 2000 200 1000 100 0 0 05/01/1987 05/07/1987 05/01/1988 05/07/1988 05/01/1989 05/07/1989 05/01/1990 05/07/1990 05/01/1991 05/07/1991 05/01/1992 05/07/1992 05/01/1993 05/07/1993 05/01/1994 05/07/1994 05/01/1995 05/07/1995 05/01/1996 05/07/1996 05/01/1997 05/07/1997 05/01/1998 05/07/1998 05/01/1999 05/07/1999 05/01/2000 05/07/2000 05/01/2001 05/07/2001 05/01/2002 05/07/2002 05/01/2003 05/07/2003 05/01/2004 05/07/2004 05/01/2005 05/07/2005 05/01/2006 05/07/2006 05/01/2007 05/07/2007 05/01/2008 05/07/2008 05/01/2009 05/07/2009 05/01/2010 05/07/2010 05/01/2011 05/07/2011 05/01/2012 05/07/2012 05/01/2013 24/07/2000 24/10/2000 24/01/2001 24/04/2001 24/07/2001 24/10/2001 24/01/2002 24/04/2002 24/07/2002 24/10/2002 24/01/2003 24/04/2003 24/07/2003 24/10/2003 24/01/2004 24/04/2004 24/07/2004 24/10/2004 24/01/2005 24/04/2005 24/07/2005 24/10/2005 24/01/2006 24/04/2006 24/07/2006 24/10/2006 24/01/2007 24/04/2007 24/07/2007 24/10/2007 24/01/2008 24/04/2008 24/07/2008 24/10/2008 24/01/2009 24/04/2009 24/07/2009 24/10/2009 24/01/2010 24/04/2010 24/07/2010 24/10/2010 24/01/2011 24/04/2011 24/07/2011 24/10/2011 24/01/2012 24/04/2012 24/07/2012 24/10/2012
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 5 II 31 II 32 IBEX and how to misled with graphs /1 IBEX and how to misled with graphs /2
16000 16000 15500 15000 http://stooq.com/q/d/?s=^ibex&c=0 15000 14000 14500 13000 14000 13500 12000 13000 11000 12500 10000 12000
9000 11500 11000 8000 10500 7000 10000
6000 9500 9000 5000 8500 4000 8000
3000 7500 7000 2000 6500 1000 http://stooq.com/q/d/?s=^ibex&c=0 6000 0 5500 02/07/2007 02/08/2007 02/09/2007 02/10/2007 02/11/2007 02/12/2007 02/01/2008 02/02/2008 02/03/2008 02/04/2008 02/05/2008 02/06/2008 02/07/2008 02/08/2008 02/09/2008 02/10/2008 02/11/2008 02/12/2008 02/01/2009 02/02/2009 02/03/2009 02/04/2009 02/05/2009 02/06/2009 02/07/2009 02/08/2009 02/09/2009 02/10/2009 02/11/2009 02/12/2009 02/01/2010 02/02/2010 02/03/2010 02/04/2010 02/05/2010 02/06/2010 02/07/2010 02/08/2010 02/09/2010 02/10/2010 02/11/2010 02/12/2010 02/01/2011 02/02/2011 02/03/2011 02/04/2011 02/05/2011 02/06/2011 02/07/2011 02/08/2011 02/09/2011 02/10/2011 02/11/2011 02/12/2011 02/01/2012 02/02/2012 02/03/2012 02/04/2012 02/05/2012 02/06/2012 02/07/2012 02/08/2012 02/09/2012 02/10/2012 02/11/2012 02/12/2012 02/01/2013 02/07/2007 02/08/2007 02/09/2007 02/10/2007 02/11/2007 02/12/2007 02/01/2008 02/02/2008 02/03/2008 02/04/2008 02/05/2008 02/06/2008 02/07/2008 02/08/2008 02/09/2008 02/10/2008 02/11/2008 02/12/2008 02/01/2009 02/02/2009 02/03/2009 02/04/2009 02/05/2009 02/06/2009 02/07/2009 02/08/2009 02/09/2009 02/10/2009 02/11/2009 02/12/2009 02/01/2010 02/02/2010 02/03/2010 02/04/2010 02/05/2010 02/06/2010 02/07/2010 02/08/2010 02/09/2010 02/10/2010 02/11/2010 02/12/2010 02/01/2011 02/02/2011 02/03/2011 02/04/2011 02/05/2011 02/06/2011 02/07/2011 02/08/2011 02/09/2011 02/10/2011 02/11/2011 02/12/2011 02/01/2012 02/02/2012 02/03/2012 02/04/2012 02/05/2012 02/06/2012 02/07/2012 02/08/2012 02/09/2012 02/10/2012 02/11/2012 02/12/2012 02/01/2013
Trade‐off between properties Inverse relationships
• Financial assets can be viewed as money imitators. • Having more of the favourable properties is ba‐ But as they cannot have maximum liquidity, they lanced by having more of the unfavourable ones. must offer something in return to be attractive. • More profitability will be accompanied by less • Liquidity & profitability. If two assets differ only in attractive qualities: more risk and/or less liquidity. liquidity and profitability, the more liquid must be the less profitable and vice versa (money vs bonds). • More liquidity will be accompanied by less attrac‐ tive qualities: more risk and/or less profitability. • Risk & profitability. If two assets differ only in risk and profitability, the riskier should be the more • More risk will be accompanied by more attractive profitable and vice versa (shares vs deposits). qualities: more profitability and/or more liquidity.
