MoneyMoney
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
Farmer
Gold Miner Blacksmith
Teacher
1M florins
1M oz gold
CENTRALBANK
“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 LIABILITIES
Gold: 1M fl Currency: 1M fl
Example: Island Economy
Farmer
Gold Miner Blacksmith
Teacher
1M florins
1M oz gold
CENTRALBANK
“M”=million
florins food florin
s
florins
food
lecture florinsservices
florins
gold
Example: Island economy
Assume no banking system No bank deposits
Money supply is completely in the form of currency
Money supply = 1,000,000 fl
Example: Island Economy
Farmer
Gold Miner Blacksmith
Teacher
florins florins
florinsflorins
Commercial Bank
Commercial Bank
Initial Purpose: Keep florins safe
Why not loan some of those florins out?
Commercial Bank Balance SheetASSETS LIABILITIESCurrency 1M fl Deposits 1M fl
Example: Island Economy
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
Reserve deposit ratio = currency/deposits
Assume required reserve deposit ratio = 20%
Commercial Bank loans out 80% of deposits 800,000 fl These are deposited back in the bank
Example: Island EconomyCommercial Bank Balance Sheet
ASSETS LIABILITIESCurrency 1,000,000 fl Deposits 1,800,000 flLoans 800,000 fl----------------------------- -----------------------------Total 1,800,000 fl 1,800,000 fl
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 EconomyConsolidated Balance Sheet of Banks
ASSETS LIABILITIESCurrency 1,000,000 fl Deposits 2,440,000 flLoans 1,440,000 fl----------------------------- -----------------------------Total 2,440,000 fl 2,400,000 fl
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 = 0.201,000,000/deposits = 0.20
1,000,000/0.20 = deposits
5,000,000 = deposits
Example: Island Economy
Equilibrium
ASSETS LIABILITIES
Currency 1,000,000 fl Deposits 5,000,000 fl
Loans 4,000,000 fl
----------------------------- -----------------------------
Total 5,000,000 fl 5,000,000 fl
Reserve deposit ratio = 1/5 = 20%
Money Supply
Banks have effect on the money supply
Bank Deposits Very liquid, can be used for transactions Are counted as part of the money supply
In example, no cash is held by public 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
Money and Inflation
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14Money Growth
Infl
ati
on
2 Y
ea
rs L
ate
r
1990-2000
1960-1980
M2 Growth Rate and CPI Inflation Rate 2 years later.
Bond Demand and Supply
From perspective of primary market 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
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
SupplyDemand
Suppliers
We could actually have two supply curves Government Firms
Factors that impact one sector may not impact the other
Government and Corporate rates are connected.
Supply – A Closer Look Three agents in economy
Government Business Households
Initial Situation Increased Gov Borrowing
Shift in SupplyIncrease in Government Borrowing
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Government B
ond Supply Curve
Changes in Government Borrowing
An increase in Government borrowing The supply curve shifts to the right Prices to decrease Yields to increase
A decrease in Government borrowing The supply curve shifts to the left Prices to increase Yields to decrease
Shift in SupplyDeclining Business Conditions
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Corporate Bond Supply Curve
Changes in Business Conditions
An improvement in business conditions The supply curve to shift to the right Prices to decrease Yields to increase
A decline in business conditions The supply curve to shift to the left Prices to increase Yields to decrease
Shift in SupplyIncrease in Corp. Tax Subsidies
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Corporate Bond Supply Curve
Changes in Corp.Tax Subsidies
An increase in Corp. Tax Subsidies The supply curve to shift to the right Prices to decrease Yields to increase
A decrease in Corp. Tax Subsidies The supply curve to shift to the left Prices to increase Yields to decrease
Shift in SupplyIncrease in Expected Inflation
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Corporate/Gove
rnment Bond Supply C
urve
Changes in Expected Inflation
An Increase in Expected Inflation The supply curve to shift to the right Prices to decrease Nominal Yields to increase
A decrease in Expected Inflation The supply curve to shift to the left Prices to increase Nominal Yields to decrease
Demand – A Closer Look Three agents in economy
Government Business Households
Initial Situation Increased Household Saving
Shift in DemandIncreased Household Wealth
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Changes in Household Wealth
An Increase in Household Wealth The demand curve to shift to the right Prices to increase Yields to decrease
A decrease in Household Wealth The demand curve to shift to the left Prices to decrease Yields to increase
Shift in DemandIncrease in Expected Stock Return
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Changes in Expected Relative Bond Returns
An Increase in Bond Yield – Return Alt. The demand curve to shift to the right Prices to increase Yields to decrease
A decrease in Bond Yield – Return Alt. The demand curve to shift to the left Prices to decrease Yields to increase
Shift in DemandDecrease in Relative Risk of Bonds
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Changes in Relative Bond Risk
A decrease in Bond Risk – Risk Alt. The demand curve to shift to the right Prices to increase Yields to decrease
An increase in Bond Risk – Risk Alt. 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 Yield
Primary Market forGovernment Bonds
Price Yield
Primary Market forCorporate Bonds
Shift in DemandIncrease in Relative Bonds Liquidity
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Changes in Relative Bond Liquidity
An Increase in Bond Liq. – Liq. Alt. The demand curve to shift to the right Prices to increase Yields to decrease
A decrease in Bond Liq. – Liq. Alt. The demand curve to shift to the left Prices to decrease Yields to increase
Shift in DemandIncrease in Expected Inflation
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Changes in Expected Inflation
A Decrease in Expected Inflation The demand curve to shift to the right Prices to increase Yields to decrease
An increase in Expected Inflation The demand curve to shift to the left Prices to decrease Yields to increase
Decrease in Expected Inflation
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Decrease in Expected Inflation
A decrease in expected inflation unambiguously causes bond prices to rise and yields to fall.
Business Cycles
Business Cycles can shift both curves
Consider what happens when economy emerges from a recession.
Jobs are created, household wealth increases Business conditions improve
Economy Emerges from Recession
Quantity of Bonds ($ billions)
Price
950 5.3%
Yield
300
900
850
800
750
200100 400 500
11.1%
17.6%
25.0%
33.0%
Economy Emerges from Recession
During expansions 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.