Summary Economics of Money Banking and Financial Markets Frederic S Mishkin PDF

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Summary Economics of Money, Banking, and Financial

Markets - Frederic S. Mishkin
Geld en Bankwezen (Universiteit van Amsterdam)
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Summary
Economics of Money,
Banking, and Financial
Markets
Frederic S. Mishkin
9th Edition

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Contents
1: Why study money, banking and financial markets? .................................................................... 2
2. An overview of financial system .................................................................................................... 5
3. What is money? ................................................................................................................................ 8
4. Understanding interest rates ........................................................................................................ 10
5. The behaviour of interest rates .................................................................................................... 14
6. The risk and term structure of interest rates ............................................................................. 22
7. The Stock Market, the Theory of Rational Expectations (RE) and the Efficient Market
Hypothesis (EMH) .............................................................................................................................. 28
8. Economic analysis of financial system ........................................................................................ 33
9. Financial crises and subprime meltdown .................................................................................... 37
10. Banking and management of financial instittutions ............................................................... 42
11. Economic analysis of financial regulation................................................................................. 50
12. Banking industry: structure and competition .......................................................................... 55
13. Goals and Structure of Central banks ....................................................................................... 59
14. Money supply process................................................................................................................. 67
15. Tools of Monetary Policy ............................................................................................................ 75
16. Conduct of Monetary Policy: Strategy and Tactics ................................................................ 82
17. Foreign exchange market ........................................................................................................... 87
18. International financial system .................................................................................................... 91
19. The demand for money ............................................................................................................... 96
20. The ISLM model ......................................................................................................................... 101
21. Monetary and Fiscal Policy in the IS-LM Model ................................................................... 109
22. Aggregate Demand and Supply Analysis ................................................................................ 118
23. Transmission Mechanisms of Monetary Policy: The Evidence ........................................... 124
24. Money and Inflation .................................................................................................................. 128
25. Rational Expectations: Implications for Policy ...................................................................... 135
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1: Why study money, banking and

financial markets?
The book offers an introduction to the theory and practice of banking and monetary
economics. The most important topics which will be covered are:
 understanding the determinants and behaviour of interest rates;

 risk and term structure of interest rates;
 economic analysis of financial structure; banking and management of financial
institutions; financial regulation;
 money supply process and tools of monetary policy;
 overview of structure, goals and conduct of central banks;
 Financial crises and overview of the recent subprime meltdown.
This chapter gives an overview of key terms and concepts in context of monetary
economics. It starts by explaining the basic difference between different types of
financial instruments, government policies to achieve their macro-economic goals. It
also explains differences between real and nominal variables (An important
distinction in Economics because economic decisions are based on considerations of
real data).
Security/financial instrument is A claim on issuer s future income or asset. Bond is a

fixed income security that makes periodic payments
Interest rates is cost of borrowing or price paid for rental of funds. NOTE (several
different kinds of interest rates but they move in same direction). Changes in into
rates impact personal, corporate and economic decisions.
Common stock is A share of ownership in corporation. Firms issue stock to raise

funding for their business. Stock markets are volatile. Constant source of speculation
on price movements of stock.
Financial intermediaries is Source that matches the lenders and borrowers in financial
markets (banks, mutual funds, investment companies). A major link within financial
system. The disruption in financial system leads to crisis (like Great Depression of
1930s and Financial Crisis of 07-08)
One form of financial innovation is E finance (improvements in Information

technology that leads to delivery of financial services electronically).
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Money supply/money is Anything that is accepted in exchange for goods and services
and repayment of debts. Plays a role in business cycle (i.e. upward and downward
fluctuations in aggregate output). Graphical evidence (Chap 1, figure 3) suggests that
rate of money growth declined prior to every recession leads to changes in money
supply impact output. Therefore we study monetary theory (theory that related
changes in money quantity to changes in aggregate economy).
Money also affects prices. Figure 4 suggests link between inflation (changes in
aggregate price level in economy) and money supply growth. Friedman (Nobel
laureate claimed inflation is always and everywhere a monetary phenomenon.
Money supply rose along with long term interest rates in 6 s and 7 s but
relationship became weak after 8 s.
Monetary policy conducted by Central bank. Federal Reserve (Fed) is Central bank of
USA. Fiscal policy involves decisions about got spending and taxation. Budget surplus
(when tax revenues > spending) and deficit (when spending > tax revenues).
International finance is important because of increased globalization. Financial

institutions of one country are based in another and seek funding (by borrowing) in
other countries. Foreign exchange rate is price of one currency in terms of other.
Fluctuations in forex rates are important because it impacts cost of imports and
exports. Appreciation (increase in value of domestic currency relative to foreign
currency) makes exports expensive and imports cheap. Depreciation makes exports
cheaper and imports expensive.
Appendix (chapter 1)
GDP/aggregate output is Market value of FINAL goods and services produced in

economy in a year (DO not include intermediary goods and services because it leads
to double counting).
Aggregate income is total income of all factors of production (land, labour, capital,
entrepreneur) in economy in 1 year. Aggregate income is the GDP
Nominal gdp is measured using current prices Versus Real gdp which measures using
fixed prices.
Better to use Real values such as Real GDP because it indicates actual growth in
output rather than growth in prices.
Measures of Inflation: i) GDP deflator is value of nominal gdp/ real gdp. Ii) Personal
consumption expenditure (PCE) deflator= nominal PCE/ real PCE iii) Consumer Price
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index (CPI) measured using a typical basket of goods and services bought by an
average household.
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2. An overview of financial system

In finance, the financial system is the system that allows the transfer of money
between savers (and investors) and borrowers.[1] A financial system can operate on a
global, regional or firm specific level. This chapter gives key insights on financial
intermediaries, money market and capital market instruments. Financial
intermediaries ensure smooth functioning of the modern financial system and
connect the lenders and depositors. Moreover, the chapter also glances over
different types of money and capital market instruments and gives detailed
explanations of how these instruments function.
Direct (borrowers get funds directly by selling instruments to lenders) and indirect
finance (vis a vis financial intermediaries).
Financial markets are important as they channel savings into profitable investments >
improved allocation of capital, increased welfare of consumers by allowing them to
borrow etc.
Debt Markets are debt instruments (e.g. bonds or mortgages)
Short- (less than 1 year), medium/intermediate- (between 1 and

10) long-term (more than 10)
Equity Markets are common stocks
Primary Market are new issue of securities
Secondary Market are securities previously issued are resold in two ways:
(1) exchanges (e.g. NYSE, Euronext, etc.); (2) over-the-counter (OTC) markets (e.g.
government bond market)
Money Market are Short-term (less than 1 year) debt instruments
Capital Market are Long-term (more than 1 year) debt and equity.
1. Money Market Instruments:

o Treasury bills (short term debt maturities of US govt. no interest
payments. Issued at a price less than face value i.e. issued at discount)
o Certificate of deposit (CD) (Sold by bank to depositors paying interest
and principal payments).
o Commercial paper (short term debt instrument issued by big companies
and banks).
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o Interbank deposits/Federal funds rate (overnight loans between banks

from their deposits at Fed. Interest rate on such loans is Fed fund rate)
o Repurchase agreements (repos) (effective short term loans of less than 2
weeks maturity where t bills serve as collateral, most important source
of bank finance).
2. Capital Market Instruments
 Stocks (equity claims on net income and assets of corporation)

 Mortgages (loans to households, firms to purchase real estate where real estate
is collateral)
 Corporate bonds ( long term bonds issued by corporation with a good credit
rating)
 Government bonds
 Local authority bonds (municipal bonds. Exempt from federal and state income
tax)
 Bank and building society bonds and loans
USA is not the most important capital market anymore because of (quicker adoption
of technology by foreign markets, greater threat of lawsuits by listing on US
exchanges, higher compliance cost of Sarbannes Oxley act)
Foreign bonds sold in foreign country and denominated in that country s currency
Eurobond (a bond denominated in currency other than that of country in which it is

sold). So a Dollar denominated bond sold in UK
Euro currency (Currency deposited in banks outside home countries. An example in

Eurodollars i.e. dollars deposited everywhere outside USA).
Why are financial intermediaries important?
1. Lower Transaction Costs (Make profits by reducing transaction costs (by

developing expertise and economies of scale)
2. Reduce Exposure to Risk (Create and sell assets with low risk and use funds to buy
assets with more risk (e.g. risk sharing or asset transformation).Help people to diversify
portfolios.
3. Reduce Asymmetric Information (Adverse Selection (AS) before transaction occurs
Borrowers most likely to produce adverse outcomes are ones most likely to seek
loans leads to lenders provide less loans
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Moral Hazard (MH) after transaction occurs
Borrowers have incentives to engage in undesirable (immoral) activities making it

more likely that won t pay loan back leading to lenders provide less loans.
Why regulate financial system?
Increasing information available to investors (asymmetric information leads to AS and

MH >Investors can be misled. Therefore, regulation by Securities and Exchange
Commission SEC requires disclosure of information to improve investor s knowledge
about companies).
Ensuring soundness of financial intermediaries (asymmetric info > collapse of

intermediaries > withdrawal of deposits by investors > collapse of system). We want
to avoid this. 6 regulations implemented such as restriction on entry, disclosure,
restriction on asset, restriction on competition, deposit insurance, limits on
competition.
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3. What is money?
An officially-issued legal tender generally consisting of currency and coin. Money is
the circulating medium of exchange as defined by a government. Money is often
synonymous with cash, including negotiable instruments such as checks. Each
country has its own money, or currency, that is used as a medium of exchange within
that country (some countries share a type of currency, such as the euro used by the
European Union). This chapter provides a succinct summary of what constitutes as
money. It defines characteristics, properties and functions of money. It also indicates
the most common ways of how monetary aggregates are measured in USA,
Eurozone and UK. The chapter will also introduce concepts which will be further
examined in Chapters 12, 13 and 14.
Economist s Meaning of Money or Money Supply : Anything that is generally

accepted in payment for goods and services or in repayment of debts
Functions of money
1. Medium of exchange: Eliminates the trouble of finding a double coincidence
of needs (reduces transaction costs). As medium of exchange money must:
 be easily standardized
 be widely accepted
 be divisible
 be easy to carry
 not deteriorate quickly
2. Unit of account: used to measure value in the economy

3. Store of value: used to save purchasing power over time; most liquid of all
assets but loses value during inflation
Evolution of payment system

Payment system: method of conducting transactions in the economy. It evolves over
time
1. Commodity money: precious metals (e.g. gold or silver)
1. Fiat Money: paper money decreed by governments as legal tender
1. Cheques: instruction to your bank to transfer money from your account
1. Electronic payments (e.g. online bill pay)
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1. E-Money (electronic money): Debit cards, Stored-value cards, Smart cards, E-

cash
How to measure money?

