Introduction to Financial and Monetary Economics
- Read: Mishkin and Serletis, Ch. 1
- Two halves to the course:
Financial economics: economics of the financial system
Monetary economics: economics of money and monetary policy.
The Financial System:
- a set of interrelated markets for financial assets
e.g. bond or stock markets
- a set of the financial institutions that deal in these assets.
e.g. banks, mutual funds, insurance companies.
- a set of government institutions and regulations
- Various regulatory bodies.
- A “central bank” (Bank of Canada).
Financial economics:
It’s concerns:
- What does the financial system do? Why is it important? How well does it
perform?
- Modeling and explaining financial market outcomes
- what determines asset prices and returns on various assets?
- explaining the structure of asset prices and interest rates.
- explaining the quantities and variety of financial assets.
- why do financial intermediaries exist? what do they do?
It’s Methods:
- A microeconomic approach:
- financial market outcomes reflect choices of many decision-makers.
- individual lenders and borrowers (households, businesses)
- managers and owners of financial institutions
- governments (as lenders, borrowers and regulators)
- outcomes are explained by modeling these decisions and their
interactions.
Monetary economics:
It’s concerns:
- Focus is on money and the economy.
The economic roles of money
History and types of monetary systems: past, present, future
Money creation and money supply control: methods
Money and financial markets: credit conditions, interest rates.
Money and the macroeconomy: effects on inflation, output,
employment.
Central banks: roles? methods?
Monetary policy: what should the central bank do? Why?
It’s approach:
- A macroeconomic approach:
a focus on aggregate variables: “interest rate”, inflation, aggregate
demand and its components.
Why teach financial and monetary economics together?
- Money is one of many financial assets.
- Banks are key players in money creation and in the financial system.
- Central banks conduct monetary policy through financial markets often
with the objective of influencing financial variables (interest rates,
assets prices).
- Central banks are often involved in regulation of financial institutions and
financial markets and play a role in promoting the stability of
financialinstitutions.
- So: lots of overlap and connections between the two fields!
Money: Functions, Origins and Measurement Questions
- Read: Mishkin and Serletis, Ch. 3.
What is money?
- In everyday language money, income and wealth are often used interchangeably.
- To an economist they are quite different concepts.
- What exactly is money?
Money: Anything that is normally accepted in exchange when goods, services and
assets are sold and when debts are repaid.
- Money plays three main roles in an economy.
Money acts as a:
(1) Medium of exchange
(2) Unit of account
(3) Store of value
Economic Roles of Money
(1) Medium of Exchange (Means of Payment)
- Money is generally acceptable in exchange for goods and services
i.e. it is a medium of exchange.
- An economy without a medium of exchange will be quite inefficient.
- Barter economy: no medium of exchange, exchange goods for goods.
- Problem:exchanges require a "double coincidence of wants".
- This makes exchange time consuming:
must find a matching buyer or seller, or
must arrange a sequence of exchanges.
- Results of not having a medium of exchange:
- wasted resources: more time and effort on exchange rather than on
production or leisure.
- specialization is discouraged (specialists: must make many
exchanges to meet their needs)
(modern economies are very specialized!)
Medium of Exchangerole of money: Confidence
- To act as a medium of exchange people must beconfident that others will
accept “money” as payment.
- How to establish confidence?
- Could use something with intrinsic value as money e.g. gold, silver.
- historically a popular solution.
- But modern money is usually something that has little intrinsic
worth.
e.g. paper or plastic bills; coins made from metals with little value.
- If money is something of little value its ability to be a medium of
exchange relies on a general expectation that others will accept it.
i.e. social convention; game theoretic equilibrium.
- I accept it because I believe others will too. Others believe the same.
- Most modern monies are like this.
- Can this social convention equilibrium break down? YES.
Failed currencies: people refuse to accept it.
e.g. Zimbabwe dollar in 2009.
