Topic 3

Financial Markets and Monetary Policies

1. Why Do We Have Financial Markets?

  • Consumer's choices are facilitated by financial markets.

2. Money, Income, and Wealth

  • Income: What you earn from working plus interest and dividends. Measured per unit of time (a flow).

  • Saving: Part of after-tax income that is not spent (also a flow).

  • Financial Wealth (Wealth): Value of all financial assets minus all financial liabilities (a stock variable, unlike income or saving).

  • Investment: Purchase of new capital goods.

  • Financial Investment: Purchase of shares or other financial assets.

  • Money: An item generally accepted as a means of payment for economic transactions.

    • Functions: medium of exchange, measure/storage of value, unit of account.

Money: Functions, Types, Measures

  • Types of Money:

    • Commodity Money: Backed by a physical commodity (e.g., precious metals).

      • Example: Bretton Woods agreement, where the U.S. dollar was convertible to gold at a fixed rate of 35 per ounce.

    • Fiat Money: Serves as payment by government declaration.

      • Fiat money became the norm after Nixon abandoned the gold standard in 1971.

  • Measures of Money (Euro Zone): --Specifics are country dependent

    • M1: Currency in circulation + overnight deposits.

    • M2: M1 + deposits with maturity up to 2 years + deposits redeemable at notice (up to 3 months).

    • M3 (Broad Money): M2 + repurchase agreements, money market fund shares/units, and debt securities with maturity up to 2 years.

3. The Banking System and Money Creation

Main Function and Risks

  • Banks act as intermediaries between depositors (S) and borrowers (I).

  • Risks:

    • Credit Risk

    • Liquidity Risk (Bank Runs)

  • Reserve Ratio (r): r = (Vault Cash + Reserves at CB) / Deposits

    • Higher reserve ratio: Lower liquidity risk but lower profitability.

  • The Role of the Central Bank

3.1 The Private Banks

  • Balance Sheet of a Bank (Simplified):

    • Assets: Reserves (vault cash, reserves at the central bank), loan portfolio, government securities, corporate bonds, shares, etc.

    • Liabilities: Deposits, loans received (from central bank or other institutions), own capital.

  • When lending, commercial banks create money.

  • 100-Percent-Reserve Banking: If banks hold 100% of deposits in reserve, the banking system does not affect the money supply.

  • Fractional-Reserve Banking: Banks create money in this system.

When Lending, Commercial Banks Create Money

  • The creation of money doesn't stop with Bank 1. It continues as loans are made and deposits are created throughout the banking system.

  • Example of Money Creation: Initial deposit = 100. Bank 1 loans out 90. Bank 2 loans out 81. The money supply increases.

  • Money Supply: M = Currency + Deposits = CU + D

  • M = Cash in the hands of public + Deposits

3.2. The Central Bank

Main Functions (I)

  1. Guarantees the smooth functioning of the banking system (deposit insurance, minimum reserve ratio, etc.).

  2. Implements monetary policies.

  3. Lender of last resort:

    • Takes deposits from banks (reserves of commercial banks).

    • Lends to commercial banks.

Functions (II)

  1. Manages the exchange rate and foreign exchange/gold reserves.

  2. Regulates and supervises the banking industry (e.g., approval of new banks, management changes).

Balance Sheet of the Central Bank

  • Monetary Base (MB): Sum of all central bank liabilities.

  • MB = CU + R < M = CU + D

  • Assets: Gold, foreign exchange reserves, loans to the government/commercial banks, government securities, other assets.

  • Liabilities: Notes and coins (in public hands and bank vaults), deposits (from commercial banks and the government).

The Monetary Policy

  • Central Bank determines M (money supply) with certain goals, and then the market determines interest rates.

  • Alternatively: Central Bank can set the official interest rate, and the market determines M and other interest rates.

The Monetary Policy

  • Main Objective: Price stability (avoid high inflation and deflation).

    • E.g., ECB target of 2% annual inflation.

  • Secondary Objective: Help manage downturns in economic activity.

The European Central Bank

  • Created on June 1, 1998, in Frankfurt am Main.

  • January 1, 1999 – Eurozone currencies irrevocably locked at fixed exchange rates.

  • The European System of Central Banks (ESCB):

    • ECB + Central Banks of all EU countries.

  • ECB decides the single monetary policy in the Eurozone, implemented by CBs of Eurozone countries.

The interbank market for euros - The European Central Bank

  • The Governing Council of the ECB sets the key interest rates for the euro area:

    • The interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system.

    • The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem.

    • The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem

  • Short-term lending (EURIBOR - Euro Inter-Bank Offered Rate)

    • 13 Interest rates for borrowing at 1 week, 1 month,…, 12 months

    • The monthly average for the 12-month Euribor is the most commonly used as a benchmark for mortgages

4. The Monetary Policy and the Interest Rate

Monetary Policy Instruments

  • Reserve Requirements (Minimum Reserve Ratio)

  • The Reference (Target) Interest Rate: Interest rate on bank reserves/loans.

  • Open Market Operations: Take place in the secondary market for bonds; the standard method to change the money stock to bring the market interest rate close to the target.

