Econ213 chapter 11

Greece in 2004 showcased

Prosperity at the Summer Olympics, financed by borrowing

Greece in 2009–2012:

Global recession and high debt, increased rates surge, borrowing collapses, consumption and investment fall, and unemployment rises.

Greece lesson, when the financial system (banks, bond and stock markets) comes under

stress

The macroeconomy often follows

Money is

anything widely accepted in exchange for goods/services or to settle debts

Historical examples of money

cowrie shells, wampum, cigarettes, giant Yap stones

Today: fiat money is

legal tender not backed by a commodity; balances move electronically

Functions of money:

Medium of exchange, unit of account, and store value

Medium of exchange:

voids costly double coincidence of wants in barter

Unit of account

common yardstick for prices, contracts, and accounting

Store of value

transfers purchasing power over time (subject to inflation risk).

Commodity money has

Intrinsic value (gold, silver)

Commodity money works best when

standardized, divisible, durable, portable, widely accepted.

Fiat money has

No intrinsic value, value from law and social acceptance.

Fiat money is

Efficient for modern, high-volume, digital transactions.

Trust and institutions

underpin money’s acceptability.

Cryptocurrency examples

Bitcoin, Ethereum, by 2022, over 10,000 existed.

Cryptocurrency storage

held in digital wallets; only the holder has access

Cryptocurrency key feature

not managed by any government or central bank

Cryptocurrency advantages

portfolio diversification; hedge against high inflation or political risk

Cryptocurrency risks

extreme volatility, no deposit insurance, vulnerability to hacking or total loss.

Currently, cryptocurrencies are

not part of the U.S. money supply

Future of cryptocurrency challenge

scaling up to handle billions of transactions per day.

Cryptocurrency potential evolution

government-regulated or central bank digital currencies (CBDCs).

Cryptocurrency for now

used mostly for speculative investment, not everyday payments

Exogenous (“outside-in”) —

money supply set by policy

Exogenous authority sets

quantity M (monetary base controlled by central bank).

Exogenous authority historiccaly

gold/silver standards, minting, convertibility leading to supply fixed by metal stock

Exogenous Fiat era

CB steers broad money via reserves, interest rates, and open-market ops

Exogenous banks act mainly as

intermediaries; policy moves M, economy adjusts.

Endogenous (“inside-out”) —

money created through credit

Endogenous loans create

deposits: banks expand balance sheets when credit demand is profitable

Endogenous money supply responds to

credit demand at the policy rate

Endogenous CB

accommodates reserves to maintain its rate target

Endogenous limits:

capital rules, liquidity needs, collateral, borrower risk

In practice CBs set

the price of reserves (interest rate), while banks create most broad money via lending

Federal Reserve task:

measure the amount of money circulating in the economy.

Key Aggregates

M1 and M2

M1

narrowest definition, highly liquid forms of money

M2

broader measure, includes M1 plus “near monies.”

Reclassification (April 24, 2020) fed removed

limits on transfers from savings and money market deposit accounts, accounts became more liquid included in M1

Result of reclassification

Savings deposits now dominate both M1 and M2

Included in M1

Currency in circulation (coins and paper), Checkable deposits, Savings deposits, and Money market deposit accounts

Included in M2

All of M1, plus Small time deposits, and Retail money market mutual fund shares

Liquidity of M1 and M2

M1 is immediately spendable; M2 includes near monies that require minor conversion

Loanable funds market analyzes

how saving (supply) and investment (demand) meet

Loanable funds market price of funds =

real interest rate r (inflation-adjusted).

Loanable funds market quantity =

billions of dollars of loanable funds exchanged.

Saving (supply side) includes

Major purchases (house, car); precautionary saving; retirement.

Saving Cultural/institutional differences:

Saving rates vary widely across countries

Saving incentive

higher r raises the reward to postponing consumption.

Borrowing/investment (demand side) includes

Households: education, vehicles, mortgages. and firms: plants, equipment, warehouses, R and D

Borrowing/investment undertake projects if

expected return decreases r

Borrowing/investment incentive

lower r makes more projects profitable

Supply S0 (savers):

upward sloping, higher r increases more saving

Demand D0 (investors):

downward sloping and higher r decreases projects.

If r > equilibirum:

excess supply increases, r falls.

r < equilibrum:

excess demand increases, r rises

Like competitive goods markets: the price

adjusts quickly to clear the market

Increases in saving (right shift)

Outlooks, incentives, income/wealth, and public saving

Outlook shifting supply right

higher recession risk increases more precautionary saving

Incentives shifting supply right

tax-advantaged saving, automatic enrollment, saving subsidies

Income/wealth shifting saving to the right

windfalls raise capacity to save

Public saving shifting saving to the right

smaller government deficit (or surplus) raises national saving.

Supply effects

r decreasing leads to S and I increasing (more funds, cheaper to borrow).

Decreasing in saving (left shifts)

Consumption booms, Incentives to Save, Income and Asset Prices

Decrease in saving due to consumption booms

larger government deficit lowers national saving

Decrease in saving due to incentives to save

retirement contribution plans, tax deferred savings and employer matches.

Incentives to save increase

private saving increasing supply of funds shifts right

Higher income shifts saving left when

people save a larger share of income.

Rising asset values (stocks, housing) create

a wealth effect, people feel richer and save less

Falling asset prices

reverse the decrease the wealth effect pattern

Supply of loanable funds includes

both private and public saving.

Budget surplus:

adds funds, increasing saving (right shift)

Budget deficit:

government borrows from the market, reducing available private savings.

Deficits leads to saving

decreasing, real interest rate increases, and private investment crowded out

Government deficits mechanism

Treasury bond issuance competes with private borrowers for the same savings pool.

Increase in investment demand (right shift) causes

Higher expected profitability, Policy, and Lower user cost of capital

Higher expected profitability increasing investment demand

new tech and higher output prices

Policy increasing investment demand

investment tax credits and accelerated depreciation

Lower user cost of capital increasing investment demand

Lower user cost of capital

Increase in investment demand effects

r increases, S and I increasing (crowding-in if supply is elastic).

Decreases in investment demand causes

Weaker outlook, tighter credit conditions, higher risk premia.

For saving and investment always use

the real interest rate r (nominal minus expected inflation)

Financial markets are

highly competitive, increasing fast adjustment toward equilibrium.

Shifts in Investment Demand for Loanable Funds

Investment tax incentives, technological advances, Regulations, Product demand, Business expectations

Investment tax incentives:

raise after-tax return increasing demand for investment

Technological advances

higher expected productivity increases more profitable projects.

Regulations:

efficient rules decreases confidence and increases D, burdensome regulation decreases

Product demand:

higher consumer demand increases higher expected profits increases demand

Business expectations:

optimism increases D and pessimism lowers it.

A tax credit on new equipment

higher after-tax rate of return

Firms increase desired investment

demand for funds increases

higher business taxes or weaker profitability

D shifts left, r decreases, I decreases

Banks, mutual funds, pension funds pool savings, assess

risk, monitor borrowers, and provide liquidity

A well-functioning system lowers

intermediation costs and raises S and allocates funds to I

Need financial system because households

sometimes have surplus funds (saving); firms often have profitable projects but need financing

Need financial system because direct lending

is costly, screening risk, negotiating terms, monitoring.

Financial institutions bridge

savers and borrowers, lowering frictions so funds reach high-return uses

Institutions:

commercial banks, S&Ls, credit unions, insurance companies, brokerages, pension/mutual funds.

Savers (households, firms, govts) supply

funds and earn interest/returns.