Why? Store of value problems (see below)
Medium of Exchange function of money: Confidence (cont’d)
- New forms of money and the confidence problem
- In recent years we have seen attempts to create new types of money.
e.g.digital money like Bitcoin
- Problem for digital currencies: how do you create confidence?
- starting out a big problem:
- new: few use it, not generally acceptable
- so: is of little value to other possible users;
- so: few new users opt to use it – remains not
generally acceptable.
- Can governments overcome the confidence problem?
- medium of exchange by law? “fiat money”
(probably not enough: still needs to be acceptable)
- can place a floor on its value: government will always accept
it as payment for taxes or in exchange for government services. i.e. always acceptable to government.
- Governments can destroy confidence by reducing the value of money:
inflation, devaluation.
(2) Unit of Account Role
- Unit of Account: unit in which we measure, record and compare values.
e.g., Canada: dollars and cents.
- Money is almost always denominated in terms of the unit of account.
- Importance of a unit of account?
- Economic decisions involve comparisons of costs and benefits.
- Such comparisons are more difficult if there is no common
unit of account.
- With no unit of account “prices” are in terms of units of one good
per unit of another good.
i.e. many prices for any given good vs. a single money price if
money serves as a unit of account.
- Lack of a unit of account complicates comparisons and raises
transactions costs.
(N goods: N money prices or N∙(N-1)/2 goods-for-goods prices)
- A particular money can only play this role if others also choose to use it as a unit
of account.
- Historical cases where money and unit of account differed.
e.g. values measured in terms of an older, defunct currency unit.
(3)Store of Value Function of Money
- Money acts as a store of value
- Money provides a means by which purchasing power can be
transferred from the present to the future.
- Why is this important?
- Reduces costs of exchange: don’t have to obtain new
purchasing power each time an exchange is made.
- Adds flexibility to decision-making: exchanges are not tied to current
income.
- Other real and financial assets are also stores of value.
- An advantage of money as a store of value: it is also the‘medium of exchange’
- money is the most “liquid” store of value
Liquidity: ease and speed with which an asset can be converted into
medium of exchange.
- other assets must be converted to medium of exchange
(may be costly; may add risk: price can change).
(3)Store of Value Function of Money(cont’d)
- Disadvantage of money as a “store of value”?
- inflation (rising prices) erodes its purchasing power;
- The ability of money to act as store of valuedepends upon its ability to
retain its real value over time.
- Store of value role of money links financial markets and money.
- money is a substitute for other stores of value such as bonds.
i.e., one asset in a decision maker's portfolio.
- changing the supply of money will affect other asset markets.
- decision makers will alter their desired portfolio in response to the
change in the money supply
(James Tobin’s approach to monetary economics)
Recessions: a Problem only for Monetary Economies?
- The three roles of money imply that the existence of money makes
economies perform better, raising well-being.
- A possible problem?
- Many macroeconomists argue that recessions are caused by a shortfall in
overall (aggregate) demand for goods and services.
i.e. less demand than is needed for full employment.
- Are such shortfalls only possible in a monetary economy?
Barter economy: you produce (supply) in order to trade
your production for other goods and services.
- production (supply) and demand are directly linked.
- supply creates demand (an old idea: Say’s Law)
Monetary economy: produce then sell production for money.
- Seller can use money to buy goods or services (creates
demand); or
- Could hoard money: this doesn't generate demand.
- Shortfalls of aggregate demand are possible if many
people save/hoard money simultaneously.
(Say’s Law: see The Economist Aug. 10, 2017 )
Nick Rowe (a monetary-macroeconomist)WCI blog Aug. 25, 2011 has a nice discussion of this:
“Recessions are always and everywhere a monetary phenomena” – recessions are situations of excess supply (or equivalently an excess demand for money). One of the things we notice about the things we call “recessions” is that it gets harder to sell stuff and easier to buy stuff (with money), and the volume of monetary trade (not just output and employment) declines. Barter trade, and home production, typically expand in a recession.