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8. Why are interest rates so important? Interest rates around the world, Jan 2013
• The rate of return associated with a financial asset is the nominal interest rate of the asset.
1.5 • An economy has nearly as many interest rates as 1 8.25 financial assets. Fortunately, all the them move in 1 6 30 4 parallel, so it is reasonable to adopt the fiction that 0.5 13.25 0.25 5 there is a unique interest rate i in the economy. 0.75 3 14 6 0 3 4.5 2 8 2.75 15.5 11.5 •Thatuniqueratecouldbetakentobetheinterest 12 5 22 rate of a loan, which is itself a reference interest 25 5.75 4.25 7.25 rate. From now on, i will represent the average 3 5 2.5 interest rate charge for a typical loan. 15.25 13.35 II 35 II http://www.tradingeconomics.com/ 36
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 6 II 37 Interest rates, Spain (Jan 95 –Nov 11) II Euribor (2 Jan 2007‐ 15 Jan 2013) 38 5,6 12,5 5,4 http://www.euribor‐ebf.eu/euribor‐org/euribor‐rates.html 12 5,2 11,5 5,0 11 4,8 10,5 4,6 10 4,4 9,5 Consumer loans (banks) 4,2 9 4,0 3,8 8,5 3,6 8 3,4 7,5 T-bills Consumer loans (savings banks) 10 yr bonds 3,2 7 3,0 Mortgages 6,5 2,8 6 2,6 Preferential rate (banks) 5,5 2,4 1 YEAR 5 2,2 4,5 2,0 4 1,8 1,6 1 MONTH 3,5 1,4 3 Euribor 1,2 2,5 1,0 2 0,8 1,5 0,6 1 0,4 1 WEEK 0,5 http://www.ine.es/jaxi/menu.do?type=pcaxis&path=/t38/bme2/t30/b092/&file=pcaxis 0,2 0 0,0 1995M01 1995M04 1995M07 1995M10 1996M01 1996M04 1996M07 1996M10 1997M01 1997M04 1997M07 1997M10 1998M01 1998M04 1998M07 1998M10 1999M01 1999M04 1999M07 1999M10 2000M01 2000M04 2000M07 2000M10 2001M01 2001M04 2001M07 2001M10 2002M01 2002M04 2002M07 2002M10 2003M01 2003M04 2003M07 2003M10 2004M01 2004M04 2004M07 2004M10 2005M01 2005M04 2005M07 2005M10 2006M01 2006M04 2006M07 2006M10 2007M01 2007M04 2007M07 2007M10 2008M01 2008M04 2008M07 2008M10 2009M01 2009M04 2009M07 2009M10 2010M01 2010M04 2010M07 2010M10 2011M01 2011M04 2011M07 2011M10 2012M01 2012M04 2012M07 2012M10 02/01/2007 13/02/2007 27/03/2007 11/05/2007 22/06/2007 03/08/2007 14/09/2007 26/10/2007 07/12/2007 23/01/2008 05/03/2008 18/04/2008 02/06/2008 14/07/2008 25/08/2008 06/10/2008 17/11/2008 02/01/2009 13/02/2009 27/03/2009 13/05/2009 24/06/2009 05/08/2009 16/09/2009 28/10/2009 09/12/2009 25/01/2010 08/03/2010 19/04/2010 31/05/2010 12/07/2010 23/08/2010 04/10/2010 15/11/2010 03/01/2011 14/02/2011 28/03/2011 11/05/2011 22/06/2011 03/08/2011 14/09/2011 26/10/2011 07/12/2011 19/01/2012 01/03/2012 16/04/2012 29/05/2012 10/07/2012 21/08/2012 02/10/2012 13/11/2012 27/12/2012
Meaning of the interest rate /1 Meaning of the interest rate /2 • Defined as the rate of return of a loan (of currency), having an interest rate of i means that a •Ontheonehand,i represents the profit of sending moneylender receives at maturity 1 + i for every money to the future: the reward for saving. unit lent. So 1 (in t) becomes 1 + i (in t +1). • On the other, i also represents the cost of bringing • For the moneylender, i measures the profit of money from the future: the cost of a loan. lending 1 unit of currency. For the borrower, i • It can also be interpreted as a measure of patience: measures the cost of receiving a loan of 1. the higher i, the more a borrower is willing to pay • For the moneylender, i is the reward of saving: by for having 1 unit of currency today instead of giving up 1 today, (s)he gets 1 + i tomorrow. For tomorrow, so the less patient the borrower is. the borrower, i is the cost of bringing currency • A positive i expresses a preference for the present: from the future: 1 + i units from tomorrow can be better to have money today than tomorrow. II transformed into 1 unit today. 39 II 40
The discount factor Interest rate and asset prices