Various definitions of monetary aggregates:
-Differences in what members of each society accept as a medium of exchange.
-Due to financial innovations, some assets are accepted as money in some societies
but not in others.
-Differences amongst institutions responsible for issuing monetary aggregates,
normally the central bank and depository institutions
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4. Understanding interest rates

An interest rate is the rate at which interest is paid by a borrower (debtor) for the use
of money that they borrow from a lender (creditor). Specifically, the interest rate
(I/m) is a percentage of principal (P) paid a certain number of times (m) per period
(usually quoted per year). For example, a small company borrows capital from a bank
to buy new assets for its business, and in return the lender receives interest at a
predetermined interest rate for deferring the use of funds and instead lending it to
the borrower. Interest rates are normally expressed as a percentage of the principal
for a period of one year the chapter provides the basic explanation of time value of
money and how a dollar today is worth more than a dollar tomorrow. It also explains
various kinds of credit market instruments. Special attention is given to various kinds
of bonds and difference between rate of return and interest rates on bonds. The
concept of yield to maturity is also introduced in this chapter.
Chapter 4
Present value is the concept is based on the notion of that a dollar paid to us today is
more valuable than a dollar paid tomorrow. This is because we can accrue interest of
dollar earned today.
Yield to maturity is the interest rate that equates present value of cash flow payments
received from a debt instrument to its value today.
Credit Market instruments

Four Main Types:
1. Simple loan (e.g. commercial loans, interbank loans)

2. Fixed-payment loan (e.g. fixed-rate mortgage)
3. Coupon bond (e.g. government and corporate bonds)
4. Discount (zero-coupon) bond (e.g. Treasury bills)
Simple Loan: lender provides the borrower with an amount of funds (principal) that
must be repaid at the maturity date, along with an additional payment for the interest
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Fixed-payment loan: must be repaid by making the same payment (consisting of a

part of principal and interest) every period, for the duration of the loan
E.g. Fixed-Payment Loan (LV=1000, FP = 126, n = 25)
Coupon bond: pays the owner of the bond a fixed payment (coupon payment) every
year until maturity date, when a specified final amount (face value) is repaid
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Relationship Between Price and Yield to Maturity
Three Key Facts

1. When bond is priced at its face value (at par) (P = F), the yield to maturity
equals coupon rate/
2. Price and yield to maturity are negatively related
3. Yield to maturity is greater (smaller) than the coupon rate when bond price is
below (above) par value
CONSOL: a bond with no maturity date that does not repay principal but pays fixed-
coupon payments forever
Pc = C / ic
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol
Can rewrite above equation as ic = C / Pc
For coupon bonds, the equation of the current yield gives an easy-to-calculate
approximation of the yield to maturity of a bond
This approximation is better, the nearer the price to par, and the longer the maturity
of the bond
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Discount (zero-coupon) bond: bought at a price below its face value (at a discount),
and face value is repaid at maturity (similar to simple loan)
Maturity and the Volatility of Bond Returns

1. Only bond whose return = yield is one with maturity = holding period
2. For bonds with maturity > holding period, i P¯ implying capital loss
3. Longer is maturity, greater is % price change associated with interest rate
change
4. Longer is maturity, more return changes with change in interest rate
5. Bond with high initial interest rate can still have negative return if i
Distinction Between Real and Nominal Interest Rates

Real Interest Rate (if) = Nominal Interest rate (i) adjusted for expected inflation rate
(pe)
if = i pe Fisher equation: i = i f + pe
1. Real interest rate reflects true cost of borrowing
2. When real rate is low, greater incentives to borrow and less to lend
if i = 5% and pe = 3% => if = 5% 3% = 2%
if i = 8% and pe = 10% => if = 8% 10% = 2%
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5. The behaviour of interest rates

Interest-rate targets are a vital tool of monetary policy and are taken into account
when dealing with variables like investment, inflation, and unemployment. The
central banks of countries generally tend to reduce interest rates when they wish to
increase investment and consumption in the country's economy the chapter
essentially discusses the market for bond according to normal framework and
liquidity preference framework. It glances over the various factors which determine
the demand and supply of bonds which in turn determines the interest rates in both
models. The chapter also explains the role of money in influencing interest rates.
Determinants of Asset Demand
1. Wealth: the total resources owned by the individual, including all assets
2. Expected Return: the return expected over the next period on one asset
relative to alternative assets
3. Risk: the degree of uncertainty associated with the return on one asset relative
to alternative assets
4. Liquidity: the ease and speed with which an asset can be turned into cash
relative to alternative asset.
Demand and Supply of Bonds
 Demand of Bonds: At lower prices (higher interest rates), ceteris paribus, the
quantity demanded of bonds is higher
Leads to negative relationship between price and quantity
 Supply of Bonds: At lower prices (higher interest rates), ceteris paribus, the
quantity supplied of bonds is lower
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Leads to positive relationship between price and quantity
Point A: i=re= (F-P)/P

P=950, F=1000 so i=5.3%. We suppose the Quantity demanded at Point A is 100
billion
Point B
P=900, F=1000 so i=11.1 %. We suppose the quantity demanded is 200 billion and so
on.
Derivation of Supply of Bonds Curve

Point F: P = 750, i = 33.0%, Bs = 100 billion
Point G: P = 800, i = 25.0%, Bs = 200 billion
Point C: P = 850, i = 17.6%, Bs = 300 billion
Point H: P = 900, i = 11.1%, Bs = 400 billion
Point I: P = 950, i = 5.3%, Bs = 500 billion
Supply Curve is Bs that connects points F, G, C, H, I, and has upward slope
Market Equilibrium
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1. Occurs when Bd = Bs, at P* = 850, i* = 17.6%

2. When P = 950, i = 5.3%, Bs > Bd (excess supply): P falls to P*, i increases to i*
3. When P = 750, i = 33.0, Bd > Bs (excess demand): P rises to P*, i falls to i*
Factors that Shift the Demand of Bonds: The Theory of Asset Demand
Factors that Shift the Supply of Bonds
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Changes in pe: Fisher Effect”
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Business Cycle Expansion
Money and Interest Rates
 So far factors affecting the demand/supply of bonds => equilibrium interest

rate in bond market
 Alternative approach: Keynes’ liquidity preference framework => equilibrium
interest rate determined by supply and demand for money (e.g. currency and
checking deposits)
Liquidity Preference Framework

Keynes s Major Assumption:
Two Categories of Assets: Money and Bonds
1. Thus: Ms + Bs = Wealth
2. Budget Constraint: Bd + Md = Wealth
3. Therefore: Ms + Bs = Bd + Md
4. Rearranging: Ms Md = Bd Bs
Money Market Equilibrium
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1. When Ms = Md then by definition Bd = Bs, so that both money and bond

markets are in equilibrium
2. If Ms - Md > 0 then Bd - Bs > 0 (excess of demand for bonds over supply)
and vice versa
Derivation of Money Demand Curve (Md)

1. Keynes assumed money pays no interest rate
2. As interest rate on bond rises ( i ) Þ opportunity cost of holding money Þ
Md ¯
3. Demand curve for money has usual downward slope
Derivation of Money Supply Curve (Ms)
1. Assume that central bank controls Ms at a fixed amount

2. Ms curve is vertical line
Market equilibrium occurs when Md = Ms, at i* = 15%

If i = 25%, (Ms > Md) (excess supply of money) => (Bd > Bs) (excess demand for bonds)
=> Price of bonds ↑, i ↓ to i* = 15%
If i =5%, Md > Ms (excess demand for money) => (Bs > Bd) (excess supply of bonds) =>
Price of bonds ↓, i ↑ to i* = 15%
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Effects of money on interest rates

1. Liquidity Effect: Ms Rise’s , Ms Shifts right, i falls
but, there are additional second-round effects (Friedman)
2. Income Effect: Ms rises, Income rises , Md , Md shifts right, i rises
3. Price-Level Effect: Ms Rise’s , Price rises , Md increases , Md shifts right, i rises
 Effect of higher rate of money growth on interest rates is ambiguous

(income, price level and expected inflation effects work in opposite direction
of liquidity effect)
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6. The risk and term structure of interest

rates
This chapter explains the risk and term structure of interest rate. Risk structure
refers to probability of default of a security and its implications. Term structure is
related to the time span of maturity and its implications on behaviour of interest
rate. These two factors are critical in explaining why bonds have different interest
rates even if they same characteristics. The chapter then goes over 3 theories of
term structure to explain 3 basic facts of bond markets.
We provide the theoretical reasoning of why:
1. Bonds with same maturity but different risk have different interest rates is Risk
structure of interest rates
2. Bonds with same risk but different maturity have different interest rates
is Term structure of interest rates
Corporate Bond Market

Risk of corporate bonds rises , DC falls, DC shifts to the left, PC falls, iC rises
Treasury Bond Market
Relative risk of Treasury bonds falls, DT rises , DT shifts right, PT rises, iT falls.
Outcome:
Risk premium (IC – iT) (spread between interest rates on bonds with default risk
and default-free bonds) rises
Are All Treasury Bonds Default-Free?
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Decrease in Liquidity of Corporate Bonds
Corporate Bond Market

Less liquid corporate bonds DC falls, DC shifts to the left, PC falls, iC rises
Relatively more liquid Treasury bonds, DT , DT shifts to the right, PT , iT falls
Outcome:
Liquidity premium (iC – iT) rises
Given the same maturity, premium reflects not only default risk, but also liquidity level
(risk and liquidity premium)
Introduction of Tax Advantages of Bonds
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Municipal Bond Market

Tax exemption raises relative after-tax RETe on municipal bonds, Dm rises, Dm shifts
right, Pm rises, im falls
Relative after-tax RETe on Treasury bonds falls, DT falls, DT shifts left, PT falls, iT rises
Outcome:
im < iT
Term Structure of Interest Rates
 Term structure of interest rates: relationship between the interest rate of bonds
(with identical risk, liquidity and tax) and the maturity
 Yield curve: plot of the yield on bonds with different maturity but same risk,
liquidity and tax considerations
 Yield curves can be classified as:
o upward-sloping short-term rates less than long-term rates
o flat short-term rates = long-term rates
o inverted short-term rates more than long-term rates
Term Structure Facts to be Explained

Fact 1: Interest rates for different maturities move together over time
Fact 2: Yield curves tend to have steep upward slope when short rates are
low and downward slope when short rates are high
Fact 3: Yield curve is typically upward sloping
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Three Theories of Term Structure

1. Expectations Theory
2. Segmented Markets Theory
3. Liquidity Premium Theory
1. Expectations Theory
Key Assumption: Bonds of different maturities are perfect substitutes

Implication: RETe on bonds of different maturities are equal.
Two investment strategies for two-year horizon (zero-coupon bonds):
1. Buy-and-hold” strategy: Buy € of two-year bond and hold till maturity
2. Rolling” strategy: Buy € of one-year bond and when it matures buy another
one-year bond
In other words: The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond
Current and expected one-year interest rates:
it=5%, iet+1= 6%, iet+2= 7%, iet+3 = 8% and iet+4 = 9%
Interest rate on two-year bond:
i2t= (5% + 6%)/2 = 5.5%
…………..
Interest rate for five-year bond:
i5t= (5% + 6% + 7% + 8% + 9%)/5 = 7%
Interest rate for one to five-year bonds:
it=5%, i2t=5.5%, i3t=6%, i4t=6.5% and i5t=7%.
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2. Segmented Markets Theory
Key Assumption: Bonds of different maturities are not substitutes at all

Implication: Markets are completely segmented: interest rate at each maturity
determined separately
Explains Fact 3 that yield curve is usually upward sloping
People typically prefer short holding periods (less interest-rate risk) and thus have
higher demand for short-term bonds, which have higher price and lower interest rates
than long bonds
Does not explain Fact 1 or Fact 2 because assumes long and short rates determined
independently
3. Liquidity Premium Theory
Key Assumption: Bonds of different maturities are substitutes, but are not perfect
substitutes
Implication: Modifies Expectations Theory with features of Segmented Markets
Theory
Investors prefer short rather than long bonds Þ must be paid positive liquidity (term)
premium (lnt) to hold long-term bonds
This implies a modification of the Expectations Theory
Current and expected one-year interest rate:

it=5%, iet+1= 6%, iet+2= 7%, iet+3 = 8% and iet+4 = 9%
Investors preferences for holding short-term bonds, liquidity premia:
lt=0%, l2t= 0.25%, l3t = 0,5%, l4t = 0.75% and l5t =1%
Interest rate on the two-year bond:
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i2t= (5% + 6%)/2 + 0.25% = 5.75%

……
Interest rate on the five-year bond:
i5t= (5% + 6% + 7% + 8% + 9%)/5 + 1.0% = 8%
Interest rate for one to five year bonds:
it=5%, i2t=5.75%, i3t=6.5%, i4t=7.25% and i5t=8%.
Comparing with those for the expectations theory (Example 1), liquidity premium
theory produces yield curves more steeply upward sloped
Explains all 3 Facts

Explains Fact 3 of usual upward sloped yield curve by investors preferences for
short-term bonds
Explains Fact 1 and Fact 2 using same explanations as expectations hypothesis
because it has average of future short rates as determinant of long rate
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7. The Stock Market, the Theory of

Rational Expectations (RE) and the
Efficient Market Hypothesis (EMH)
In finance, the efficient-market hypothesis (EMH) asserts that financial markets are
"informationally efficient". In consequence of this, one cannot consistently achieve
returns in excess of average market returns on a risk-adjusted basis, given the
information available at the time the investment is made.
There are three major versions of the hypothesis: "weak", "semi-strong", and
"strong". The weak form of the EMH claims that prices on traded assets (e.g., stocks,
bonds, or property) already reflect all past publicly available information. The semi-
strong form of the EMH claims both that prices reflect all publicly available
information and that prices instantly change to reflect new public information. The
strong form of the EMH additionally claims that prices instantly reflect even hidden
or "insider" information. Critics have blamed the belief in rational markets for much
of the late-2000s financial crisis. The chapter explains EMH (efficient market
hypothesis) i, e, the markets fully reflect and price all the available information in the
price of security. It starts by providing the 3 theories of equity valuation. It then
discusses two different kinds of expectations, i) adaptive expectations and ii) rational
expectations and how they play a role in determing price of security.
1. Theories of stock valuation:

