Course Outline 320.326 (KS) WS 2014-15 Monetary Economics and the European Union

Instructor: Professor Robert J. Hill Office: 04-F-28 Telephone: 380-3442 E-mail address: [email protected]

Consultation times for summer semester 2014: Mondays 10:00-12:00 Textbooks: Mishkin F. S. (2006), The Economics of Money, Banking and Financial Markets, Pearson: Addison-Wesley, Eighth Edition (MK) De Grauwe P. (2012), Economics of Monetary Union, Oxford University Press, Ninth Edition (DG) Assessment: Class participation Midterm exam Final exam 5 percent 40 percent 55 percent

Provisional Lecture Schedule

Week 1 – (28 October 2014) – Uses of money, commodity and fiat money, and the quantity theory of money MK – Chapters 3, 18, 19 Week 2 – (4 November 2014) – Keynes theory of liquidity preference, Hicks and ISLM MK – Chapters 19, 20, 21 Week 3 – (11 November 2014) – Friedman and monetarism MK – Chapters 19, 23 Week 4 – (18 November 2014) – Rational expectations and optimal policy design MK – Chapter 25 (supplemented by additional readings) Week 5 – (25 November 2014) – Tutorial covering material from Weeks 1-4 Week 6 – (2 December 2014) – Midterm exam

Week 7 – (9 December 2014) – Inflation targeting MK – Chapter 16, 23 (supplemented by additional readings) Week 8 – (16 December 2014) – Lessons from the global financial crisis (assigned readings) Week 9 – (12 January 2015) – Optimum currency areas and the costs and benefits of monetary union (including lessons learned from the Eurozone crisis) DG – Chapters 1-5 Week 10 – (13 January 2015) – The transition to monetary union in the European Union and the European Central Bank – DG – Chapters 6-8 Week 11 – (19 January 2015) – Monetary and fiscal policy in the European Union – DG – Chapters 9-11 Week 12 – (20 January 2015) – Tutorial covering material from Weeks 7-10 Week 13 – (27 January 2014) – Final exam

The lecture overheads and tutorial questions will be posted on the institute website. Click on

http://volkswirtschaftslehre.uni-graz.at/

Then select "Lehren".

Then scroll down until you find my name and select it.

320.326: Monetary Economics and the European Union Lecture: Week 1 Instructor: Prof Robert Hill Uses of Money, Commodity and Fiat Money, and the Quantity Theory of Money Mishkin – Chapters 3, 18 and 19

1. What Is Money?

(i) A unit of account Consider an economy consisting of N commodities. Money reduces a matrix of N(N-1)/2 relative prices (see next slide) to a vector of N-1 prices that market participants need to keep track of. (Note P AB = 1/P BA ) The prices should be transitive, i.e., P AB × P BC = P AC For example: suppose 1 apple trades for 2 bananas, and 1 banana trades for 3 carrots. Then one apple should trade for 6 carrots.

Otherwise there will be arbitrage opportunities.

If the no-arbitrage condition holds, then it follows that P BC = P AC /P AB = 6/2 = 3 That is, all the relative prices in the matrix (next slide) can be derived by taking ratios of pairs of prices from the first row (i.e., P AB , P AC , P AD and P AE ).

Apples Bananas Carrots Doughnuts Eggs Apples 1 p BA p CA p DA p EA Bananas p AB 1 p CB p DB p EB Carrots p AC p BC 1 p DC p EC Doughnuts p AD p BD p CD 1 p ED Eggs p AE p BE p CE p DE 1 where p AB is the price of one apple measured in units of bananas.

When apples are the unit of account, all we need to consider are the prices p BA , p CA , p DA , and p EA (i.e., the first column of the matrix).

(ii) A means of payment (medium of exchange) A medium of exchange eliminates the need for a double coincidence of wants or complicated sequences of transactions.

By dramatically reducing the transaction costs of trading, the existence of money encourages the division of labour. Everyone can then focus on producing whichever good or service they have a comparative advantage in and then trade. This increases total output as compared with a situation where everyone tries to be self sufficient.

Example: suppose you want to sell apples and buy eggs.

