vwlwww 11w hill monecon lecture 1

7/29/2019 Vwlwww 11w Hill Monecon Lecture 1

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Course Outline

320.326 WS11-12Monetary Economics and the European Union

Instructor: Professor Robert J. Hill

Office: 04-F-28

Telephone: 380-3442

E-mail address: [email protected]

Consultation times: Wednesdays 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. (2007), Economics of Monetary Union, Oxford University Press,

Seventh Edition (DG)

Assessment: Class participation 5 percent

Midterm exam 40 percent

Final exam 55 percent


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Lecture Schedule (Note: this schedule is provisional)

Week 1 (11 October 2011) Uses of money, commodity and fiat money,

and the quantity theory of money

MK Chapters 3, 18, 19

Week 2 (18 October 2011) Keynes theory of liquidity preference, Hicks

and ISLM

MK Chapters 19, 20, 21

Week 3 (25 October 2011) Friedman and monetarismMK Chapters 19, 23

Week 4 (8 November 2011) Rational expectations and optimal policy design

MK Chapter 25 (supplemented by additional readings)

Week 5 (15 November 2011) Tutorial covering material from Weeks 1-4

Week 6 (22 November 2011) Midterm exam


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Week 7 (29 November 2011) Inflation targeting and asset prices

MK Chapter 16, 23 (supplemented by additional readings)

Week 8 (6 December 2011) Optimum currency areas and the costs and

benefits of monetary union

DG Chapters 1-5

Week 9 (13 December 2011) The transition to monetary union in the

European Union and the European Central Bank

DG Chapters 6-8

Week 10 (10 January 2012) Monetary and fiscal policy in the European Union

DG Chapters 10-11

Week 11 (17 January 2012) The Eurozone and the Financial Crisis

Readings will be announced in class

Week 12 (24 January 2012) Tutorial covering material from Weeks 7-11

Week 13 (31 January 2012) Final exam


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The lecture overheads and tutorial questions will be postedon the institute website.

Click on http://www.uni-graz.at/vwlwww

Then select "Lehre". Then select "LV-Informationen".

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


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320.326: Monetary Economics

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


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1. Uses of Money

(i) 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 ofN-1 prices that market participants need to keep track of. (Note PAB= 1/PBA)

The prices should be transitive. For example: PAB

PBC

= PACOtherwise there will be arbitrage opportunities.

If the no-arbitrage condition holds, then it follows that PBC = PAC/PAB

That is, all the relative prices in the matrix (next slide) can bederived by taking ratios of pairs of prices from the first row (i.e., PAB,PAC, PAD and PAE).


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1pEDpECpEBpEAEggs

pDE1pDCpDBpDADoughnuts

pCEpCD1pCBpCACarrots

pBEpBDpBC1pBABananas

pAEpADpACpAB1Apples

EggsDoughnutsCarrotsBananasApples


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(ii) 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 theexistence of money encourages the division of labour.

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

You could try and find someone who just so happens to want to dothe reverse transaction (i.e., sell eggs and buy apples). This is

called a double coincidence of wants.


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Such a person may not exist.

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

For example, suppose you find someone who is willing to swap eggs forcarrots. Now if you can find someone who is willing to swap carrots forapples, you can get to your desired outcome in two stages. Or perhapsyou find someone willing to trade carrots for bananas. Now you seeksomeone willing to trade bananas for apples, etc.

Clearly, without money, trading is a complicated, time consuming andhit and miss process.

With money, all you need is to find a person X who wants to buy applesand another person Y who wants to sell eggs. It does not matter whatperson X wants to sell or what person Y wants to buy.


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(iii) Store of value

The store of value function of money allows a temporal separationof selling and buying

Other assets are also stores of value (e.g., housing, shares, works

of art)

Money is the most liquid asset. Liquidity is defined as the relativeease and speed with which an asset can be converted into amedium of exchange.

Example: When you sell your house, you have to pay a fee to areal estate agent and if you want to sell quickly, you may have tosettle for a lower price.

How good a store of value money is depends on the rate ofinflation. A doubling of the price level implies a halving of thevalue of money. Under high inflation, people no longer want to

hold much money.


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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

(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 ofbanknotes eventually became the preserve of the central bank.


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The money supply in such cases consists of the banknotes incirculation 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 amountof the commodity.

In 1816, the value of a pound sterling was set equal to 113 fine grainsof 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 partiallyalleviates this problem.


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(ii) The money supply will vary over time in response to changes inthe availability of the commodity.

