Money, Asset Markets and monetary policy Flashcards
(23 cards)
classical dichotomy
printing money doesn’t stimulate the real economy and will just create inflation
The quantity theory of money
MV+PY
Money (M) time the velocity of money (V) is equal to nominal GDP (PxY)
V- how many times average unit of money spent during a year
this theory led to money growth as a policy to maintain stable inflation as V was believed to be stable over time, V is not stable over time
Money
- means of payment
-unit of account
- store of value
-standard of deferred payment
M= currency in circulation + bank deposits
How is money created
central bank (bankers bank), mechanism with commercial banks to get money into and withdraw money from the financial system
bank reserves (funds held by banks at the central bank)
taken together this is base money (CB have an amount of control over base money, underpins rest of the financial system)
fractional reserve banking
someone makes deposit, bank doesn’t keep all money, keeps an amount (reserve ratio) and lends the rest of the money out
idea of money multiplier- bank is creating money
initial deposit triggers a series of loans, money supply is larger than initial deposit
works as long as no bank run, everyone wants their money back
CB can control money using reserve ratio (don’t really except china)
commercial bank asset
loans are part of commercial banks assets, as they provide an income stream of repayments
risk is loan repayments not being made
fractional reserve banking in practice
commercial banks do create money
if a customer seeks a loan, loan will be made if creditworthy
different from model , new loans being made don’t need to be backed by a previous deposit
due to excess reserves
or bank refinancing itself by borrowing from another bank (interbank rate) or the central bank (refinancing rate)
policymakers do have some control over money creation
Open Market operations
CB also increase the money supply via open market operation
purchasing assets from commercial banks increases the money supply
-selling assets to commercial banks decrease the money supply
control over the money supply gives CB control over the interest rate
what does control of money supply allow
control over the money supply gives CB control over the interest rate
(monetary policy)
setting the interest rate
commercial banks liquidity needs can be met by borrowing from the CB
also lend to and borrow from one another without collateral or guarantees
The annualised overnight interest rate at which this happens is known as the interbank interest rate
Bank rate- the rate set by the monetary policy committee, which is the annualised interest rate that commercial banks receive on reserves held within the BOE
summary of setting interest rate
CB influence the interest rates using
reserve ratios
interest rates paid on commercial bank reserves held at the CB and or from borrowing from one another
open market operation son asset prices
Asset Markets- basic intuition
-paying money today to receive an income stream in the future
-closely linked to investment and saving- consumption
-price of asset (stock/bond) equals present value of expected future income stream
Bonds
what we are prepared to pay today for some future income stream
key part of understanding monetary policy
government issues bonds- to finance deficits
firms issue corporate bonds- to raise debt finance
buying a bond entitles you to the promise of a clearly defined income stream
coupon- is an ongoing payment
par payment- final payment
risk free- buy bond today definitely receive the income stream
discounting, how much should you pay for income stream
𝑃 = 𝑐/(1 + 𝑦) + 𝑐/(1 + 𝑦)^ 2 + 𝑐/(1 + 𝑦)^ 3 + ⋯ + 𝑐 + 𝑚/(1 + 𝑦)^ 𝑛
Where 𝑐 is the annual coupon payment, 𝑦 is the annual yield, 𝑚 is the par payment, and 𝑛 is the number of years to maturity
interpreting 10 year zero coupon yields
4.3% yeild
how much are markets going to pay to purchase from the US govt of receiving £100 in 10 years
c=0
𝑃 = $100/(1 + 0.043)^10 = $65.64
this is risk free, US always pays debts, likely to be solvent in 10 years
how to make yields go down
CB make P go up, create money buy bonds, price of bonds go up yields go down (interest rates)
yield curve (term structure)
debt matures at different times
joining up the implied yields over time is the yield curve
Open Market operations (yield curve)
buying and selling short maturity bonds is part of how CB controls/set short term policy rates
ensuring the money supply is consistent with the interest rate it wants (lower interest rates looser, greater, money supply)
Commercial banks can choose to hold reserves at the BoE or hold bonds close to maturity
Quantitative Easing
buying longer-maturity bonds as a way to boost the money supply
(also extend to stocks and corporate bonds)
printing electronically money to buy longer maturity bonds to push up prices to lower longer maturity yields and to increase money in circulation
tries to flatten the yield curve
monetary policy objectives
Low and Stable inflation
GDP growth
High employment
Exchange Rate
Stable stock market
Climate change
monetary policy target
CB uses interbank rates, reserve ratios, QE etc
to meet intermediate targets ->
growth in money supply, exchange rates, inflation targeting
monetary policy transmission channels
interest rate channel- affecting long and short ir influence households and firms consumption and investment decisions
Asset price channel- interest rates influence asset prices changing wealth which can affect consumption and investment
Credit channel- availability of credit can help support economy by reducing borrowing constraints
Exchange rate channel- policy that affects the exchange rate has the potential to stimulate the economy via increased competitiveness (cheaper exports)
Taylor Rule
𝑖 = 𝑖 (bar)+ 𝑎 (𝜋 − 𝜋 (bar)) + 𝑏 (𝑌 − 𝑌(bar)/Y (bar)
bars indicate target levels
i bar is the neutral interest rate the CB thinks appropriate for the economy
Taylor rule says a CB will set a higher interest rate if inflation is above target and/or output is above its natural rate
