slides_mf

Money and Financial Markets

PD Dr. M. Pasche

Friedrich Schiller University Jena

Creative Commons by 3.0 license – 2015 (except for included graphics from other sources)

Work in progress! Bug Report to: [email protected]

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Outline:

1. Financial Markets

1.1 Overview over Financial Markets1.2 Interest Rate Theory

2. Theory of Financial Structure

2.1 Financial Intermediates2.2 Management of Return, Risk and Liquidity2.3 Adverse Selection Problems2.4 Moral Hazard Problems2.5 Efficient Market Hypothesis and its Limits

3. The Money Supply Process

3.1 Function and Measurement of Money3.2 Creation of Central Bank Money3.3 Deposit Creation and the Multiplier3.4 Endogenous Money Supply

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4. Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference4.2 Portfolio Theory of Money Demand

5. Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy5.2 Transmission Channels5.3 Targets, Strategies, and Rules5.4 The Taylor Rule on Macro Models

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Basic Literature:

◮ Mishkin, Frederic S. (2012), The Economics of Money,Banking, and Financial Markets, 10th ed., Boston et al:Pearson International Edition.

◮ Bailey, Roy E. (2005), The Economics of Financial Markets,Cambridge: Cambridge University Press.

◮ Bofinger, Peter (2001), Monetary Policy: Goals, Institutions,Strategies, and Instruments. Oxford: Oxford University Press.

References to more specific literature can be found in the slidecollection.

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Preliminary time schedule (summer 2015):

17.4. ch. 124.4. ch. 11.5. (Labor Day)8.5. ch.215.5. ch.222.5. ch.229.5. ch.25.6. ch.2,312.6. ch.319.6. ch.326.6. ch.43.7. ch.510.7. ch.517.7. ch.5

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1. Financial Markets1.1 Overview over Financial Markets

Outline:

1.1.1 Asset Market Classifications

1.1.2 Bond Markets

1.1.3 Loan Markets

1.1.4 Equity Markets

1.1.5 Further Markets

Basic literature:

Mishkin (2012), chapter 2 and parts of chapter 5

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1. Financial Markets1.1 Overview over Financial Markets1.1.1 Asset Market Classifications

(Financial) Asset: Money ⊂ Financial Assets ⊂ All AssetsExamples: Currency, checkable deposits, bonds, stock shares,claims from loan contracts,...

Different assets have different properties:

1. Expected returns (interest rates, dividends, difference in buyingand selling price) – an increase in expected returns makes an assetc.p. more attractive ⇒ demand will increase

2. Risk (returns may have a variance, possible covariance with otherassets) – an increase of risk makes an asset c.p. less attractive ⇒demand will decrease

3. Liquidity (how fast can the asset be sold or used for transactions) –the more liquid the asset is c.p., the more attractive it is ⇒ demandwill increase

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Asset markets: In contrast to goods markets (“producer”,“consumer”) it is possible that an individual or an institution is onthe supply and the demand side.

Economic theory is interested into the questions (e.g.):

◮ How do different types of agents (e.g. banks, non-banks)structure their balance sheet = how do they behave on thedemand and supply side on the asset markets?

◮ How can the price movements in aggregated markets beexplained?

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a) Debt and Equity Markets

Debt:

◮ Contractual agreement, where the borrower pays the holder ofthe asset a fixed amount (interest rate) per period until aspecified expiration date (maturity date). The borrowedamount is returned until (or at) the maturity date.

◮ The maturity of a debt is the time until the expiration date(short-term < 1 year, long-term > 10 years)

◮ Examples: Consumer loans/credits, mortgages, bonds

◮ Depending on the contract, the borrower can sell the asset,especially bonds.

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Equity:

◮ The buyer of an equity has a claim to share the net incomeand the assets of the seller’s business. The net income is anuncertain residual and is often payed as dividends. Theinstrument has usually no expiration date, hence the funds arenot returned to the holder of the equity.

◮ Example: Stock shares

◮ The holder of an equity can sell the asset e.g. on the stockexchange market.

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Advantages and disadvantages:

Debt: Regular payments are more or less certain (unless the debitorstays solvent).

Equity: Residual payments are uncertain. “Residual” means that thefirm has to pay the debitors (and taxes) first.

Debt: In case of insolvency the creditor has a prior claim on theremaining assets.

Equity: Secondary claim on remaining assets in case of insolvency.

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Advantages and disadvantages: (cont.)

Debt: Holder do not profit from increasing profitability andincreasing firm value since their payments are fixed.

Equity: The holder profits directly by higher dividends and increasedvalue of their shares.

Debt: Holder has not the right to vote about management issuesand about the distribution of the net income of the firm.

Equity: Holder has these rights.

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b) Primary, Secondary and Derivative Markets

Primary Market:

◮ New issues of assets are sold to initial buyers.Examples: firm sells new stock shares or new bonds to aninvestment bank; a bank and a firm sign a loan contract; centralbank issues currencies by open market operations.

Secondary Markets:

◮ Once an asset has been issued it can be traded at the current price.The transactions are often performed by brokers instead of the assetholders themselves.Example: stock exchange, foreign exchange.

Derivative Markets:

◮ Not the assets themselves are traded but other claims related to theunderlying assets, e.g. the right to buy a certain asset to a certainprice within a certain period.Example: options, futures. S.13


◮ Secondary markets make assets more liquid: contract can besold to a current price. Increasing liquidity makes the assetsmore desirable.

◮ On secondary markets the price is determined by the flow ofinformation as well as by expectations of many agents. Inefficient markets price movements reflect the risk-returnperformance of an asset due to new information. The(expected) price on secondary markets may also affect theprice on the primary market.

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c) Exchanges and OTC Markets (→ secondary markets):

Exchange:

◮ Organized, centralized, regulated trading of assets, hightransparency of bids, asks and price setting, very competitive,almost arbitrage-free.

Over the counter (OTC):

◮ Decentralized market where the seller sells the assets “overthe counter” to a buyer. Since OTC dealers are connected bycomputer networks, there is also high price transparency andcompetitivenes, but much less regulation.

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d) Money and Capital Markets:

Money Maket:

◮ Short-term contracts (maturity < 1 year) with high liquidity

Capital Markets:

◮ Long-term contracts (maturity > 1 year, assets withoutexpiration date like stock shares)

Note, that this definition of a “money market” differs from theterm as used in macroeconomics where “money” is defined in aspecific manner.

Sometimes “money market” = market for central bank reserves(e.g. interbank market).

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1. Financial Markets1.1 Overview over Financial Markets1.1.2 Bond Markets

Bonds are issued by firms (corporate bonds) or by government(governmental, treasury, municipal bonds).

Two types of bonds:

◮ Coupon-bond: owner of the bond receives a fixed paymentper year (coupon rate) until the maturity date. At thematurity date the specified final amount (face vaule, pairvalue) is payed. Special case: perpetuity bond without anexpiration date.

◮ Discount bond (zero-coupon bond): There is no couponinterest rate. The bond is sold to a price below the face value.At the maturity date the owner receives the face value.

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Interest rate i when holding the bond until maturity:

P0 =F

(1 + i)n+

n∑

t=0

C

(1 + i)t

with P0 = bonds price in t = 0, F = face value, C = coupon rate,n = maturity date.

Expected return r when holding the bond for one period (beforematurity, without discounting):

r =C + Pt+1 − Pt

Pt

where Pt+1 is the expected bonds price in t + 1.

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◮ In both formulas there is an inverse relationship betweeninterest rate/return and the bonds price!

◮ If the interest rate is lower than expected return it would beprofitable for all bonds holders to hold the bond only for oneperiod and to sell it in t + 1. Therefore, it can be expectedthat Pt+1 will fall, which results in a decreasing r .

In the opposite case, the holders would decide to hold thebond for a longer time (until maturity). The prices in t + 1will therefore rise until i and r will be equal.

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Slope of demand and supply curves:

◮ The demand for bonds is negatively related to the bondsprice but positively related to the interest rate i .

◮ If the interest rate is low and – vice versa – the bonds price ishigh it is more attractive for governments, firms or institutionsto issue bonds to finance their activities. The supply curvecan be assumed to be downward sloped in i . Alternatively, inthe short run the bonds supply can be assumed to beexogenously fixed.

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B

BD

BDBS

BS

B

price interestrate

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1. Financial Markets1.1 Overview over Financial Markets1.1.3 Loan Markets

Types of loans:

Simple loan: borrowed amount L is paid back plus interestpayment IP at the maturity date n. The interest rate i then solves:

L =L+ IP

(1 + i)n

Fixed-payment loan: borrowed amount is paid back includinginterest in fixed payments FP (amortisation plus interest) perperiod until maturity date. The interest rate i then solves

L =n∑

t=1

FP

(1 + i)t

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◮ Solvency: ability of the borrower to pay back the loan plusinterest.

◮ Risk: probability distribution for the cases that the borrower isable to pay back α percent of {loan plus interest}; typicalmeasure for risk: variance.

Example: full return (probability p) versus total loss(probability 1− p)

Expected return: r = pi + (1− p)(−1)Variance of return: σ2

r = p(i − r)2 + (1− p)(−1− r)2

(If p = 1 then r = i and σ2r = 0)

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◮ Borrower has to provide collaterals. The lender can claim thecollateral in case of insolvency.

◮ In case of mortgages the borrower is not allowed (or it is notpossible) to sell the collateral. The lender has the right toclaim the collateral unless the loan is fully returned.

◮ There is asymmetric information about p before thecontract (adverse selection problem), and after the contractwhen the loan is used to finance an uncertain project (moralhazard problem). See section 2.3 – 2.4.

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1. Financial Markets1.1 Overview over Financial Markets1.1.4 Equity Markets

◮ Stock shares as the most common type of equities.◮ An owner of a stock share has

◮ claims on the net residual profits⇒ occasionally paid dividends.

◮ claims on the “firm value”.◮ What is the “firm value”?

◮ Net present value of expected cash flow?◮ Value of the physical and non-physical assets?

◮ Different models on pricing stock shares◮ Problems:

◮ Expectations depend sensitively on news flow.◮ Expectations may be driven by less rational determinants

(moods, herding effects etc.)◮ Expectations are a source of speculation, speculation may drive

the prices, price movements confirm speculation (→ bubbles).

◮ High volatility of stock prices, high risk.

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1. Financial Markets1.1 Overview over Financial Markets1.1.4 Equity Markets

A case for bubbles? (Dow Jones Index)

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1. Financial Markets1.1 Overview over Financial Markets1.1.5 Further Markets

Options:

◮ Option contracts are derivatives.◮ The holder of an option has the right (not the obligation) to

buy or to sell an underlying asset (e.g. stock shares, bonds,foreign exchange, oil, crop,...) to a predetermined price until adefined expiration date.

Buy = call optionSell = put option

◮ The option itself can be traded. The institution which issuesthe option has the obligation to buy/sell the underlying assetif the holder of an option wishes to exert his right.

◮ The pricing of options is complicated and is not addressed inthis lecture. The volatility of option prices is high. If the rightis not exercised until the expiration date (this can berational!) there is a 100% loss for the buyer of the option.

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Futures:

◮ Future contracts are derivates similar to options.

◮ The main difference is that buyer and seller are obliged toexecute the transaction (and option holder has only the rightto do that).

◮ The date of transaction is determined in the contract.

Why options and futures?

◮ Derivative contracts are like “bets” when expectations ofbuyers and sellers are divergent.

◮ Instrument to incorporate more information into the pricesystem.

◮ Leverage effect: potential for high profits from speculativederivative contracts.

◮ Derivatives can be used to hedge risks of the underlying asset.S.28


Foreign Exchange Markets:

◮ Foreign exchange/currency are also assets.

◮ Transactions on foreign exchange markets can be caused byunderlying transactions on goods or capital markets (e.g.change sale earnings into domestic currency, demand forforeign exchange in order to pay back a loan).

◮ Transactions can also be caused by the expectation that thedemanded foreign exchange will appreciate (speculation).

◮ There are spot markets and future markets for foreignexchange. The latter can e.g. be used for hedging the risks ofan underlying transaction on the goods market.

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1. Financial Markets1.2 Interest Rate Theory

Outline:

1.2.1 Behavior of Interest Rates

1.2.2 Risk Structure of Interest Rates

1.2.3 Term Structure of Interest Rates

Literatur:

Mishkin (2012), chapter 4, 5, parts of chapter 6

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1. Financial Markets1.2 Interest Rate Theory1.2.1 Behavior of Interest Rates

Equilibrium interest rates for bonds changes with demand andsupply on the bonds market:

◮ Demand shifts by Net Financial Wealth (+), expectedinflation (-), changes in expected returns (+), risk (-), liquidity(+) of bonds (or vice versa in case of alternative assets).

◮ Supply shifts by changed profitability of investmentopportunities (+), expected inflation (+), governmentalactivities (deficit spending) (+).

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The role of expected inflation

◮ Real interest rate = nominal interest rate - (expected)inflation rate (Fisher equation):

i real = i − p

◮ Debt contracts specify fixed payments per time interval. Thereal value of the payments decreases with inflation. This isbad for the creditor/lender but good for the debitor/borrower(distribution effect of inflation).

◮ Holding debt assets becomes less attractive, portfolios arerestructured in favor of alternative assets. This leads to anincrease of the nominal interest rates so that real interestrates are not affected by monetary variables (Fisher effect).

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B

interestrate

BS1

BS2

BD1

BD2

expected inflationraises

Source: Mishkin (2010)

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Source: Mishkin (2010)

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1. Financial Markets1.2 Interest Rate Theory1.2.2 Risk Structure of Interest Rates

Risk: (details in Bailey (2005), chapter 4)

◮ Realized returns are uncertain, they are dispersed around an(estimated) mean.

◮ Agents can assumed to be risk averse = utility function isconcave in returns: u′(r) > 0, u′′(r) < 0.

Risk premium:

Given a return of a risk-free asset A. Which risk premium RP onthe return will be neccessary so that the utility of the uncertainasset B equals the utility of the risk-free asset A?

µA = µA, µB = µB + ǫ, E [ǫ] = 0, V [ǫ] > 0

E [u(µA)] = E [u(µB)] ⇐⇒ µA + RP = µB

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r

u(r)

RP

µB

E [u(µA)] = E [u(µB)]

µA

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◮ The risk premium increases with the risk V [ǫ].

◮ In case of fixed-payment debt instruments, risk is determinedby risk of default of the debitor.

◮ Debt assets with higher risk have a higher nominal interestrate (→ spread of interest rates).

◮ The interest rates of more risky bonds are higher than of lowrisk bonds – e.g. corporate bonds are more risky than USgovernment bonds, bonds of AAA-rated firms are less riskythan of BBB-rated firms etc..

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interestrate

BS

interestrate

treasury bonds corporate bonds

BS

BD1

BD2

BD1

BD2

spread

increasing risk of corporate bonds

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source: Mishkin (2010)

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source: German Council of Economic Experts

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Interest rate differentials can furthemore be explained by

◮ different liquidity of bonds or loan contracts: The moreilliquid an asset is, the higher the interest rate must be inorder to compensate this disadvantage.

◮ different income taxes on interest payments: The more theinterest payments are taxed, the higher the nominal interestrate will be.

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1. Financial Markets1.2 Interest Rate Theory1.2.3 Term Structure of Interest Rates

Yield Curve:

Describes the term structure of interest rates for bonds of a giventype (with identical risk and liquidity characteristics) or for abundle of bonds.