1. One-Period Valuation Model
2. Generalized Dividend Valuation Model
3. Gordon-Growth Model
2. Role of expectations on behaviour of stock price (Theory of Rational
Expectations (RE) known as the Efficient Market Hypothesis (HMH)
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One-Period Stock Valuation Model
3. Gordon Growth Model
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How the Market Sets Prices
 The price is set by the buyer willing to pay the highest price
 The market price will be set by the buyer who can take best advantage of the
asset (e.g. house purchase)
 Superior information about an asset can increase its value by reducing its
perceived risk
 Information is important for individuals to value each asset

 When new information is released about a firm, expectations about future
dividends or risk of these dividends lead to price changes
 Market participants constantly receive information and revise
their expectations, so stock prices change frequently
Application: The Subprime Financial Crisis and the Stock Market
 Financial crisis that started in August 2007 led to one of the worst bear
markets in 50 years
 Downward revision of growth prospects: ↓g
 Increased uncertainty: ↑ke
 Gordon model predicts a drop in stock prices
Adaptive Expectations
 Expectations are formed from past experience only

 Changes in expectations will occur slowly over time as data changes
 However, people use more than just past data to form their expectations and
sometimes change their expectations quickly
Theory of Rational Expectations
 Expectations will be identical to optimal forecasts using all available

information (Muth, 1961)
 Even though a rational expectation equals the optimal forecast using all
available information, a prediction based on it may not always be perfectly
accurate
o It takes too much effort to make the expectation the best guess possible
o Best guess will not be accurate because predictor is unaware of some
relevant information
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Unpredictable shocks, chance and coincidence
Implications
 If there is a change in the way a variable moves, the way in which expectations
of the variable are formed will change as well
o Changes in the conduct of monetary policy (e.g. target the federal funds
rate)
 The forecast errors of expectations will, on average, be zero and cannot be
predicted ahead of time
Efficient Markets: Application of Rational Expectations
At the beginning of the period, we know Pt and C.

Pt+1 is unknown and we must form an expectation of it.
The expected return then is
Expectations of future prices are equal to optimal forecasts using all currently
available information so
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Supply and Demand analysis states Re will equal the equilibrium return R*, so Rof = R*
 Current prices in a financial market are set such that the optimal forecast of a
security s return using all available information equals the security s
equilibrium return (Rof = R*)
 In an efficient market, a security s price fully reflects all available information
Rationale:
•Recommendations from investment advisors cannot help us outperform the market

•A hot tip is probably information already contained in the price of the stock
•Stock prices respond to announcements only when the information is new and
unexpected
A buy and hold strategy is the most sensible strategy for the small investor
(commission savings
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8. Economic analysis of financial system

The chapter provides a succinct analysis of various sources of financing available for
firms in the economy and explains 8 crucial facts about financial system. These facts
are mainly explained by market imperfections that exist with in money market.
These imperfections result mainly from disparity of information between different
stakeholders.
Sources of External Funds for Investment
Financial Structure of Nonfinancial Businesses
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Basic Facts of Financial Structure
Basic Facts of Financial Structure
1. Stocks are not the most important source of external finance for businesses
1. Issuing marketable equity securities is not the primary funding source for
businesses
1. Indirect finance is more important than direct finance

2. Banks are the most important source of external finance.
1. Financial system is among most heavily regulated sectors in the economy

2. Only large, well established firms have easy access to securities markets to
finance their activities
1. Collateral is a prevalent feature of debt contracts

2. Debt contracts are extremely complicated legal documents with restrictions on
the behaviour of borrowers
How financial intermediaries reduce transaction cost?
1. Economies of scale: Bundling investor s funds to reduce average costs
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2. Expertise: Develop new technology or offer better liquidity services to reduce

costs.
Asymmetric information: when one party s insufficient knowledge about other party
makes it impossible to make accurate decisions in transaction.2 kinds of Asymmetric
information problems.
1) Adverse selection: occurs before transaction. Also called lemons problem which
was based on presence of lemons and peaches in used car markets. The buyer s
knowledge about car is less than sellers. SO a buyer will be willing to pay somewhere
between price of poor quality and high quality used car. Seller always knows about
the car. So he will accept price if car is of poor quality but reject if price is of high
quality. Thus, fewer transactions.
Application of AS in equity/bond market: an investor does not know about the quality
of firm. He would only pay an average price/accept an interest rate that accounts for
average default risk. Owners of good firm won t accept average price/pay high
interest but owners of bad firms would. But investor knows this and hence won t buy
stocks/bonds
Tools to help AS
1. Private production and sale of information: Makes information available to

buyers but problem of free riders i.e. people get information without paying for
it.
2. Government regulation: SEC or other regulatory authorities can increase
available information for investors but politically difficult.
3. Financial intermediation: Create private parties who match lenders and
depositors and avoid problem of free riders as loans are made privately.
4. Collateral and net worth: Borrowers ought to give some sort of collateral to
lenders in case of default. Collateral enables lenders to lend without fear of
default.
2a) Moral hazard in equity contracts: occurs after the transaction where seller might
engage in activities which are undesirable for buyers. Called principal agent
problem . There is separation of management and ownership. Thus managers engage
in activities which are bad for firm but benefits them personally.
Tools to solve MH in equity
1. Production of information (monitoring): shareholders have less info than

managers. Therefore, they like the firm to get audited. This is expensive and
still has free rider problem
2. Government regulation to increase information.
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3. Financial intermediation: Venture capital firms pool their own resources and
helps new firms. They get a share of profit and a voice in management.
2b) Moral hazard in debt markets: borrower might engage in activities to boost profits
which increases risk of default.
Tools to solve MH in debt
1. Net worth and collateral: It reduces incentive for borrower to engage in risky
activities.
2. Monitoring and enforcement of restrictive covenants: Such covenants would
include covenants to discourage bad behaviour and covenant to encourage
good behaviour.
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9. Financial crises and subprime meltdown

The financial crisis of 2007 2008, also known as the Global Financial Crisis and 2008
financial crisis, is considered by many economists to have been the worst financial
crisis since the Great Depression of the 1930s. It threatened the total collapse of
large financial institutions, which was prevented by the bailout of banks by national
governments, but stock markets still dropped worldwide. In many areas, the housing
market also suffered, resulting in evictions, foreclosures and prolonged
unemployment. The crisis played a significant role in the failure of key businesses,
declines in consumer wealth estimated in trillions of U.S. dollars, and a downturn in
economic activity leading to the 2008 2012 global recession and contributing to the
European sovereign-debt crisis. The active phase of the crisis, which manifested as a
liquidity crisis, can be dated from August 9, 2007, when BNP Paribas terminated
withdrawals from three hedge funds citing "a complete evaporation of liquidity".
1. Theories of stock valuation:

1. One-Period Valuation Model
3. Gordon-Growth Model
2. Role of expectations on behaviour of stock price (Theory of Rational
Expectations (RE) known as the Efficient Market Hypothesis (HMH)
One-Period Stock Valuation Model
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3. Gordon Growth Model
How the Market Sets Prices
 The price is set by the buyer willing to pay the highest price
 The market price will be set by the buyer who can take best advantage of the
asset (e.g. house purchase)
 Superior information about an asset can increase its value by reducing its
perceived risk
 Information is important for individuals to value each asset

 When new information is released about a firm, expectations about future
dividends or risk of these dividends lead to price changes
 Market participants constantly receive information and revise
their expectations, so stock prices change frequently
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Application: The Subprime Financial Crisis and the Stock Market
 Financial crisis that started in August 2007 led to one of the worst bear
markets in 50 years
 Downward revision of growth prospects: ↓g
 Increased uncertainty: ↑ke
 Gordon model predicts a drop in stock prices
Adaptive Expectations
 Expectations are formed from past experience only

 Changes in expectations will occur slowly over time as data changes
 However, people use more than just past data to form their expectations and
sometimes change their expectations quickly
Theory of Rational Expectations
 Expectations will be identical to optimal forecasts using all available

information (Muth, 1961)
 Even though a rational expectation equals the optimal forecast using all
available information, a prediction based on it may not always be perfectly
accurate
o It takes too much effort to make the expectation the best guess possible
o Best guess will not be accurate because predictor is unaware of some
relevant information
Unpredictable shocks, chance and coincidence
Implications
 If there is a change in the way a variable moves, the way in which expectations
of the variable are formed will change as well
o Changes in the conduct of monetary policy (e.g. target the federal funds
rate)
 The forecast errors of expectations will, on average, be zero and cannot be
predicted ahead of time
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Efficient Markets: Application of Rational Expectations
At the beginning of the period, we know Pt and C.

Pt+1 is unknown and we must form an expectation of it.
The expected return then is
Expectations of future prices are equal to optimal forecasts using all currently
available information so
Supply and Demand analysis states Re will equal the equilibrium return R*, so Rof = R*
 Current prices in a financial market are set such that the optimal forecast of a
security s return using all available information equals the security s
equilibrium return (Rof = R*)
 In an efficient market, a security s price fully reflects all available information
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Rationale:
•Recommendations from investment advisors cannot help us outperform the market

•A hot tip is probably information already contained in the price of the stock
•Stock prices respond to announcements only when the information is new and
unexpected
A buy and hold strategy is the most sensible strategy for the small investor
(commission savings
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10. Banking and management of financial

institutions
Financial intermediaries (in particular banks) play a key role in the financial system
It is now time to examine:
(i) Structure of the balance-sheet of banks
(ii) How banks manage their liquidity, assets, liabilities and capital
This will also help in understanding the Importance of regulation of the banking
sector and the recent financial crisis and the Role of banks in the money supply
process.
Bank Balance Sheet: Liabilities
1. Sight deposits
2. Time deposits
1. Banks deposits and borrowings:
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From banks (interbank borrowing) and from central banks
1. Debt and other securities

2. Foreign currency deposits
3. Bank capital or equity or net worth :
= Total assets liabilities

Bank Balance Sheet: Assets
1. Reserves:
Required reserves (RR) and excess reserves (ER)
2. Bonds and other securities:

Corporate and government bonds
1. Loans:
1. Business
2. Mortgages
3. Consumer (e.g. overdrafts and credit card loans)
4. Banks (interbank loans)
4. Other Assets
Basic Banking: Cash Deposit
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Basic Banking: Payment Transaction
Basic Banking: Making a Profit
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Principles of Bank Management

1. Liquidity Management
2. Asset Management: Managing Credit Risk & Managing Interest-Rate Risk
3. Liability Management
4. Capital Adequacy Management
Liquidity Management
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Liquidity Management: Options
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Asset Management
Three main goals: Maximize rate of return on loans and securities, minimize risk
associated with them and maintain adequate liquidity.
Four main ways:
1. Find borrowers who pay high interest rates and have low default risk
2. Purchase securities with high returns and low risk (diversifying between
different types of securities)
3. Lower credit and interest-rate risk
4. Balance need for liquidity against increased returns from less liquid assets
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Managing Credit Risk

Strategies to Manage Credit Risk
1. Screening and information collection credit score

2. Specialize in lending (trade-off with diversification)
3. Monitoring and enforcement of restrictive covenants
4. Establish long-term customer relationships
5. Loan commitment to increase info collection
6. Collateral and compensating balances
7. Credit rationing
Liability Management
 Banks no longer primarily depend on sight and time deposits as primary bank
funds
 When banks see loan opportunities, they borrow from other banks in the
interbank market or issue CDs to raise funds
 Banks manage the asset and the liability sides of the balance sheet in
conjunction (Asset-Liability Management - ALM)
 Goal: Minimize cost of deposits and borrowing
Capital Management
 Bank capital ( asset liabilities) as cushion to prevent bank failure

 However, there is trade-off between safety and returns on equity (ROE) (see
next slide for a proof)
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 Banks hold capital to meet capital requirements as necessary buffer against

losses (see Basel Accords)
Strategies for Managing Bank Capital:

