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ECON 304 Monetary Economics - Everything You Need to Know for Final Exam

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ECON 304
Matthew Doyle

      Fall   16   ECON  304  MONETARY  ECONOMICS   Ingrid  Liu   Introduction  to  Central  Banks  (5)  Central  Banks  and  the  Money  Supply  (6)  Money  and  Prices   (7)  Aggregate  Spending  and  Monetary  Transmission  (8)  Introduction  to  Financial  Markets  (9)   Debt  and  Equity  (10)  Asymmetric  Information  Problems  (11)  Financial  Intermediation  (12)   Banking  and  Leverage    (13)  Hedging  and  Derivatives  &  (14)  Current  Events   University  of  Waterloo   TOPIC 2     WHAT  IS  MONEY?     Problems  with  barter   1) Double  Coincidence   a. Need  sellers  who  wants  to  buy  certain  output   b. Becomes  more  severe  with  variety  of  goods  &  specialization   2) Number  of  Prices   a. 3  goods  -­‐>  3  prices,  1000  goods  =>  499,500  prices   b. General  formula:   C =rn!/[(n!t)!r!]   3) Other  Impracticalities   –  storage  &  transport     Properties  of  Money   1) Unit  of  Account   a. Measures  all  prices  in  terms  of  it   b. Reduces  number  of  prices   2) Store  of  Value   a. Some  value  is  durable   b. Doesn’t  have  to  be  only/best  store  of  value   3) Medium  of  Exchange   a. Uses  money  to  trade  for  other  goods   b. Reduces  double  coincidences     Money  is  memory    When  trading  –  important  to  keep  track  of  who  has  right  to  takes  goods  by  virtue  of  having  contributes  goods    Money  helps  keep  track  because  the  only  way  to  get  money  is  to  have  alr eady  produced  &  sold  goods         TOPIC   3   INTRODUCTION  TO  INTEREST  RATES     Debt  Instrument:  device  by  which  you  can  borrow  some  money  now,  and  pay  some  money  back  in  future   -­‐ Loans,  bonds     Different  Varieties    Simple  Loan     borrow  now,  pay  back  later  with  interest    Fixed-­‐Payment  Loan   borrow  now,  pay  a  set  amount  each  month    Zero-­‐Coupon  Bond   pays  back  only  at  maturity    Coupon  Bond     regular  payment  to  bondholder  (specified  final  payment  at  maturity)     General  formula  for  simple  interest,  where   I  is  interest  rate  and  n  is  number  of  years:   P = A*(1+i) n     CF Generally,   PV = n ,  where  PV  =  present  value  and  CF  =  cash  flow   (1+i)   Yield  to  Maturity  (YTM):   (constant)  interest  rate  that  equates  PV  of  stream  of  cash  payments  from  debt  instrument   to  its  value  today    Measure  of  interest  rate    For  simple  loan,  YYM  =  simple  interest  rate  (i)     Yield  to  Maturity:  Bonds   $100 $100 $100 $1000  P = + + +...+   (1+i) (1+i) 2 (1+i) 3 (1+i) 10  When  P  =  face  value  of  bond     i  (YTM)  =  coupon  rate    When  P  falls,  i  rises     Rate  of  Return   Two  parts   -­‐   Coupon  Payment       -­‐   Capital  Gain     Nominal  Rate  of  Interest   Interest  without  inflation   Real  Rate  of  Interest     $1  next  year  doesn’t  have  same  buying  power  as  $1  this  year           About  purchasing  power  of  financial  asset           r  =  i  –  m     Term  Structure  of  Interest  Rates    Interest  rate  on  bonds  at  different  maturities  move  together    Yield  curve  plot  of  interest  r ates  of  similar  bonds  of  different  maturities   -­‐>  describe  term  structure  of  rates    3  other  facts:   o Interest  rates  move  together   o Almost  always  slopes  upward   o More  likely  to  slope  upwards  when  short  rates  are  low  (and  vice  versa)         Expectations  Theory   Yield  on  a  long-­‐term  bond  should  equal  average  of  interest  rates  on  (future)  short -­‐term  bonds    