Transcript Chapter 2 of Cecchetti Money and the Payments System

Chapter 2 of Cecchetti
Money and the Payments
System
Money
Money

Money is an asset that is generally accepted as payment
for goods and services or repayment of debt.
1. A means of payment.


Transferability
Information
2. A unit of account


Allocation of resources
Relative prices
3. A store of value

Liquidity
Example: Island Economy
1M florins
1M oz gold
Gold Miner
Blacksmith
Farmer
Teacher
CENTRAL
BANK
“M”=million
Example: Island Economy

Central bank declares it stands ready
to redeem 1 florin for 1 ounce of gold
from anyone at any time.
Balance Sheet of
Central Bank
ASSETS
Gold: 1M fl
LIABILITIES
Currency: 1M fl
Example: Island Economy
1M florins
1M oz gold
gold
Gold Miner
florins
Blacksmith
CENTRAL
BANK
florins
food
lecture
florins
florins
Farmer
Teacher
food
“M”=million
Example: Island economy

Assume no banking system

No bank deposits

Money supply is completely in the form
of currency
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Money supply = 1,000,000 fl
Example: Island Economy
Gold Miner
Blacksmith
Commercial Bank
florins
florins
Farmer
florins
florins
Teacher
Commercial Bank

Initial Purpose:

Keep florins safe
Commercial Bank Balance Sheet
ASSETS
LIABILITIES
Currency 1M fl
Deposits 1M fl
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Why not loan some of those florins
out?
Example: Island Economy
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Bank Reserves: liquid assets held by
banks to meet demands for withdrawls
from investors.
Central Bank mandates bank must
hold some fraction of florins in vaults
called reserves.
Example: Island Economy
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Reserve deposit ratio = currency/deposits
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Assume required reserve deposit ratio = 20%
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Commercial Bank loans out 80% of deposits
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800,000 fl
These are deposited back in the bank
Example: Island Economy
Commercial Bank Balance Sheet
ASSETS
LIABILITIES
Currency 1,000,000 fl
Deposits 1,800,000 fl
Loans
800,000 fl
--------------------------------------------------------Total
1,800,000 fl
1,800,000 fl
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
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Reserve deposit ratio = 1/(1.8) = 60%
Only need .20  1,800,000 =360,000 fl
Can loan out 1,000,000 – 360,000 = 640,000 fl
Deposited back in bank
Example: Island Economy
Consolidated Balance Sheet of Banks
ASSETS
LIABILITIES
Currency 1,000,000 fl
Deposits 2,440,000 fl
Loans
1,440,000 fl
--------------------------------------------------------Total
2,440,000 fl
2,400,000 fl
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Reserve deposit ratio = 1/(2.4) = 42%
Only need .20  2,440,000 =488,000 fl
Can loan out 1,000,000 – 488,000 = 512,000 fl
Does this just go on forever . . . . . ?
Example: Island Economy

Equilibrium is achieved when
Currency/deposits = 0.20
1,000,000/deposits = 0.20
1,000,000/0.20 = deposits
5,000,000 = deposits
Example: Island Economy
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Equilibrium
ASSETS
Currency 1,000,000 fl
Loans
4,000,000 fl
----------------------------Total
5,000,000 fl

LIABILITIES
Deposits 5,000,000 fl
----------------------------5,000,000 fl
Reserve deposit ratio = 1/5 = 20%
Money Supply
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Banks have effect on the money supply
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Bank Deposits
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
In example, no cash is held by public
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Very liquid, can be used for transactions
Are counted as part of the money supply
Money supply = total deposits
Risk of bank runs
Measuring Money
Different Definitions of money based upon
degree of liquidity.
Federal Reserve System defines
monetary aggregates: measures of money
Monetary Aggregates
Link to Current Data
Growth Rates in Monetary
Aggregates
Money and Inflation
Inflation 2 Years Later
14
12
1960-1980
10
8
1990-2000
6
4
2
0
0
2
4
6
8
Money Growth
10
M2 Growth Rate and CPI Inflation Rate 2 years later.
12
14
Changes in Rates
Chapter 6 of Cecchetti
Fluctuations of 1-year T-bond
Rate
1-month T-bill Rate: 1953-2007
Bond Demand and Supply
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From perspective of primary market
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Market in which firms issue debt, sell to investors
Suppliers: Firms and Government
Demanders: Investors
Looking at secondary market, does not allow us
to investigate firm behavior