- Buy back/issue new stocks
- Pay higher/lower dividends to stockholders
- Increase/decrease bank s asset change of bank capital
relative to assets)
 ROE = Returns on equity = P/E
Where P = net profits after taxes

E = equity capital
 ROA = return on assets = P/A
where A = assets
 EM = Equity multiplier = A/E

 This implies that ROE = ROA * EM
For a given ROA, if E ↓ then ROE

Off-Balance-Sheet Activities
 Result of the competitive environment of recent years

 Generate profits from activities not appearing in the balance sheet:
o Loan sales
o Fees from specialized services linked to securitization, derivative and
foreign exchange transactions, guarantees of securities and backup
credit lines, etc.
 These services do not appear in balance sheet, but dramatically affect the risk
that the bank faces
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11. Economic analysis of financial

regulation
Financial regulation is a form of regulation or supervision, which subjects financial
institutions to certain requirements, restrictions and guidelines, aiming to maintain
the integrity of the financial system. This may be handled by either a government or
non-government organization. Financial regulation has also influenced the structure
of banking sectors, by decreasing borrowing costs and increasing the variety of
financial products available. The chapter discusses the importance of regulating
banking system due to existence of asymmetric info. It also provides details of
evolution of regulation is USA and internationally and discusses various regulatory
mechanisms that are in place.
Asymmetric Information and Bank Regulation
 Government safety net: Deposit insurance and

the FDIC
o Short circuits bank failures and contagion effect
o Payoff method
o Purchase and assumption method
 Moral Hazard
o Depositors do not impose discipline of marketplace
o Banks have an incentive to take on greater risk
 Adverse Selection
o Risk-lovers find banking attractive
o Depositors have little reason to monitor bank
Too Big to Fail: Government provides guarantees of repayment to large uninsured

creditors of the largest banks even when they are not entitled to this guarantee. Uses
the purchase and assumption method. Increases moral hazard incentives for big banks
Financial Consolidation: Larger and more complex banking organizations challenge
regulation. Increased too big to fail problem. Extends safety net to new activities,
increasing incentives for risk taking in
these areas
Restrictions on Asset Holding and Bank Capital Requirements: Attempts to restrict
banks from too much risk taking. Promote diversification, Prohibit holdings of
common stock ,Set capital requirements ,Minimum leverage ratio, Basel Accord: risk-
based capital requirements and Regulatory arbitrage
Bank (Prudential) Supervision: Chartering and Examination
Chartering (screening of proposals to open new banks) to prevent adverse selection
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Examinations (scheduled and unscheduled) to monitor capital requirements and

restrictions on asset holding to prevent moral hazard
 Capital adequacy, Asset quality, Management ,Earnings, Liquidity, Sensitivity to

market risk
Filing periodic call reports
 Assessment of Risk Management: Greater emphasis on evaluating soundness

of management processes for controlling risk
 Trading Activities Manual of 1994 for risk management rating based on
o Quality of oversight provided
o Adequacy of policies and limits
o Quality of the risk measurement and monitoring systems
o Adequacy of internal controls
 Interest-rate risk limits
o Internal policies and procedures
o Internal management and monitoring
o Implementation of stress testing and Value-at risk (VAR)
Disclosure Requirements: Requirements to adhere to standard accounting principles

and to disclose wide range of information. Eurocurrency Standing Committee of the
G-10 Central Banks also recommends estimates of financial risk generated by the
firm s internal monitoring system be adapted for public disclosure
Consumer Protection: Truth-in-lending mandated under the Consumer Protection Act
of 1969, Fair Credit Billing Act of 1974, Equal Credit Opportunity Act of 1974,
extended in 1976, Community Reinvestment Act
Restrictions on Competition: Justified by moral hazard incentives to take on more risk
as competition decreases profitability
Branching restrictions (eliminated in 1994) and Glass-Steagall Act (repeated in 1999)
Disadvantages: Higher consumer charges and Decreased efficiency
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International Banking Regulation: Similar to U.S.

Chartered and supervised, Deposit insurance, Capital requirement
Particular problems: Easy to shift operations from one country to another and Unclear
jurisdiction lines.
 1980s S&L and Banking Crisis: Financial innovation and new financial
instruments increasing risk taking
 Increased deposit insurance led to increased moral hazard
 Deregulation
o Depository Institutions Deregulation and Monetary Control Act of 1980
o Depository Institutions Act of 1982
Managers did not have expertise in managing risk, Rapid growth in new lending, real
estate
in particular, Activities expanded in scope; regulators at FSLIC did not have expertise
or resources. High interest rates and recession increased incentives for moral hazard.
1980s S&L and Banking Crisis: Later Stages
 Regulatory forbearance by FSLIC

o Insufficient funds to close insolvent S&Ls
o Established to encourage growth
o Did not want to admit agency was in trouble
 Zombie S&Ls taking on high risk projects and attracting business from healthy
S&Ls
 Competitive Equality in Banking Act of 1987
o Inadequate funding
o Continued forbearance
Principal-Agent Problem for Regulators and Politicians
 Agents for voters-taxpayers

 Regulators
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o Wish to escape blame (bureaucratic gambling)

o Want to protect careers
o Passage of legislation to deregulate
o Shortage of funds and staff
 Politicians
o Lobbied by S&L interests
o Necessity of campaign contributions for expensive political races
 Federal Deposit Insurance Corporation Improvement Act of 1991: Recapitalize

the Bank Insurance Fund
o Increase ability to borrow from the Treasury
o Higher deposit insurance premiums until the loans could be paid back
and reserves of 1.25% of insured deposits maintained
 Reform the deposit insurance and regulatory system to minimize taxpayer
losses
o Too-big-to-fail policy substantially limited
o Prompt corrective action provisions
o Risk-based insurance premiums
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12. Banking industry: structure and

competition
A bank is a financial intermediary that accepts deposits and channels those deposits
into lending activities, either directly by loaning or indirectly through capital markets.
A bank links customers that have capital deficits and customers with capital
surpluses.
Due to their importance in the financial system and influence on national economies,
banks are highly regulated in most countries. Most nations have institutionalised a
system known as fractional reserve banking, under which banks hold liquid assets
equal to only a portion of their current liabilities. In addition to other regulations
intended to ensure liquidity, banks are generally subject to minimum capital
requirements based on an international set of capital standards, known as the Basel
Accords.
The chapter discusses the history of banking in USA and responsiveness of banking
system to changes in technology, rapid financial innovation and economic crisis.
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Timeline of early US banking history
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13. Goals and Structure of Central banks

A central bank, reserve bank, or monetary authority is an institution that manages a
state's currency, money supply, and interest rates. Central banks also usually oversee
the commercial banking system of their respective countries. In contrast to a
commercial bank, a central bank possesses a monopoly on increasing the amount of
money in the nation, and usually also prints the national currency, which usually
serves as the nation's legal tender. Examples include the European Central Bank
(ECB) and the Federal Reserve of the United States.
The primary function of a central bank is to manage the nation's money supply
(monetary policy), through active duties such as managing interest rates, setting the
reserve requirement, and acting as a lender of last resort to the banking sector
during times of bank insolvency or financial crisis.
The chief executive of a central bank is normally known as the Governor, President
or Chairman.
The chapter discusses the goals and structure of various Central banks around the
world. It starts off by discussing pros and cons of main goal of Central banks i.e. the
price stability. It then explains the problem of time inconsistency and how CB have
to make trade-offs to achieve their stated goals. It also describes the structure of
Feds, ECB and Bank of England... It also evaluates pros and cons of Central bank
independence.
 Main goal of central banks: price stability

 Benefits of price stability
1. Improving transparency of relative prices
2. Reducing distortions of tax and social security systems
3. Preventing arbitrary redistribution of wealth and income
4. Reducing inflation risk premia in interest rates
5. Avoiding unnecessary hedging activities
6. Increasing benefits of holding cash
 Empirical evidence: higher inflation produces lower economic growth in the
long run (e.g. particularly in hyperinflation countries)
Other Goals of Monetary Policy
 High employment or low unemployment (consistent with natural rate of

unemployment)
 Economic growth in the long run
 Stability of financial markets
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 Interest-rate stability
 Foreign exchange market stability
Price Stability as the Primary Goal?
 Long run: no trade-off between price stability and other goals (e.g. price
stability enhances long-run economic growth as well as financial and interest-
rate stability)
 Short run: trade-off between price stability and other goals (e.g. monetary
expansion (M or i ↓) causes output and inflation )
 Time-inconsistency problem: stimulating systematically output in the short run
leads to long-run inflation
Time-Inconsistency Problem
 Good long-run plan, reneged by short-run temptations causes good long-term

plan is time-inconsistent
 In monetary policy:
o Long-run goal: price stability
o Short-run temptation: expansionary short-term policy to increase output
(but this produces higher inflation)
o Rational agents (workers and firms) are aware of these short-term
incentives and raise their inflation expectations
o Higher inflation expectations drive wages and prices up
 How to solve the time-inconsistency problem?
 Delegate monetary policy to an independent central bank with a pre-
set behaviour rule to achieve price stability
Behavioral Rule and Nominal Anchor
 Behaviour rule implies choosing a nominal anchor (or target) to which the
central bank commits its policy
 Typical nominal anchors: exchange rate, monetary aggregate, inflation rate (next
week)
 If behaviour rule is credible (likely with independent central bank), the time-
inconsistency problem is solved
 Nominal anchor as basis to which agents can form their inflation expectations
which drive current inflation
Structure of the Bank of England
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 Founded in 1694, the Bank of England (BoE) is one of the oldest in the world
 Main decision making body: Monetary Policy Committee (MPC)
 MPC meets monthly and consists of 9 members: Governor (Mark Carney) + 2

Deputy Directors + 6 other members
 Decisions on monetary policy made by voting
Structure of Federal Reserve System

Main entities of the Federal Reserve System:
1. 12 Federal Reserve Banks (FRBs)

2. Board of Governors (BG)
3. Federal Open Market Committee (FOMC)
Federal Reserve Banks: Structure
 Quasi-public institution owned by private commercial banks in the district that

are members of the Fed system
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 Bank members in each district elect 6 directors; 3 more are appointed by

the BG
 9 directors appoint the president of the bank subject to approval by the BG
 5 of the 12 FRB s presidents have a vote in the Federal Open Market
Committee (FOMC) the president of the NY Fed permanent member of
the FOMC
Federal Reserve Banks: Functions
 Hold deposits for banks in the district

 Administer and make loans to banks in their districts
 Ensure working of payment system
 Supervise and regulate financial institutions
 Issue new currency and withdraw damaged currency from circulation
 Collect data on local conditions and research topics related to the conduct of
monetary policy
Board of Governors: Structure
 7 members headquartered in Washington, D.C.

