M pasches money and finance slides

Money and Financial Markets PD Dr M Pasche Friedrich Schiller University Jena Creative Commons by 3.0 license – 2015 (except for included graphics from other sources) Work in progress! Bug Report to: markus@pasche.name S.1 Outline: Financial Markets 1.1 Overview over Financial Markets 1.2 Interest Rate Theory Theory of Financial Structure 2.1 2.2 2.3 2.4 2.5 Financial Intermediates Management of Return, Risk and Liquidity Adverse Selection Problems Moral Hazard Problems Efficient Market Hypothesis and its Limits The Money Supply Process 3.1 3.2 3.3 3.4 Function and Measurement of Money Creation of Central Bank Money Deposit Creation and the Multiplier Endogenous Money Supply S.2 Theory of Money Demand 4.1 Keynesian Theory of Liquidity Preference 4.2 Portfolio Theory of Money Demand Central Banking and Transmission of Policy 5.1 5.2 5.3 5.4 Goals of Monetary Policy Transmission Channels Targets, Strategies, and Rules The Taylor Rule on Macro Models S.3 Basic Literature: ◮ Mishkin, Frederic S (2012), The Economics of Money, Banking, and Financial Markets, 10th ed., Boston et al: Pearson International Edition ◮ Bailey, Roy E (2005), The Economics of Financial Markets, Cambridge: Cambridge University Press ◮ Bofinger, Peter (2001), Monetary Policy: Goals, Institutions, Strategies, and Instruments Oxford: Oxford University Press References to more specific literature can be found in the slide collection S.4 Preliminary time schedule (summer 2015): 17.4 24.4 1.5 8.5 15.5 22.5 29.5 5.6 12.6 19.6 26.6 3.7 10.7 17.7 ch ch (Labor Day) ch.2 ch.2 ch.2 ch.2 ch.2,3 ch.3 ch.3 ch.4 ch.5 ch.5 ch.5 S.5 1.1 Financial Markets Overview over Financial Markets Outline: 1.1.1 Asset Market Classifications 1.1.2 Bond Markets 1.1.3 Loan Markets 1.1.4 Equity Markets 1.1.5 Further Markets Basic literature: Mishkin (2012), chapter and parts of chapter S.6 Financial Markets 1.1 Overview over Financial Markets 1.1.1 Asset Market Classifications (Financial) Asset: Money ⊂ Financial Assets ⊂ All Assets Examples: Currency, checkable deposits, bonds, stock shares, claims from loan contracts, Different assets have different properties: Expected returns (interest rates, dividends, difference in buying and selling price) – an increase in expected returns makes an asset c.p more attractive ⇒ demand will increase Risk (returns may have a variance, possible covariance with other assets) – an increase of risk makes an asset c.p less attractive ⇒ demand will decrease Liquidity (how fast can the asset be sold or used for transactions) – the more liquid the asset is c.p., the more attractive it is ⇒ demand will increase S.7 Financial Markets 1.1 Overview over Financial Markets 1.1.1 Asset Market Classifications Asset markets: In contrast to goods markets (“producer”, “consumer”) it is possible that an individual or an institution is on the supply and the demand side Economic theory is interested into the questions (e.g.): ◮ How different types of agents (e.g banks, non-banks) structure their balance sheet = how they behave on the demand and supply side on the asset markets? ◮ How can the price movements in aggregated markets be explained? S.8 Financial Markets 1.1 Overview over Financial Markets 1.1.1 Asset Market Classifications a) Debt and Equity Markets Debt: ◮ Contractual agreement, where the borrower pays the holder of the asset a fixed amount (interest rate) per period until a specified expiration date (maturity date) The borrowed amount is returned until (or at) the maturity date ◮ The maturity of a debt is the time until the expiration date (short-term < year, long-term > 10 years) ◮ Examples: Consumer loans/credits, mortgages, bonds ◮ Depending on the contract, the borrower can sell the asset, especially bonds S.9 Financial Markets 1.1 Overview over Financial Markets 1.1.1 Asset Market Classifications Equity: ◮ The buyer of an equity has a claim to share the net income and the assets of the seller’s business The net income is an uncertain residual and is often payed as dividends The instrument has usually no expiration date, hence the funds are not returned to the holder of the equity ◮ Example: Stock shares ◮ The holder of an equity can sell the asset e.g on the stock exchange market S.10 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.2 Targeting the money volume The long run relationship between inflation and monetary expansion is an argument for the “neutrality” of money all 110 countries Subsamples: 21 OECD countries 14 latin american countries Correlation with M0 M1 M2 0.925 0.958 0.950 0.894 0.973 0.940 0.992 0.958 0.993 (Source: McCandless/Weber (1995), Some Monetary Facts, in: Federal Reserve Bank of Minneapolis Quarterly Review, Vol.19, M.3, pp.2-11) S.286 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.2 Targeting the money volume In the short run and/or in countries with low inflation rates the correlation is not very strong: (Spahn (2006), p.116) S.287 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.2 Targeting the money volume (Mishkin (2006), p.10) S.288 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.3 Targeting the exchange rate ◮ ◮ ◮ This approach may be reasonable for small open economies with high inflation rates Targeting the exchange rate (to a country with low inflation rate) means to “import stability” The idea is that there exists a relation between the exchange rate and the price level (PT = price level of tradable goods, ∗ indicates the foreign