Bond  prices  adjust  to  equalize  expected  yields    Shape  of  yield  curve  depends  on  expectations  of  future  short  rates   o If  short  rates  expect  to  rise    long  rates  will  be  above  current  short  rates   o If  long  rate  is  average  of  today’s  (low)  short  rate  and  expected  (high)  future  rates     Segmented  Markets  Theory   • Bonds  of  different  maturities  are  not  substitutes   o Implies  each  maturity  is  a  different  market   o Different  traders  want  bonds  o f  different  maturities   • Investors  generally  prefer  bonds  with  shorter  maturities  (less  interest  risk)     Liquidity  Premium  Theory   • Bonds  are  imperfect  substitutions   • Trades  want  equalized  return   • Some  bonds  have  characteristics  that  allow  them  to  pay  lower  inter est     Short-­‐term  Bonds   More  liquid  than  long  term  bonds         Less  interest  rate  risk     All  else  equal,  traders  would  prefer  short -­‐term  bonds     Use  of  the  Yield  Curve   • Shape  –  contains  information  about  market  expectations  of  future  short  rates   • Information  on  very  short  and  long  run  in  yield  curve   • Central  bank  cut  short  rates  during  economic  downturns     yield  curve  as  forecaster  of  future  recessions         TOPIC   4   INTRODUCTION  TO  CENTRAL  BANKS     Overview   • Quasi-­‐government  agency  (crown  corporation     all  shares  held  by  Minister  of  Finance)   • Responsibilities  for  Canada’s  monetary  policy,  bank  notes,  financial  system  and  funds  management     Roles  of  Bank  of  Canada   1) Issue  Currency    Issue  currency  (notes)    Preserve  integrity  of  Canadian  currency   2) Financial  Services  to  Government    Provides  gov’t  debt  and  asset  management  services    Administers  bondholder  accounts    Manages  foreign  exchange  reserves   3) Central  Bank  Services    Lender  of  last  resort    Regulatory  oversight  of  Large  Value  Transfer  System  (LVTS)   -­‐-­‐>  overnight  instant  liquid  transfer    Holds  deposits  of  federal  gov’t  and  other  financial  institutions   4) Monetary  Policy    Control  of  money  supply     open  market  operations    Targets  overnight  rate  by  borrowing  from  and  lending  to  financial  institutions    Low  and  predictable  inflation         TOPIC   5   CENTRAL  BANKS  AND  THE  MONEY  SUPPLY     Bank  of  Canada  Balance  Sheet         Assets           Liabilities       Government  Securities       Notes  in  Circulation       Advances  to  Banks       Settlement  Balances     Monetary  Base:  currency  +  settlement  balances  (called  high  powered  money)     Bank  Reserves       Currency  =  Vault  Cash  +  Circulating  Currency   Bank  Reserves  =  Settlement  Balances  +  Vault  Cash     Monetary  Base  (MB)  =  Circulating  Currency  (C)  +  Bank  Reserves  (R)       MB    =     Liabilities  of  Currency     +     Settlement  Balances         -­‐    Circulating  Currency     -­‐    Settlement  Balances         -­‐    Vault  Cash     MB   =   Circulating  Currency   +     Bank  Reserves     Large  Value  Transfer  System  (LVTS)   • Electronic,  real  time  settlement  network   • Clears  payments  in  real  time     Overnight  Rate   • Banks  (and  other  financial  institutions)   often  want/need  to  borrow  money  for  short  periods  of  time    Overnight  market   • Overnight  rate:  interest  rate  at  which  borrowing  and  lending  takes  place  ( price  of  liquidity)     Operating  Band   • BOC  conducts  monetary  policy  by  intervening  in  overnight  market   • Operational  objective:  keep  overnight  rate  within  band  of  50  basis  points  (target  is  midpoint)   • Upper  bound  is  bank  rate    Interest  