 Each member appointed by the U.S. president and confirmed by the Senate
 Required to come from different districts
 To limit government s control, -year non-renewable term
 Chairman (Janet Yellen - since 2013) is chosen from the governors and serves
four-year (renewable) term
 BG has the majority of the votes in the FOMC
Board of Governors: Functions
 Votes on the conduct of open market operations within the FOMC

 Board also sets reserve requirements
 Controls the discount rate
 Bank regulation functions: (i) approves bank mergers and applications for new
activities, (ii) specifies permissible activities of bank holding companies, (iii)
supervises activities of foreign banks operating in the U.S.
Federal Open Market Committee
 12 members: 7 BG members + president of NY Fed (permanent) + 4 presidents

of other FRBs (rotation)
 Meets eight times a year (about every six weeks)
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 Issues directives to the trading desk at the NY Fed (implementation of

monetary policy is centralized)
Structure of the European Central Bank
 Structure similar to the Federal Reserve System

 European System of Central Banks (ESCB) = ECB + 27 National Central
Banks (NCBs) of all EU countries
 Euro system: ECB + 17 NCBs of the euro countries
 Main ECB s decision-making bodies
o Executive Board (EB): 6 members
o Governing Council (GC): 6 EB members + 17 NCB governors
Governing Council
 23 members: 6 EB members (President, vice-president and four other

members) + 17 NCB governors
 Meets every month at ECB in Frankfurt (Germany)
 Decides on key interest rates, reserve requirements and provision of liquidity
to banking system of euro area
 Normally operates by consensus
 As new countries join EMU, the GC will be on a system of rotation with vote
 President: Mario Draghi
(Since 1st Nov 2011)

National Central Banks
 Similar functions as FRBs

 Implement monetary policy set by the GC (providing liquidity to banking
system in their countries)
 Ensure settlement of domestic and cross-border payments (payment system)
 Issuing and handling euro notes in their countries
 Collection of national statistical data
 Depending on national laws, NCBs might be involved in banking
supervision/regulation in particular with reference
to liquidity and capital requirements (e.g. DNB)
Central Bank Independence
 How independent from political pressures (e.g. government) are central banks?
 Two main types of independence of central banks:
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1. Instrument Independence: ability of the central bank

to set monetary policy instruments
2. Goal Independence: the ability of the central
bank to set the goals of monetary policy
How Independent is the BoE?
 Instrument independence: Government can overrule the Bank and set rates
only in in extreme economic circumstances
 Goal independence: Inflation target set by the Chancellor of the Exchequer
 Financial independence: determines its own budget
 Political independence: Governor appointed by Chancellor (5-year term,
renewable)
 Bank of England less independent than Fed and ECB
How Independent is the Fed?
 Both instrument and goal independent

 Financial independence: independent revenue due to holdings of securities
(and loans to banks)
 Political independence: Fed is structured by legislation from Congress and
accountable for its actions
Also presidential influence
 Through his influence on Congress

 Appoints members of Board of Governors
 Appoints chairman although terms are not concurrent
How Independent is the ECB?
 Most instrument and goal independent in the world
(based on Maastricht Treaty)
 Financial independence: determines its own budget and Euro system is

prohibited from financing governments
 Political independence:
o Executive-Board members: 8-year term (non-renewable)
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Removal only in case of incapacity and serious miss-conduct appointed

by heads of states of all EMU members
 NCB governors appointed by national governments for a minimum 5 years
Cases For Independence:
1. Independent central bank likely to have longer-run objectives (e.g. price

stability), politicians don't
1. Avoids political business cycle (e.g. stimulating economy to maximize re-

election chances)
1. Less likely budget deficits financed by printing money or directly purchasing

government bonds
2. Too important (and complicated) to leave to politicians
Cases Against Independence:
1. Undemocratic lack of accountability

2. Lack of coordination between monetary and fiscal policy
3. Independent central bank not always operate successfully (e.g. Fed during the
Great Depression)
=> Trend towards greater independence (empirical evidence: higher independence =>
lower inflation)
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14. Money supply process

The chapter takes a look at various players involved in monetary system, the tools
and instruments available at disposal to those players and how their decisions affect
money supply, interest rates and critical monetary variables. It starts off by a
discussion on various components of bank's balance sheet and how policies of
central banks influence a bank's balance sheet position. It also discusses process of
deposit multiplier and creation of money. The chapter ends by discussion if CB can
really control the money supply.
Three Players:
1. Central bank (CB) government agency that oversees the banking system and
is responsible for the conduct of monetary policy (Fed, ECB, BoE, etc.)
1. Banks - depository institutions like commercial banks and saving and loan
institutions
1. Depositors individuals and institutions holding deposits at banks
The CB s Balance Sheet

Liabilities
Currency in circulation (C): in the hands of the public
Reserves (R): bank deposits at the CB and vault cash. Two categories: required
reserves and excess reserves
Monetary Base (or high-powered money) (MB)
MB = C + R
Assets
Government securities (S): holdings by the CB that affect money supply and earn
interest
Loans to Banks (LB): provision of reserves or loans to banks by CB at the lending rate
Control of the Monetary Base

How is the MB (= C + R) controlled by the CB?
1. Open Market Operations (OMOs): purchase or sale of
government securities in the open market
2. Loans to Banks (LB): loans to banks by CB at a lending rate
The composition of the MB can change as a result of
3. Currency Withdrawal (e.g. shifts from deposits into
currency)
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How is the MB (C + R) controlled by the CB?
Open Market Operations
Loans to Banks from CB
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Currency Withdrawal
Deposit Creation: Single Bank
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Simple Deposit Multiplier
ΔD = change in total chequable deposits ΔR = change in reserves

r = required reserve ratio
Deposit Creation::Banking System as a Whole
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Money Multiplier
 The money supply process is more complicated than the simple model
 Money Multiplier Model extends the latter with:
1. Banks decision on level of excess reserves (ER)

Assumption: ER = e * D
(e = excess reserve ratio)
2. Depositors decision on currency holding (C)
Assumption: C= c*D
(c = currency ratio)
Deriving the Money Multiplier
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 Numerical example
Required reserve ratio r = 10 %

Excess reserve ratio e = 10 %
Currency Ratio c = 20 %
m = (1+0.2)/(0.1+0.1+0.2) = 3
With simple deposit multiplier => 1/r = 1/0.1 = 10
Factors Affecting the Money Supply
MBn = non-borrowed MB (controlled with OMOs by CB)

BR = borrowed reserves from CB under banks discretion
1. Changes in MBn (MBn ↑ , M ↑ )

2. Changes in BR (BR ↑ , M ↑ )
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3. Changes in the Required Reserve Ratio, r (r ↑ , m ↓ , M ↓)

4. Changes in the Currency Ratio, c (c↑ , m ↓ , M ↓ )
5. Changes in the Excess Reserve Ratio, e ( e ↑ , m ↓ , M ↓ )
Can the CB Control the Money Supply?
 If c and e are stable and predictable, we can expect a close link

between MB and M (e.g. m stable)
 However, money multiplier m tends to show large swings (mostly due to
changes in c and e)
 Money supply control very difficult in practice
 One of the main reasons why nowadays most CBs don t use monetary base as
instrument but interest rates
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15. Tools of Monetary Policy

Monetary policy is the process by which the monetary authority of a country
controls the penny of a state or government the supply of money and loans a bank
can offer, often targeting a rate of interest for the purpose of promoting economic
growth and stability. The official goals usually include relatively stable prices and low
unemployment. Monetary economics provides insight into how to craft optimal
monetary policy.
Monetary policy is referred to as either being expansionary or contractionary, where

an expansionary policy increases the total supply of money in the economy more
rapidly than usual, and contractionary policy expands the money supply more slowly
than usual or even shrinks it. Expansionary policy is traditionally used to try to
combat unemployment in a recession by lowering interest rates in the hope that easy
credit will entice businesses into expanding. Contractionary policy is intended to
slow inflation in order to avoid the resulting distortions and deterioration of asset
values. The chapter discusses most critical tools and instruments of monetary policy
such as overnight bank interest rates, reserve manipulation etc. and discusses pros
and cons of using these tools and instruments.
Open market operations (OMOs): Central bank buys and sells securities to affect the
quantity of reserves and the monetary base
Standing facilities: Central bank sets interest rates at which banks on their own
initiative can borrow (at lending rate) and deposit (at deposit rate) reserves at the
central bank
Reserve requirements: Central bank sets the required reserve ratio, which is the
fraction of deposits that banks need to hold at the central bank
Overnight Interbank Interest Rate
 Banks make overnight loans of reserves to each other in the interbank market
 Overnight interbank interest rate (i) - the interest rate on overnight loans of
reserves from one bank to another
o EONIA (euro overnight index average) in the euro area
o FFR (Federal Funds Rate) in the U.S.
 How do tools of monetary policy affect the overnight interest rate?
 Need to model the market for reserves
Demand for Reserves
 Rd = RR + ER
(RR=required reserves, ER=excess reserves)
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 ER are held as insurance against deposit outflows

 The cost of holding ER is the interest rate that could have been earned
(i) minus the deposit rate (id) that is paid on these reserves by the CB
 If i ↑ relative to id opportunity cost of holding ER ↑ , demand of reserves Rd ↓
 This implies a downward sloping demand curve which becomes flat (infinitely
elastic) at id
 Why? If i < id, then banks would rather hold excess reserves at the central bank
than lend to each other
Supply of Reserves
 Rs is NBR + BR
(NBR = non-borrowed, BR = borrowed reserves)
 Cost of borrowing from the CB is the lending rate il

 Borrowing from the CB is a substitute for borrowing from other banks
 If i < il, then banks will not borrow from the CB and borrowed reserves are zero
=> Rs is vertical
 As i rises above il, banks will borrow more and more at il, and re-lend
at i (arbitrage opportunity) => Rs is horizontal (perfectly elastic) at il
Market for Reserves
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Response of i to OMOs
Response of i to Lending Rate
Response of i to Deposit Rate
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Response of i to Required Reserves
Open Market Operations

Two Types of Open Market Operations (OMOs)
1. Outright: outright purchase or sale of securities
1. Temporary: temporary purchase (repurchase agreements - repos) or sale

(reverse repurchase agreements reverse repos) of securities
Advantages of Open Market Operations (OMOs)

1. Central bank has complete control over their volume
2. Flexible and precise
3. Easily reversed
4. Quickly implemented no administrative delays
Open Market Operations of the ECB
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 ECB buys and sells eligible assets to affect reserves and, as a result, interest
rate (e.g. EONIA) that European banks charge each other for overnight funds
 Implemented by NCBs (decentralized)
 Main form: Main Refinancing Operations (MROs) (weekly repos with a week
maturity)
 Main Refinancing Rate (MRR) is applied in MROs
 Other forms of OMOs: (i) Long-Term Refinancing Operations (LTROs), (ii) Fine-
Tuning Operations and (iii) Structural Operations
Standing Facilities at ECB
 Available to banks on their own initiative

 Two standing facilities:
1. Marginal lending facility to obtain overnight liquidity from NCBs
 Marginal lending rate is MRR + 100 basis points (!currently 75bp)

 No limit in size, as long as collateral is provided
 Ceiling for EONIA rate
2. Deposit facility to make overnight deposits at NCBs
 Deposit rate is MRR 100 basis points (!currently 75bp)

 Floor for EONIA rate
How Standing Facilities Limit Fluctuations in i
Standing Facilities
Advantages
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1. Operational facilities to put a ceiling and a floor to the overnight interest rate
corridor system
2. Lender of Last Resort: lending facilities prevents banking and financial
panics triggered by shortage of liquidity and bank failure (e.g. sub-prime crises
of 2007) or by other factors (e.g. Black Monday in 1987, 9/11 terrorist attack)
Disadvantage
1. Moral hazard problems leading banks to take on more risk making them more
vulnerable to negative shocks
Reserve Requirements of ECB
 In euro area, all deposit-taking institutions are required to hold 2% (of short-
term deposits, debt securities and money market papers) in reserves at their
respective NCB
 ECB pays interest rate on required reserves (average MRR over maintenance
period)
 Institutions subject to reserve requirements have access to the ECB s standing
facilities and participate in OMOs
Crisis and Unconventional Tools
 During recent financial crisis, CBs lowered interest rates to historically low
(virtually zero) levels
 But this was not considered enough to avoid risks of depression and deflation
 CBs adopted unconventional tools: i new lending facilities (ii) management of
expectations (mostly the Fed) (iii) outright purchases of public and private
securities from bank and non-bank sectors ( Quantitative Easing or QE) (see
figure below)
 First experience of QE in Japan in 2001-2006
 Measures differ from country to country, but the balance sheets of the ECB,
BoE and Fed increased dramatically
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Quantitative Easing
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16. Conduct of Monetary Policy: Strategy

and Tactics
In practice, to implement any type of monetary policy the main tool used is
modifying the amount of base money in circulation. The monetary authority does
this by buying or selling financial assets (usually government obligations). These open
market operations change either the amount of money or its liquidity (if less liquid
forms of money are bought or sold). The multiplier effect of fractional reserve
banking amplifies the effects of these actions.
Constant market transactions by the monetary authority modify the supply of

currency and this impacts other market variables such as short term interest rates
and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the
set of instruments and target variables that are used by the monetary authority to
achieve their goals. The chapter discusses the policies employed by Fed, ECB and
other CBs around the world to achieve their monetary policies. It first describes the
role of choosing targets in order to use right tools to achieve their end goals. It then
looks at pros and cons of using targets but also affirms the importance of sticking to
certain targets.
Behavioral Rule and Nominal Anchor
 Last week we saw that to solve the time-inconsistency problem, independent

central banks have to commit (credibly) to a behaviour rule
 This implies choosing a nominal anchor (or target)

 Typical nominal anchors are: monetary aggregate, inflation rate and exchange
rate
 Nominal anchor as basis to which agents can form their inflation expectations
which drives current inflation
Monetary Policy Strategies