You could try and find someone who wants to do the reverse transaction (i.e., sell eggs and buy apples). This is called a

double coincidence of wants

.

8

Such a person may not exist.

The alternative, in the absence of money is to find a path from apples to eggs.

For example, suppose you find someone who is willing to swap eggs for carrots. Now if you can find someone who is willing to swap carrots for apples, you can get to your desired outcome in two steps. Or perhaps you find someone willing to trade carrots for bananas. Now you seek someone willing to trade bananas for apples, etc. Clearly, without money, trading is a complicated, time consuming and ‘hit and miss’ process. With money, all you need is to find a person X who wants to buy apples and another person Y who wants to sell eggs. It does not matter what person X wants to sell or what person Y wants to buy.

(iii) A store of value The store of value function of money allows a temporal separation of selling and buying.

Other assets are also stores of value (e.g., houses, cows, shares, works of art).

Money is the most liquid asset. Liquidity is defined as the relative ease and speed with which an asset can be converted into a medium of exchange.

Example: If you want to sell your house quickly, you may have to settle for a lower price. How good a store of value money is depends on the rate of inflation. A doubling of the price level implies a halving of the value of money. Under high inflation, people no longer want to hold much money since then it is no longer a good store of value.

2. Commodity Money

A commodity (e.g., cattle, salt, seashells, beads, cigarettes, gold, silver) is used as money. A suitable candidate should have the following properties: (i) easy to standardize (ii) easy to transport (iii) widely accepted (it must be perceived to have some intrinsic value and be sufficiently scarce) (iv) durable (v) divisible (vi) easy to store Most commodities are difficult to carry around in large amounts. Hence there is a role for banks that issue banknotes (or IOUs) linked to the commodity money. In most countries, the issue of banknotes eventually became the preserve of the central bank.

The money supply in such cases consists of the banknotes in circulation and deposits at banks rather than the commodity itself.

A commodity standard exists when a country maintains an equality between the value of a domestic monetary unit and a specified amount of the commodity.

In 1816, the value of a pound sterling was set equal to 113 fine grains of pure gold. There are two main problems with a commodity standard: (i) An otherwise useful commodity is diverted for monetary use. The use of banknotes convertible into the commodity partially alleviates this problem.

(ii) The money supply will vary over time in response to changes in the availability of the commodity. Example: Under a gold standard, the discovery of a new gold mine causes a loosening of monetary policy.

This is because the new discovery increases the supply of gold, and hence pushes down its price. This means that the price of everything else expressed in units of gold (and the currency) rises. In other words, the discovery generates inflation.

It would be better if changes in the money supply were deliberate acts of a central bank rather than somewhat random events.

From 1816 to 1851, prices fell in Britain, after which they rose until 1873, before falling again until the end of the century.

These inflations and deflations can be explained as follows: 1816-1851: the increase in the supply of gold did not match the rate of economic growth 1851-1873: large increase in the supply of gold from California 1873-1895: In 1850 only Britain and Portugal were on the gold Standard. By 1880 America and almost all of Western Europe had also adopted it. This increase in demand for gold pushed up its price. 1895-1913: New discoveries of gold in the Transvaal and the Klondike and new mining technologies saw gold production rise.

Falling prices caused real interest rates to rise imposing considerable hardship on borrowers (the nominal interest rate cannot become negative). This encourages households and firms to delay purchases and discourages investment. Together these effects could push the economy into recession.

3. Bretton Woods

The Bretton-Woods system was adopted in 1945. It was an attempt to get back to the stability of the gold standard system of fixed exchange rates that existed prior to 1914. All currencies were fixed against the dollar (within 1 percent bands). Only the US dollar was convertible into gold (at $35 per ounce). Only central banks could trade dollars for gold.

Periodically, rates could be adjusted (e.g., the pound sterling in 1949 was devalued from $4.03 to $2.80. In 1967 it was again devalued from $2.80 to $2.40). Bretton Woods collapsed in 1971 and was replaced by a system of floating exchange rates.

Why did Brettons-Woods collapse?