◮ Upward sloping yield curve (“normal yield curve”): long-terminterest rate above short-term interest rates

◮ Downward sloping yield curve (“inverted yield curve”): viceversa

◮ Flat yield curve: same interest rate in short and long run

◮ (Inverted) U-shaped yield curve etc.

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residual maturity in years

rateinterest

normal yield curve

flat yield curve

inverted yield curve

(Daily and historical yield curves can be interactively calculated on the ECB’s

home page. Estimation on the basis of a bundle of specific bonds, for details

see homepage.)

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Stylised empirical facts:

1. Interest rates of bonds with different maturities move jointly.

2. If the short term rate is low it is likely that yield curve isupwards sloped; vice versa if the short-term rate is high.

3. The upwards sloped yield curve is the typical case.

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Expectations Theory

◮ Assume that short-term rate is low. Agents expect increasingeconomic activity (productivity, profitability, but also inflationincrease). Therefore the demand for funds to financeadditional investments will increase. The expected interestrate level will rise (= falling bonds prices). If you buy along-term bond today, the expected higher short-term interestrates in the future have to be reflected in the currentlong-term interest rate.

◮ Explains the first two stylised facts but not the third one.

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Example: Amount L is invested for two periods.

Question: Buying one long-term contract or two subsequentshort-term contracts?

Rlong = L · (1 + i0,2)2

Rshort = L · (1 + i0,1)(1 + i1,1)

where ij ,k is the interest rate at time j for a k-period contract.

In an arbitrage-free market we have Rlong = Rshort which implies

i0,2 =√

(1 + i0,1)(1 + i1,1)− 1

where i1,1 is the expected interest rate. The current long-terminterest rate is the geometric mean of the current and the expectedshort-term interest rate in the future.

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If expectations are not systematically false, there should be acorrelation between the slope of yield curves and the businesscycle: before a cyclical downturn the yield curve will become flat orinverted. Before an economic recovery the slope of the yield curvewill rise.

Empirical Literature:

Bernhard, H., Gerlach, S. (1998), Does the Term Structure PredictRecessions? The International Evidence. International Journal ofFinance and Economics Vol. 3(3), 195-215.

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Segmented Markets Theory:

◮ Long- and short-term bonds are no close substitutes.

◮ Investors have different preferences for different maturities.

◮ Bonds are traded in different (segmented) markets.

◮ It seems to be plausible that investors prefer short-termmaturities which would explain the stylised fact 3 but not fact1 and 2.

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Liquidity Theory:

◮ Bonds of different maturities are (imperfect) substitutes⇒ expected returns correlate like in expectations theory.

◮ Investors prefer short-term maturities so that short-termmarkets are more liquid. Buying a less liquid bond requires a“liquidity premium”.

◮ Since this incorporates the expectations theory, all threestylised facts are explained.

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2. Theory of Financial Structure2.1 Financial Intermediates

Outline:

2.1.1 Economic Functions of Financial Intermediates (FI)◮ Asset Transformation◮ Reducing Transaction Costs◮ Risk Sharing◮ Dealing with Asymmetric Information

2.1.2 Types of Financial Intermediates

Literature:

Mishkin (2006), chapter 2

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2. Theory of Financial Structure2.1 Financial Intermediates2.1.1 Economic Functions of Financial Intermediates

Provider:1. Households2. Firms3. Government4. Foreign

1. Households2. Firms3. Government4. Foreign

Receiver:Market

Financial Intermediates:1. Banks2. Mutual Funds3. Pension Fonds4. etc.

Direct Finance

Indirect Finance

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a) Asset Transformation:

(Note that liabilities of the intermediate = asset of the houshold or firm)

◮ Lot size transformation:e.g. many small deposits, few large credits

◮ Maturity transformation:short run liabilities, long-run assets

◮ Risk transformation:e.g. less risky liabilities, more risky credits (see below)

◮ Liquidity transformation:high liquid liabilities, less liquid assets

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b) Reducing Transction Costs:

◮ FI have economies of scale:

getting information about demanded and provided funds,assessing risks, bargaining, designing and enforcing contracts,buying/selling stock shares – these tasks can be accomplishedby FI with much lower transaction costs due to specializedinformation processing abilities, large transaction volumes,specific human capital (expertise).

◮ FI have economies of scope:

FI provide additional services like risk diversification,optimizing portfolios, and consulting. Sometimes theseservices need the same infrastructure and the same humancapital. Hence it may reduce cost when one FI provides theseservices.

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c) Evaluating, Pooling and Allocating Risk:

◮ Risk: e.g. investment projects may fail, borrowers may becomeinsolvent.

◮ Evaluating risks ⇒ calculating risk premia.

◮ Reducing the risk by pooling and diversification.

◮ Transforming the risk structure of financial assets.Examples:

◮ Depositors hold “safe” asset and receive low interest rates.Bank provide risky loans with high interest rates (including riskpremia).

◮ Securitization of risky loans and selling them ⇒ changes assetstructure and re-allocates the risk.

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d) Dealing with Asymmetric Information (see 2.3 – 2.4)

◮ Adverse Selection:◮ Hidden characteristics of a potential borrower before

contracting.◮ Borrower knows his risk better than the lender.◮ If lender offers a contract which is optimal for a borrower with

average risks, this may be unattractive for those with goodrisks. This may result in a market failure.

◮ Moral Hazard:◮ Hidden action of a borrower after contracting.◮ Borrower takes the money to engage in a prject that is

undesireable for the lender. This reduces the probability for asuccessfully returned credit.

◮ FI may mitigate this problem e.g. by screening, collaterals,optimal design of contracts. Again, they have the resources todo that with low transaction costs.

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2. Theory of Financial Structure2.1 Financial Intermediates2.1.2 Types of Financial Intermediates

Depository institutions (banks):

◮ Accept deposits from individuals and institutions as liabilities,providing loans and mortgages as assets.

◮ Example: Commercial banks, thifts.

Contractual savings institutions:

◮ Accept premiums and contributions from government, firmsand individuals as liabilities, investment in bonds, stocks andgovernment securities.

◮ Example: life insurance, retirement funds

Investment intermediates:

◮ Selling commerical stocks, bonds or shares as liabilities,providing business loans and investment in stocks and bondsas assets.

◮ Example: Finance companies, private equity fundsS.56


Type of FI Primary Liabilities Primary Assets Value

Depository Institutions

Commercial Bank Deposits Loans, mortgages,bonds 12,272

Saving/loan associations Deposits Mortgages,and mutual saving banks consumer loans 1,518

Contractual saving Institutions

Life Insurance Companies premiums Bonds, mortgages 4,798Fire/Caaualty Insur. Comp. premiums bonds, stocks 1,337Pension funds employer/employee bonds, stocks

contributions 5,193Gov. retirement funds employer/employee bonds, stocks

contributions 2,730

Investment Intermediates

Finance Companies commercial papers, loansstocks, bonds 1,910

Mutual Funds issued shares bonds, stocks 6,538Money market mutual funds issued shares money market instr. 3,376

(US Data 2008 , Bill. Dollar; source: Mishkin (2010), Tables 3 and 4, data from Federal Reserve)S.57


Non-bank Financial Intermediaries (NBFI) are sometimes called“shadow banks”

◮ Risk originators:◮ Depository institutions (commercial bank 6∈ NBFI)◮ Broker dealer (investment banks)◮ Finance companies

◮ Risk bearers:◮ Managed funds (insurance companies, retirement funds etc.)◮ Institutional investors (mutual funds, money market funds,

hedge funds)

◮ Special Purpose Vehicles (intermediary institution for thesecuritization process)

Poschmann, J. (2012), The Shadow Banking System – Survey and Typological

Framework. Global Financial Markets Working Papers No.27, Jena/Halle.

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Why do NBFI exist?

◮ Specialisation on transactions where no deposits are involved.

◮ Financial intermediation combination with different privategoods (e.g. insurance).

◮ Regulatory arbitrage: Banks are highly regulated, but“shadow banks” are much less regulated ⇒ they can do riskyinvestments to less costs. But: no access to short-run centralbank liquidity and “safety nets” like deposit insurance.

◮ This can utilized also by banks e.g. by securitization andselling the claims from loans to NBFI.

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2. Theory of Financial Structure2.2 Portfolio Selection and the Management of Return, Risk and Liquidity

Outline:

2.2.1 General Principles of Bank Management

2.2.2 Theory of Portfolio Selection

2.2.3 The Value at Risk Approach

Literature:


Bailey (2005), chapter 5

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2. Theory of Financial Structure2.2 Portfolio Selection and the Management of Return, Risk and Liquidity2.2.1 General Principles of Bank Management

The Bank’s Balance Sheet

Assets Liabilities◮ Reserves (required, excess)

◮ Cash

◮ Securities/Bonds◮ firm bonds◮ governmental bonds

◮ Loans◮ industrial◮ consumer◮ real estate◮ inter-bank◮ other

◮ Other assets(e.g. physical assets)

◮ (Checkable) Overnightdeposits

◮ Nontransaction desposits◮ Time deposits◮ Redeemable deposits

(saving accounts)

◮ Borrowings◮ Inter-bank loans◮ Central bank loans◮ Other

◮ Bank Capital / Net WorthS.61


a) Liquidity Management

◮ Inflows are stochastic (e.g. risk of non-repayment ofdebt/interest rates), outflows are stochastic (e.g. suddendeposit withdrawals) ⇒ need for liquid assets like cash orreserves.

◮ If there are not enough liquid assets, the bank needs expensiveovernight loans, or has to sell other assets (“fire sales”), or itbecomes illiquid.

◮ Problem: If customers receive a signal of possible liquidityproblems, they wish to draw their deposits. This enforces theliquidity problem and may induce bankruptcy (bank runequilibrium, see Diamond/Dybvig model).

◮ Given a probability distribution of inflows and outflows on theliability side, the asset side should consist of enough liquidassets to meet the obligations to the depositors and creditors.

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Excourse: Interbank market

◮ Most transactions are deposit transfers from bank A to bank B.Bank A is then in need for liquid reserves while bank B has excessliquidity.

◮ Interbank market for “clearing” the demand and supply of liquidreserves by short-run interbank loans (often called money market).

◮ The money market interest rate is the primary operative goal of thecentral bank policy.

◮ What happens if banks do not supply excess liquidity on theinterbank market, e.g. because of distrust to other banks or fear ofliquidity distress? ⇒ increased central bank loans; central bank aimsto avoid liquidity problems in the banking sector.

◮ Financial crisis 2008/2009 (and also later): drastically increasedcentral bank loans but also drastically increased excess reserveholding at the central bank.

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b) Asset Management

◮ Management of risk and return of the assets. Investing into amix of risky and riskless assets with the highest expectedutility (portfolio approach). But: portfolio approach requiresassumption of risk aversion which is empirically questionable.

◮ Restrictions to asset management:◮ Liquidity considerations: The need for sufficient liquiditiy is a

restriction for asset management.◮ Capital regulation (Basel II/III): value of rsiky assets is risk

weighted, capital requirements for these risk weighted assets.

This prevents from holding too many too risky assets.

⇒ Incentive for securitization

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Excourse: Securitization

◮ Illiquid assets like loans are pooled to a specific portfolio.

◮ This portfolio is transferred to an entity called SpecialPupose Vehicle (SPV).

◮ The SPV securitizes this portfolio and issues rated AssetBacked Securities e.g. to funds, and receives liquid assets inexchange which are transferred back to the bank.

◮ From the bank’s perspective, and illiquid asset is thereforetransformed into a liquid asset. The risk of the underlyingsecurities is transferred to the fund (and fund share holders).Although the amount of issued risky loans is the same asbefore, the bank has a better loans/capital ratio.

◮ Different types of securitization and ABS (not to be discussedhere).

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c) Liability management

◮ Deposits are not “given” and not the only source of funds.Decision how to aquire which types of liabilities.

◮ Differences of liabilities:◮ Hows fast could an additional liability be aquired?◮ Probability of outflows◮ Differences in maturity◮ Costs = interest rates (e.g. for time deposits, for inter-bank or

central bank loans)

◮ Development of new financial instruments (e.g. certificates ofdeposits (CD) which are similar to bonds)

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d) Bank Capital Management

◮ Most assets have risks: Credits may fail, bonds prices may fall.Hence, the value of the asset side is under risk of beingdepreciated.

◮ With a certain probability the losses of the asset side mayexceed the bank capital: the bank becomes insolvent.

◮ Trade-off: More risky investments enlarge c.p. the return onequity capital, but also the risk of insolvency!

◮ This is regulated by Basel II / III (see above)

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2. Theory of Financial Structure2.2 Portfolio Selection and the Management of Return, Risk and Liquidity2.2.2 Theory of Portfolio Selection

Outline of Portfolio Theory

(Bailey (2005), chapter 5)

◮ We address the case of two risky and one risk-free asset.“Risky” means, that the returns are stochastic.

◮ Notation:

µi expected return of risky asset i = 1, 2σ12 covariance between the returns of asset 1 and 2σii variance of returns of asset i = 1, 2ai proportion of portfolio invested in asset i ,

∑

i ai = 1r0 return of the risk-free asset

S.68


a) The portfolio P of risky assets

We have

µP =∑

i

aiµi (1)

σ2P =

∑

i

∑

j

aiajσ2ij (2)

In case of two risky assets the proportion a1 (obviously a2 = 1− a1)determines the expected return and the variance of the portfolio.

S.69


b) Efficiency Frontier

◮ In case of more than two risky assets the convex set ofproportions a1, ...an define a convex set of(µP , σ

2P)-combinations.

◮ Most of these combinations are inefficient, since there existmany portfolios with the same µP but different σ2

P .

◮ In the first step, the efficiency frontier has to be derived byminimizing σ2

P (over ai = 1, ...n) under the constraints ofgiven µP = µP and

∑

i ai = 1

◮ In case of two risky assets, this step is not necessary since aidetermines a unique (µP , σ

2P)-combination.

S.70


The shape of the efficiency frontier EF depends on the covariance

(ρ12 = σ212/(σ1σ2) is the correlation coefficient).

σP

µP

Asset 1

Asset 2

E

F

with ρ12 = −1

with ρ12 = 1

with ρ12 ∈ (−1, 1)

S.71


c) Optimal portfolio without a risk-free asset

◮ From the set of efficient portfolios choose the optimalportfolio wich maximizes the utility function.

◮ Mean-Variance-Approach:

maxai

E [u(rP)] = µP − θσ2P with

∑

i

ai = 1

with θ > 0 as the degree of risk aversion.Note: This is a special type of utility function. From a theoretical

point of view it is not necessary that the preferences can be

represented by a utility function of this type.

◮ In a (µP , σP)-diagram the indifference curves are upwardssloped. The tangential point (R) of the indiffrenece curve withthe efficient portfolio frontier is the solution of theoptimization problem.

S.72


σP

µP

Asset 1

Asset 2

indifference curves

R

optimal portfolio withouta risk-free asset

S.73


d) Optimal portfolio with one risk-free asset

◮ The riskless asset has a return r0 and zero variance.

◮ The risky portfolio Z is a mix of two risky assets with

µZ = λZµ1 + (1− λZ )µ2 (3)

σ2Z = λ2

Zσ21 + (1− λZ )

2σ22 + 2λZ (1− λZ )σ

212 (4)

⇒ σZ =√

λ2Zσ

21 + (1− λZ )2σ

22 + 2λZ (1− λZ )σ12 (5)

where λZ has to be determined in an optimal way. Theresulting portfolio Z must lie on the efficiency frontier.

