Ch. 5 Financial markets Flashcards
(34 cards)
Income
Definition
what we earn by working, plus what we receive as interest and dividends. It is a flow variable, expressed per unit of time: monthly, annual income.
Savings
Definition
Savings are the part of the after-tax or disposable income that is not spent on consumption. It is also a flow variable.
Wealth
Defintion
Wealth is the stock of things owned or the value of that stock. It is a stock variable: measured at a given point in time: “his wealth at the end of the year was 10 million euros.”
Invesment
Definition
Investment: it refers to the acquisition of new capital goods: machines, office buildings, etc. It does not include the purchase of shares or other financial assets, that is financial investment
Money functions
-
Medium of exchange: something that buyers give to sellers when they want to buy goods and services. This function is what defines money .
- To facilitate exchanges, agents reach an agreement to use a medium of exchange. Think of an economy without money: a pure barter or exchange economy.
- Bartering is very expensive: we are buyers and sellers at the same time, we must find a double match to make an exchange.
- Unit of account: criteria that agents use to set prices and record debts. A measure is needed to compare the value of different goods and services. Because goods and services are mostly exchanged for money, it is natural to express their economic value in terms of money. In countries with very high inflation, money is not a good unit of account because prices change frequently, then agents tend to use a more stable unit of account (like the US dollar), even if everyday transactions use the domestic currency.
- Store of value: An item that people can use to transfer purchasing power from the present to the future. Money is a store of value because it remains valuable over time. There are other assets that are a store of value: jewelry, houses, art; the difference is that the value of money comes from its function as a medium of exchange. It is valuable because we know that someone will accept it in exchange for a good or service.
Money
Definition
- It’s an asset that can be used directly to purchase goods or services. It includes coins and bills, bank deposits (we will be more specific later).
- Money does not pay interest rates and it is the most liquid asset.
- It is accepted as way of payment because others can use it for the same purpose. Trust is key. It is a stock variable.
Money: Liquidity
Ease with which an asset can become the economy’s medium of exchange. Money is the economic term for the stock of assets that are widely used and accepted as payment, by definition it is the most liquid assets.
The greater the liquidity of an asset, the lower its return. Money is the most liquid asset and has the lowest return of all assets. When people decide how to preserve their wealth, they consider liquidity versus return.
Money types
- Commodity money: when money takes the form of a commodity with intrinsic value. Intrinsic value means that the item would have value even if it were not used as money (it has other uses). Examples: gold, silver; cigarettes in prison/war; horses.
- Fiat money: A government-issued currency not backed by a commodity (like gold).
- Fiduciary money: Money issued with the backing of a commodity
Two financial assets we asume
The demand for money
- Money: it is used as a medium of exchange (it includes cash, deposits, more details later). No positive return.
- Bonds: they cannot be used immediately as a medium of exchange, there is a cost associated with buying and selling bonds, but they yield a positive return (interest rate).
Portfolio decision
Given a certain financial wealth
The proportion of money and bonds will depend mainly on two factors:
* Transaction level: to have enough money available without having to sell bonds too frequently.
* The interest rate ( i ): the only reason for holding bonds is their return relative to money.
Reasons to demand money
- Transaction demand for money: agents demand money for their transactions because it is not possible to buy goods and services directly through bonds.
- Demand for money for precautionary reasonsThe agents demand money to face unforeseen expenses (the car breaks down, they get sick) .
These two reasons depend on the agent’s income: the higher the income, more transactions and more costly unforeseen events.
Holding money has an oportunity cost: the interest rate of the bonds not being holded because holding money.
Nominal and real demand for money related to income and interest
Nominal income, income expressed in euros, not real income. If real income does not change but both prices and nominal income increase, individuals need more money to buy the same goods, so the nominal demand for money increases. We distinguish:
- The nominal demand for money, 𝑀^𝑑, depends positively on nominal income and prices, and negatively on the interest rate.
- The real demand for money or real balances: 𝑀^𝑑/P = 𝐿^𝑑 = L(Y, i), depends positively on real income (Y) and negatively on the interest rate (i).
The demand for money - graphically: 𝐿^𝑑
- 𝐿^𝑑 and i have an inverse relationship: for a given income Y, at point a, the interest rate is i and the money is M.
- The curve 𝑳^𝒅 represents the relationship between the demand for money and the interest rate for a given level of income.
- It has a negative slope: the lower the interest rate (i), the larger the amount of money agents want
- The 𝐿^𝑑 curve is defined for a given level of income. If income changes, the curve will shift. From Y(0) to Y(1) the curve will shift to the right or upwards.
- For a given level of the interest rate (i ), an increase in income increases the demand for money: it shifts the demand for money to the right
The demand for money: Linear function
𝑳^𝒅 = kY - hi [k, h > 0]
k: sensitivity of the demand for money to changes in income.
h: sensitivity of the demand for money to changes in the interest rate.
Relation between price of the bonds and interest rate
Like and index number:
i=(Pv-Pb)/Pb
* Pb: current price of the bonds.