“The unemployed hairdresser wants her nails done. The unemployed manicurist wants a massage. The unemployed masseuse wants a haircut. If a 3-way barter deal were easy to arrange, they would do it, and would not be unemployed. There is a mutually advantageous exchange that is not happening. Keynesian unemployment assumes a short- run equilibrium with haircuts, massages, and manicures lying on the sidewalk going to waste. Why don’t they pick them up? It’s not that the unemployed don’t know where to buy what they want to buy.
If barter were easy, this couldn’t happen. All three would agree to the mutually-improving 3-way barter deal. Even sticky prices couldn’t stop this happening. If all three women have set their prices 10% too high, their relative prices are still exactly right for the barter deal. Each sells her overpriced services in exchange for the other’s overpriced services…. The unemployed hairdresser is more than willing to give up her labour in exchange for a manicure, at the set prices, but is not willing to give up her money in exchange for a manicure. Same for the other two unemployed women. That’s why they are unemployed. They won’t spend their money.
Keynesian unemployment makes sense in a monetary exchange economy…it makes no sense whatsoever in a barter economy, or where money is inessential.”
- Paul Krugman (Princeton U. and NY Times columnist) gives an intuitive
illustration of the idea based on a 1978 paper by Sweeney and Sweeney.
(see "Baby-Sitting Coop" handout -- also on website)
- Monetary policy and this problem?
- Can recessions be combatted by increasing the supply of money?
- People don’t need to reduce spending to hoard money if money is
abundant.
The Evolution of Money
- Early forms of money: commodity money
- something of intrinsic value that was portable, durable, divisible and
scarce.
- why scarce? High value for a small amount.
- common choice: precious metals (gold, silver)
- being of value itself promotes it as a medium of exchange: confidence.
- possible government role: standardized coinage (units; precious metal
content)
- control of the money supply with commodity money?
- dependent on the supply of the commodity.
e.g. new mines
- Convertible paper money:
- early paper money grows out of commodity money.
- early paper money: a claim to precious metals
- convertible into precious metals.
e.g. Early banks: - providedsafe storage of precious metals (often coins).
- receipts or notes issued to owner.
- notes were soon used in exchange: paper money!
- banks realize that depositors ask for only a fraction of
their gold on a given day
- banks issue additional notes: as loans or in
payment for goods and services.
- value of bank notes exceeds value of metalsdeposited.
i.e. a bigger money supply is possible.
- a danger? What happens if everyone redeems their
notes at the same time? (bank run)
- Sweden: copper money -- copper is a low value metal, needlots
of it for high value exchanges.
- encouraged early use of convertible paper money.
- Types of commodity standards: (see Table 2.2 from Lewis and Mizen)
- precious metal itself (coins)
(possibly more than one type of precious metal: “bimetallism”)
- precious metal coins and convertible paper money (convertible into
precious metal/coins)
- coins (not precious metal) and paper money: both convertible into precious
metal.
- coins and paper money convertible into currency of another country whose
currency is convertible.
(like the Early banks above: precious metals available for conversion
often only a fraction of paper money outstanding)
- all of these retain a link to precious metals.
Fiat money:
- Modern money is legal tender by government decree or “fiat”.
- however it needs confidence of the public to be able to act as money.
- confidence that others will accept it in exchange.
- confidence that it will retain value.
e.g. Zimbabwe (see article on course website and text pp.520-521):
- hyperinflation: prices doubling every 1.3 days;
- money is no longer a store of value even for short periods.
- Zimbabwe’s currency displaced by barter and foreign
currencies (esp. South African, US currency)
i.e. no longer acceptable as a medium of exchange.
- Supply of fiat money is in government hands.
- this is a key role of a country’s “central bank”
Canada: Bank of Canada
US: Federal Reserve Bank
Europe: European Central Bank (ECB)
- Ability to create new fiat money is a source of revenue (seigniorage) to the
government .
- cost of creating a new coin or bill is well below its face value:
difference is revenue to the government.
(Origin of Zimbawe’s hyperfinflation: printing money to pay
government’s bills)
Bank money or deposit money:
- Another important form of modern money.