S.74


◮ If portfolio Z is mixed with the riskless asset (share λP). Theresulting portfolio P has the properties:

µP = λP r0 + (1− λP)µZ (6)

σ2P = (1− λP)

2σ2Z (7)

⇒ σP =√

(1− λP)2σ2Z = (1− λP)σZ (8)

Thus, the risk and return of P is a linear combination of Zand the riskless asset.

S.75


◮ In a (σ, µ)-diagram we can therefore write(see also the figure):

µP = r0 + bσP (9)

= r0 +

(µZ − r0

σZ

)

σP (10)

σ

r0

µ Z

b

σ

r0

µ Z

(λZ = 0)

(λZ = 1)

Asset 2

Asset 1

S.76


How to determine the risky portfolio Z?

◮ Note, that an optimal portfolio P will be a tangential pont ofthe indifference curve with the linear function (9).

◮ Every point on a steeper linear function (9) dominates thepoints on a flatter linear function since we obtain a higherreturn with the same standard deviation.

◮ Therefore, we maximize the slope b = (µZ − r0)/σZ withrespect to λZ under the condition that µZ , σZ are definedaccording to (3) and (5). This guarantees that Z lies on theefficiency frontier.

◮ Obviously, Z must be a tangential point on the efficiencyfrontier!

S.77


maxλZ

b =µZ − r0

σZs.t. (3), (5)

⇒ λ∗

Z =(µ1 − r0)σ2 − (µ2 + r0)σ12

(µ1 − r0)σ2 + (µ2 − r0)σ1 + 2r0σ12 − (µ1 + µ2)σ12

◮ Now the optimal risky portfolio Z is determined. The linearequation (9) with λ∗

Z (and henceforth b∗) is called CapitalAllocation Line (CAL).

◮ Now, the optimal mix between Z and the riskless asset isdetermined as usual as the tangential point of the indifferencecurve with the CAL. The solution depends on the degree ofrisk aversion. But it is remarkable, that irrespective to theindividual risk aversion, all rational investors will choose thesame risky portfolio Z (Tobin separation).

S.78


σP

µP

Asset 1

Asset 2

r0

capital allocation line

Z

S.79


σP

µP

Asset 1

Asset 2

r0

capital allocation line

Z

Poptimal portfolio withtwo risky assets andone risk-free asset

S.80


Limitations:

◮ Risky assets have to be backed by capital.

◮ The bank needs a certain liquidity of their assets. Liquidity isnot addressed in the portfolio approach (see below).

◮ Banks have to hold specific securities in order to have accessto Central Bank credits.

⇒ These things are constraints to the Portfolio Approach.

◮ Empirically seen, there is not much risk aversion.

S.81

2. Theory of Financial Structure2.2 Portfolio Selection and the Management of Return, Risk and Liquidity2.2.3 The Value at Risk Approach

Now we turn back to solvency and liquidity managementconsiderations.

◮ Once, the optimal portfolio is determined, the value of theassets is uncertain: Bad loans have to be depreciated, thebonds prices may fall ⇒ the value of the assets is a stochasticvariable.

◮ For a given period (e.g. 1 month) it is possible to construct aprobability distribution F for the losses of value (wherenegative losses are gains).

◮ Assume that the bank management (or the regulationauthority) wishes that in the given period the bank stayssolvent with a probability of 1− α%. Then the upper α-fractilof the distribution F denotes the (tolerated) losses – the VaRα

benchmark – which can be expected with probability of α%.

S.82


0 lossVaRα

α% tolerated loss

(1− α)%

F

S.83


◮ In order to stay solvent the bank has to keep bank capitalwhich covers (at least) the VaRα benchmark, for exampleBC ≥ VaR1%. Staying solvent means that the obligations tothe depositors can be fulfilled.

◮ If VaRα is determined, then rα denotes the percentage of theasset volume A which will be lost with probability α:

VaRα = rαA

⇒BC

A≥ rα

◮ Example: If α = 0.01 and r0.01 = 0.15 then 15% of the assetvolume are lost with probability of 1%. If BC ≥ r0.01A thenlosses which exceed bank capital (insolvency) have aprobability less than 1%.

S.84


Applying VaR to Liquidity Management:

◮ Consider a liquid asset (e.g. excess reserves), while thedeposits D are stochastic. The bank’s liquidity managementshould ensure that the bank stays liquid when depositors wishto draw their deposits.

◮ The VaR approach can also be applied to this task: Let G bethe pobability distribution of daily deposit net outflows (wherenegative outflows are net inflows). Then β is the probabilitythat the outflows exceeds the liquid excess reserves and thebank gets into liquidity troubles.

◮ Similar to the BC/A = rα ratio in case of solvency we have aratio rβ of excess reserves and deposits to ensure liquidity witha probability of β percent.

S.85


◮ It has to be noted that the VaR approach to liquidity is anadditional constraint for the portfolio management: Theshare of the most liquid asset (here e.g.: excess reserves) isdetermined by the degree of risk aversion of the bank but isalso restricted by the VaR approach.

◮ Summing up: The bank makes simultanous decisions aboutthe volume and the structure of the asset and the liability side.

S.86

2. Theory of Financial Structure2.3 Adverse Selection Problems

Outline:

2.3.1 Introduction

2.3.2 How Adverse Selection Influences Financial Structure

2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

2.3.4 What Stylized Facts are Explained by Adverse Selection?

Literature:


Wolfstetter, E. (1999), Topics in Microeconomics, chapter 9

S.87

2. Theory of Financial Structure2.3 Adverse Selection Problems2.3.1 Introduction

Information Asymmetries:

◮ Principal: offers contract, lack of information

◮ Agent: signs contract, private information

Before contracting: hidden characteristics → adverse selection

◮ buying shares or bonds of a firm ⇒ characteristics are notknown to the buyer

◮ providing a loan to a borrower with unknown ability to payback the loan (credit risk)

⇒ Principal’s decision is based on expectations about agent’scharacteristics

⇒ expectations are built on information

⇒ limited possibilities to reveal the unknown characteristics

⇒ Pooling vs. Separating equilibria

S.88

2. Theory of Financial Structure2.3 Adverse Selection Problems2.3.2 How Adverse Selection Influences Financial Structure

After contracting: hidden action → moral hazard

◮ Agent uses the funds for financing projects which are morerisky than announced to the principal, or he reduces themanagerial effort because this might enhance his benefits.

◮ Principal cannot observe this, but he can expect that there isan incentive for moral hazard.

◮ Optimal design of the contract in order to mitigate or avoidMH.

S.89


Markets for Lemons

◮ Akerlof, G.A. (1970), The Market for Lemons: QualitativeUncertainty and the Market Mechanism. Quarterly Journal ofEconomics Vol. 84, 499-500.

◮ Wolfstetter, E. (1999), Topics in Microeconomics. (Chapter9.2.1)

Nobel Prize 2001 to George A. Akerlof, A. Michael Spence, JosephE. Stiglitz

”for their analyses of markets with asymmetric

information“.

Foundation of market imperfections or market failures due toinformation asymmetries.

S.90


The original version: Market for used cars

◮ Cars have a different quality q (from “very good” q = b to“bad” q = 0, bad cars = “lemons”)

◮ The seller is privately informed about the quality q ∈ [0, b].

◮ The seller will accept any price p ≥ q.

◮ The buyer is willing to pay any price p ≤ α · q with α > 1.

◮ For any given q there exists a price ∈ [q, αq] where buyer andseller mutually benefit from the deal.

◮ But: The buyer is not able to observe q⇒ building expectations E [q].

S.91


Assume that the quality q is uniformly distributed on [0, b]. This isknown by the buyer. For any used car the expected quality is henceE [q] = b/2. Therefore

p(E [q]) ≤ α ·b

2

Two cases:

◮ Case 1: α ≥ 2. Then the buyer is willing to pay p ≥ b and allcars will be sold.

◮ Case 2: 1 < α < 2. Then the market breaks down!

S.92


Market breakdown:

◮ For α < 2 the buyer will never pay p = b.

◮ No high quality cars (q = b) will be sold. They can be removedfrom the interval (e.g. q ∈ [0, b − ǫ]).

◮ This can be anticipated by the buyer. The expected average qualitydecreases (e.g. E [q] = (b − ǫ)/2).

◮ The willingness to pay also decreases.

◮ The remaining best quality cars leave the market.

◮ and so forth... (“race to the bottom”)

S.93


Or in another way:

◮ Assume an arbitrary merket price p > 0. Obviously there areonly sellers i the market with qi ∈ [0, p]. The average quailityis hence E [q] = p

2 .

◮ This is known by the buyers. The are willing to pay maximump(E [q]) = α/2 · p.

◮ For α < 2 this is lower than the market price and no dealcomes about.

S.94


Financial Markets:

◮ Firm needs funds to finance a risky project. Assume that thefirm demands for a loan L.

◮ The firm is willing to pay an interest rate iL which does notexceed the expected return of the project r .

◮ The bank will provide the loan L when the interest rate coversat least the interest rate for a secure asset iS plus the riskpremium RP .

◮ Assume that the loan is either returned successfully withprobability 1− p or it fails completely with probability p. Theminimum risk premium is therefore:

L(1 + iS) = L(1 + iL)(1− p) + 0 · p (11)

⇒ RP = iL − iS =p

1− p(1 + iS) (12)

S.95


◮ Problem: p is private information of the firm!

◮ Offering a loan contract with an interest rate iL (incl. riskpremium) based on the expected probability E [p] taken froma prior distribution of risks.

◮ Typically the expected return and the risk of investmentprojects are positively correlated. Firms with profitable lowrisk projects with

r < iS +E [p]

(1− E [p])(1 + iS)

will not have in incentive to sign a loan contract!

◮ The remaining projects are hence more risky which leads toan increase of E [p] ⇒ a similar mechanism as in the “marketfor lemons” example applies.

S.96


Credit Rationing:

Adverse Selection Effect: With an increasing interest rate more andmore good (= low risk) projects leave the market and the expectedrisk increases:

E [p] = E [p(iL)],dE [p(iL)]

diL> 0

Profit maximizing bank: (L given)

maxiL

π = (1− E [p(iL)])(1 + iL)L (13)

⇒dπ

diL= −

dE [p(iL)]

diL(1 + iL)L+ (1− E [p(iL)])L = 0 (14)

⇒ i∗L =(1− E [p(iL)])−

dE [p(iL)]diL

dE [p(iL)]diL

(15)

S.97


What are the consequences?

◮ The profits do not monotonously increase with market interestrate iL.

◮ If loans demand increases, there is not neccessarily aWalrasian adjustment of the equilibrium interest rate!

◮ The demand side of the loans market will be rationed.

◮ Existence of rationing equilibria.

◮ The notional plans of the firms cannot be fulfilled⇒ spillover to other markets

◮ e.g. markets for bonds or equities to finance the project◮ e.g. markets for investment goods

S.98


iL

iL

π

LLS

LD

i∗

rationing

S.99


Literature:

◮ Stiglitz, J., Weiss, A. (1981), Credit Rationing in Marketswith Imperfect Information. American Economic Review 71,393-410.

◮ Greenwald, B., Stiglitz, J., Weiss, A. (1984), InformationImperfections in the Capital Market and MacroeconomicFluctuations. American Economic Review 74, 194-199.

Note:

◮ The problem of rationing may be (partially) overcome e.g. bycollaterals.

◮ The problem may also occur in bonds and stock markets: theprice which the buyer is willing to pay reflects his uncertaintyabout the risk type of the firm!

S.100

2. Theory of Financial Structure2.3 Adverse Selection Problems2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

There are different ways how to solve or to alleviate the problem:

◮ Providing better information = decreasing informationasymmetry

◮ Screening: The less informed agent has an incentive◮ to collect information by himself◮ to buy additional information supplied by other agents◮ to provide different contracts with self-selection effects

◮ Signalling: The privately informed agent has an incentive toprovide a trustworthy (costly) signal about his characteristics.

◮ Governmental Regulation

◮ Collateral and Net Worth

The information asymmetry is not neccessarily resolved buthas minor consequences since in case of a failed project thereturn of the loan is backed.

S.101


Screening by collecting information

◮ High information costs, especially for lenders with lowexpertise.

◮ Bank as a financial intermediate with expertise and specializedhuman capital reduces such information costs:

◮ Multiple lender of funds ⇒ bank deposits◮ Bank is pooling the risks and guarantees the depositor an

interest rate◮ Screening costs of multiple non-specialized lenders are reduced

and transferred to the bank◮ The bank as the intermediate lender faces a lower information

asymmetry

◮ The existence of a professional banking system is aprerequisite for a working credit market.

S.102


Screening by buying information provided by others

◮ Rating agencies (e.g. Standard & Poors, Moody): (large)borrowers are rated according to a standardized scale (seeMishkin (2006), chapter 6, p.123)

◮ In Germany: SCHUFA (Schutzgemeinschaft fur allgemeineKreditsicherung)

Problems:

◮ Free-rider problem since information is a non-rival good.Once, when information is made public, there is no incentiveanymore to pay for it.

◮ How trustworthy is that information? RA typically payed bythe better informed party. Less informed party is not able toasses the reliability of the information ⇒ Moral Hazardproblem.

S.103


Screening and self-selection (separating equilibrium):

◮ High/low risk investors with probabilities of default pH > pL wherepj is private information.

◮ Bank offers two types of contracts: (iL,CL > 0) and (iH ,CH = 0).

◮ For a high risk investor it is more likely that he will have to pay thecollateral. Both investors compare the expected costs:

(1− pj)iL + pjCL ≷ (1− pj)iH

⇒pj

1− pj≷

iH − iLCL

Since the l.h.s. is larger for the risky investor, there existscombinations of (iL, iH ,CL) where the inequality sign is different forboth investor types.

⇒ Investors will choose different contracts and therefore reveal theirtype (separating equilibrium)!

S.104


Governmental Regulation:

If investors need financial funds, e.g. by demanding credits orselling bonds or stocks, they can be forced by law to provide someinformation to reduce the information asymmetry. E.g.

◮ adhere standard accounting principles

◮ providing information about the balance sheet and other(financial) indicators like sales, earnings, assets

◮ in case of stock markets: publish relevant informationsregularly; annual meeting of shareholders etc.

S.105


Signalling:

◮ A firm with a low risk project has an incentive to provide asignal so that the lender is informed about the low risk.

◮ If signalling should make sense...

(a) the signal must be costly(b) there must exist signals that are too expensive for a high risk

firm but not too expensive for low risk firms⇒ discrimination is possible.

◮ Otherwise high risk firms have an incentive to imitate thesignal so that signalling provides no information (poolingequilibrium).

S.106


Signalling means “building reputation”. Reputation signals (e.g.):

◮ Loans have been successfully returned in the past.

◮ Projects are financed also with equity capital.

◮ Firm provides voluntarily more sensitive information thanrequired by law.

◮ Firm has valuable assets (→ similar to collaterals).

This may be a problem for new and small firms.

S.107


Collaterals:

◮ In case of failure of the investment project the investor hasother assets which can be sold to meet the debt obligations.

◮ Borrower must prove that he has such collaterals beforesigning the credit contract.

◮ Credit contract includes the obligation that the collateralmust not sold until the credit is returned successfully.

◮ Cedit contract includes that lender automatically becomes theowner of an asset in case of a credit failure.