• The interest rate transforms today’s money into • The price of an asset and the price of money (= the tomorrow’s money: 1 today is (1 + i) tomorrow. nominal interest rate) move in opposite directions. • The discount factor does the opposite: it transforms • Illustration. A T‐bill has face value V and price P. tomorrow’s money into today’s money. It determi‐ Let i be defined for a loan with the same maturity nes present values out of future values as follows. as the T‐bill. If you have P €, you have two options. t t + 1 •The discount factor transforms . Option 1: lend P. At maturity, you get (1 + i)∙P. 1 1 + i 1 into . This is the value that, . Option 2: buy the T‐bill. At maturity, you get V. 1 with interest rate i, becomes 1. 1 ∙ 1 1 • If the results must be equal, then (1 + i)∙P = V,so • By the rule of three, = = is the discount V factor (it depends on i). 1 + i 1 + i P = : the larger i, the smaller P. 1 + i II 41 II 42
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 7 II 44 Arbitrage in action /1 Arbitrage in action /2 •IfV >(1+i)P, € are borrowed in the loan market. • Suppose V >(1+i)∙P. An arbitrageur can then Dloans shifts to the right and i rises. T‐bills are bought obtain sure profits (even having no money at all). with the borrowed €. This shifts DT‐bills to the right and P goes up. Thus, P(1 + i) approaches V. •First,P € are borrowed, so (1 + i)∙P must be repaid Loan market T‐bill market the next period. A T‐bill is purchased with the P €. i P Sloans S Dloans DT‐bills T‐bills •Atmaturity,theT‐bill pays V.AsV >(1+i)∙P,the D’loans D’T‐bills V arbitrageur repays the loan and pockets a profit of V (1 + i)∙P. If V = 1000, P = 800, and i = 10%, each T‐bill financed by a loan generates a profit of 120. b (1 + i)P b i P • If this is done by many arbitrageurs, both i and P tend to rise, so V (1 + i)∙P diminishes. a a loans T‐bills II 43
Prices of assets as present values Equalization of rates of return
• The future value of the T‐bill is V. With interest rate • It is reasonable to expect the equalization of the in‐ i, the present discounted value of V is terest rates of all financial assets, for otherwise the assets with smaller rate would have no demand. 1 1 V, where is the discount factor. V P 1 + i 1 + i • The interest rate i implicit in the T‐bill is i = B B P • Therefore, the condition and i represents the interest rate of a loan. V P = • Accordingly, the equalization i = iB of rate leads to 1 + i V P V V i = iB == 1, so 1 + i = . states that the price of a T‐bill coincides with the P P P V present discounted value of its face (future) value. • Solving for P yields the conditionP = . 1 + i II 45 II 46
9. How does an economy create money? Relationship between M0 and M1
• The real side of an economy comprises all the • Define the cash reserve ratio r = R/D to be the amo‐ activities related to the production, exchange, and unt of reserves banks must hold per euro of depo‐ consumption of goods. Real GDP, the inflation rate, sit. It is the percent of deposits banks cannot lend. the unemployment rate, and the accounting identities summarize the outcomes of the real side. • Define the liquidity ratio l = E/D to be the amount of currency that people hold per euro of deposits. • The financial side of an economy comprises all the 1 + l activities related to the issuing, purchasing, and • The money multiplier is mm =. reselling of financial assets. The interest rate is one r + l of the main financial prices. The money stock is one • It then follows that M1 = mm∙M0, so mm = M1/M0. the main financial quantities and it is created by the Hence, if mm remains constant, ΔM1 = mm∙ΔM0. interaction between the real and the financial side.