rate  BOC  always  willing  to  lend  to  LVTS  participants    BOC  stands  ready  to  lend  any  amount  at  this  rate   • Lower  bound  is  interest  rate  on  settlement   balances    Willing  to  borrow  any  amount  at  this  rate     Repos,  or  Special  Purchase  and  Resale  Agreements  (SPRAs)    Buy  government  T-­‐bills  or  bonds,  and  sell  them  back  tomorrow    Note  that  this  is  the  same  as  the  Bank  of  Canada  lending  money  overnight    When  it  buys  the  bonds,  it  lends  out  cash,  and  when  it  sells  them  back,  it  gets  cash  back    Choose  the  prices  to  work  out  to  the  target  overnight  rate     Reverse  repos,  or  Sale  and  Repurchase  Agreements  (SRAs)    Sell  government  t-­‐bills  or  bonds,  and  buy  them  back  tomorrow    Note  that  this  is  same  as  Bank  of  Canada  borrowing  money  overnight    When  it  sells  bonds,  it  borrows  cash,  and  when  it  buys  them  back,  it  pays  cash  back    Choose  the  prices  to  work  out  to  the  target  overnight  rate   TOPIC   6   MONEY  AND  PRICES     The  Quantity  Equation     M !V = P!Y     where   M     Some  measure  of  money   V   Velocity  of  money  (avg  no  of  times  per  yr  that  $  is  spent)               P   Price  level             Y     Real  aggregate  income  (real  GDP)     The  Quantity  Theory  of  Money    Place  restrictions  on  behaviour  of  variables  in   quantity  equations    M !V = P!Y   Assume  V  is  fixed  or  exogenous    Changes  in  M  are  reflected  in  changes  in  nominal  income  (either  P  or  Y)    M !V = P!Y    Prices  change  proportionally  with  money,  no  effect  on  output    Money  is  neutral     Monetary  Neutrality  –  Weak  Form    Suppose   (2!M)!V = (x!P)!Y    x  must  equal  2    Monetary  neutrality :  an  increase  in  stock  of  money  leads  to  proportional  increase  in  price  level    Changes  in  level  of  money  supply  have  no  effect  on  real  activity     Monetary  Superne utrality    Monetary  superneutrality :  an  increase  in  growth  rate  of  stock  of  money  leads  to  proportional  increase  in   growth  rate  of  price  level    Changes  in  growth  rate  of  money  supply  have  no  effect  on  real  activity     Neutrality:  Short  Run    Is  money  neutral  (or  superneutral)  in  the  short  run?    Few  people  think  so    Changes  in  supply  of  money  appear  to  affect  real  activity  in  short  run    Sticky  prices,  other  transmission  mechanisms    Many  economists  think  that  increasing  the  money  supply  causes  output  to  rise  in  short  ru n     Neutrality:  Long  Run    Theoretically  reasonable    Suppose  added  some  zeroes  to  all  nominal  quantities    LR  neutrality  falls  out  of  many  models     Superneutrality:  Extreme  Cases    Absolutely  100%  sure  money  is  not  superneutral    Hyperinflation    Monetary  system  brea ks  down  and  real  activity  affected    Intermediate  Cases:  less  clear    little  correlation  between  money  and  output  growth         TOPIC   7   AGGREGATE  SPENDING  AND  MONETARY  TRANSMISSION     Monetary  Transmission   Standard  theory  of  why  money  affects  output  in  short  run     Two  steps   Output  determination       Monetary  factors     Model  of  Output  Determination:  Keynesian  Cross     Spending  determines  output     Two  key  assumptions:   1. Aggregate  spending  fluctuates   2. Prices  don’t  adjust  in  short  run  (sticky  prices)     p P AE =C+I +G+NX           I    includes  inventory  accumulations         Depends  on  decisions  of  consumers  and  firms     P     I > I     If  firms  sell  less  than  expected     Let  some  components  of  spending  depend  on  income:   C =C+b(Y !T)   C =  Portion  