(i) Governments were supposed to intervene in the foreign exchange markets (with the assistance of the IMF if necessary) to maintain their exchange rate within the allowed range. This could be difficult because of: (a) Imbalances in the purchasing power of currencies: Countries with higher inflation rates end up with overvalued currencies and current account deficits (since imports become cheaper and exports more expensive).

(b) Balance of payments crises: A country running a current account deficit must sell foreign exchange reserves if it wishes to maintain the peg. Britain had to devalue in 1949 and 1967 as it was running out of foreign exchange/gold reserves.

(ii) Revaluations could create arbitrage opportunities – although only central banks could really exploit these opportunities.

(iii) Rising inflation in the US in the late 1960s (partly due to the Vietnam war) caused the price of gold on the open market to rise significantly above $35 per ounce. Central banks therefore had an incentive to buy gold at the Brettons-Woods price from the US Federal Reserve and then sell on the open market (another arbitrage opportunity).

4. Fiat Money

The abandonment of Bretton Woods led to the emergence of

fiat

money.

Fiat money is not backed by any commodity. Its intrinsic value depends on the reputation of the central bank.

5. Can Fixed Exchange Rates Still Work – the Case of the ERM?

The European Exchange Rate Mechanism (ERM) was supposed to maintain exchange rate fluctuations for European currencies within 6 percent bands.

Britain joined the ERM in 1990. The joining rate of 2.95DM soon came to be seen as overvalued (largely due to relatively high inflation in the UK). Speculators started betting on a depreciation of the pound by converting pounds into DM. Note: unlike under Bretton-Woods, capital controls no longer existed. To maintain the exchange rate, the British government had to sell its foreign exchange reserves. When it became clear this strategy was not sustainable, British abandoned the ERM in 1992. George Soros made over $1 billion from betting on a depreciation of the pound.

Soros borrowed in pounds and converted them into DM. After the depreciation he converted back into pounds, paid off the loan and had more than $1 billion left over.

6. What Are the Alternatives to the ERM?

Even with draconian capital controls it might not be possible to maintain a fixed exchange rate (due to balance of payment imbalances and differing inflation rates).

Capital controls usually take the form of taxes on foreign exchange transactions and/or restrictions on the amount of domestic currency that can be taken out of the country.

Such capital controls are no longer an option given the extent of globalization.

This leaves the international community with two alternatives: (i) Monetary union (ii) Floating exchange rates

7. The Demand for Money

Equilibrium in the money market depends on the demand and supply of money. What determines the demand for money?

The first answer to this question was provided by the Classical Quantity Theory of Money.

The quantity theory of money is particularly associated with Irving Fisher and his 1911 book entitled “The Purchasing Power of Money”. It starts from the following

equation of exchange

: MV = PY M = money supply V = velocity of circulation of money (spent on final goods) P = price level Y = real income (or output) 20

As stated, this equation is an identity (i.e., it is true by definition).

Assuming that V and Y are constant in the short-run, it explains why P falls when M falls and P rises when M rises. This is consistent with Britain’s inflation/deflation experience in the 19 th century under the gold standard.

The quantity theory of money transforms from an identity to a theory of the demand for money with two assumptions: (i) Velocity is constant (ii) The money market is in equilibrium (i.e., M s = M d ) Irving Fisher argued that velocity is determined by the institutional and technological features of an economy which are reasonably constant in the short run. Example: increased use of credit cards will act to increase velocity.

21

Taking velocity over to the right hand side M = (1/V) PY When the money market is in equilibrium, M = M d . Now setting (1/ V) = k, we obtain that M d = k PY The nominal demand for money is a linear function of nominal income.

or M d /P = k Y Real money demand is a linear function of real income. 22

Is velocity constant?

See Figure 1 in Mishkin (2006), chapter 19, p.496.

Velocity fluctuates quite a bit in the short run. Furthermore, it tends to rise systematically in booms and fall in recessions. The classical economists did not know this, since they did not have access to the required data. National accounts (which measure P and Y) had not yet been invented.

Hence the premise on which the quantity theory of money is based (i.e., that V is constant) seems suspect.

23

24