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Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 8 The money multiplier Money creation process /1
• Calling M1 the money stock, the money multiplier • Suppose M0 is increased by 600 million €. For mm indicates how many units of money stock is instance, the central bank buys financial assets generated by one unit of monetary base. from the banks and pays by increasing in 600 million the reserves of banks on the central bank. • In fact, M1 = E + D and l =E/DimplyM1=lD+D= D(1 + l).Inaddition,M0=E+R,l =E/D,andr = • Since the deposits D on banks have not changed, R/D imply M0 = lD+rD=D(r + l). Therefore, banks have an excess of reserves equal to 600. They can then lend the 600 million to consumers and M1 D(1 + l) 1 + l firms. Let consumers and firms be always willing = == mm. M0 D(r + l) r + l to borrow any amount offered by banks. • In sum, M1 (the money stock) is a fixed multiple • The people that borrows the 600 million will spend (mm) of M0 (the monetary base). them buying goods or financial assets. II 49 II 50
Money creation process /2 Money creation process /3
• The sellers of the goods or the financial assets will • This means that people deposit 500 million on receive de 600 million. Suppose l =1/5=0.2.This banks and hold 100 million in cash. Suppose r =0.1. meansthatpeopleholdincash0.2centsforeach Hence, banks only need to keep as reserves the 10% euro deposited on banks. of new deposits and can lend the rest. The following table summarizes the process so far. • People must then allocate the 600 million in cash and deposits to make the increase in cash ΔE round M0 D E R loans = D R M1 = D + E divided by the increase of deposits ΔD equal 0.2. 1 600 600 600 The equations providing the solution are 2 500 100 50 450 600 ΔE + ΔD = 600 • Now the process recommences: people borrow and ΔE / ΔD = 1/5 or, equivalently, ΔD = 5∙ΔE. spend 450, and those receiving the 450 keep a part As a result, ΔD = 500 and ΔE = 100. in cash (75) and deposit the rest (375) on banks. II 51 II 52
Money creation process /4 Money creation process /5
• The following table represents the process. • M0 was initially increased by 600. What fraction is finally held in cash? The sum 100 + 75 + 56.25 + round M0 D E R loans = D R M1 = D + E 42.18 + …, which converges to 400. 1 600 600 600 2 500 100 50 450 600 •SinceM0=E+R,ΔM0 = ΔE+ΔR. That is, 600 = 400 3 375 75 37.5 337.5 450 + ΔR. Thus, ΔR = 200. This is also the value to 4 281.25 56.25 28.125 253.125 337.5 which the sum 50 + 37.5 + 28.125 + 21.09 + … 5 210.9... 42.1... 210.9... 189.84... 253.125 converges (the 600 at round 1 should not be ∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙ counted because banks lend this amount: they represented voluntary, not legal reserves). TOTAL 600 2,000 400 200 1,800 2,400 •M1=E+DyieldsΔM1 = ΔE+ΔD. As ΔE = 400 and • Deposits grow continuously: 500 + 375 + 281.25 + ΔD = 2,000, ΔM1 = 2,400: an increase of 600 in M0 210.9 + … In the limit, the sum converges to 2,000. has multiplied itself into an increase of 2,400 in M1. II 53 II 54
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 9 II 56 Money creation process /6 Summary of the money creation process
Central 600 600 • This suggests that the money multiplier mm must Banks Consumers be 4: ΔM0=600generatesΔM0=1=2,400.Infact, Bank loans mm =(1+l)/(r + l)=(1+0.2)/(0.1+0.2)=12/3=4. purchases 600 E = 100 R = 50 • mm captures the total effect on the cash held by the people and the deposits generated by the process D = 500 450 Producers Banks Consumers … deposits loans expenditures loans revenues deposits loans … purchases 450 E = 75 R = 37.5 • This sequence illustrates the interaction between the financial side (deposits and loans) and the real D = 375 337.5 Producers Banks Consumers side (purchases of goods). loans II 55