◮ In some contracts, the lender has property rights on the assetwhich is financed by the credit. These property rights arereturned to the borrower in case of a successfully returnedcredit ⇒ mortgages (e.g. in case of housing)

S.108


Collaterals C lower the risk premium:

L(1 + iS) = L(1 + iL)(1− p) + pC (16)

⇒ RP = iL − iS =p

1− p(1 + iS)−

p

1− p

C

L(17)

with C = argmax{0, (1 + iS)L}. In case of C = L(1 + iS) there isno credit risk for the lender anymore.

Problems:

◮ Providing collaterals and liquidation is costly (e.g. opportunitycosts).

◮ The access to collaterals is limited (e.g. start-up companies).

◮ The value of collaterals may be uncertain (see the housing crisis inthe U.S. – dramatic decrease of house prices = decrease of thevalue of collaterals)

S.109


Literature on Collaterals:

◮ Bester, H. (1985), Rationing in Credit Market with ImperfectInformation. American Economic Review 75, 850-855.

◮ Besanko, D., Thakor, A. V. (1987), Collateral and Rationing:Sorting Equilibria in Monopolistic and Competitive CreditMarkets. International Economic Review 28, 671-689.

S.110

2. Theory of Financial Structure2.3 Adverse Selection Problems2.3.4 What Stylized Facts are Explained by Adverse Selection?

1. Credit and loans are an importnat source of financing business

◮ One could think that there is an incentive for a firm to financetheir business primarly by selling equities (e.g. stocks), sincethe stock owner only have claims on the residual profit.

◮ Due to information asymmetries about risky business projectsthe owner of financial funds prefer to buy assets with a lowerrisk like bonds, or to buy “risk-free” assets like time depositswhich are used by the financial intermediates to providecredits.

◮ Financial intermediates have lower costs to achieveinformation about the risky business.

S.111


(Source: Mishkin (2006), p.171)

S.112


2. Indirect Financing via Intermediates (like banks) is much moreimportant than Direct Financing

◮ The same argument applies

3. The financial system is one of the most regulated sectors in theeconomy.

◮ Regulation is needed to alleviate the problems of informationasymmetries.

S.113


4. Large well-established firms have a more easy access to financialfunds than small or new firms.

◮ Large firms have more expertise as well as more economies ofscale to provide detailed information.

◮ Only large firms are rated by rating agencies.

◮ Well-established firms have built up reputation.

◮ Large firms can provide much more collaterals.

5. Collaterals are a prevalent ingredient of loan contracts for firmsand households.

◮ Collaterals lead to a drastic decrease of risk premiums whatalleviates the adverse selection effect.

◮ Combining different interest rates and collateral requirementsmay lead to self-selection (separating eqilibrium).

S.114


Excourse: Microfinance in Developing Countries

◮ Many small businesses with small amounts of required loans.

◮ Typically no collaterals!

◮ Consequently, extremely high interest rates for private lending or noaccess to capital.

Idea:

◮ Bundling several borrowers to a group (group lending). Everygroup member is liable for all repayments ⇒ screening andmonitoring task is partially shifted to the borrowers.

◮ Self-selection of “reliable” lenders, incentive to monitor the effortsin creating profitable business.

◮ Repayment scheme which incentivices monitoring. Short-runopportunistic behavior will reduce likelihood of loan prolongation orfuture loans.

However: Could lead to severe social pressure within a group.S.115

2. Theory of Financial Structure2.4 Moral Hazard Problems

Outline:

2.4.1 Introduction into Principal-Agent-Problems

2.4.2 How Moral Hazard Affects the Choice Between Debt andEquity

2.4.3 Solving Moral Hazard Problems

2.4.4 What Stylized Facts are Explained by Moral Hazard?

Literature:


Wolfstetter, E. (1999), Topics in Microeconomics. Cambridge University

Press, chapter 11

S.116

2. Theory of Financial Structure2.4 Moral Hazard Problems2.4.1 Introduction into Principal-Agent-Problems

General Structure:

◮ Principal offers a contract to the agent.

◮ The payoff depends on the unobservable behavior of the agentas well as on stochastic variables.

Examples◮ Employer-employee relationship: The outcome for the employer

depends on the unobservable effort of the employee.◮ Borrower-lender relationship: The risk of debt failure depends

on the project choice of the borrower (high risk or low risk)

◮ The agent has an incentive to exploit the unobservability ofhis choice in order to maximize his own utility instead ofmaking decisions in accordance to the preferences of theprincipal (= moral hazard). This can be anticipated by thepricinpal.

S.117


P A

A

equity contract

accept

reject

high effort

low effort

(uP , uA)

(uP2, uA2)

(opportunism)

(uP1, uA1)

randomvariable

S.118


P A

A

debt contract(low risk premium)

accept

reject

low risk project

risky project

(uP , uA)

(uP2, uA2)

(opportunism)

(uP1, uA1)

randomvariable

S.119


◮ The principal is (at the best case) able to observe theoutcome of the agent’s deicion, not the decision itself =hidden action (except for monitoring).

◮ In some cases it is possible to conclude from the outcome tothe underlying actions of the agent (revelation), in other casesthis is not possible (non-revelation).

◮ Therefore, the contractual payments can depend on theoutcome but not on the behavior of the agent.

S.120


reveal not reveal reveal not reveal

high effort or high risk

low effort or low risk low effort or low risk

high effort or high risk

S.121


Two types of Moral Hazard problems:

◮ Agent = manager: In case of equity contracts the agent tendsto reduce his effort, since the equity holder benefits from thereturns due to his efforts. In case of a debt contract, thelender receives fixed payments, and the agent has an incentivefor high efforts since he benefits from the increasing expectedreturn.

◮ Agent = investor: In case of debt contracts the agent tends toinvest into too risky projects than negotiated with thelender. The reason is that in case of negative returns of theproject the debt fails = the lender also carries the risk. Therisk of the agent, however, is limited.

⇒ How to construct a financial contract which incentivices theagent to decide according to the principal’s preferences?

S.122

2. Theory of Financial Structure2.4 Moral Hazard Problems2.4.2 How Moral Hazard Affects the Choice Between Debt and Equity

Contracting in the presence of Moral Hazard:

◮ The financial contract regulates how the (stochastic) returnand how the risk is allocated to the principal and the agent(risk-return-scheme).

◮ Each type of a risk-return-scheme incentivices a certainbehavior of the agent.

◮ The principal anticipates the incentive structure of the agent.He proceeds in two steps:

1. What is the optimal risk-return-scheme which incentives theagent to choose a certain project or a certain effort level?

2. Which risk-return-scheme maximizes the utility of theprincipal?

S.123


Two extreme cases:

◮ Fixed payments (= low risk) for the agent,residual return (= high risk) for the principal

Examples: fixed wages in case of employer-employee-relationships; shareholder and fixed payed manager of a firm

◮ Residual returns for the agent,fixed payments for the principal

Example: premium wages for employee and fixed return forthe employer; fixed interest payments for the bank, residualreturn for the investor

S.124


A note on guarantees (suretyship):

◮ Guarantees from third parties (like government) reduces therisk of the lender in case of a credit failure.

◮ The lender has a bias towards financing too risky projects.

◮ Similar to Moral Hazard effects in case of insurances.

◮ Example: bank crisis in 2008 – if large banks could expectthat in case of insolvency there will be a governmental bailoutthey might be less cautious in buying risky assets.

S.125

2. Theory of Financial Structure2.4 Moral Hazard Problems2.4.3 Solving Moral Hazard Problems

Equity Markets:

a) Monitoring:

◮ Providing information about the decisions of the investor andtheir consequences for earnings and profits. Thus, the actionsare less “hidden”.

◮ This is costly!

◮ Legal constraints.

◮ If there are many principals, a free-riding problem arises.

S.126


b) Governmental Regulation:

Same argument as in case of adverse selection (see above).

c) Co-determination of management decisions

This is only possible in case of financial intermediation: Financialfunds are given to a FI (e.g. an investment corporation) that buysequities of a firm but also participate in the management.

S.127


d) Manager contracts

If managers are payed according to the impact of their decisions onthe firm value (e.g. by stock options), it could be expected thatthey have similar preferences than other holders of equity shares.

e) Mixing with debt contracts

Similar effect: The lender receives fixed payments, the agentreceives the residual profit. He will show more effort and chooseprojects according to his risk preferences.

S.128


Especially in loan markets:

a) Net Worth

Sum of assets minus liabilities = Net Worth. A failure of theproject (negative returns) reduces the agent’s own net worth.Hence agent has incentive to choose projects with proper riskinsetad of exploiting the moral hazard effect and shifting the risk ofloss to the lender.

b) Collaterals

Most debt contracts contain covenants to keep some valuablecollaterals. In case of debt failure the lender can claim thesecollaterals. This works similar to the net worth effect (see above).

S.129


c) Provision of information / Monitoring

The debt contract contains covenants that the borrower mustprovide (regularly) information about his activities. There may becontractual penalties in case of verified false information.

d) Financial intermediation

Restrictions in contracts must be monitored and enforced.Intermediates can do this more effectively and with lowertransaction cost than an individual lender.

S.130


Summary:

◮ Moral Hazard (MH) arises in both, equity and debt contracts.

◮ MH may result in (a) too low effort of the agent, (b) choosingtoo risky projects.

◮ Financial contracts should be designed in an incentivecompatible way, i.e. that agent’s utility maximizing decisionsare compatible with the preferences of the principal. This isnot always perfectly possible.

◮ Financial intermediates have better possibilities to alleviatethe MH problem.

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2. Theory of Financial Structure2.4 Moral Hazard Problems2.4.4 What Stylized Facts are Explained by Moral Hazard?

1. Credit and loans are an importnat source of financing business

2. Indirect Financing via Intermediates (like banks) is much moreimportant than Direct Financing

3. The financial system is one of the most regulated sectors in theeconomy.

5. Collaterals are a prevalent ingredient of loan contracts for firmsand households.

6. Debt contracts are typically complicated and contain manyrestrictions on the behavior of the borrower.

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2. Theory of Financial Structure2.5 Efficient Market Hypothesis and its Limits

We leave the theory of financial intermediation and turn tosecondary markets where financial assets are valued by marketparticipants.

◮ Mishkin, Frederic S. (2012), The Economics of Money,Banking, and Financial Markets, 10th ed., Boston et al:(chapter 7)

◮ Malkiel, B.G. (2003), The Efficient Market Hypothesis and ItsCritics. Journal of Economic Perspectives 17(1), 59-82

S.133


◮ Study of behavior of stock prices by L. Bachelier (1900):random character of stock prices.

◮ E. Fama (1960ies):◮ Started as a “technical analyst”: trying to find “patterns” in

past data which enables investor to predict stock prices◮ But: Random Walk – successive price changes are

independent⇒ interpreted RW as an indicator that all relevant information is

processed efficiently!

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Idea:

◮ If we could predict in t from available information that pricept+1 will exceed pt then it would be rational for allparticipants to buy in t (speculation). Thus, pt willinstantanously increase until the level pt+1 so that pt is thebest predictor for pt+1.

◮ Thus speculation is seen as an acrtivity making marketsinformationally efficient.

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“An efficient market is defined as a market where there are a largenumber of rational profit-maximizers actively competing, with eachtrying to prdict future market values of individual securities, andwhere important current information is almost freely available toall participants [...] on average, competition will cause the fulleffects of new information on intrinsic value to be reflectedinstantanously in actual prices. ” (Fama 1965)

S.136


◮ “Informational no-arbitrage”: a further analysis is useless

◮ Not possible to “beat the market” (generate excess returns)

◮ Consistent with the “Rational Expectations” Hypothesis

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Lot of empirical work in late 1980ies. Resume in Fama (1970,Journal of Finance), elaborated EMH in three forms:

◮ Weak efficiency: prices fully reflect all information from pastdata (technical analysis cannot have any advantages); nosystematic market inefficiencies which could be exploited.

◮ Prices should follow Random Walk ⇒ testable hypothesis

◮ Mixed evidence: main problem is the “momentum effect”(persistence of temporary trends); episodes of euphoria andglooms.

◮ Example: Pesaran, M.H. (2010), Predictability of AssetReturns and the Efficient Market Hypothesis. CESifo WorkingPaper No. 3116.

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◮ Semi-strong efficiency: prices fully reflect all informationfrom past data and all current information which is publicilyavailable.

◮ New informations which are relevant for fundamental value ofthe asset is incorporated in the prices immediately.

◮ Returns from an asset: general market moves versus individual(residual) component. Which infiormations drive the residualcomponent? E.g.: announced stock splits, quarterly earningsreports, issuing new stock shares, other relevant information

◮ Mainly empirical support of semi-strong efficiency.

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◮ Strong efficiency: same as semi-strong but also incorporatingprivate information of market participants.

◮ However: in most legislations this is forbidden (insider trade).

◮ Not much evidence for strong efficiency.

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Implications of EMH:

◮ Only surprising news are moving the market (very quickly).Published information which has been anticipated already,does not move the prices.

◮ Don’t trust “hot tips” (either forbidden insider trades, oruseless)

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Critique:

◮ Micro-perspective:

◮ Bounded rationality, various cognitive biases which preventeven sophisticated people to make statistically correctpredictions (e.g. over-confidence, distorted risk-perception

◮ Herding behavior, irrational exuberance.⇒ Behavioral Finance (e.g. Robert Shiller)

◮ Macro-perspective:

◮ Bublles and crashes; global financial crisis

(Note: Eugene Fama and Robert Shiller as well as Lars Peter Hansen won 2013

the Nobel Prize in Economics....)

S.142


However:

◮ Fama argues that “bubbles do not exist”: a theory whichdefines and explains bubbles should be able to predict them.As long as there is no such a theory there is no reason to“believe” in bubbles. They are seen as an ex post attributionof an observed rapid price decline.

◮ Detection of a “bubble” requires that we know somethingabout the “fundamental value”. According to EMH, allrelevant information about this is already included in the price.Thus a sudden crash could be explained by the occurence ofnew (even small) information triggering the expectations.

◮ Problem of self-reference of (rational) expectations:expectations about future fundamental firm value ⇒fundamental firm value: net present value of future expectedcash flow.

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Joint Hypothesis Problem:

◮ To test efficiency, the modeler has to consider all relevantinformation which is necessary to compute the “best”prediction.

◮ If test does not reject EMH, we cannot reject that marketparticipants are doing the same as the modeler (EMH is notrejected 6= proven as “true”).

◮ If test rejects EMH, than this shows that the underlying modelis not completely specified (e.g. the modeler did not use allthe information which the market participants have used).

◮ Therefore, EMH is not testable ⇒ ?

S.144

3. The Money Supply Process3.1 Function and Measurement of Money

Outline:

3.1.1 Functions

3.1.2 Monetary Aggregates

3.1.3 Other Definitions of Money

Literature:

Bofinger (2001), chapter 1


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3. The Money Supply Process3.1 Function and Measurement of Money3.1.1 Functions

”Money is what money does. Money is defined by itsfunction.“ (J. Hicks 1976)

Functions:

◮ Medium of Exchange

◮ Unit of Account

◮ Store of Value

S.146


Medium of Exchange:

◮ Without money each good can possibly exchanged with eachother good (bartering). Hence we have for n goods n(n− 1)/2exchange relations = relative prices.

◮ Finding a transaction partner with symmertic exchange wishes(A: books → whiskey, B: whiskey → books) is extremlyexpensive ⇒ transaction costs. Since there are numerouspossibilities to exchange goods “over several edges” (e.g.books → butter → cutting hair → whiskey) there are extremehigh information costs to find the best exchange relation.