Example: Under a gold standard, the discovery of a new gold minecauses a loosening of monetary policy.

This is because the new discovery increases the supply of gold, andhence pushes down its price. This means that the price of everythingelse 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 deliberateacts of a central bank rather than somewhat random events.

From 1816 to 1851, prices fell in Britain, after which they rose until1873, before falling again until the end of the century.


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These inflations and deflations can be explained as follows:

1816-1851: the increase in the supply of gold did not match the rateof economic growth

1851-1873: large increase in the supply of gold from California

1873-1895: In 1850 only Britain and Portugal were on the goldStandard. By 1880 America and almost all of Western Europe hadalso adopted it. This increase in demand for gold pushed up its price.

1895-1913: New discoveries of gold in the Transvaal and theKlondike and new mining technologies saw gold production rise.

Falling prices caused real interest rates to rise imposing considerablehardship on borrowers (the nominal interest rate cannot becomenegative). This encourages households and firms to delay purchasesand discourages investment. Together these effects could push theeconomy into recession.


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3. Bretton Woods

The Bretton-Woods system was adopted in 1945. All currencies

were fixed against the dollar (within 1 percent bands). Only theUS dollar was convertible into gold (at $35 per ounce). Onlycentral banks could trade dollars for gold.

Periodically, rates could be adjusted (e.g., the pound sterlingin 1949 was devalued from $4.03 to $2.80. In 1967 it wasagain devalued from $2.80 to $2.40).

Bretton Woods collapsed in 1971 and was replaced by asystem of floating exchange rates.


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Why did Brettons-Woods collapse?

(i) Governments were supposed to intervene in the foreign exchangemarkets (with the assistance of the IMF if necessary) to maintaintheir exchange rate within the allowed range. This could be difficultbecause of:

(a) Balance of payments crises:A country running a current account deficit must sell foreignexchange reserves if it wishes to maintain the peg. Britain had to

devalue in 1949 and 1967 as it was running out of foreignexchange/gold reserves.

(b) Imbalances in the purchasing power of currencies:Countries with higher inflation rates end up with overvalued

currencies and current account deficits (as imports become cheaperand exports more expensive).

(ii) Revaluations could create arbitrage opportunities.


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(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 significantlyabove $35 per ounce. Central banks therefore had an incentive to buygold at the Brettons-Woods price from the US Federal Reserve andthen sell on the open market.

4. Fiat Money

The abandonment of Bretton Woods led to the emergence of fiatmoney.

Fiat money is not backed by any commodity. Its intrinsic valuedepends 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 tomaintain exchange rate fluctuations for European currencieswithin 6 percent bands.


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Britain joined the ERM in 1990. The joining rate of 2.95DM sooncame to be seen as overvalued (largely due to relatively highinflation in the UK). Speculators started betting on a depreciationof 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 itsforeign exchange reserves. When it became clear this strategywas not sustainable, British abandoned the ERM in 1992. GeorgeSoros made over $1 billion from betting on a depreciation of thepound.

Soros borrowed in pounds and converted them into DM. After thedepreciation he converted back into pounds, paid off the loan andhad $1 billion left over.


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6. What Are the Alternatives to the ERM?

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

Capital controls usually take the form of taxes on foreign exchangetransactions or restrictions on the amount of domestic currencythat can be taken out of the country.

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

This leaves the international community with two alternatives:

(i) Monetary union

(ii) Floating exchange rates


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7. What Determines the Demand for Money?

The first answer to this question was provided by the ClassicalQuantity Theory of Money

The quantity theory of money is particularly associated with IrvingFisher and his 1911 book entitled The Purchasing Power of Money.

It starts from the following equation of exchange:

MV = PY

M = money supplyV = velocity of circulation

P = price levelY = real income (or output)

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


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It transforms from an identity to a theory of the demand for money withtwo assumptions:

(i) Velocity is constant

(ii) The money market is in equilibrium (i.e., Ms = Md)

Irving Fisher argued that velocity is determined by the institutional andtechnological features of an economy which are reasonably constantin the short run.

Example: increased use of credit cards will act to increase velocity.


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Taking velocity over to the right hand side

M = (1/V) PY

When the money market is in equilibrium, M = Md. Now setting(1/ V) = k, we obtain that

Md = k PY

The demand for money is a linear function of nominal income.


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Is velocity constant?

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

Velocity fluctuates quite a bit in the short run. Furthermore, ittends 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 had not yetbeen invented.

Hence the premise on which the quantity theory of money is

based seems suspect.


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