II 57 II 58 Loans and deposits (eurozone) Global bank deposits
http://www.ecb.int/pub/pdf/mobu/mb201301en.pdf http://www.mckinsey.com/insights/mgi/research/financial_markets/mapping_global_capital_markets_2011
II 59 II 60 Financial depth Debtors and creditors
http://www.mckinsey.com/insights/mgi/research/financial_markets/mapping_global_capital_markets_2011 http://www.mckinsey.com/insights/mgi/research/financial_markets/mapping_global_capital_markets_2011
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 10 Fragility of the financial sector /1 Fragility of the financial sector /2
• The next example illustrates the fragility of the • The investors obtain a 20% rate of return: they pay financial sector and its power to magnify (in either 100 for something whose actual value is 120. Yet, direction) the outcomes the real sector generates. investors run short of cash and ask a big bank for a loan. The bank grants a loan of 100 at a 15%. • There is a firm worth 120 (million €) that plans to carry out an investment project to enhance its • But the bank is also short of liquidity and obtains productive capacity. To raise the necessary funds, from a small bank a loan of 100 at a 10%. shares for the 100% value of the firm are issued. • The small bank’s vault is empty. The bank offers • To attract investors, the price 100 of the shares is prefential clients a 5% reward for new deposits. set below the value 120 of the firm. An investment The bank succeeds and collects 100, which are lent company buys all the shares. to the big bank, which are lent to investors, which are paid to the firm in return for the shares. II 61 II 62
Fragility of the financial sector /3 Fragility of the financial sector /4
• The sketch summarizes all the transactions made • Everybody gets a profit in the process: the firm and the net worth effect on investors and banks. funds the project, and investors, banks, and 20% 15% 10% 5% depositors earn 5 each. Thanks to the financial issued shares loan loan deposits sector, the firm’s expansion generates a profit for investors, banks, and depositors. Firm Investment Big Small People company bank bank • The example also shows the leverage effect of the financial sector. There are assets in the economy FIRM’S VALUE SHARE LOAN LOAN DEPOSITS 120 120 115 110 105 worth 430: shares, 100; loans from the big bank, 115; loans from the small bank, 110; and deposits ASSETS 120 ASSETS 115 ASSETS 110 by clients, 105. But those assets are all backed by LIABILITIES 115 LIABILITIES 110 LIABILITIES 105 NET WORTH 5 NET WORTH 5 NET WORTH 5 the firm’s value, which is merely 120. II 63 II 64
Fragility of the financial sector /5 Fragility of the financial sector /6 • Therefore, financial wealth worth 430 is lifted by • Given that depositors put their money on the small real wealth (wealth created by the real sector, that bank, they cannot buy the new goods the firm is, goods) worth 120. produces using the expanded productive capacity. Let us assume that, as a result, the firm goes • This is the positiva magnifying effect of the bankrupt and closes down. financial: real assets worth 120 sustain financial assets worth 430. • Shares become worthless. Investors cannot settle their debt with the big bank, which cannot repay • The magnifying effect also works in the reverse. the loan to the small bank, which cannot give back For instance, imagine that the investment project the money to depositors. In sum: everybody loses. fails because the customers that would have bought the goods produced thanks to the project • Where have the depositors’ funds gone? The firm are those depositing money on the small bank. made use of them to finance an unsuccessful project. II 65 II 66
Introduction to macroeconomics 21 January & 4 February 2013 IIMoney 11