Main monetary policy strategies (characterized by different nominal anchors) are:
1. Monetary Targeting (MT): use of a specific monetary aggregate (e.g. M1, M2 or

M3) as intermediate target
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1. Inflation Targeting (IT): use of a specific medium-term numerical target for

inflation
1. Implicit Nominal Anchor (e.g. Fed)
Monetary Targeting
 Adopted by several countries in the 1970s and 1980s (Germany, Switzerland,

Canada, the U.K., and the U.S.)
 Advantages
o Almost immediate signals help fix inflation expectations and produce
less inflation
o Almost immediate accountability
 Disadvantages
o Rely on stable relationship between inflation and targeted monetary
aggregate
o Must have full control over monetary aggregate
Inflation Targeting
 First introduced by New Zealand in 1990, then Canada (1991), the U.K. (1992),
Sweden and Finland (1993), etc.
Main elements of IT:
 Public announcement target for inflation (e.g. 2% or between 2-3%) over the
medium-term (e.g. 2 years)
 Institutional commitment to price stability as the primary, long-run goal of
monetary policy and a commitment to achieve the inflation goal
 Information-inclusive approach in which many variables are used in making
decisions
 Increased transparency through communication
 Increased accountability for obtaining the inflation goal
Inflation Targeting
 Advantages
o Does not rely on one variable (e.g. monetary aggregate) to achieve
target as in MT
o Easily understood by public
o Increased transparency and accountability force a better communication
(e.g. Inflation Report and Fan Charts)
 Disadvantages
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o Delayed signalling about achievement of target

o Could impose too much rigidity
o Potential for increased output fluctuations and low economic growth if
sole focus on inflation
ECB s Monetary Policy: Goal

Price stability, defined as …a year-on-year increase in the Harmonized Index of
Consumer Prices HICP for the euro area, close but below %
…maintained over the medium term roughly years
No mention of other goal is the hierarchical mandate
ECB s Two-Pillar Strategy
 First pillar: Economic Analysis

o Monitoring of indicators (wages, energy prices, exchange rate, yield
curve, etc.) to assess the short to medium-term risks to price stability
Second pillar: Monetary Analysis
 Money stock is reference value to assess the medium to long-term risks to

price stability
 M reference value : . % consistent with % inflation in the long run this
numerical value no longer mentioned by the ECB)
 Similar procedure to Bundesbank
Strategy with Implicit Nominal Anchor
 Fed just do it strategy based on achieving price stability in the long run (with
no explicit target) but also maximum sustainable employment is the dual
mandate
 Advantages
o Uses many sources of information
o Demonstrated success over the years
 Disadvantages
o Lack of transparency leading to higher uncertainty on future inflation
and output
o Low accountability
o Strong dependence on the preferences, skills and trustworthiness of the
individuals in change
Tactics: Choosing the Policy Instrument
 Tools (directly controlled by the CB)

o Open market operations
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o Standing facilities (lending rate and deposit rate)

o Reserve requirements
 Policy instrument (operating instrument): variable that responds to tools
o Reserve aggregates (R, NBR, MB, MBn)
o Short-term interest rates (e.g. EONIA, Federal Funds Rate)
 Question: Can the CB target the reserves and interest rates at the same time?
 Answer: No, interest and reserve targets are incompatible
Targeting Non-Borrowed Reserves
Targeting the Interest Rate
Criteria for Choosing the Instrument
 Observability and Measurability: policy instrument should be quickly

observable and measurable
 Controllability: policy instrument should be fully controlled with tools
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 Predictable Effect on Goals: policy instrument must have a stable and

predictable relationship with goal
 Nowadays , most central banks target short-term interest rates as policy

instrument
 Tactics: Taylor Rule
 Inflation gap is (inflation rate inflation target)

o If inflation rate above target, CB should increase i
o Taylor principle: if inflation rate ↑ 1% , then CB should ↑ i 1.5%
 Output gap is (% deviation of real GDP from its potential level)
o Stabilizing real output is an important concern
o Output gap is an indicator of future inflation
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17. Foreign exchange market

The foreign exchange market (forex, FX, or currency market) is a global decentralized
market for the trading of currencies. The main participants in this market are the
larger international banks. Financial centres around the world function as anchors of
trading between a wide range of multiple types of buyers and sellers around the
clock, with the exception of weekends. The foreign exchange market determines the
relative values of different currencies.
The foreign exchange market works through financial institutions, and it operates on
several levels. Behind the scenes banks turn to a smaller number of financial firms
known as dealers, who are actively involved in large quantities of foreign exchange
trading. Most foreign exchange dealers are banks, so this behind-the-scenes market
is sometimes called the interbank market , although a few insurance companies and
other kinds of financial firms are involved. Trades between foreign exchange dealers
can be very large, involving hundreds of millions of dollars. Because of the
sovereignty issue when involving two currencies, Forex has little (if any) supervisory
entity regulating its actions.
The chapter discusses the basics of foreign exchange market, Balance of payments,
exchange rate regime. It provides the differences in how the exchange rates are
determined in short and long run and basics of Purchasing Power parity.
Two kinds of foreign exchange transactions

i)spot transactions are the ones which take place immediately ii)forward= at some
specified date in future.
When domestic currency gains value relative to foreign currency, it is known as
appreciation and the reverse scenario is called depreciation.
Exchange rates are important because they determine relative prices of foreign and
domestic goods.
-When a country s currency appreciates, it makes its goods abroad expensive and
foreign goods in its own currency cheaper
-when a country s currency depreciates. It makes its goods abroad cheaper and
foreign goods in its own currency expensive.
Foreign exchange market has no centralized exchange and transactions usually occur
OTC (over the counter)
Exchange rate in long run
Exchange rates are determined by Law of 1 price. If goods produced are homogenous,
there are no or low barriers to trade and small transport costs, the goods will cost
same in two countries.
PPP is the theory of Purchasing power parity= the theory states that the exchange
rates will reflect changes in price levels in two countries. (NOTE: It applies to national
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price level average and NOT the price of individual goods). So if price levels in
Country 1 rises, currency of country 1 will depreciate and country 2 will appreciate.
PPP can t predict exchange rate movements in short run.
Reasons why PPP can t predict exchange rate movements- Due to presence of
transport costs, trade barriers, non-tradable goods and most products are not totally
identical.
FACTORS THAT AFFECT EX RATE IN LONG RUN; any factor that increases demand
of domestic goods relative to foreign goods will cause an appreciation of domestic
currency and vice versa, the factors are
1) relative price levels: if price level in country 1 rises, it decreases demand for its
goods and hence depreciation of its currency
2) trade barriers= trade barriers restrict trade. For e.g., the tax on import is called
tariff. If country 1 imposes tariffs on goods from outside, the demand for its own
goods rises and hence appreciates its own currency.
3) Preference for foreign vs domestic goods= If consumers in country 1 prefer
domestic goods relative to foreign goods and if consumers in country 2 prefer foreign
goods, then currency of country 1 appreciates.
4)productivity= if country experiences productivity boost in tradable sector, it
decreases price levels and hence boosts demand for those goods, causing
appreciation
EXCHANGE RATE- demand and supply in short run

Exchange rates are essentially price of country s domestic assets in terms of other
country s assets denominated in other country s currency . Import and export
demand play a small role in determining ex rates as their volume in overall currency
transactions is small. Decisions to hold/sell assets is more important.
Supply curve for domestic assets= quantity of asset supplied is sum of deposits, bonds
and equities in domestic country. It is vertical as it does not depend on ex rate.
Demand curve for domestic assets= We hold other factors constant in determining
demand. The only factor that should matter is relative return of domestic asset. For
example, the domestic currency depreciates but expected ex rate for next period is
constant. Thus, we can expect domestic currency to appreciate back, thus increasing
returns of domestic assets, thus demand curve is downward sloping.
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Explaining changes in ex rates

Since supply curve is vertical, we only examine impacts on demand curve.
1) interest rate on domestic assets= if interest rate rises, it increases returns thus
causing increased demand for domestic currency
2) interest rate on foreign assets= if interest rate rises on foreign assets, it increases
returns on those assets, thus reducing demand for domestic currency and increasing
demand for foreign currency,
3) expected future ex rate= any factor that causes appreciation in future expected ex
rate will cause increase in relative returns and cause appreciation of currency now
(hence rising demand)
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APPLICATION
1) changes in interest rates)We said previously, that when domestic interest rates rise,
the currency appreciates. It is important to tell difference between real and nominal
interest rates. Fisher equation states
Nominal interest rate is real rate + expected inflation.
So if real rate rises, the domestic currency appreciates but if nominal interest rate
increases due to increase in expected inflation, then domestic currency depreciates.
2) Changes in money supply: if CB increases money supply, it increases price levels in
future and causes decline in expected ex rate. Hence, the demand falls and domestic
currency depreciates.
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18. International financial system

The global financial system is the worldwide framework of legal agreements,
institutions, and both formal and informal economic actors that together facilitate
international flows of financial capital for purposes of investment and trade
financing. It has evolved substantially since its emergence in the late 19th century
during the first modern wave of economic globalization. Marked by the
establishment of central banks, multilateral treaties, and intergovernmental
organizations aimed at improving the transparency, regulation, and effectiveness of
international markets.
The chapter provides a discussion on exchange rate mechanisms and agreements of
past. It discusses the role of IMF as lender of last resort and the effectiveness of
exchange rate targeting policies.
Foreign exchange intervention and money supply= CB holds foreign currency known
as international reserves. Suppose if Fed sells over 1 billion dollars worth of foreign
currency (yen) for dollars, it causes decline in monetary base as it removes money
from public s hands. Thus, it reduces money supply which increases interest rates and
reduces price levels, thus leading to increase in expected value of currency and
appreciation of currency.
Such kinds on transaction that affect monetary base are called unsterilized foreign ex
intervention. If government wants monetary base to remain constant, it can conduct
open market purchase of bonds, thus overall it has no effect on monetary base.
Balance of payments= a bookkeeping system to record payments and receipts that

have effect on moving funds between 2 countries. Current account shows
transactions involving currently produced goods and services. Trade balance is
difference between exports and imports.
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Current account= trade balance + net income from service + net income from
investments + unilateral transfer (aid, grants etc.)
Capital account= receipts and payments involving capital transactions like buying and
selling equities, bonds etc.
Capital + current account= changes in government s international reserves
Exchange rate regimes
1) floating rates are when currency is allowed to fluctuate 2) fixed ex rate is when
currency is pegged to value of other currency 3)managed float is when country
interferes in foreign currency market to stabilize value of currency if it fluctuates too
much.
 Past Exchange Rate Regimes: Gold standard

o Fixed exchange rates
o No control over monetary policy
o Influenced heavily by production of gold and
gold discoveries
 Bretton Woods System
o Fixed exchange rates using U.S. dollar as
reserve currency
o International Monetary Fund (IMF), World Bank and General Agreement
on Tariffs and Trade (GATT) and World Trade Organization
European Monetary System: Exchange rate mechanism
 How a Fixed Exchange Rate Regime Works: When the domestic currency is
overvalued, the central bank must purchase domestic currency to keep the
exchange rate fixed, but as a result, it loses international reserves
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 When the domestic currency is undervalued, the central bank must sell
domestic currency to keep the exchange rate fixed, but as a result, it gains
international reserves
How Bretton Woods Worked: Exchange rates adjusted only when experiencing a
fundamental disequilibrium large persistent deficits in balance of payments)
Loans from IMF to cover loss in international reserves, IMF encourages contractionary
monetary policies
Devaluation only if IMF loans are not sufficient, No tools for surplus countries, U.S.
could not devalue currency
 Managed Float: Hybrid of fixed and flexible

o Small daily changes in response to market
o Interventions to prevent large fluctuations
 Appreciation hurts exporters and employment
 Depreciation hurts imports and
stimulates inflation
 Special drawing rights as substitute for gold
European Monetary System: 8 members of EEC fixed exchange rates with one
another and floated against the U.S. dollar. ECU value was tied to a basket of
specified amounts of European currencies. Fluctuated within limits. Led to foreign
exchange crises involving speculative attack.
 Capital Controls: Outflows

o Promote financial instability by forcing
a devaluation
o Controls are seldom effective and may increase capital flight
o Lead to corruption
o Lose opportunity to improve the economy
 Inflows
o Lead to a lending boom and excessive risk taking by financial
intermediaries
Controls may block funds for productions uses