country): PT = ePT∗ P = αPT + (1 − α)PN (38) (39) ◮ Hence, the exchange rate e changes with the difference of inflation rates: ˆT − P ˆ∗ eˆ = P T ◮ If α is large then targeting eˆ ≃ leads to similar inflation rate than in the foreign country S.289 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.3 Targeting the exchange rate ◮ Another mechanism is based on the interest rate parity : If the owner of a financial fund has to decide whether to invest in domesitic or foreign opportunities the no-arbitrage-condition reads like i − i ∗ = eˆexpected ◮ Monetary policy has to take the depreciation expectations into consideration Targeting the exchange rate and thus lowering eˆexpected makes domestic capital markets more attractive and the interest rate is accomodated to i ∗ ◮ Problem: Speculative attacks against the central bank if the targeted exchange rate is expected to be not fundamentally justified S.290 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.4 Inflation Targeting ◮ The idea is that due to the complexity of the transmission process and the limited knowledge about it the operational target or the policy instrument should directly respond to expected deviations of the inflation rate and the targeted inflation rate: ˆe − P ˆ target ), ∆i = β(P β>0 ◮ The central bank is committed to an inflation target Since β could be estimated from central bank’s behavior, this policy rule provides a high transparency ◮ Problem: ◮ ◮ no theoretical considrations about the transmission process low flexibility S.291 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.4 Inflation Targeting Inflation targeting has been a successful policy strategy e.g in New Zealand, United Kingdom, Sweden, Canada (Mishkin (2006), p.503) S.292 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.4 Inflation Targeting (Mishkin (2006), p.503) S.293 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.5 The Taylor Rule ◮ ◮ Taylor, J.B (1993), Discretion versus Policy Rules in Practice Carnegie Rochester Conference Series on Public Policy 9(4), 195-314 ˆ The operating target (real money market interest rate i − P) should respond to the equilibrium real interest rate r0 , the deviation of current and targeted inflation rate, as well as to the “output gap” Y − Y p ˆt + α(P ˆt − P ˆ target ) + β(Yt − Ytp ) ittarget = r0 + P ◮ In case of accelerating inflation the central bank increases the target rate (by + α) In case of a boom where the output gap becomes positive the target rate is also increased (by β) S.294 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.5 The Taylor Rule Taylor (and several others) has shown that the rule is a good empirical description for the behavior of most central banks For ˆ target = 2, the USA Taylor showed that the rule with r = 2, P α = 0.5, β = 0.5 is a good predictor for the Fed policy (Mishkin (2006), p.430) S.295 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.5 The Taylor Rule The results for Germany: (Gischer/Herz/Menkhoff (2005), p.317) S.296 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.5 The Taylor Rule Operationalizing the Taylor rule: ◮ ◮ ◮ ◮ ◮ Inflation is measured e.g by the HCPI Income is measured e.g by the nominal GDP while the production potential has to be estimated (e.g econometric estimation of a production function) Targets for the inflation rate and the “equilibrium” real interest rate may be theoretically justified Different lag structures may be chosen An additional goal may be to smooth interest rates Hence the Taylor interest rate should not fluctuate too much Possible smoothing rule: itsmooth = λittarget + (1 − λ)it−1 S.297 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.5 The Taylor Rule The main advantages: ◮ Very simple and transparent rule ◮ Combines inflation targeting with anticyclical policy It compromises rule-binding with a certain degree of flexibility ◮ Different macroeconomic views of the transmission process are compatible with the rule (i.e it does not depend critically on a specific macroeconomic paradigm) ◮ Empirically robust description of central bank behavior Main problem: How to determine r0 ? S.298 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.5 The Taylor Rule Variants of the Taylor rule: ◮ One problem is that in the original version the central bank responds to realized (=past) changes in the variables ◮ Due to lags there is the danger of procyclical results ◮ It is reasonable that the central bank responds to expected values instead: pot,e e e e ˆt+1 ˆt+1 ˆ target ) + β(Yt+1 i target = r + P + α(P −P − Yt+1 ) S.299 Central Banking and Transmission of Policy 5.3 Targets, Strategies, and Rules 5.3.5 The Taylor Rule Remark: ◮ With given values for Y pot and r the Taylor rule provides a stable relation between i, Y , and P Hence the Taylor rule is a proper replacement of the LM curve in the (i, Y )-diagram ⇒ Course “Monetary Macroeconomics” S.300 ... Selection Problems Moral Hazard Problems Efficient Market Hypothesis and its Limits The Money Supply Process 3.1 3.2 3.3 3.4 Function and Measurement of Money Creation of Central Bank Money Deposit... money market” differs from the term as used in macroeconomics where money is defined in a specific manner Sometimes money market” = market for central bank reserves (e.g interbank market)... Creation and the Multiplier Endogenous Money Supply S.2 Theory of Money Demand 4.1 Keynesian Theory of Liquidity Preference 4.2 Portfolio Theory of Money Demand Central Banking and Transmission