of  consumption  that  doesn’t  depend  on  income     AE =C+bY !bT +I + NX +G P   P P AE =[C!bT +I + NX +G]+bY P AE = A+bY     * P At   ,   =Y   Equilibrium   There  is  enough  output  for  everyone  to  meet  spending  plans   Therefore,  no  need  to  change  behavior     P A =C+I +G+ NX !bT   Notes:  at  Y*,  planned  spending  =  output   P  Firms  accumulate  desired  amount  of  inventories,   I = I    Y*  is  equilibrium   i. Given  what  everyone  else  is  doing,  I  have  no  incentive  to  change  behaviour   ii. Statement  i.  is  true  for  eve ryone     Extend  basic  model  to  incorporate  monetary  factors:     Allow  spending  decisions  to  depend  on  interest  risks         PROBLEM  SET.    Suppose  central  bank  conducts  expansionary  monetary  policy.    Outline  all  of  the  steps  by  which  the   policy  affects  output,  acco rding  to  the  standard  interest  rate  channel  of  monetary  transmission.             Central  bank  increases  money  supply  by  buying  bonds  &  adding  money  into  circulation.   * At L 0  people  don’t  want  to  hold  more  money     central  bank  increases  bond  p rices  up     *  Bond  yields  are  inversely  related  to  bond  prices     drives  yield  down  Lti )  assuming  expected   inflation  is  sticky  and  yield  curve  shifts    Fall  in  short  nominal  rates  drives  long  real  rates  down   When  r  falls,  firms  find  it  che aper  to  finance  investment    Investment  rises    planned  aggregate  expenditure  rises   at   AE 0 ,  but SR output  is  below  spending   0  Firms  depleting  inventories  faster  than  desired,   assuming  that  prices  are  slow  to  adjust    Firms  respond  by  increasing  production   As  Income  rises,  consumer  spending  rises     additional  rise  in  planned  spending  etc   Until   * is  reached   SR1   Monetary  Policy     Expansionary  Monetary  Policy   !m "#i " r#"!I " AE !"Y ! P     Contractionary  Monetary  Pol icy   P !m "#i " r#"!I " AE !"Y !     In  the  long  run,  expect  prices  to  adjust  to  monetary  policy   Essential  tradeoff  of  monetary  policy:  between   output  and  inflation     Problems     (A)   General/Theoretical  Complaints  About  Model     I. Model  of  Aggregates    No  individual  decision  problems    Decisions  modeled  as  if  decision  makers  have  fixed  rules  of  behaviour    Used  these  models  for     Forecasting   Policy  Analysis       II. Policy  maker  is  not  modeled  sensibly   –  should  incorporate  policy  reaction  function   III. Static  Model  of  Dynamic  Process    Makes  it  difficult  to  incorporate  expectations    Tends  to  imply  current  policy  is  less  important  than  expected  future  policy   IV. No  real  financial  sector    No  banks,  debts,  imperfect  information  functions…     (B)   Concerns  About  Standard  Rate  Transmission  Mechanism     I. Magnitude    Standard  channel  works  via  cost  of  capital    Difficult  to  find  quantitatively  important  effects  of  cost  of  capital  on  investment   II. Timing    Empirical  work  doesn’t  show  close  timing  of  supposed  cause  &  effect   III. Price  Stickiness    How  sticky  do  prices  have  to  be  t o  get  realistic  non-­‐neutralities?    Median  actual  price:  changes  every  4  months    Model:  requires  several  quarters  of  rigidity  to  generate  persistent  non -­‐neutralities     Monetary  Transmission  Mechanisms    Standard  Interest  Rate  Channel    Exchange  Rate  Channel   P !m "CDN$#"!NX " AE !...    