* Pv: the face value (the amount that the issuer pays at the time of maturity).
* i: annual return of the bonds (maturity date in one year).
What are monetary aggregates? Why do they exist?
The similarities between money and other liquid assets led central banks to consider measures that included money and other assets.
A monetary aggregate is an overall measure of the money supply
Types:
1. Monetary base (M0 or MB): it includes cash (banknotes and conis) and accounts held by commercial banks at the central banks
2. M1: Money in the strict sense, it includes the currency in circulation and overnight deposits.
3. M2: it includes M1 plus deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months.
4. M3: it includes M2 plus: repos, money market fund units, money market instruments and non-share securities issued up to two years.
The comercial banks
Definition and balance sheet
Banks are a type of financial intermediaries: they receive funds from individuals and companies, and make loans to other individuals and companies.
Banks keep some of the funds they receive as reserves . The reserves are partly in cash and partly in an account at the central bank.
* Balance sheet:
* Assets=Reserves+Loans+Bonds
* Liabilities= Deposits
* Net worth= Assets-Liabilities
The banks: reasons for mantaining reserves
- Cash inflows and outflows are not necessarily the same every day. They need to cover the money withdrawn by depositors.
- Transactions between individuals from different banks generate the need to cover those payments.
These two reasons are voluntary.
- Non-voluntary reason: forced by the monetary authority. Until January 2012, euro area banks had to hold a minimum of 2% of certain liabilities, mainly customers’ deposits, at their national central bank. Since then, this ratio has been lowered to 1%.
Reserve ratio or reserve coefficient (rr or θ)
θ=Reserves (R) / Deposits (D)
It includes the minimum legal coefficient plus voluntary reserves.
The comercial banks and money creation
Assume agents don’t hold cash
The total amount of money includes cash plus deposits (𝑀 = 𝐶 + 𝐷)
1. Banks recieve deposits (i.e. 100 m.u.). the reserve the estimated % (for example 10%= 10m.u. ) and the rest (90m.u.) they loan it.
2. Supose the one who loans the 90 m.u. buys goods. The seller of the good then deposits the 90m.u. in the same bank and they proceed to do the same 10% reserve and 90 % loan. Now the bank has a deposit of 100 and another one of 90 so total amount of money= 190€
3. Rinse and repeat.
The total money supply will increase by the sum of all deposits:
100 + 100 x 0,9 + 100 x 0,9^2 +100 x 0,9^3… = 100 x (0,9+0,9^2+…)
Calling D1 to the first deposit and θ the reserve ratio:
D1 x (1- θ) + (1- θ)^2 + … That converges to D1/θ
Banks: Money multiplier
The money multiplier is the amount of money that the financial system generates for each euro of monetary base. The ratio **1/θ ** is called the money multiplier or bank multiplier (under the assumption that agents do not hold cash).
Since reserve ratio is ≤ 1 then bank multiplier (1/θ)≥1
The comercial banks and money creation + Money multiplier
Assume agents hold a constant proportion of cash
For simplicity, we assumed in our example that agents did not keep any cash. Now we see what happens if agents keep a constant proportion of loans in cash: cr=C/D.
cr= cash ratio
Money supply (M):
* Legal cash (C)
* Deposits (D)
Monetary Base (MB):
* Reserve or bank reserves (R)
* Legal cash (C)
The bank multiplier is defined: m= M/MB → m= (C+D) / (C+R) common denominator D makes it → m= (C/D + D/D) / (C/D+R/D) simplifying:
→m=(cr+1) / (cr+θ)
What are the central banks?
Central banks are in charge of the monetary policy: “the set of decisions and measures taken by the monetary authority of a country – or, as in the euro area, a monetary union – to influence the cost and availability of money in the economy.”
Central banks have different instruments to achieve their objectives. We highlight three general instruments: the purchase and sale of bonds in the so-called open market operations, the control of the discount rate, and the minimum reserve requirements
Central banks instruments of monetary policy: Open market operations
Open market operations: A central bank can buy or sell securities, including government securities. They are called “open market” because the central banks do not buy securities directly from the government. Securities dealers compete on the open market.
- If the central bank buys securities, like government bonds, it deposits funds into the accounts of the sellers. This payment becomes part of the reserve balances of commercial banks, increasing the amount of funds that banks have available to lend. The central bank is injecting money into the economy and increasing the money supply. This injection of money puts downward pressure on the market interest rates, encouraging more borrowing by the different agents in the economy. Policymakers refer to this as “easing” or expansionary monetary policy.
-
If the central bank sells securities, buyers pay with money from their accounts, reducing the amount of funds that banks have available to lend. The central bank is withdrawing money from the economy and decreasing the money supply, creating upward pressure on the interest rates, since banks have fewer reserves available to lend and will charge more to lend them. As the interest rate increases, agents are less likely to borrow and more likely to save. Policymakers call this “tightening” or contractionary monetary
policy.