Produce substantial distortion and misallocation
Lead to corruption
Strong case for improving bank regulation and supervision
The IMF: Lender of Last Resort: Emerging market countries with poor central bank
credibility and short-run debt contracts denominated in foreign currencies have
limited ability to engage in this function. May be able to prevent contagion and the
safety net may lead to excessive risk taking (moral hazard problem)
how should the IMF Operate?
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 May not be tough enough

 Austerity programs focus on tight macroeconomic policies rather than financial
reform
 Too slow, which worsens crisis and increases costs
Direct Effects of the Foreign Exchange Market on the Money Supply: Intervention in
the foreign exchange market affects the monetary base.U.S. Dollar has been a reserve
currency: monetary base and money supply is less affected by foreign exchange
market
Balance-of-Payments Considerations: Current account deficits in the U.S. suggest that
American businesses may be losing ability to compete because the dollar is too strong.
U.S. deficits mean surpluses in other countries large increases in their international
reserve holdings
world inflation.
Exchange Rate Considerations: A contractionary monetary policy will raise the

domestic interest rate and strengthen the currency. An expansionary monetary policy
will lower interest rates and weaken currency.
Advantages of Exchange-Rate Targeting: Contributes to keeping inflation under
control, Automatic rule for conduct of monetary policy, Simplicity and clarity.
Disadvantages of Exchange-Rate Targeting: Cannot respond to domestic shocks and
shocks to anchor country are transmitted, Open to speculative attacks on currency,
Weakens the accountability of policymakers as the exchange rate loses value as signal
Exchange-Rate Targeting for Industrialized Countries: Domestic monetary and
political institutions are not conducive to good policy making. Other important
benefits such as integration
Exchange-Rate Targeting for Emerging Market Countries: Political and monetary
institutions
are weak. Stabilization policy of last resort
 Currency Boards: Solution to lack of transparency and commitment to target

 Domestic currency is backed 100% by a foreign currency
 Note issuing authority establishes a fixed exchange rate and stands ready to
exchange currency at this rate
 Money supply can expand only when foreign currency is exchanged for
domestic currency
Stronger commitment by central bank

Loss of independent monetary policy and increased exposure to shock from anchor
country
Loss of ability to create money and act as lender of last resort
Dollarization: Another solution to lack of transparency and commitment
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 Adoption of another country s money

 Even stronger commitment mechanism
 Completely avoids possibility of speculative attack on domestic currency
 Loss of independent monetary policy and increased exposure to shocks from
anchor country, Inability to create money and act as lender
of last resort
 Loss of seignorage
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19. The demand for money

The demand for money is the desired holding of financial assets in the form of
money: that is, cash or bank deposits. It can refer to the demand for money narrowly
defined as M1 (non-interest-bearing holdings), or for money in the broader sense of
M2 or M3.
Money in the sense of M1 is dominated as a store of value by interest-bearing assets.

However, money is necessary to carry out transactions; in other words, it provides
liquidity. This creates a trade-off between the liquidity advantage of holding money
and the interest advantage of holding other assets. The demand for money is a result
of this trade-off regarding the form in which a person's wealth should be held. In
macroeconomics motivations for holding one's wealth in the form of money can
roughly be divided into the transaction motive and the asset motive. These can be
further subdivided into more micro economically founded motivations for holding
money.
The chapter covers 2 specific theories on money namely Keynes liquidity preference
theory and Friedman's quantity theory of money. It explains the background and
historical perspective being each of these theories. It also explains major differences
between these theories and how they are still applicable in today's monetary policy
making.
Velocity of Money and Equation of Exchange
Quantity Theory: Velocity fairly constant in short run
 Aggregate output at full-employment level
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 Changes in money supply affect only

the price level
 Movement in the price level results solely from change in the quantity
of money
 Keynes s Liquidity Preference Theory: Transactions Motive

 Precautionary Motive
 Speculative Motive
 Distinguishes between real and nominal quantities of money
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The Three Motives:
There is an opportunity cost and benefit to holding money. The transaction

component of the demand for money is negatively related to the level of interest
rates
Precautionary Demand: Similar to transactions demand
 As interest rates rise, the opportunity cost of holding precautionary

balances rises
 The precautionary demand for money is negatively related to interest rates
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Speculative Demand: Implication of no diversification
 Only partial explanations

developed further
o Risk averse people will diversify
o Did not explain why money is held as a store of wealth
Friedman s Modern Quantity Theory of Money:
Variables in the Money Demand Function: Permanent income (average long-run

income) is stable, the demand for money will not fluctuate much with business cycle
movements
 Wealth can be held in bonds, equity and goods; incentives for holding these are
represented by the expected return on each of these assets relative to the
expected return on money
 The expected return on money is influenced by:
o The services proved by banks on deposits
o The interest payment on money balances
Differences between Keynes s and Friedman s Model: Friedman
 Includes alternative assets to money

 Viewed money and goods as substitutes
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 The expected return on money is not constant; however, rb – rm does stay

constant as interest rates rise
 Interest rates have little effect on the demand for money
 The demand for money is stable Þ
velocity is predictable
 Money is the primary determinant of aggregate spending
Empirical Evidence: Interest rates and money demand
 Consistent evidence of the interest sensitivity of the demand for money

 Little evidence of liquidity trap
 Stability of money demand

o Prior to 1970, evidence strongly supported stability of the money
demand function
o Since 1973, instability of the money demand function has caused
velocity to be harder to predict
Implications for how monetary policy should be conducted.
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20. The ISLM model

The IS LM model (Investment Saving Liquidity Preference Money Supply) is a
macroeconomic tool that demonstrates the relationship between interest rates and
real output, in the goods and services market and the money market. The
intersection of the IS and LM curves is the "general equilibrium" where there is
simultaneous equilibrium in both markets. Two equivalent interpretations are
possible: first, the IS LM model explains changes in national income when the price
level is fixed in the short-run; second, the IS LM model shows why the aggregate
demand curve shifts. Hence, this tool is sometimes used not only to analyse the
fluctuations of the economy but also to find appropriate stabilisation policies.
The model discusses the Keynesian cross and the derivation of IS-LM model which in
short examines the effect of variable changes like investment etc. on interest rates
and GDP. It also focuses on role of multipliers whereby small autonomous changes in
one of the factors in IS-LM could induce bigger changes in GDP.
Determination of Aggregate Output:
Consumption Expenditure and the Consumption Function:
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 Investment Spending: Fixed investment always planned, Inventory

investment can be unplanned. Planned investment spending
o Interest rates
o Expectation
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Expenditure Multiplier:
Changes in Autonomous Spending:
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Government s Role
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Role of International Trade:
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The ISLM Model
 Includes money and interest rates in the

Keynesian framework
 Examines an equilibrium where aggregate output equals aggregate demand
 Assumes fixed price level where nominal and real quantities are the same
 IS curve is the relationship between equilibrium aggregate output and the
interest rate
 LM curve is the combinations of interest rates and aggregate output for
which MD = MS
IS curve
 Interest rates and planned investment spending

o Negative relationship
 Interest rates and net exports
o Negative relationship
 The points at which the total quantity of goods produced equals the total
quantity of goods demanded
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 Output tends to move toward points on the curve that satisfies the goods
market equilibrium
LM curve:
 Demand for money called liquidity preference

 Md/P depends on income (Y) and interest rates (i)
 Positively related to income
o Raises the level of transactions
o Increases wealth
 Negatively related to interest rates
 Connects points that satisfy the equilibrium condition that MD = MS
 For each level of aggregate output, the LM curve tells us what the interest rate
must be for equilibrium to occur
 The economy tends to move toward points on the LM curve
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21. Monetary and Fiscal Policy in the IS-

LM Model
The chapter discusses the factors impacting IS and LM curve and how the authorities
can react to disturbances in IS-LM model by devising appropriate fiscal and
monetary policies.
 Factors that Shift the IS Curve: A change in autonomous factors that is

unrelated to the interest rate
o Changes in autonomous consumer expenditure
o Changes in planned investment spending unrelated to the interest rate
o Changes in government spending
o Changes in taxes
o Changes in net exports unrelated to the
interest rate
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Factors that Shift the LM Curve
 Changes in the money supply

 Autonomous changes in money demand
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 Response to a Change in Monetary Policy: An increase in the money supply

creates an excess supply of money
 The interest rate declines
 Investment spending and net exports rise
 Aggregate demand rises
 Aggregate output rises
 The excess supply of money is eliminated
 Aggregate output is positively related to the money supply
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Response to a Change in Fiscal Policy: An increase in government spending raises

aggregate demand directly; a decrease in taxes makes more income available for
spending
 The increase in aggregate demand cause aggregate output to rise

 A higher level of aggregate output increases the demand for money
Monetary versus Fiscal Policy
 Complete crowding out

o Expansionary fiscal policy does not lead to a rise in output
o Increased government spending increases the interest rate and crowds
out investment spending and net exports
 The less interest-sensitive money demand is, the more effective monetary
policy is relative to fiscal policy
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 Targeting Ms versus Interest Rates: If the IS curve is more unstable (uncertain)

than the LM curve, a Ms target is preferable
 If the LM curve is more unstable
than the IS curve, an interest-rate target is preferred
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 ISLM Model in the Long Run: Natural rate level of output (Yn)
o Rate of output at which the price level has no tendency
to change
 Using real values, so when the price level changes, the IS curve does not
change
 The LM curve is affected by the price level
o As the price level rises, the quantity of money in real
terms falls, and the LM curve shifts to the left until it reaches Yn (long-
run monetary neutrality)
 Neither monetary or fiscal policy affects output in the long run
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Shifts in the Aggregate Demand Curve: ISLM analysis shows how the equilibrium level
of aggregate output changes for a given price level
 A change in any factor except the price level, that causes the IS or LM curve to
shift, causes the aggregate demand curve to shift
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22. Aggregate Demand and Supply

Analysis
The AD AS or aggregate demand aggregate supply model is a macroeconomic
model that explains price level and output through the relationship of aggregate
demand and aggregate supply. It is based on the theory of John Maynard Keynes
presented in his work The General Theory of Employment, Interest, and Money. It is one
of the primary simplified representations in the modern field of macroeconomics,
and is used by a broad array of economists, from libertarian, Monetarist supporters
of laissez-faire, such as Milton Friedman, to Post-Keynesian supporters of economic
interventionism, such as Joan Robinson.
The conventional "aggregate supply and demand" model is, in actuality, a Keynesian
visualization that has come to be a widely accepted image of the theory. The
Classical supply and demand model, which is largely based on Say's law that supply
creates its own demand depicts the aggregate supply curve as being vertical at all
times (not just in the long-run)
The chapter evolves from discussion on IS-LM model to aggregate demand- supply
model which relates to price levels and gdp. The chapter is split into discussion on
short run and long run aggregate demand-supply models.
 Aggregate Demand: The relationship between the quantity

of aggregate output demanded and the
price level when all other variables are
held constant
 Based on the quantity theory of money
o Determined solely by the quantity of money
 Based on the components parts
o Consumption, investment, government spending and net exports
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Quantity Theory of Money Approach
Behaviour of Aggregate Demand s Component Parts
Factors that Shift Aggregate Demand: An increase in the money supply shifts AD to
the right because it lowers interest rates and stimulates investment spending. An
increase in spending from any of
the components C, I, G, NX, will also shift AD to the right.
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 Aggregate Supply: Long-run aggregate supply curve

o Determined by amount of capital and labour and the available
technology
o Vertical at the natural rate of output generated by the natural rate of
unemployment
 Short-run aggregate supply curve
o Wages and prices are sticky
o Generates an upward sloping SRAS as firms attempt to take advantage
of short-run profitability when price level rises
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Factors that Shift SRAS: Costs of production, Tightness of the labour market,
Expected price level, Wage push, Change in production costs unrelated to wages
(supply shocks)
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 Self-Correcting Mechanism: Regardless of where output is initially,

it returns eventually to the natural rate
 Slow
o Wages are inflexible, particularly downward
o Need for active government policy
 Rapid
o Wages and prices are flexible
o Less need for government intervention
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Shifts in Long-Run Aggregate Supply
 Economic growth
 Real business cycle theory
o Real supply shocks drive short-run fluctuations in the natural rate of
output (shifts of LRAS)
o No need for government intervention
 Hysteresis
o Departure from full employment levels as a result of past
high unemployment
o Natural rate of unemployment shifts upward and natural rate of output
falls below full employment
o Expansionary policy needed to shift aggregate demand
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23. Transmission Mechanisms of