◮ Money as a generally accepted medium of exchange leads to adramatic decrease in transaction costs (only n money prices).

S.147


Unit of Account:

◮ Money as a numeraire: Money prices makes comparisons veryeasy (what is “cheap”, what is “expensive”?), hence moneyreduces information costs.

◮ Money as a precondition for accounting systems: A generalunit enables accounting systems like balance sheets to measurethe financial wealth or current accounting systems to measurethe inflow and outflow of money and eranings per period.

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Store of Value:

◮ Receiving money (instead of goods or services) enables themoney holder to buy goods and servies to an arbitrary time.His purchaising power is conserved.

◮ If the disposition of the agent changes over time, the storedmoney can be used for varying expenditures → concept ofliquidity, money as the asset with the highest degree ofliquidity.

◮ The possibilities for intertemporal decisions (like savings in t0for additional production and consumption in t1) increasedramatically with such a store of value.

◮ Problem: Inflation! Money may be substituted by real assets.This function of money is fulfilled by another asset.

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◮ The functions define money in an abstract manner.

◮ There are different forms of apparance of money (financialassets) like currency, deposits, time deposits, checks etc.

◮ It is reasonable to define collections of financial assets whichare called monetary aggregates.

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3. The Money Supply Process3.1 Function and Measurement of Money3.1.2 Monetary Aggregates

M1 = currency in circulation+ overnight deposits

M2 = M1 + deposits with an agreed maturity of up to two years+ deposits redeemable at notice of up to three months.

M3 = M2 + repurchase agreements+ money market fund shares+ debt securities with a maturity of up to two years

S.151


Monetary aggregates in 02/2014 (Bill. Euro)(source: ECB):

currency in circulation 919overnight deposits 4574 ⇒ M1= 5493deposits mat. < 2 years 1663red. deposits < 3 months 2117 ⇒ M2= 9273repos 130money market fund shares 427debt sec. < 2 years 87 ⇒ M3= 9918

S.152


(Source: ECB)

S.153


(Source: ECB)

S.154


S.155

3. The Money Supply Process3.1 Function and Measurement of Money3.1.3 Other Definitions of Money

Definition by the transmission mechanism

◮ There are different transmission theories on how monetaryshocks affects the real sphere or the inflation rate.

◮ Take a transmission theory: monetary aggregate M thenincludes all financial assets which are consistent with thetransmission theory.

◮ Advantage: If the transmission theory is “true”, the aggregateM is a good intermediate goal for monetary policy.

◮ Problem: If M is defined in this way then the underlyingtransmission theory can not be falsified. It is a tautology.

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3. The Money Supply Process3.1 Function and Measurement of Money3.1.3 Other Definitions of Money

Econometric definition

◮ There are diffreent theories of money demand. In the long runit can be assumed that the money market is in equilibrium,i.e. money equals money demand.

◮ Take a theory of money demand. Money includes then allfinancial assets which are demanded by the agents (example:Keynes theory Ld(Y , i)). Statistical regression then decideswhether a type of financial asset is significant to explainmoney demand.

◮ Advantage: The definition of money is based on an economictheory rather than being arbitrary or a matter of convention.

◮ Problem: If M is defined in this way, the underlying moneydemand theory can not be falsified.

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3. The Money Supply Process3.2 Creation of Central Bank Money (Money Base)

Outline:

3.2.1 Balance Sheets of the Financial Sector

3.2.2 Basic Operations of the Central Bank

3.2.3 Overview: Policy Instruments

Literature:

Bofinger (2001), chapter 3.1-3.3Mishkin (2010), chapter 15, parts of chapter 16ECB (2004), The Monetary Policy of the ECB (downloadable)

McLeay, M., Radia, A., Ryland, T. (2014), Money creation in the modern

economy. Bank of England, Quarterly Bulletin 2014 Q1

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3. The Money Supply Process3.2 Creation of Central Bank Money (Money Base)3.2.1 Balance Sheets of the Financial Sector

central bank’s balance sheet (simplified)

Assets Liabilities

• Foreign reserves F • Currency (C )

• Loans to commercial • Deposits of commercialbanks (Lc) banks (reserves) (R)

• Securities (Scb,B) • Other Liabilities(e.g. bonds) • Net Worth

Monetary Base M0 = C + R

S.159

3. The Money Supply Process3.2 Creation of Central Bank Money (Money Base)3.2.1 Balance Sheets of the Financial Sector

commercial bank’s balance sheet (simplified)

Assets Liabilities

• Reserves (R) • Loans:= required reserves – central bank loans (Lc)

+ excess reserves – inter-bank loans

• Loans (L): • Deposits of non-banks (D):– inter-bank loans – overnight deposits– commercial loans – time deposits– reals estate – saving deposits

• Bonds/Securities (B): • Other debt instruments• Cash items• Other assets • Bank Capital/Net Worth (BC )

S.160

3. The Money Supply Process3.2 Creation of Central Bank Money (Money Base)3.2.2 Basic Operations of the Central Bank

Central bank can create money M0:

◮ non-borrowed reserves: purchasing securities like bonds on thesecurity market: ∆Scb or ∆B > 0

◮ borrowed reserves: providing a loan to a commercial bank:∆Lc > 0

◮ Since there is a inter-bank market for (borrowed) reserves, themain central bank loans are also called “open marketoperations”.

◮ Furthermore, banks could borrow reserves overnight →“standing facilities”.

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Case 1: Central bank buys a security from a commercial bank

central bank

Assets Liabilities

∆B = 100 ∆R = 100

commercial bank

Assets Liabilities

∆B = −100∆R = 100

◮ With the additional reserves the commercial bank is able toprovide additional loans to the non-bank sector or to buyother assets.

◮ This is a restructuring of the bank’s portfolio. The bank willdo this only if it is profitable.

S.162


Similar accounting records (e.g.):

◮ Central bank buys securities from a commercial bank and payswith currency: ∆Scb = ∆C .

◮ Central bank buys foreign reserves from a non-bank and payswith currency: ∆F = ∆C .

◮ etc. (see Mishkin (2010) for examples)

Reserves may be changed into currency and vice versa(no effect on M0):

∆R = −∆C

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Case 2: Central bank loan to a commercial bank

central bank

Assets Liabilities

∆Lc = 100 ∆R = 100

commercial bank

Assets Liabilities

∆R = 100 ∆Lc = 100

◮ Again, with the additional reserves the commercial bank isable to provide additional loans to the non-bank sector or tobuy other assets.

◮ This extends the commercial bank’s balance sheet and shiftsthe debt/equity ratio of the liability side.

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Some characteristics of the central bank loans:

◮ The commercial bank has to pay interest rates. These interestrates are the primary policy instrument.

◮ The loan contract has typically a maturity of one week orthree months (“open market operations”), or it is anovernight loan (“standing facilities”). In times of financialdistress there are also long-term contracts.

◮ The banks must provide securities = function of a collateral.

◮ When the loan is returned at the maturity date, the monetarybase M0 decreases ⇒ reverse accounting record.

S.165

3. The Money Supply Process3.2 Creation of Central Bank Money (Money Base)3.2.3 Overview: Policy Instruments

Overview over ECB policy instruments:

1. Reserve requirements: The bank must hold a part of theirdeposits as reserves. There is a need to borrow liquidity from thecentral bank.

2. Open Market Operations: The central bank provides liquidity tothe banks while the banks provide specified securities; tenderprocedures.

◮ Main operations: interest rates weekly adjusted; maturity 1week

◮ Long term-operations: interest rates monthly adjusted;maturity three months.

◮ Structural and fine-tuning operations: also definitve purchasesand sales of securities are possible.

3. Standing Facilities:◮ Short-run (overnight) loans◮ Overnight deposits

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Reserve requirements:

◮ Liabilities with positive reserve ratio:

◮ Deposits (including overnight deposits, deposits with an agreedmaturity up to two years and deposits redeemable at a periodof notice of up to two years)

◮ Debt securities issued with a maturity of up to two years

◮ Liabilities with zero reserve ratio

◮ Deposits (including deposits with an agreed maturity of overtwo years and deposits redeemable at a period of notice ofover two years)

◮ Debt securities issued with a maturity of over two years◮ Repurchase agreements

S.167


(source: ECB (2004))

S.168


Market for (borrowed) reserves:

◮ Supply of liquid excess reserves e.g. in case of inflowingdeposits.

◮ Demand for liquid reserves e.g. in case of outflowing depositsor expansion of loans.

◮ Collateralized and non-collateralized borrowing.

◮ Interbank (money) market interest rate: e.g. EONIA (EuroOvernight Index Average)

◮ Since interbank loans and central bank loans are closesubstitutes, the central bank has a strong impact on themoney market rate, and it determines the circulating reserves.

◮ Fixed reserve supply and aggregated “net” demand forreserves.

S.169


Stylized market for (borrowed) reserves:(i cb = “discount rate”, iM = market interest rate)

reserves

rateinterest

demand

supply (cb)

iM

icb

S.170


Effects of monetary policy on borrowed reserves and interest rates:

reserves

rateinterest

reserves

rateinterest

Changing thediscount rate

Outright purchasesof securities

S.171


How to respond to a increasing demand for reserves?

reserves

rateinterest

reserves

rateinterest

full accomodation(goal: stable i) (goal: stable M0)

no accomodation

⇒ CB cannot fully control both, interest rate and M0. Most CB use

interest rate as operational target, thus they accomodate demand for M0.

S.172


(source: Deutsche Bundesbank)

S.173

3. The Money Supply Process3.3 Multiple Deposit Creation and the Multiplier

Outline:

3.3.1 The Money Multiplier

3.3.2 Determinants of the Multiplier

3.3.3 Objections against Static Multiplier Analysis

Literature:

Bofinger (2001), chapter 3.4Mishkin (2010), chapter 16

S.174

3. The Money Supply Process3.3 Multiple Deposit Creation and the Multiplier3.3.1 The Money Multiplier

◮ Monetary aggregat M1 defined as

M1 = C + D (18)

with C as currency and D as deposits.

◮ The monetary base, “controlled” by the central bank, istdefined as

M0 = C + R (19)

where R are the reserves with

R = RR + ER = r · D + ER (20)

where RR are the required reserves and r is the requiredreserve ratio. ER are the excess reserves.

S.175


◮ Behavior of the non-bank public:

People have certain transaction customs. They wish to holdcurrency and deposits in a certain ratio (= assumption)

c =C

D⇒ C = cD (21)

◮ Behavior of commercial banks:

Due to liquidity considerations they hold excess reserves as ahigh liquidity risk-free asset (as a reaction to expected depositoutflows). The ratio of excess reserves and deposits areassumed to be

e =ER

D⇒ ER = eD (22)

S.176


Inserting (21 ) and (22) into (18) and (19) we have:

M0 = cD + rD + eD = (c + r + e)D (23)

M1 = cD + D = (1 + c)D (24)

Solving (23) to D and inserting into (24) we have the moneymultiplier

M1 =1 + c

r + c + eM0

∆M1

∆M0=

1 + c

r + c + e≡ m (25)

From (23), the deposit multiplier is

∆D

∆M0=

1

c + r + e(26)

S.177

3. The Money Supply Process3.3 Multiple Deposit Creation and the Multiplier3.3.2 Determinants of the Multiplier

◮ Required reserve rate r : fixed by the central bank; negativecorrelation with the money supply.

◮ Currency/deposit ratio c : depends on the behavior ofnon-banks; negative correlation with the money supply (thechange of the denominator is relatively large compared to thechange of the numerator).

◮ Excess reserves/deposit ratio e: depends on bank behavior ;negative correlation with the money supply.

⇒ What drives c and e?

S.178


◮ Excess Reserves are an asset with low return, no risk, and highliquidity. Bank holds excess reserves e.g. to meet depositoutflows or, generally, to avoid illiquidity.

◮ If the interest rate (for bonds and/or loans) increases, theopportunity costs of holding excess reserves increas. Hence,the excess reserves are negatively correlated with i .

◮ Excess reserves can be borrowed to other banks (inter-bankmarket). This depends primarly on trust, and also on thedifference between money market rate and central bank’sdeposit rate.

◮ Normally, excess reserves do not play a major role, the effctson the multiplier are small.Exception: Financial crisis 2008/2009 – sharp increase of E !

S.179


(Source: Mishkin (2006), p.381)

S.180


(Source: ECB)

S.181


◮ For the determination of c we have no theory about paymentcustoms.

Further determinants of M1 = m ·M0:

◮ The money base M0 changes according to◮ the central bank’s activities on the security market

(purtchasing/selling securities Scb)◮ the demand for central bank loans Lc

◮ The major policy instrument is Lc . Central bank can reducedeposit rate but cannot force banks to demand Lc . They canalso not completely refuse to provide Lc in case of strongliquidity needs ⇒ market interest rate would increase, losingcontrol over the interest rate.

S.182

3. The Money Supply Process3.3 Multiple Deposit Creation and the Multiplier3.3.3 Objections against Static Multiplier Analysis

The static multiplier approach M1 = m ·M0 suggests that thecentral bank is able to determine money supply. However, there aresome objections:

◮ The approach suggests that the multiplier process is initiated by thecentral bank, not by the demand for loans (deposits). However,credit demand initiates the demand for M0 which is thenaccomodated by the CB.

◮ It is assumed that additional reserves are transformed intoadditional credits. But credit supply and demand behavior is notfounded by microeconomic reasoning. Thus, you cannot “push” Mby an increase of M0.

◮ The determinants c , e are assumed to be fixed in the multiplierprocess. But the behavior of banks and non-banks may changebecause the multiplier process takes place since it affects e.g.interest rates and liquidity positions. Furthermore, if a monetaryimpulse has real effects (e.g. Y increases) then this has a feedbackon credit demand.

S.183

3. The Money Supply Process3.3 Multiple Deposit Creation and the Multiplier3.3.3 Objections against Static Multiplier Analysis

S.184

3. The Money Supply Process3.4 Endogenous Money Supply

Outline:

3.4.1 Bofinger’s price theoretic model

3.4.2 The Bernanke/Blinder approach

3.4.3 Outline of an integrated model

Literature:

Bofinger (2001), chapter 3.4Bernanke, B., Blinder, A.S. (1988), Credit, Money, And AggregateDemand. American Economic Review, Papers And Proceedings Vol.78,435-439.

Palley, T.I. (2002), Endogenous Money: What It Is And Why It Matters.

Metroeconomica Vol. 53, 152-180.

S.185

3. The Money Supply Process3.4 Endogenous Money Supply3.4.1 Bofinger’s price theoretic model

Simplified version of the Bofinger model – Basic Ideas:

The multiplier approach provides no microeconomic foundationneither of the bank’s credit supply nor of the credit demand. Thisfoundation should be (partially) provided.

◮ The loan interest rate (“price”) coordinates supply anddemand of credits.

◮ In order to provide credits the bank needs reserves.

◮ The equilibrium interest rate on the credit market determinesthe bank’s demand on the market for (borrowed) reserves.

◮ The central bank can accomodate the reserve demand or itcan change the discount rate for borrowed reserves. Hence thediscount rate affects the credit supply function.

S.186


◮ Simplified bank’s balance sheet: rD + L = D + Lc◮ Simplified central bank’s balance sheet: Lc = rD

◮ In the simplified version there is no currency, thereforeM1 = D and M0 = R = rD and therefore m = 1/r .

◮ The multiplier relation is then D = mLc .

The loan supply is derived from a profit maximizing calculus:

maxL

π = iL− icLc − βL2 (27)

where the term βL2 describes the increasing risk of debt failures.

