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Summary Monetary Economics (FEB23010)
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Comprehensive summary of the elective Monetary Economics (EUR)
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Week 1Money
Money (or the money supply): anything that is generally accepted as payment for goods or
services or in the repayment of debts
Money as a stock concept
It is different from
- Wealth: the total collection of pieces of property that serve to store value
- Income: flow of earnings per unit of time (a flow concept)
Money as medium of exchange
It eliminates the trouble of finding a double coincidence of needs (reduces transaction costs),
and it promotes specialization. A medium of exchange must be easily standardized, widely
accepted, divisible, easy to carry and not deteriorate quickly
Money as unit of account
Used to measure value in the economy and it reduces transaction costs
Money as store of value
Used to save purchasing power over time. Other assets also serve this function. Money is the
most liquid of all assets but loses value during inflation
Evaluation of the payments system
- Commodity money: valuable, easily standardized and divisible commodities (e.g. precious
metals, cigarettes)
- Fiat money: paper money decreed by governments as legal tender
- Cheques: an instruction to your bank to transfer money from your account
- Electronic payment (e.g. online bill pay)
- E-money: debit card, stored-value card, mobile payment services, e-cash, cryptocurrency
Measuring money
There is M1 which contains the most liquid assets, and M2 which adds to M1 other assets that
are less liquid.
M1 = currency + demand deposits + other checkable deposits
M2 = time deposits (2-year maturity) + deposits redeemable at notice of up to three months
Money growth
If the rate of money growth declines, then the real output is expected to fall, the price level is
expected to fall and the interest rate is expected to fall
Week 2
Determinants of asset demand
- Wealth: the total resources owned by the individual, including all assets, positive relation
- Expected Return: the return expected over the next period on one asset relative to
alternative assets, positive relation
- Risk: the degree of uncertainty associated with the return on one asset relative to
alternative assets, negative relation
- Liquidity: the ease and speed with which an asset can be turned into cash relative to
alternative assets, positive relation
Bond prices and interest rates
Consider a one-year discount bod with 𝐹 the face value of the discount bond, 𝑃 the current
price of the discount rate and 𝑖 the interest rate or called the expected return on the bond.
!"# !
Then 𝑖 = # . The current bond price is negatively related to the interest rate: 𝑃 = $%&
Market equilibrium
Occurs when the amount that people are willing to buy (demand) equals the amount that
people are willing to sell (supply) at a given price. 𝐵' = 𝐵 ( defines the equilibrium (or market
, clearing) price and interest rate. When 𝐵' > 𝐵 ( there is excess demand, price will rise and
interest rate will fall. When 𝐵' < 𝐵 ( there is excess supply, price will fall and interest rate will
rise
Shifts in the demand for bonds
- Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the
right
- Expected Returns: higher expected interest rates in the future lower the expected return
for long-term bonds, shifting the demand curve to the left
- Expected Inflation: an increase in the expected rate of inflations lowers the expected
return for bonds, causing the demand curve to shift to the left
- Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left
- Liquidity: increased liquidity of bonds results in the demand curve shifting right
Shifts in the supply of bonds
- Expected profitability of investment opportunities: in an expansion, the supply curve shifts
to the right
- Expected inflation: an increase in expected inflation shifts the supply curve for bonds to
the right
- Government budget: increased budget deficits shift the supply curve to the right
Liquidity preference framework
Keynesian model that determines the equilibrium interest rate in terms of the supply of and
demand for money. There are two main categories of assets that people use to store their
wealth: money and bonds. The total wealth in the economy 𝐵 ( + 𝑀 ( = 𝐵' + 𝑀' , or
𝐵 ( − 𝐵' = 𝑀' − 𝑀 ( . If the market for the money is in equilibrium (𝑀' = 𝑀 ( ), then the
bond market is also in equilibrium (𝐵' = 𝐵 ( )
Liquidity preference framework
Demand for money in the liquidity preference framework says that as the interest rate
increases, the opportunity cost of holding money increases and the relative expected return
of money decreases. Therefore, the quantity demanded of money decreases, and the demand
for bonds increases
Shifts in the demand for money
- Income effect: a higher level of income causes the demand for money at each interest rate
to increase and the demand curve to shift to the right
- Price-level effect: a rise in the price level causes the demand for money at each interest
rate to increase and the demand curve to shift to the right
A rise in income or the price level shifts the money demand curve rightward and the
equilibrium interest rate increases
Shifts in the supply of money
Assume that the supply of money is controlled by the central bank. An increase in the money
supply engineered by the central bank will shift the supply curve for money to the right
Money and interest rates
A rising price level will raise interest rates because people will expect inflation to be higher
over the course of the year. When the price level stops rising, expectations of inflation will
return to zero. Expected-inflation effect persists only as long as the price level continues to
rise
Response over time to an increase in money supply growth
- If the liquidity effect is larger than the other effects (income and price-level), the interest
rate decreases first, then increases, but stays lower than first
, - If the liquidity effect is smaller than the other effects and there is slow adjustment of
expected inflation, the interest rate decreases first, then increases and ends up higher
than first
- If the liquidity effect is smaller than the other effects and there is fast adjustment of
expected inflation, the interest rate increases and ends up higher than first
Increasing money supply growth is not the answer to reducing interest rates; rather, money
growth should be reduced to lower interest rates
Week 3
Eurosystem
The Eurosystem comprises the ECB and the NCBs of those EU member states that have
adopted the euro
European system of central banks (ESCB)
The ESCB comprises the ECB and NCBs of all EU countries
ECB
The balance sheet of the ECB (i.e., its assets and its liabilities) is held by the NCBs. The capital
stock of the ECB is owned by the central banks of the current 27 EU member states. The shares
of the NCBs in the total capital stock of the ECB are weighted according to the shares of the
respective member states in the total population and GDP of the EU
Structure ECB
- Governing council: the main decision-making body of the ECB
- Executive board: the organ responsible for implementing monetary policy for the
Eurozone in line with the guidelines and decisions taken by the governing council
- General council: comprises the President of the ECB, the Vice-President of the ECB and
the governors of the NCBs of the 27 EU Member States
Objectives ECB
The three main objectives of the ECB are to:
- maintain price stability in the economies of the EU (ECB aims to maintain a medium-term
inflation rate closely below 2%)
- support the economic policies of the Eurozone nations
- ensure an independent and open market economy
Policy interest rates
The Governing Council of the ECB sets the following three key policy interest rates:
- Deposit facility rate, which is the interest banks receive for depositing money with the
Eurosystem overnight. Since June 2014, this rate has been negative
- Main refinancing rate, at which banks can borrow from the central bank for a period of
one week (against collateral)
- Marginal lending facility rate, which is the rate on overnight credit to banks from the
Eurosystem
Monetary policy instruments
The ECB’s operational framework consists of the following set of conventional monetary
policy instruments:
- open market operations
- standing facilities to provide and absorb overnight liquidity
- minimum or required reserve requirements for credit institutions
Since September 2008, the ECB has introduced a number of unconventional or non-standard
monetary policy measures: complement the regular operations of the Euro system when
standard monetary policy has become ineffective
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