- Bank deposits which can perform as medium of exchange are a
form of money.
- Convertible into fiat money though.
- Originally money supply measures included only:
“demand deposits”: deposits at banks that were accessible on
demand.
(vs. “notice” deposits: notice period required prior to
withdrawal)
- Methods of access to deposits:
- direct withdrawal e.g. from bank branch
- cheques (chequing deposits)
- More recently: debit cards, electronic bill payment systems, etc.
- Unlike bills and coins, deposits may exist only as a record (electronic or
otherwise).
- Like early paper moneydeposits are backed by reserves to meet depositors
needs.
- The supply of deposit money can be influenced by government (central
bank) by altering the quantity of reserve assets.
- Lessons of history
- Evolution of money driven by convenience, advantages of new forms of
money vs. old forms.
e.g. concerns over security of money holdings; record keeping and speed of the cheque-clearing system vs. modern electronic systems.
- Future money: what’s next?
- Will cash (coins and bills) disappear or just diminish?
- convenience considerations
- should central banks encourage it’s disappearance?
e.g. Rogoff: yes – vs. tax evasion and crime.
Monetary policy and negative interest rates: easier?
( )
- New forms of e-money, e.g. Bitcoin (see text p. 57)
- independent of central banks and government.
- Is this the future? - confidence problem
- volatility issues.
- Is e-money issued through a central bank the next step?
- Households and firms with accounts at the central bank.
- The end of traditional banks?
- See Andolfatto; Cochrane.
Money Today: the Composition of the Canadian Money Supply
Types of money:
(1) Currency: coins and bills
(2) Deposit money or "bank money"
- Should all types of deposit be included?
- Some types of deposits:
- Sensible to include deposits whose funds are easily accessible
e.g. by cheque or debit.
- Demand deposits: chequable deposits, repayable on demand.
(also called current accounts: businesses)
- included in all definitions of the money supply.
- Personal chequeing deposits (households), other Chequable savings
deposits: accessible by cheque or debit
- Non-chequable savings deposits
- not always included in money supply measures.
- it does not serve as readily as a medium of exchange.
- Term deposits: can be withdrawn only after a certain date.
- often not included as part of money supply – illiquid.
- Should any other assets be included in money supply?
- newer forms of ‘e-money’: stored-value or smart cards
(quite important in some countries)
- any liquid asset could be counted as part of the money supply.
i.e. liquid if can be readily converted to purchasing power.
- some Bank of Canada measures even include some types of
mutual funds as part of the money supply.
- how do credit cards fit in?
- a common method of payment.
- is a credit card balance money? It is a debt not purchasing
power.
- There is no single, correct measure of the money supply: central banks monitor
several measures.
- Narrow and Broad measures of the money supply
-Narrow: assets used directly in exchange
e.g. M1+ below.
- Broad: narrow money plus assets that are readily convertible into
assets that can be used in exchange
i.e., at the extreme: any liquid asset.
Measures of the Canadian money supply:
- Text Table 3-1, Figure 3-1 contains several Canadian money supply measures.
- The Bank of Canada currently publishes data on several measures.
-See: Part E (updated each
month)
- Statistics Canada provides some of the Bank of Canada data through
CANSIM (Table 176-0025):
Data from Bank of Canada website for August 2016:
Money supply measures:
M1+ $864 billion (narrow)
M2+$1836 billion
M2++$2841 billion (broad)
Some details (August 2016):
M1+- currency outside of banks ($77 billion)
($864 b)- Chequable deposits at chartered banks and “near banks”
(“near banks”: credit unions, trust companies)
($787 billion)
M2+- M1+ ($864 billion)
($1844b)- Other deposits at banks and near banks ($906 billion)
- Life insurance annuities ($39 billion)
- Money market mutual funds ($22 billion)
- Deposits at government savings institutions ($13 billion).
M2++- M2+ ($1836 billion)
($2841b)- Canada Savings Bonds ($5 billion)
- Non-money market mutual funds ($1000 billion).
- Composition and size of the money supply