When required reserves R = rD are subtracted from the balancesheet and applying D = mLc , we have the multiplier:

L = Lc + (1− r)mLc = mLc (28)

S.187


Solving (28) to Lc = 1/m · L and inserting into the profit functionthe maximizing calculus (27) leads to credit supply function

L = L(i , ic , β) =1

2β(i − ic/m) (29)

which depends positively on i and negatively on ic and β.

On the other market side we have a decreasing credit demandfunction LD(i , y) with ∂LD/∂i < 0 and ∂LD/∂y > 0.

The equilibrium L(i∗, ic , β) = LD(i∗, y) determines the

equilibrium interest rate i∗ = i∗(ic , β, y).

S.188


Now we turn to the demand for reserves:

Taking the optimal loan supply (29) and substituting L into (28)we obtain the optimal reserve demand:

Lc(i , ic , β) =1

2mβ(i − ic/m) (30)

which is a linear decreasing function of ic . It is parametrized by theequilibrium interest rate on the credit market.

S.189


The Bofinger model:

L

Lc

L = mLc

LD(i , y)

i

ic

L(i , ic , β)

(multiplier)

demand for

credit market

interest raterelation

borrowed reserves

S.190


Interpretation:

◮ Upper right: The credit market with upward sloping creditsupply function (29) and a linear cerdit demand function.

◮ Lower right: The multiplier relation – translates the desiredlevel of loans L into the level of required reserves which areneccessary to create deposits to finance these loans.

◮ Lower left: The demand for borrowed reserves Lc (eq. (30)).

◮ Upper left: The market equilibrium interest rate i∗ is animplicit function of the discount rate ic . In case of linearfunctions also this relationship is linear.

S.191


Case 1: Central bank increases the discount rate ic

L

Lc

LD(i , y)

i

ic

L(i , ic1, β)

L(i , ic2, β)

ic1ic2

S.192


Case 2: The demand for loans increases, central bank does not adapt ic

L

Lc

i

ic

L(i , ic , β)

LD(i , y1)

LD(i , y2)

S.193


◮ For an extensive analysis (e.g. the case of fluctuating creditdemand) see Bofinger (2001), chapter 3.4 and appendix

The model has implications for the macroeconomic IS-LM analysis:

◮ Demand shocks on the credit market may lead to a reactionof the central bank. Depending on their primary goals(stabilizing the interest rate vs. stabilizing the money base)different types of LM curves occur.

◮ If the central bank does not respond to the demand shock, anincreasing y leads to an increasing credit demand and thus toa monetary expansion. In the traditional IS-LM analysis this isnot the case ⇒ Money creation is (partially) demand driven.

S.194


Increasing income Y1 → Y2 leads to a right-shift of money demand(credit demand) and hence to a shift of the demand for borrowedreserves.

◮ Case 1 – Money volume targeting: Central bank will keepthe money volume on the same level. It has to increase thediscount rate. This leads to a left-shift of the credit supplycurve. The LM curve will be steep.

◮ Case 2 – Discount rate targeting: Central bank will keepthe discount rate on the same level. Hence it will provide morecentral bank loans and the money volume increases. The LMcurve will be more flat (positively sloped).

◮ Case 3 – Loans rate targeting: Central bank will keep theinterest rate on the loans market on the same level. It willfully accomodate the additional money demand by decreasingthe discount rate. The LM curve will be horizontal.

S.195


L

Lc

i

ic

L(i , ic )

LD(i ,Y1)

LD(i ,Y2)

i

ic Y2Y1 Y

L(i , i∗c )

i∗c

money volume targeting

LM (case 1)

S.196


L

Lc

i

ic

discount rate targeting

L(i , ic )

LD(i ,Y1)

LD(i ,Y2)

i

ic Y2Y1 Y

LM (case

S.197


L

Lc

i

ic

interest rate targeting

LD(i ,Y1)

LD(i ,Y2)

i

ic Y2Y1 Y

L(i , ic )L(i , ic )

i ′c

LM (case 3)

S.198


i

Y2Y1 Y

i

Y2Y1 Y

LM (case 1)

LM (case 2)

S.199


◮ Don’t confuse these “LM curves” with the LM curve of thestandard Keynesian IS-LM model. The latter assume a fixedM, determined by the central bank. This is only a very specialcase in the Bofinger framework.

◮ For most “LM curves” in this framework there is no fixed (butan endogenously determined) money supply.

S.200

3. The Money Supply Process3.4 Endogenous Money Supply3.4.2 The Bernanke/Blinder approach

Assume that the commercial bank’s balance sheet is

rD + E︸︷︷︸

R

+L+ B = D

→ E + L+ B = (1− r)D

where B are bonds. The is no currency C and no central bankloans Lc . The central bank determines the money base R bypurchasing or selling bonds.

The acitivity of the bank is to choose an appropriate portfoliostructure of the asset side.

S.201


The asset side contains two risky assets L and B , and a risk-freeasset E . The structure of the portfolio is given by:

E (i) = λE (i)(1− r)D

L(i , ρ) = λL(i , ρ)(1− r)D

Bb(i , ρ) = (1− λE (i)− λL(i , ρ))︸︷︷︸

λB (i ,ρ)

(1− r)D

where i is the interest rate of the bonds, ane ρ is the interest rateof loans.

The portfolio share λL ∈ [0, 1] depends positively on ρ, negativelyon i , and vice versa for λB , λE depends negatively on i .

S.202


The reserves of the commercial bank are

R = rD + E = rD + λE (i)(1− r)D = (r + λE (i)(1− r))D (31)

Hence the money multiplier is

∆D

∆R= m(i) =

1

r + λE (i)(1− r)

The multiplier depends on the bank’s portfolio considerations andis endogenously determined by the bonds interest rate i . Note,that i is determined on the bonds market and that the centralbank is an agent on the bonds market.

S.203


The equilibrium on the credit market is determined by

Ld(i , ρ, y) = L = λL(ρ, i)(1− r)D

It is assumed that non-banks also hold a portfolio of bonds andmoney so that the loan demand is determined by i (+) and ρ (-).

Money supply is given by the multiplier D = m(i)R while themoney demand follows the standard assumptions Dd(i , y)(positive dependency on y and negative dependency on i).

Money market equilibrium is given by (LM curve)

Dd(i , y) = m(i)R

S.204


Comparison:

Bofinger model:

◮ only borrowed reserves = discount rate policy

◮ banks have only loans as an asset, no portfolio approach

◮ Fixed multiplier, but an endogenously determined money base

Bernanke/Blinder model:

◮ only non-borrowed reserves = open market operations on thesecurity market

◮ banks use a portfolio approch to determine their portfolio whichcontains loans, bonds, and excess reserves

◮ Exogenously determined money base, but an endogenouslydetermined money multiplier

S.205

3. The Money Supply Process3.4 Endogenous Money Supply3.4.3 Outline of an integrated model

Remind the stylized balance sheet of a bank:

Assets Liabilities◮ Reserves (required, excess)

◮ Cash

◮ Securities/Bonds

◮ Loans to non-banks

◮ Inter-bank loans

◮ Deposits

◮ Inter-bank loans

◮ Central bank loans

◮ Other debt instruments

◮ Bank Capital / Net Worth

S.206


◮ Bank decides about◮ structure of the asset side◮ structure of the liability side◮ size of the balance sheet

◮ Decisions depend on expected returns, risks, and liquidity ofassets, as well as the interest rates to be paid for deposits,interbank and central bank loans (costs).

◮ Decisions are made under constraints such like Basel II/III.

S.207


◮ Deposits are created by new loans.

◮ Hence, the loans supply and demand determines the loansinterest rate and the loan (deposit) volume.

◮ The central bank influences (not: determines) this process bythe conditions for borrowing reserves, amount ofnon-borrowed reserves, the required reserve rate: Theelasticity how loan supply depends on these monetary policyvariables, depends also on other endogenous variables.

◮ The central bank has to respond to changes e.g. on the loansmarket and to changed reserve demand. Central bank’s role ina phase of financial distress.

◮ Increased role of non-bank financial intermediates (“shadowbanks”) – might change the transmission of monetary policyand even the ability of the central bank to affect the liquidity.

S.208

3. The Money Supply Process3.4 Endogenous Money Supply

Some Implications:

◮ Monetary policy has some impact on the money supply butdoes not control it. Monetary expansion is primarlydetermined by the money demand of the private sector (andthe government).

⇒ If money is created according to the money demand, it isquestionable to construct a “money market equilibrium”(supply = demand) like the LM curve.

◮ Inflation by monetary expansion is therefore not only a matterof a “wrong” central bank policy but a consequence ofmassive credit expansion e.g. by governmental debt. Successof monetary policy depends also e.g. on fiscal discipline.

S.209

4. Theory of Money Demand4.1 Keynesian Theory of Liquidity Preference

Outline:

4.1.1 Transaction Motive

4.1.2 Money as an asset

4.1.3 Precautionary Motive

4.1.4 Evidence

Literature:



S.210

4. Theory of Money Demand4.1 Keynesian Theory of Liquidity Preference4.1.1 Transaction Motive

◮ Money is used for transaction purposes:

Mv =∑

i

pi ti

with M = money (stock variable), v = velocity, pi , ti as theprices and the quantities determining transaction i in theperiod (flow variable).

◮ Since there is no statistical data about all transactions, we usethe price index P and the real income Y as a proxy:

Mv = PY ⇒M

Pv = Y ⇒ M rv = Y (32)

◮ The velocity v is a matter e.g. of payment customs. Eq. (32)is called the quantity theory of money.

S.211


Income velocity of M3 in Euro area:

(Source: Brand, C., Gerdsmeier, D., Roffia, B. (2002), Estimating the Trend of M3 Income Velocity Underlying the

Reference Value for Monetary Growth. ECB Occasional Papers No. 3)

S.212


◮ If money is primarly needed for transactions, the demand formoney is (so called Cambridge form)

Md =1

vPY = kPY

or in real terms

Md

P≡ LT (Y ) = kY (33)

◮ This is the only motive in “classical” (pre-Keynes) economics.

◮ While the quantity theory (32) is a pure definition (and hencealways “true”), the Cambridge form (33) is interpreted as abehavioral hypothesis.

S.213

4. Theory of Money Demand4.1 Keynesian Theory of Liquidity Preference4.1.2 Money as an asset

◮ Keynes assumes that agents could choose to hold eithermoney or bonds as a financial asset.

◮ Money: No return, no risk◮ Bonds. Positive return, positive risk

◮ Assume that bonds have no maturity date and are held foronly one period (no discounting).

◮ Agents are assumed to be risk-neutral = they decide onlyaccording to expected return.

S.214


Bt price of the bond in tBet−1 expected price in t + 1

C regular coupon rate payments

The effective interest rate is defined by

it =C

Bt⇒ Bt =

C

itHolding the bond for one period is profitable if

π = C + Bet+1 − Bt > 0

⇒ C +C

iet+1

−C

it> 0

⇒ 1 +1

iet+1

−1

it> 0

⇒ it >iet+1

1 + iet+1

= ic

S.215


◮ For it > ic there are positive returns from holding the bond,and negative returns in case of it < ic .

◮ Depending on individual expectations iet+1 the agent will holdfinancial wealth either in bonds or in money.

◮ Similar calculations can be made for the case that money (e.g.deposits) have a positive interest rate.

◮ Different individuals have different expectations iet+1 andhence different ic . If market interest rate falls, more and moreindividual critical interest rates are undercut, and more andmore individuals sell bonds and hold money instead.

S.216


LS

i

ic

individual demand

LS

iaggregated demand

S.217


The money demand from the asset motive(or as Keynes said: “speculation”) is:

Ls = Ls(i),dLSdi

< 0

Note:

◮ The money asset LS is limited by the financial wealth: LS incase of money is the unique asset type for all individuals.

◮ If you consider other alternatives than “bonds” (e.g. timedeposits), there is a dependency on multiple interest rates.

◮ Instead of interest rate it may be plausible to use real interestrates since LT , LS are real values.

S.218


◮ Bringing both motives together, we have the money demand

L = L(Y , i), with∂L

∂Y> 0,

∂L

∂i< 0

◮ Defining the velocity by

v =Y

M r=

Y

L(Y , i)

Keynes’ liquidity preference theory can be interpreted as theCambridge approach with an endogenous velocity:

L =1

v(Y , i)Y = k(Y , i)Y

S.219

4. Theory of Money Demand4.1 Keynesian Theory of Liquidity Preference4.1.3 Precautionary Motive

◮ Money is hold to make unexpected transactions = to avoidilliquidity in case of neccessary unexpected transactions.

◮ Money holder faces opportunity costs i .

◮ Also from this motive we have a dependency fromY (+) and i (-):

LP = LP(Y , i)

◮ Original Keynesian idea: liquidity preference (hording) as aresponse to fundamental uncertainty because liquidity can betransformed in everything if the economy evolves in anunperceived way, and if people lack knowledge to form reliableexpecattions about that.

S.220

4. Theory of Money Demand4.1 Keynesian Theory of Liquidity Preference4.1.4 Evidence

Empirical Evidence:

◮ Since the money demand reflects plans which are notobservable, it is assumed (!) that the money market is alwayssufficiently close to the equilibrium, i.e. that real moneycirculation is a good proxy for the money demand.

◮ For M r = L(Y , i) we assume a log-linear form like

lnM rt = β0 + β1 lnYt + β2it + ǫt

where β0, β1, β2 are coefficients to be estimated, and ǫt is aserially uncorrelated stochastic variable.

◮ Derivation with respect to time t shows that

β1 =d lnM r/dt

d lnY /dt≈

dM r

dY

Y

M r

is the income elasticity of money demand, while β2 is thesemi-interest rate elasticity of money demand.

S.221


Questions:

◮ Which monetary aggregat? (M1, M2, M3)

◮ Which income? → usually real GDP

◮ Which interest rate? → usually bond interest rates;short term, long term interest rates?

◮ Regression analysis; cointegration

S.222


Some results (details in Bofinger (2001)):

◮ Positive income elasticity (some studies: near 1)

◮ Negative interest rate elasticity (but mostly small)

◮ In Europe more or less stable parameters, in USA not stable(eventually due to financial innovations)

◮ Large monetary aggregates do not depend on short terminterest rates.

S.223

4. Theory of Money Demand4.2 Portfolio Theory of Money Demand

Outline:

4.2.1 Money and Bonds in a Portfolio Equilibrium

4.2.2 Effect of Interest Rate Changes

Literature:

Bofinger, Peter (2001), Monetary Policy: Goals, Institutions, Strategies,and Instruments. Oxford: Oxford University Press.

Thompson, N. (1993), Portfolio Theory and the Demand for Money.

Hampshire.

S.224

4. Theory of Money Demand4.2 Portfolio Theory of Money Demand4.2.1 Money and Bonds in a Portfolio Equilibrium

Keynes Speculation Motive:

◮ Risk Neutrality

→ only iet+1 (expected mean) is relevant

→ (0, 1)-decision between money and bonds

◮ Mixture of money and bonds in a population withheterogenous expectations.

Portfolio Approach:

◮ Risk Aversion

→ the distribution of iet+1 is relevant

→ each individual mixes money and bonds

S.225


◮ Let i be the expected return from holding a bond, and σ2B is

the variance of these returns.◮ The Financial Wealth of an individual is composed of money

and bonds: FW = M + B . Let l = M/FW be the fraction ofmoney in the portfolio, while 1− l = B/FW is the fraction ofbonds.