Monetary policy

  1. Reserve Requirements

    • Higher reserve requirements reduce amounts available for new loans, lowering the money supply.

    • Lower reserve requirements increase amounts available for new loans, increasing the money supply.

  2. The Reference (Target) Interest Rate

    • Effective Federal Funds rate.

3. Open Market Operations

  • Expansionary Open Market Operation: Central bank buys bonds, increasing the money supply.

  • Contractionary Open Market Operation: Central bank sells bonds, decreasing the money supply.

3. Open Market Operations

  • The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy. An open market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount

  • Example: a bond trader sells bonds worth 100 to the CB in the secondary market and deposits the proceeds in Bank 1. Reserve requirement: 10%

  • What are the effects of bond purchasing on Money supply? Money supply increases by 100 + 90 + 81 = 271…

The Money Multiplier

  • Cash (CU): Currency in the hands of the public, including nonfinancial companies.

  • Reserves (R): Vault cash and reserves held by private banks with the central bank.

  • Monetary Base (MB): The value of money in the economy (CB balance sheet).

    • MB = CU + R

  • Money Supply (M): Cash in the hands of the public and deposits held in private banks.

    • M = CU + D

  • The money multiplier: \frac{M}{MB} = \frac{CU+D}{CU+R}

  • When the CB increases the monetary base (MB) by 1 unit, the money stock (M) goes up by more

Monetary Policies - Summary

Policy Type

Tool (Instrument)

Effect on Money Supply

Ultimate Effect

Expansionary

Lower reserve requirements, Lower the reference interest rate, Open market operations (buying bonds)

Increase

GDP (eventually inflation)

Contractionary

Raise reserve requirements, Raise the reference interest rate, Open market operations (selling bonds)

Decrease

GDP (eventually disinflation or deflation)

5. Monetary Policy and Prices

  • Money Neutrality: The quantity of money affects the price level and nominal variables (e.g., nominal GDP) but not real variables (e.g., real income) in the medium to long run.

    • In the medium and long run money is neutral

    • In the short run money is not neutral

Monetary policy and prices

  • The quantity theory of money (in the long run): M \, v = P \, Y

    • M: The size of the money supply (in nominal terms)

    • v: Velocity of money (times a given euro is spent in a year)

    • P: The price level

    • Y: Real GDP

  • In changes (\DeltaY is a small change in Y): \DeltaM + \Deltav = \DeltaP + \DeltaY$

6. The 2008 Financial Crisis

  • The 2008-2009 financial crisis saw many American banks' borrowers defaulting on their mortgages.

  • Many banks became insolvent: in the US, only 27 banks went bankrupt during the period 2000-2007, on the contrary, 166 went bankrupt during the period 2008-2009.

  • This crisis quickly spread to other countries in the world, such as Spain.

7. Unconventional Monetary Policy

RECAP: Conventional Monetary Policy

  1. Cut down the official interest rate to make all other interest rates in the economy go down.

  2. CB gives loans / makes open market operations (buying debt) to make sure all other interest rates in the economy go down.

    • Doing that the size of the balance sheet of the CB increases (both assets and liabilities)!!!

Unconventional Monetary Policy

  • The transmission mechanism of the conventional monetary policy is broken when:

    • Interest rates are close to zero, a rate cut does not create an additional demand for loans (Zero Lower Bound).

    • If banks do have balance sheet problems, they use all the liquidity they get from the CB to improve their position and do not increase the flow of credit.

  • The liquidity trap – interest rates are close to zero

  • The “money multiplier” – the transmission mechanism of monetary policy no longer works

  • Further reduction in interest rate does not lead to an increase in lending

  • Hence the need for:

    • Quantitative easing: printing money to purchase assets held by banks (government securities and corporate bonds)

• Non Conventional Monetary Policy (1):

  • Increase in a very large magnitude the size of the CB assets (although the official interest rate is already close to zero)

  • Buy a large amount of Assets, both public debt and corporate debt (Large Scale Asset Purchase or, Quantitative Easing, QE)

  • It moves down the level of interest rates of the economy

    • Some investors do not want to buy certain assets which they perceive as having high risk, with the QE the CB buys all type of assets, and those types of bonds perceived to be riskier go back to normal (investors buy assets again at the normal rates)

Unconventional monetary policy

  • Non Conventional Monetary Policy (2):

  • The Fed implemented two rounds of QE

    • QE1: from Nov 2008 to March 2010: bought government bonds and assets related to mortgages with a total value of 1,75 trillions of \$

    • QE2: from Nov 2010 to June 2011: Public Debt with a value of 600 billion \$

    • QE3: From sept 2012 on every month acquired 40 billion $$\$ of assets related with mortgages.

Unconventional monetary policy

  • Almost all the large Central Banks in the global economy implemented similar QE strategies in 2008 and kept using it for several years.

  • The exception was the ECB which only started this types of monetary policies later on, in 2015.

Unconventional monetary policy

  • The QE implies some risks:

    • A very inflationary policy.

    • All the available liquidity at a zero rate can be used to buy assets in certain markets (for instance, stock markets) and create bubbles in this markets.