Monetary Policy: The Evidence
According to the ECB. ''Transmission mechanism is the process through which
monetary policy decisions affect the economy in general and the price level in
particular. The transmission mechanism is characterised by long, variable and
uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy
actions on the economy and price level.''
.The chapter provides insights on how changes in money supply affect interest rate
using various channels. It analyses the differences between reduced and structural
form of model building. It then proceeds to explain the monetarist critique of early
Keynesian observations about monetary policies and gives historical evidence in
favour of monetarist arguments.
Structural Model: Examines whether one variable affects another by using data to
build a model that explains the channels through which the variable affects the other
 Transmission mechanism
o The change in the money supply affects
interest rates
o Interest rates affect investment spending
o Investment spending is a component of aggregate spending (output)
Reduced-Form: Examines whether one variable has an effect on another by looking

directly at the relationship between the two
 Analyses the effect of changes in money supply on aggregate output (spending)

to see if there is a high correlation
 Does not describe the specific path
Structural Model Advantages and Disadvantages
 Possible to gather more evidence more confidence on the direction

of causation
 More accurate predictions
 Understand how institutional changes affect the links
 Only as good as the model it is based on
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Reduced-Form Advantages and Disadvantages

No restrictions imposed on the way monetary policy affects the economy
 Correlation does not necessarily

imply causation
o Reverse causation
o Outside driving factor
Early Keynesian Evidence: Monetary policy does not matter at all
 Three pieces of structural model evidence

o Low interest rates during the Great Depression indicated expansionary
monetary policy but had no effect on the economy
o Empirical studies found no linkage between movement in nominal
interest rates and
investment spending
o Surveys of business people confirmed that investment in physical capital
was not based on market interest rates
Objections to Early Keynesian Evidence
 Friedman and Schwartz publish a monetary history

of the U.S. showing that monetary policy was actually contractionary during
the Great Depression
 Many different interest rates
 During deflation, low nominal interest rates do not necessarily indicate
expansionary policy
 Weak link between nominal interest rates and investment spending does not
rule out a strong link between real interest rates and investment spending
 Interest-rate effects are only one of many channels
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Timing Evidence of Early Monetarists
 Money growth causes business cycle fluctuations but its effect on the business
cycle operates with long and variable lags
 Post hoc, ergo propter hoc
o Exogenous event
o Reduced form nature leads to possibility of
reverse causation
o Lag may be a lead
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Historical Evidence: If the decline in the growth rate of the money supply is soon
followed by a decline in output in these episodes, much stronger evidence is
presented that money growth is the driving force behind the business cycle
 A Monetary History documents several instances in which the change in the

money supply is an exogenous event and the change in the business cycle soon
followed
Lessons for Monetary Policy: It is dangerous always to associate the easing or the
tightening of monetary policy with a fall or a rise in short-term nominal interest rates
 Other asset prices besides those on

short-term debt instruments contain important information about the stance of
monetary policy because they are important elements in various monetary
policy transmission mechanisms
 Monetary policy can be highly effective in reviving a weak economy even if
short-term interest rates are already near zero
 Avoiding unanticipated fluctuations in the price level is an important objective
of monetary policy, thus providing a rationale for price stability as the primary
long-run goal for monetary policy
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24. Money and Inflation

In economics, inflation is a sustained increase in the general price level of goods and
services in an economy over a period of time. When the general price level rises,
each unit of currency buys fewer goods and services. Consequently, inflation reflects
a reduction in the purchasing power per unit of money a loss of real value in the
medium of exchange and unit of account within the economy. A chief measure of
price inflation is the inflation rate, the annualized percentage change in a general
price index (normally the consumer price index) over time.
Economists generally believe that high rates of inflation and hyperinflation are
caused by an excessive growth of the money supply. However, money supply growth
does not necessarily cause inflation. Some economists maintain that under the
conditions of a liquidity trap, large monetary injections are like "pushing on a string".
Views on which factors determine low to moderate rates of inflation are more
varied. Low or moderate inflation may be attributed to fluctuations in real demand
for goods and services, or changes in available supplies such as during scarcities, as
well as to changes in the velocity of money supply measures; in particular the MZM
("Money Zero Maturity") supply velocity. However, the consensus view is that a long
sustained period of inflation is caused by money supply growing faster than the rate
of economic growth
The chapter discusses the historical perspective on inflation and establishes link
between inflation and money supply changes. It also discusses if Central banks
should actively try to boost employment at expense of inflation or not.
Money and Inflation: Evidence
 Inflation is always and everywhere a monetary phenomenon

 Whenever a country s inflation rate is extremely high for a sustained period of
time, its rate of money supply growth is also extremely high
 Reduced-form evidence
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Views of inflation
•Money Growth
•Fiscal Policy
•Supply Shocks
•Always a monetary phenomenon
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Origins of Inflationary Monetary Policy: Cost-push inflation
 Cannot occur without monetary authorities pursuing an accommodating policy
 Demand-pull inflation
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 Budget deficits
o Can be the source only if the deficit is persistent and is financed by
creating money rather than by issuing bonds
 Two underlying reasons
o Adherence of policymakers to a high employment target
o Presence of persistent government
budget deficits
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Activist/Nonactivist Policy Debate
 Activists view self-correcting mechanism as slow

 Policy lags slow activist policy
o Data lag
o Recognition lag
o Legislative lag
o Implementation lag
o Effectiveness lag
 No activists believe government should not get involved
o Activist accommodating policy produces volatility in both the price level
and output
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Expectations and the Activist/No activist Debate
 If expectations about policy matter the accommodating, activist policy with

high employment targets may lead to inflation
 No activist policy may prevent inflation and discourage leftward shifts in short-
run aggregate supply that lead to excessive unemployment
o Must be credible
 Constant-money-growth-rate rule
Origins of Inflationary Monetary Policy: Cost-push inflation
 Cannot occur without monetary authorities pursuing an accommodating policy
 Demand-pull inflation
 Budget deficits
o Can be the source only if the deficit is persistent and is financed by
creating money rather than by issuing bonds
 Two underlying reasons
o Adherence of policymakers to a high employment target
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o Presence of persistent government

budget deficits
Activist/Nonactivist Policy Debate
 Activists view self-correcting mechanism as slow

 Policy lags slow activist policy
o Data lag
o Recognition lag
o Legislative lag
o Implementation lag
o Effectiveness lag
 No activists believe government should not get involved
o Activist accommodating policy produces volatility in both the price level
and output
Expectations and the Activist/No activist Debate
 If expectations about policy matter the accommodating, activist policy with

high employment targets may lead to inflation
 No activist policy may prevent inflation and discourage leftward shifts in short-
run aggregate supply that lead to excessive unemployment
o Must be credible
 Constant-money-growth-rate rule
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25. Rational Expectations: Implications for

Policy
Rational expectations is a hypothesis in economics which states that agents'
predictions of the future value of economically relevant variables are not
systematically wrong in that all errors are random. Equivalently, this is to say that
agents' expectations equal true statistical expected values. An alternative
formulation is that rational expectations are model-consistent expectations, in that
the agents inside the model assume the model's predictions are valid. The rational
expectations assumption is used in many contemporary macroeconomic models,
game theory and applications of rational choice theory.
The chapter discusses if it is realistic to assume the existence of rational

expectations hypothesis and its impact on policy making. It highlights shortcomings
of Old Keynesian and Classical models and explains how newer economic models
attempt to overcome their shortcomings. There is also a discussion on how the
monetary policy should be implemented i.e. with swiftness or at a gradual pace.
Econometric Policy Critique
 Econometric models are used to forecast

and to evaluate policy
 Lucas critique, based on rational expectations, argues that policy evaluation
should not be made with these models
o The way in which expectations are formed (the relationship of
expectations to past information) changes when the behaviour of
forecasted
variables changes
o The public s expectations about a policy will influence the response to
that policy
New Classical Macroeconomic Model
 All wages and prices are completely flexible with respect to expected change in
the
price level
 Workers try to keep their real wages from falling when they expect the price
level to rise
 Anticipated policy has no effect on aggregate output and unemployment
 Unanticipated policy does have an effect
 Policy ineffectiveness proposition
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Implications for Policymakers: Distinction between effects of anticipated and

unanticipated policy actions
 Policymakers must know expectations to know outcome of the policy
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o Nearly impossible to find out expectations

o People will adjust expectations guessing what the policymaker will do
 Design policy rules so prices will remain stable
New Keynesian Model: Objection to complete wage and

price flexibility
 Labor contracts
 Reluctance by firms to lower wages
 Fixed-price contracts
 Menu costs
 Model assumes rational expectations but wages and prices are sticky
Implications for Policymakers
 There may be beneficial effects from activist stabilization policy

 Designing the policy is not easy because the effect of anticipated and
unanticipated policy is very different
 Must understand public s expectations
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Stabilization Policy: Traditional
 It is possible for an activist policy to stabilize

output fluctuations
 New Classical
o Activist stabilization policy aggravates output fluctuations
 New Keynesian
o Anticipated policy does matter to output fluctuations
o More uncertainty about the outcome than Traditional
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Credibility in Fighting Inflation
 Public must expect the policy will be implemented

 New Classical
o Cold turkey
 New Keynesian
o More gradual approach
 Actions speak louder than words
Impact of the Rational Expectations Revolution
 Expectations formation will change when the behaviour of forecasted variables

changes
 Effect of a policy depends critically on the public s expectations about that
policy
 Empirical evidence on policy ineffectiveness proposition is mixed
 Credibility is essential to the success of anti-inflation policies
 Less fine-tuning and more stability
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Summary Economics of Money Banking and Financial Markets Frederic S Mishkin PDF

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Summary Economics of Money, Banking, and Financial

StuDocu is not sponsored or endorsed by any college or university

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1: Why study money, banking and

 understanding the determinants and behaviour of interest rates;

Security/financial instrument is A claim on issuer s future income or asset. Bond is a

Common stock is A share of ownership in corporation. Firms issue stock to raise

One form of financial innovation is E finance (improvements in Information

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International finance is important because of increased globalization. Financial

GDP/aggregate output is Market value of FINAL goods and services produced in

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2. An overview of financial system

Debt Markets are debt instruments (e.g. bonds or mortgages)

Short- (less than 1 year), medium/intermediate- (between 1 and

Equity Markets are common stocks

Primary Market are new issue of securities

Money Market are Short-term (less than 1 year) debt instruments

1. Money Market Instruments:

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o Interbank deposits/Federal funds rate (overnight loans between banks

2. Capital Market Instruments

 Stocks (equity claims on net income and assets of corporation)

Eurobond (a bond denominated in currency other than that of country in which it is

Euro currency (Currency deposited in banks outside home countries. An example in

Why are financial intermediaries important?

1. Lower Transaction Costs (Make profits by reducing transaction costs (by

3. Reduce Asymmetric Information (Adverse Selection (AS) before transaction occurs

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Moral Hazard (MH) after transaction occurs

Borrowers have incentives to engage in undesirable (immoral) activities making it

Why regulate financial system?

Increasing information available to investors (asymmetric information leads to AS and

Ensuring soundness of financial intermediaries (asymmetric info > collapse of

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Economist s Meaning of Money or Money Supply : Anything that is generally

2. Unit of account: used to measure value in the economy

Evolution of payment system

1. Commodity money: precious metals (e.g. gold or silver)

1. Fiat Money: paper money decreed by governments as legal tender

1. Cheques: instruction to your bank to transfer money from your account

1. Electronic payments (e.g. online bill pay)

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1. E-Money (electronic money): Debit cards, Stored-value cards, Smart cards, E-

How to measure money?

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4. Understanding interest rates

Credit Market instruments

1. Simple loan (e.g. commercial loans, interbank loans)

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Fixed-payment loan: must be repaid by making the same payment (consisting of a

E.g. Fixed-Payment Loan (LV=1000, FP = 126, n = 25)

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Relationship Between Price and Yield to Maturity

Three Key Facts

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Maturity and the Volatility of Bond Returns

Distinction Between Real and Nominal Interest Rates

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5. The behaviour of interest rates