◮ Expected return and standard deviation of a portfolio unit isthen

µ(l) = l · 0 + (1− l) · i (34)

σ(l) = (1− l)σB (35)

Solving (35) to 1− l and inserting into (34) gives the linearrestriction

µ = i ·σ

σB(36)

S.226


◮ We have a utility function u(µ, σ) with the standardproperties for a risk-averse agent. The indifference curve inthe (µ, σ)-space are increasing and convex (see figure).

◮ Maximizing utility with respect to l conditional to the linearconstraint (36) gives the tangential solution

∂u/∂µ

∂u/∂σ=

i

σB

(see figure)

◮ Thus, for a given (i , σB) the optimal portfolio structure isdetermined.

S.227


σ

µ

µ = i · σ

σB

(1− l) = σ

σB1

l

(1− l)

S.228

4. Theory of Money Demand4.2 Portfolio Theory of Money Demand4.2.2 Effect of Interest Rate Changes

What happens if the interest rate increases from i0 to i1?

σ

µ

(1− l) = σ

σB1

(1− l)

µ = i0 ·σ

σB

µ = i1 ·σ

σB

substitution effectincome effect

l0 l1

S.229


The result depends on the income and the substitution effect!Typical result: dl

di< 0 ⇒ dM

di< 0

i

M

S.230


Substitution effect:

◮ An increasing it makes bonds more attractive relative to money:Portfolio will be restructured in favor of bonds. This effect isunambigous (l decreases, see figure).

Income effect:

◮ An increasing it shifts the expected profits with given standarddeviations upwards, or shifts the risks downwards with given profits.According to the preferences, this leads to an adaption of theportfolio where the direction is ambigous: l might decrease orincrease. If it increases, it might outweight the substitution effect ornot.

◮ In the figure we assumed that the income effect increases l but doesnot outweight the substitution effect.

S.231


◮ The total effect is henceforth:

M(i) = l(i)FW ,dM

di=

dl

diFW

◮ Note, that money demand depends on Financial Wealth!

◮ Adding a transaction motive gives:

M(Y , i) = l(Y , i)FW∂l

∂Y> 0

S.232

5. Central Banking and Transmission of Policy5.1 Goals of Monetary Policy

Outline:

5.1.1 Social Welfare and Inflation

5.1.2 Social Costs of Inflation

5.1.3 Operationalization of the Inflation Goal

Literature:

Mishkin (2006), chapter 18, 26


S.233

5. Central Banking and Transmission of Policy5.1 Goals of Monetary Policy

Goals versus Targets:

◮ Ultimate goals like “social welfare” or “low inflation” couldnot directly affected by monetary policy tools.

◮ It is assumed (based on macroeconomic theory ontransmission channels) that intermediate targets have aninfluence on the goals Example: Monetary aggregates M1,M2, M3, loans volume, interest rates, inflation expectations.

◮ Also the intermediate targets could not be accomplisheddirectly. It is assumed that they depend on operating targetsor instrument targets. These targets are close to the policytools. Example: reserves, monetary base M0, interest rate forborrowed reserves.

Policy tools → operating targets → intermediate targets → goals

S.234

5. Central Banking and Transmission of Policy5.1 Goals of Monetary Policy5.1.1 Social Welfare and Inflation

Ultimate goal “social welfare”

◮ E.g. high employment, economic growth, price stability

◮ Conflicts among the goals, e.g. price stability and lowunemployment (short run Phillips curve)

◮ In many models maximizing welfare means minimizing a lossfunction (= maximizing −loss), e.g. like

L = −(P − Ptarget)2 − γu2, γ > 0

with u as the unemployment rate, or

L = −(P − Ptarget)2 − γ(Y − Y pot)2

with Y pot as the potential output.

S.235


Reasons why most central banks are primarly focussedon the inflation goal (price stability):

◮ Rational Expectations and Commitment problems

◮ Policy Assignment

◮ Long-term orientation of the policy

S.236


Rational Expectations and Commitment problems:

◮ Barro, R.J., Gordon, D.B. (1983), Rules, Discretion, and Reputation in aModel of Monetary Policy. Journal of Monetary Economics 12, 101-122.

◮ Assume a central bank which announces the goal of zero inflation.It is always possible that the central bank is able to realize the goal.

◮ If the public is believing this zero inflation goal, they incorporatethese expectations in their dispositions, e.g. wage contracts.

◮ By doing so it is no longer optimal for the central bank to achievezero inflation. Their policy is hence time-inconsistent. It will exploitthe low inflation expectations by choosing a positive inflation rateand positive real effects on output and employment.

◮ Rational agents will anticipate this time-inconsistency and notbelieve the zero inflation goal.

◮ The only time-consistent optimal inflation rate is positive.

⇒ Rule-binding to zero inflation better than discretion.S.237


Policy Assignment:

◮ “Tinbergen rule” (Jan Tinbergen, 1903-1994): In a frameworkof conflicting goals you need as many (linearly independend)instruments as you have goals. These instruments areassigned to the goals.

◮ Monetary Policy → assigned to the inflation goal, since moneyis assumed to be “neutral” in the long run.

◮ Fiscal Policy → assigned to the output goal.

(However, requirements of the Tinbergen model are rarely met.)

S.238


Long-term orientation:

◮ Many macroeconomists agree (with except for e.g.Post-Keynesian macroeconomists) that in the long runinflation is a monetary phenomenon, and monetary policy isnot able to affect real decisions. Real economic processesdepend in the long run only on relative prices rather than onthe price level.

◮ Achieving a low inflation level is assumed to be good forallocation efficiency and growth.

S.239


From the ECB’s statute (chapter II, article 2):

“To maintain price stability is the primary objective ofthe Eurosystem and of the single monetary policy forwhich it is responsible. This is laid down in the Treatyestablishing the European Community, Article 105 (1).”

“Without prejudice to the objective of price stability”,the Eurosystem will also “support the general economicpolicies in the Community with a view to contributing tothe achievement of the objectives of the Community”.These include a “high level of employment” and“sustainable and non-inflationary growth”.

S.240

5. Central Banking and Transmission of Policy5.1 Goals of Monetary Policy5.1.2 Social Costs of Inflation

◮ Transaction costs for price changes (menu costs)

◮ Confusion about absolute and relative price changes distortsthe allocation (loss of efficiency), i.e. there is no perfectanticipation which part of a single price change is due to“inflation”.

◮ Biases in fixed-payment-contracts: disadvantage for thereceiver, since the real value of the payment is reduced.

◮ fixed wages◮ retirement pensions◮ debt contracts (!)

⇒ Bias in the distribution of financial wealth, and⇒ Distortion of intertemporal allocation

Solution: Indexed contracts (in most cases not allowed since this

would accelerate inflation)

S.241


Inflation and taxation

◮ “Cold Progression” (nominal increase in income leads toincreasing tax rates)

◮ Inflation tax: Inflation reduces real net interest rates◮ Fisher equation: i = r + p

(nominal interest rate = real interest rate + inflation rate)◮ After taxation with tax rate t:

rN = (r + p)(1− t)− p

rN > 0 ⇐⇒ r >tp

1− t

Inflation reduces the incentive to invest.

t10

P

S.242


◮ Money loses its function as a “store of value”: Inflation raisesthe opportunity costs of holding money.

⇒ Sub-optimal level of holding money. Other assets serve as asubstitue for storing purchasing power, e.g.foreign currency (⇒ depreciation of domestic currency),real estate or gold (⇒ with accompanying price effects)

⇒ This distorts the portfolio structure.

Some negative aspects occur only in case of unanticipatedinflation. However, the higher the inflation rate, the higher is thevolatility.

S.243


Positive effects of inflation?

◮ Some negative effects are alleviated when the inflation rate isstabilized because the effects of inflation could be anticipatedand taken into consideration (e.g. in contracts).

◮ Since nominal wages have downward rigidity, inflation “helps”to make real wages to become more flexible.

◮ Allowing for small positive inflation rates means thatmonetary policy can be used for short-run real effects.

S.244

5. Central Banking and Transmission of Policy5.1 Goals of Monetary Policy5.1.3 Operationalization of the Inflation Goal

Price index:

◮ Two common concepts:Laspeyres-Index PL and Paasche-Index PP

PL =

∑ni=1 p

ti q

0i

∑ni=1 p

0i q

0i

, PP =

∑ni=1 p

ti q

ti

∑ni=1 p

0i q

ti

where pji is the price of good i in period j (with j = 0 as the

base period) and qji as the quantity share in the basket.

◮ The shares qji may be adjusted according to the “consumerbehavior of typical houshold”.

◮ Different price indices e.g. for consumer prices. In Europe:HCPI (Harmonized Consumer Price Index) according to theLaspeyers concept, and the GDP-deflator according to thePaasche concept.

S.245


Inflation target of the ECB:

“... narrow below 2% of an increase of the HCPI.”

⇒ Why not zero inflation?

◮ The HCPI (as all Laspeyres indices) overestimates inflation.

◮ Allowing for small positive inflation rates allows for usingmonetary policy in the short run for other goals.

◮ Since P∗ could not exactly be achieved (stochastic effects)and deflation causes more welfare losses than inflation a smallpositive rate minimizes the expected losses.

S.246


p

lossexpected loss

p∗

S.247


Biases in the inflation index:

◮ Quality bias (example: computer)

◮ New goods bias (example: consumer electronics)

◮ Relative price changes lead to substitution effects which arenot incorporated in the fixed q0i .

◮ There is not a single price for a good but a price dispersion;while pji reflects an average price, consumer tend to chooselow price offers.

S.248


Excursus: On the economically correct measure of inflation

◮ Alchian, A.A., Klein, B., (1973), On a correct measure of inflation.Journal of Money, Credit and Banking 5(1), 173-191.

◮ All known indices are based on a standardized basket of goods (e.g.HCPI index for a “representative” household) or the basket of goodswhich have been produced in a period (GDP deflator).

◮ The logic of saving/investing is that you can produce consumptiongoods in the future. The expectation of future prices are hence thebasis for saving/investment decisions.

◮ The net present value of accumulated savings (capital stock) = theprice of the asset stock reflects the value of future consumption.

◮ To measure not only the loss of real wealth of present(consumption) goods but also of future goods a price index shouldprimarly be based on asset prices.

◮ These issues are actually discussed in monetary policy.

S.249

5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)

Outline:

5.2.1 Basic Problems: Limited Knowledge, Lags

5.2.2 Quantity Theory as a Black-Box Approach

5.2.3 Interest Rate Channels

5.2.4 Credit Channels

5.2.5 Expectation Channels

Literature:



S.250

5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)5.2.1 Basic Problems: Limited Knowledge, Lags

◮ There exist different causal relationships between policyinstruments, intermediate targets and final goals.

◮ Some of them are complementary, some may havecountervailing effects.

◮ The magnitude of effects depend on the value of exogenousand endogenous variables.

◮ The effects occur with time lags (timing of monetary policy,role of forecasts).

◮ The causal relationships are controversially discussed in theory(e.g. Are prices sticky? Do reserves determine lending or doeslending determine reserves? Are investments limited by creditrationing?).

S.251


“Monetary Policy – Art or Science?” (O. Blanchard 2006)

“Der Transmissionsprozess der Geldpolitik ist trotz intensivertheoretischer und empirischer Forschung weiterhin nur luckenhaftbekannt.” (O. Issing 1995)

Transmission channels might change because of:

◮ new financial products and intermediaries

◮ increasing gloval integration of financial markets

◮ changed behavior of banks due to regulation

◮ specific economic situations (e.g. ZLB)

S.252


(Mishkin (2006), p.619)

S.253


S.254

5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)5.2.2 Quantity Theory as a Black-Box Approach

Quantity Theory:

M · v = P · Y

⇒ M + v = P + Y

⇒ m + M0 + v = P + Y

◮ Forecasting: m, v , Y

◮ Goal: P (e.g. close to zero)

◮ Target: M0

◮ Idea: M → used for transactions in goods market → Y D → P◮ Price level changes determined by excess demand Y D − Y .◮ It is not clear how the money affects the aggregated demand

(black box).S.255

5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)5.2.3 Interest Rate Channels

In the standard IS-LM framework it isassumed that the central bank determines(via fixed multipliers) the money volume.This induces a shift of the LM curve. An(e.g.) excess supply of money leads to anexcess demand of bonds. Hence the bondsprice increases and the interest rate falls:policy → M → i → I (i) → Y D .

i

Y

IS

LM

LM’

However, (a) CB does not “determine” M (endogeneity of M), (b) most

CB consider i as the operating or intermediate target rather than M,

thus i could be seen as a policy instrument.

S.256


◮ The central bank’s discount rate ρc affects the market forborrowed reserves (Lc).

◮ This affects the bank’s loans supply, and other dispositionsabout the bank’s balance sheet structure and size.

⇒ Effects on bonds interest rates i , stock prices, and loaninterest rate ρ. Portfolios are hence restructured.

◮ In case of outright purchases of securities, there is animmediate effect on the bonds price ⇒ interest rate i .

◮ Interest rate channels consider the effects of changing interestrates on the aggregated demand.

S.257


a) The standard interest rate effects

◮ Demand for investment goods:◮ investors calculate whether to invest into a physical investment

project I or into bonds. Aggregated investment demanddepends on real interest rate:

→ i → I (i − pe , ·) → Y d → ...◮ investors have to finance the physical investment projects by

bank loans:

→ ρ → I (·, ρ) → Y d → ...

◮ Demand for (durable) consumption goods, financed by loans:

→ ρ → C (·, ρ) → Y d → ...

S.258


b) The Tobin-q-effect

◮ Firms hold a portfolio with different assets, especially physicalassets. They finance these assets by debt and equity.

◮ The market value of a firm (MVF ) reflects the discountedflow of expected returns from the asset side.

◮ If there is a new enterprise = a new need for productioncapacities, then it has to calculated whether(i) it is more profitable to buy an existing firm (price = MVF )

or(ii) to buy/produce new capital goods (price = costs forfinancing capital goods, CC )

S.259


◮ Let R be the return from the new enterprise. Then theeffective return depends on the cases (i) and (ii):

r(i) =R

MVF

r(ii) =R

CCThe demand for new investment goods requires r(ii) > r(i) or(in Tobin’s concept)

q =r(ii)

r(i)=

MVF

CC> 1 (37)

◮ CB policy affects financing costs for capital as well as thestock prices = market value of firm. An expansive policy leadsto lower interest rates and higher stock prices due to portfoliorearrangements ⇒ increase of Tobin’s q ⇒ stimulatesinvestments ⇒ aggregated demand.

S.260


c) Exchange rate channel

◮ If the domestic interest rate increases the domestic currencybecomes more attractive than foreign currencies. A change inthe interest rate differential leads to a change in the exchangerate e:

◮ i increases → domestic currency is appecreiated (c.p.)◮ i decreases → domestic currency is depreciated (c.p.)

◮ The exchange rate affects exports and imports and hence thetrade balance NX = Ex − Im which is a part of theaggregated income.

→ i → e → NX (e) → Y d →

S.261


d) Wealth effects

◮ Monetary policy may have an effect on bonds and stockprices. An increase in bonds/stock prices leads to anincreasing nominal level of financial wealth FW .

◮ According to the Pigou effect a higher financial wealth FWstimulates the consumption demand (shift in theintertemporal consumption/saving decision in favor ofconsumption because FW is kept on an optimal level).

→ stock/bonds prices → FW → C (FW , ·) → Y d →

S.262


Remarks:

◮ The strength of the interest rate channels depend on the sensitivity...