Market in which investors buy and sell bonds among
themselves
Supply And Demand Curves
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Suppliers
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We could actually have two supply curves
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Government
Firms
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Factors that impact one sector may not
impact the other
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Government and Corporate rates are
connected.
Supply – A Closer Look
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Three agents in economy
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Government
Business
Households
Initial Situation
Increased Gov Borrowing
Shift in Supply
Increase in Government Borrowing
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Government
Borrowing
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An increase in Government borrowing
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The supply curve shifts to the right
Prices to decrease
Yields to increase
A decrease in Government borrowing
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The supply curve shifts to the left
Prices to increase
Yields to decrease
Shift in Supply
Declining Business Conditions
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Business Conditions
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An improvement in business
conditions
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The supply curve to shift to the right
Prices to decrease
Yields to increase
A decline in business conditions
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The supply curve to shift to the left
Prices to increase
Yields to decrease
Shift in Supply
Increase in Corp. Tax Subsidies
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Corp.Tax
Subsidies
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An increase in Corp. Tax Subsidies
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The supply curve to shift to the right
Prices to decrease
Yields to increase
A decrease in Corp. Tax Subsidies
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The supply curve to shift to the left
Prices to increase
Yields to decrease
Shift in Supply
Increase in Expected Inflation
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Expected Inflation
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An Increase in Expected Inflation
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The supply curve to shift to the right
Prices to decrease
Nominal Yields to increase
A decrease in Expected Inflation
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The supply curve to shift to the left
Prices to increase
Nominal Yields to decrease
Demand – A Closer Look

Three agents in economy
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Government
Business
Households
Initial Situation
Increased Household Saving
Shift in Demand
Increased Household Wealth
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Household Wealth
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An Increase in Household Wealth
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The demand curve to shift to the right
Prices to increase
Yields to decrease
A decrease in Household Wealth
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The demand curve to shift to the left
Prices to decrease
Yields to increase
Shift in Demand
Increase in Expected Stock Return
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Expected
Relative Bond Returns
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An Increase in Bond Yield – Return Alt.
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The demand curve to shift to the right
Prices to increase
Yields to decrease
A decrease in Bond Yield – Return Alt.
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The demand curve to shift to the left
Prices to decrease
Yields to increase
Shift in Demand
Decrease in Relative Risk of Bonds
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Relative Bond
Risk
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A decrease in Bond Risk – Risk Alt.
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The demand curve to shift to the right
Prices to increase
Yields to decrease
An increase in Bond Risk – Risk Alt.
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The demand curve to shift to the left
Prices to decrease
Yields to increase
Example: Crowding Out

Increased government borrowing
“crowds out” firms from borrowing
Price
Primary Market for
Government Bonds
Yield
Price
Primary Market for
Corporate Bonds
Yield
Shift in Demand
Increase in Relative Bonds Liquidity
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Relative Bond
Liquidity
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An Increase in Bond Liq. – Liq. Alt.
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The demand curve to shift to the right
Prices to increase
Yields to decrease
A decrease in Bond Liq. – Liq. Alt.
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The demand curve to shift to the left
Prices to decrease
Yields to increase
Shift in Demand
Increase in Expected Inflation
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Changes in Expected Inflation

A Decrease in Expected Inflation
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The demand curve to shift to the right
Prices to increase
Yields to decrease
An increase in Expected Inflation
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The demand curve to shift to the left
Prices to decrease
Yields to increase
Expected Inflation

Expected inflation shifts both curves
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Consider a decrease in expected
inflation
Decrease in Expected Inflation
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Decrease in Expected Inflation
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A decrease in expected inflation
unambiguously causes bond prices to
rise and yields to fall.
Business Cycles
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Business Cycles can shift both curves
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Consider what happens when economy
emerges from a recession.
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Jobs are created, household wealth increases
Business conditions improve
Economy Emerges from Recession
Price
Yield
950
5.3%
900
11.1%
850
17.6%
800
25.0%
750
33.0%
100
200
300
400
Quantity of Bonds ($ billions)
500
Economy Emerges from
Recession
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During expansions
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Wealth increases (demand shifts right)
Business Conditions improve (supply shifts
right)
Effect could be ambiguous
Data shows during expansions

Bond prices decline, yields increase
Credit Markets August 28
Relative Risk of U.S. treasuries has dropped.
Demand curve shifts right. Prices jump up,
yields decline.
Relative return of U.S. treasuries is higher.
Demand curve shifts right. Prices jump up,
yields decline.
Credit Markets July 2
Softer inflation causes demand curve to
shift right, supply curve to shift left. Both
effects cause prices to increase, yields
to decrease.