Tobin’s  q  Theory   !m "!P assets"  more  expensive  to  raise  cash  by  issuing ! I"! AE "   P    Household  Wealth  Effects   !m "!P "!wealth " AE ! P   assets       TOPIC   8   INTRODUCTION  TO  FINANCIAL  MARKETS     Overview  of  Financial  Sector     Matching  up  borrowers  and  savers     Advantages      De-­‐couple  consumption  from  income    Move  purchasing  power  through  time    Finance  investment:   i. Capital   ii. Human  Capital   iii. Research  &  Development           TOPIC   9   FINANCIAL  INSTRUMENTS     Two  main  classes  of  instrument    Debt  instrument     Borrower  agrees  to  make  specified  set  of  payments  (bonds,  loans)    Equity  instrument   Borrower  agrees  to  give  lender  on  ownership  stock  in  enterprise  (stocks)     Debt   Pros   Known  payments     Only  risk  is  default  (debt  holders  have  priority  claims  on  incoming  money)   Cons   No  upside  if  enterprise  succeeds  big     Equity   Pros   Big  payoff  in  good  case   Cons   Paid  poorly  in  bad  case     Primary  vs.  Secondary  Markets     Primary  Markets   Issue  new  securities  (where  borrowing  &  lending  happens)     Secondary  Markets   Trade  existing  securities  (no  new  borrowing  &  lending,  pricing  existing  claims)     Direct  vs.  Indirect  Finance     Direct  Financing     Borrow  directly  from  ultimate  lenders  (bonds)     Indirect  Financing   Borrow  from  a  financial  intermediary  (bank)     Advantages  of  Indirect  Finance    Expertise  in  evaluating  leading  opportunities    Economies  of  scale  in  servicing  loans  (monitoring,  collecting)    Diversification/pooling  of  savings     LEVERAGE   Borrowing  money  to  purchase  a n  (financial)  asset     Investor  earns  difference  between  return  on  asset  and   cost  of  borrowing  for  each  dollar  borrowed.   If  return  is  (-­‐),  then  investor  loses  money  on  each  dollar  borrowed.     Example:   Asset  returns  -­‐10%       Cost  of  borrowing  5%     No  leverage:  invest  $10,000  =>  lose  $1,000     Leverage:  invest  my  $10,000  +  $10,000  borrowed  money       Returns:  $18,000  and  owe  bank  $10,500       Leaves  $7,500  and  lose  $2,500     Leverage  magnifies  return  on  good  investment  &  loss  on  bad  investment         Modigliani-­‐Miller  Theorem   Basic  Idea:  both  debt  and  equity  are  claims  on  future  profits  of  firm     EXAMPLE  1.    Firm  generates  $100  in  profits   (A)   Sell  100%  of  equity  and  issue  no  debt       Value  of  equity       $100       Value  of  debt     $0                   $100   (B)   Borrow  $50  then  sell  the  100%  of  equity       Value  of  debt     $50       Value  of  equity     $50             $100     EXAMPLE  2.  Dairy  farmer  sells  milk.   (A)   Sell  the  whole  milk   (B)   Split  milk  into  cream  and  skim  milk   –  sell  them  separately     Theorem:  Value  of  whole  milk  has  to  equal  value  of  cream  +  skim  milk     Suppose  Vm  >  Vc  +  Vs     Should  buy  cream  and  skim  milk   –  mix  together  to  get  whole  m ilk     REQUIREMENTS    Need  to  be  able  to  costlessly  split  and  join    Need  to  be  able  to  make  trades  costlessly    Need  to  be  able  to  leverage    Tax  treatment  has  to  be  the  same    No  asymmetric  information    No  default         TOPIC   10   ASYMMETRIC  INFORMATION     Lack  of  information  isn’t  important  in  economics   What  matters  more:  when  one  party  to  a  transaction  knows  more  than  the  other     Two  Types  of  Asymmetric  Information     I. Moral  Hazard    Informational  problem  occurs  after  loan    Cannot  observe  what  you  will  do  with  money    Needs  incentives  to  be  misaligned  (usually  the  case)   EXAMPLE   Makes  a  loan  –  wants  maximization  to  pay  back       Borrower  obtain  money,  but  might  like  high -­‐risk,  high-­‐reward  strategies   PROBLEM   Can’t  obser
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