(a) ...how portfolio depend on changes in relative prices. Alsoliquidity and other considerations may be important for theportfolio structure.

(b) ...how sensitive demand depends on interest rates and wealtheffects. In a recession the investment behavior is moredetermined by pessimistic expectations rather than interestrates.

◮ Change/Reduction of the discount rate...

(a) ...only has an effect when it is not significantly larger than themoney market interest rate. The behavior of agents on themoney market then determines the effectiveness of policy.

(b) ... is only possible if it is larger than zero ⇒ negative lendingrates?

S.263

5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)5.2.4 Credit Channels

Basic idea:

◮ In contrast to interest rate channels which depend on changesin relative prices and portfolio rearrangements, the creditchannels are related to the volume of lending acrtivity.

◮ Therefore the commercial bank sector (financialintermediates) plays a central role.

S.264


a) Bank lending channel

◮ The idea is that an expansion of reserves stimulates themultiplier process: deposits and loans supply increases.Consumption and investments which have to be financed byloans should then be stimulated because it is easier to getloans (no quantitative restriction)

→ reserves → deposits → availability of loans → I ,C → Y d

◮ Even if this process may be accompanyied by a change of theloans interest rate ρ the focus is on the quantitative effect.

S.265


Problem:

◮ The demand for loans depends onthe loans interest rate, the income,and eventually on the bondsinterest rate (Ld(ρ, i , y)). It is notreasonable to argue why a creditexpansion should take place, sincean increase in reserves does notdirectly affect the loans demand.

◮ If the bonds interest rate idecreases, this may induce acontractive effect on the loansdemand (bonds and loans assubstitutes). As a result the effecton loans is unclear (see figure).

L

ρL(ρ1c)

L(ρ2c)

Ld (i1)Ld (i2)

ρc → i

S.266


Another justification:

◮ Assume that there arerationing effects due toadverse selection. Some firmsdo not receive loans and thereis no tendency to adapt interestrates to the market equilibrium.

◮ An expansion of reserves shiftsloans supply function so that –without changes in the interestrate – the loans volumeincreases by alleviating therationing effect.

L

ρL(ρ1c)

LL(ρ2c)

Ld

rationing

S.267


b) Balance Sheet Channels

◮ The channel is based on the adverse selection and moralhazard effects. These effects lead to credit rationing. Therationing effect can be alleviated e.g. by collaterals, net worth,and own capital.

◮ Since monetary policy has an effect on stock prices, this alsoaffects the value of collaterals and net worth. Furthermore theratio between the value of debt and the value of equity + networth changes.

◮ This leads to a lower rationing effects and hence creditexpansion.

→ stock/bonds prices → adverse selection/moral hazard →lending → I → Y d

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c) Cash Flow Channels

◮ Monetary policy affects the interest rates to be paid in debtcontracts. Lower debt payments = higher cash flow, moreliquidity. This works similar as in the balance sheet channel:The soundness of the firm increases and the rationing effect isalleviated.

d) Liquidity effect

◮ Increasing nominal financial wealth by increasing stock pricesreduces the likelihood of financial distress. The soundness ofthe household/firm is improved. Hence it is easier to receive aloans contract.

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Remarks:

◮ Several channels depend on the effect on stock prices as wellon the bonds interest rate (and hence the bonds prices).

◮ Expansive monetary policy leads to higher asset prices whichserve as a channel for the effects of monetary policy on thereal sphere (see ECB transmission scheme).

◮ But higher nominal asset prices are asset price inflation!Inflation is measured usually in terms of the price for(consumption) goods and services. Asset price inflation mayalso be a source of a loss of efficiency and welfare.

◮ If asset prices properly reflect the discounted net revenues, anincrease in asset prices due to monetary policy implies higherexpected future prices (= inflation in the future).

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5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)5.2.5 Expectation Channels

◮ Prices and wages are more or less rigid in the short run:

◮ Transaction/menu costs of price changes◮ Negotiation costs (wage contracts) ⇒ long-term contracts◮ Uncertainty whether costs and/or demand has changed

systematically or due to stochastic fluctuation

◮ If monetary policy affects demand, it has effects on quantitiesbut almost no price effects in the short run.

◮ Downward sloped short run Phillips curve (see section 6)!

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5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)5.2.5 Expectation Channels

What happens when these future price changes are expected(expected inflation)?

◮ Forming expectations: static, extrapolative, adaptive, rationalexpectations.

◮ Economic agents will incorporate their inflation expectationsinto their contracts.

◮ The expectation augmented Phillips curve shifts. The realeffects of monetary policy decrease (to zero).

◮ Hence, monetary policy aims to keep inflation expectations ona low level !

◮ The central bank policy has to be credible! All changes inpolicy variables may induce changing inflation expectations.

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5. Central Banking and Transmission of Policy5.2 Transmission Mechanisms (Channels)

Some empirical findings:

“Recent findings on monetary policy transmission in the euroarea”, ECB Monthly Bulletin, October 2002, pp.43-53

◮ Monetary policy works; no real effects in the long run.

◮ Difficult to decompose the transmission effects.

◮ Significant interest rate effects on investments, also cash flowand liquidity effects play a (minor) role; less evidence for banklending channels.

After financial crisis and European debt crisis (“Euro crisis”)it is highly questionable whether transmission channels workin th same way!

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5. Central Banking and Transmission of Policy5.3 Targets, Strategies, and Rules

Outline:

5.3.1 Which targets to choose?

5.3.2 Targeting the money volume

5.3.3 Targeting the exchange rate

5.3.4 Inflation Targeting

5.3.5 The Taylor Rule

Literature:

Mishkin (2006), chapter 18, 21


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5. Central Banking and Transmission of Policy5.3 Targets, Strategies, and Rules5.3.1 Which targets to choose?

◮ Since the final goals could not be achieved directly bymonetary policy there is a need for intermediate andoperational targets.

◮ These targets should have the following properties:

◮ Measurability◮ Controllability◮ Predictive effects on the goals (this depends on the adopted

transmission theory)◮ Not too long delays of the effects

◮ “Targets” may also be referred to as “indicators”

◮ Monetary policy should be reliable and transparent. Thestrategy is not to design an “optimal” monetary policy basedon very complicated transmission models, but to find “goodperforming” simple rules.

S.275


◮ Operating targets:◮ money market rate

◮ Intermediate targets:◮ interest ratess (loans, bonds) and their structure◮ money volume (M1, M2, M3)◮ exchange rate◮ output gap

◮ Final target:◮ Price level target or inflation rate target?

S.276


Intermediate targets may be conflicting!

⇒ Remind the price-theoretic model by Bofinger:

◮ Targeting the loans interest rate→ then the loans volume = money volume changes.

◮ Targeting the loans volume→ then the loans interest rate changes.

S.277


Price level target or inflation rate target?

◮ Price level target: p∗t (example: p∗t = p∗)

◮ Inflation rate target: p∗ (example: p∗ = 0)

◮ Both targets are equivalent in case of perfect controllability!

◮ Differences occur in case of imperfect control (control errors)

S.278


Evolution of the price level with a fixed inflation rate p∗ incontinous time:

pt = e p∗tp0 ⇒ ln pt = ln p0 + p∗t

In one time step with realized inflation rate pt = p∗ + ζt :

ln pt+1 = ln pt + pt ⇒ ln pt+1 = ln pt + p∗ + ζt

and the control error ζt has the property E [ζt ] = 0,Var [ζt ] > 0and it is serially uncorrelated. How to respond to these errors?

S.279


◮ Inflation rate goal p∗ = 0: Price level follows a RandomWalk, since the control error is neutral there is no need toadapt policy measures:

ln pt+1 = ln pt + ζt

◮ Price level goal p∗: Random deviations from the price levellead to adaptions of the policy measures:

ln pt+1 = ln pt + λ(ln p∗ − ln pt) + ζt , λ ∈ (0, 1)

Result of control errors:

◮ Price level is more volatile in case of inflation goal

◮ Inflation rate is more volatile in case of a price level goalS.280

5. Central Banking and Transmission of Policy5.3 Targets, Strategies, and Rules5.3.2 Targeting the money volume

◮ The monetary policy of the Deutsche Bundesbank (beforethe monetary union) was primarly based on money volumetargets.

◮ Possible in a regime of flexible exchange rates (after BrettonWoods)

◮ Stable demand for money L(y , i), that means stablefunctional form and parameters. This has empirically provento be the case for M3.

◮ Stable relation between interest rate i and the target M: Sincechanges in interest rates lead to a restructuring of assets (e.g.overnight deposits, time deposits etc.), M1 and M2 seem tobe too volatile. The Deutsche Bundebank had chosen M0(1974-1988), and later M3 (from 1988-2001).

◮ Stable relation between target M and goal P in the long run.

S.281


◮ In accordance to quantity theory we have the“potential formula”

M3 + v trend = Pgoal + Y pot

where Y pot is the (estimated) production potential. Themonetary policy has been oriented on the long run growthpath.

◮ The current velocity v depends on the busniness cycle(increasing in boom, decreasing in recession). An orientationon the trend of v means that the policy does not respond tobusiness cycles.

◮ The goal P as the “unavoidable inflation rate” is 1-2 %.

S.282


The targets for M3 is formulated

◮ for a certain period : e.g. 1 year

◮ as an average goal (the target e.g. M3 = 6% should beachieved at the end of 1 year, fluctautions within this yeardon’t matter) or as a permanent goal (the target is controlledwithin the period, e.g. every month → higher transparency ofthe policy)

◮ as a dot target (“exactly M3 = 6%”) or as a target corridor(“M3 = 6%± x%”). A dot target will be violated with aprobability of nearly 100%. A “broad” corridor target willrarely be violated but is not a meaningful target anymore.

S.283


Money volume targets have rarely been achieved. Nevertheless, theBundesbank policy was successful regarding the final goal.

(Gischer/Herz/Menkhoff (2005), p.308)

S.284


The relation between the development of M and the developmentof the price level P is

◮ very close◮ in case of very high inflation◮ in the (very) long run

◮ not very close◮ in case of low inflation

As remarked above there is also a relation to asset prices (moneyused for transactions on asset markets rather than goods markets).

S.285


The long run relationship between inflation and monetaryexpansion is an argument for the “neutrality” of money.

Correlation withM0 M1 M2

all 110 countries 0.925 0.958 0.950Subsamples:21 OECD countries 0.894 0.940 0.95814 latin american countries 0.973 0.992 0.993

(Source: McCandless/Weber (1995), Some Monetary Facts, in: Federal Reserve

Bank of Minneapolis Quarterly Review, Vol.19, M.3, pp.2-11)

S.286


In the short run and/or in countries with low inflation rates thecorrelation is not very strong:

(Spahn (2006), p.116)

S.287


(Mishkin (2006), p.10)

S.288

5. Central Banking and Transmission of Policy5.3 Targets, Strategies, and Rules5.3.3 Targeting the exchange rate

◮ This approach may be reasonable for small open economieswith high inflation rates.

◮ Targeting the exchange rate (to a country with low inflationrate) means to “import stability”.

◮ The idea is that there exists a relation between the exchangerate and the price level (PT= price level of tradable goods, ∗indicates the foreign country):

PT = eP∗

T (38)

P = αPT + (1− α)PN (39)

◮ Hence, the exchange rate e changes with the difference ofinflation rates:

e = PT − P∗

T

◮ If α is large then targeting e ≃ 0 leads to similar inflation ratethan in the foreign country.

S.289

5. Central Banking and Transmission of Policy5.3 Targets, Strategies, and Rules5.3.3 Targeting the exchange rate

◮ Another mechanism is based on the interest rate parity : If theowner of a financial fund has to decide whether to invest indomesitic or foreign opportunities the no-arbitrage-conditionreads like

i − i∗ = eexpected

◮ Monetary policy has to take the depreciation expectations intoconsideration. Targeting the exchange rate and thus loweringeexpected makes domestic capital markets more attractive andthe interest rate is accomodated to i∗.

◮ Problem: Speculative attacks against the central bank if thetargeted exchange rate is expected to be not fundamentallyjustified.

S.290

5. Central Banking and Transmission of Policy5.3 Targets, Strategies, and Rules5.3.4 Inflation Targeting

◮ The idea is that due to the complexity of the transmissionprocess and the limited knowledge about it the operationaltarget or the policy instrument should directly respond toexpected deviations of the inflation rate and the targetedinflation rate:

∆i = β(Pe − Ptarget), β > 0

◮ The central bank is committed to an inflation target. Since βcould be estimated from central bank’s behavior, this policyrule provides a high transparency.

◮ Problem:

◮ no theoretical considrations about the transmission process◮ low flexibility

S.291


Inflation targeting has been a successful policy strategy e.g. in New

Zealand, United Kingdom, Sweden, Canada.

(Mishkin (2006), p.503)

S.292


(Mishkin (2006), p.503)

S.293

5. Central Banking and Transmission of Policy5.3 Targets, Strategies, and Rules5.3.5 The Taylor Rule

◮ Taylor, J.B. (1993), Discretion versus Policy Rules in Practice.

Carnegie Rochester Conference Series on Public Policy 9(4),

195-314

◮ The operating target (real money market interest rate i − P)should respond to the equilibrium real interest rate r0, thedeviation of current and targeted inflation rate, as well as tothe “output gap” Y − Y p.

i targett = r0 + Pt + α(Pt − Ptarget) + β(Yt − Y pt )

◮ In case of accelerating inflation the central bank increases thetarget rate (by 1 + α). In case of a boom where the outputgap becomes positive the target rate is also increased (by β).

S.294


Taylor (and several others) has shown that the rule is a goodempirical description for the behavior of most central banks. Forthe USA Taylor showed that the rule with r = 2, Ptarget = 2,α = 0.5, β = 0.5 is a good predictor for the Fed policy.

(Mishkin (2006), p.430)

S.295


The results for Germany:

(Gischer/Herz/Menkhoff (2005), p.317)

S.296


Operationalizing the Taylor rule:

◮ Inflation is measured e.g. by the HCPI.

◮ Income is measured e.g. by the nominal GDP while theproduction potential has to be estimated (e.g. econometricestimation of a production function).

◮ Targets for the inflation rate and the “equilibrium” realinterest rate may be theoretically justified.

◮ Different lag structures may be chosen.

◮ An additional goal may be to smooth interest rates. Hencethe Taylor interest rate should not fluctuate too much.Possible smoothing rule:

i smootht = λi targett + (1− λ)it−1

S.297


The main advantages:

◮ Very simple and transparent rule.

◮ Combines inflation targeting with anticyclical policy. Itcompromises rule-binding with a certain degree of flexibility.

◮ Different macroeconomic views of the transmission process arecompatible with the rule (i.e. it does not depend critically ona specific macroeconomic paradigm).

◮ Empirically robust description of central bank behavior.

Main problem: How to determine r0?

S.298


Variants of the Taylor rule:

◮ One problem is that in the original version the central bankresponds to realized (=past) changes in the variables.

◮ Due to lags there is the danger of procyclical results.

◮ It is reasonable that the central bank responds to expectedvalues instead:

i target = r + Pet+1 + α(Pe

t+1 − Ptarget) + β(Y et+1 − Y pot,e

t+1 )

S.299


Remark:

◮ With given values for Y pot and r the Taylor rule provides astable relation between i , Y , and P . Hence the Taylor rule is aproper replacement of the LM curve in the (i ,Y )-diagram.

⇒ Course “Monetary Macroeconomics”.

S.300

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