1'1 Money and the Macroeconomy

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1.1 Money and the Macroeconomy

• Output (nominal/real GDP) Classical Vs
  Keynesian.
• Inflation (CPI, GDP deflator) Friedman.
• Interest rates (short/long rates) central bank
  and inflation expectations.

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1.2 Functions of Money

• Medium of exchange an acceptable means of
  payment, specialisation Vs double coincidence of
  wants, reduction in transaction costs.
• Store of value converted into durables with an
  interest cost.
• Unit of account a standard/common measure.
• Standard of deferred payment a unit of account
  for future payments (such as debts).

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1.3 Properties of Money

• Portability easily carried and transferred.
• Durability maintenance of physical quality.
• Divisibility fractions.
• Standardizability unvaried quality.
• Recognizability easily to be known as money.

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1.4 Types of Money

• Commodity money I (cattle, leather, clothes and
  shells), started in about 2000 B.C.
• Commodity money II (iron, copper, silver and
  gold), started in West Chou dynasty in about 1000
  B.C.
• Paper money under commodity standard, Sung
  dynasty in 990.
• Paper money under Gold Exchange Standard (after
  WWI) convertible only in official accounts.
• Fiat or credit money, popular today.

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1.5 Definitions of Money

• Transactions approach and liquidity approach.
• Empirical definitions created in the past few
  decades, M1, M2 ...
• Monetary base currency depository
  institutions reserve deposits with the central
  bank.
• M1 currency in circulation demand deposits
  with depository institutions.
• M2 M1 savings time deposits with depository
  institutions.

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• AMCM defines monetary base, M1, M2 in Macau.
• Monetary base notes and coins in circulation
  deposits of OMIs with AMCM.
• M1 currency circulation demand and savings
  deposits with monetary credit institutions
  (MCIs).
• M2 M1 quasi-monetary liabilities of MCIs
  (notice deposits, time deposits and CDs held
  outside the banking sector).
• The best definition? Ability to control, link to
  major economic variables.

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1.6 Electronic Money

• New electronic means of retail payment (a card,
  mechanisms via Internet) currently being tested
  in a number of markets, e.g. multi-purpose-prepai
  d cards or stored-value cards (smart cards).
• Digital representation of money (via microchip).
• Originality inter-bank payment system via
  telegraph (1918).
• Reduced transaction costs and settlement risk,
  more efficient for cross border retail payments.
• No access to a credit line or a deposit account,
  but a pooled liability of an issuer (i.e. money).
  

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Concerns

• Status of issuers (banks only?)
• Risk to issuers (investment, liquidity, credit,
  market, foreign exchange, settlement and
  clearing).
• Technical considerations such as counterfeiting,
  security, money laundering and equipment cost
  reducing).

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2.1 The Origin of Banks

• Banca bench from Italy and banking business
  in Tang dynasty (618-907).
• Banks Vs money.
• Deposit Ka Fong in Tang dynasty.
• Remittance flying money in Tang.
• Money exchange multi-currency system and
  non-standard, private money issues since Tang.
• Fractional reserve banking (lending and
  investment) adopted by An Ho or goldsmiths.

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2.2 Functions of Modern Banks

• Financial intermediary/ indirect finance.
• Benefits to the economy lower transaction costs,
  diversification of risk, specicalisation in
  credit information collection.
• Liabilities financed assets ? conservative
  banking.
• Dis-intermediation (what does it mean? why?)

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2.3 Types of Financial Institutions

• Depository (commercial banks), non-depository and
  government.
• The rise of universal banking (German model - a
  single legal entity and British model - a holding
  co. with separate subsidiaries).
• Objections to universal banking unfair
  competition favouring depository institutions,
  prudent consideration.
• System in Macau allow to issue/place securities,
  sale of insurance contracts issued by insurance
  companies (Decree Law No. 32/93/M).

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2.4 Types of Financial Instruments

• Equity, debt, asset-backed securities, hedging
  instruments.
• Short-term papers commercial papers, government
  bills (monetary bills in Macau).
• Medium- and long-term bonds corporate bonds,
  government bonds (Treasury bonds in the US,
  Exchange Fund notes in Hong Kong).

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2.5 Financial Markets

• Direct finance means for lenders/borrowers.
• Banks (intermediaries of indirect finance) also
  take part in financial markets, e.g. holding debt
  instruments.
• Primary (sources of securities) and secondary
  (liquidity) markets.
• Secondary markets physical exchange (equity) and
  OTC (debts).
• Money and capital markets (defined by maturity).

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Money Market

• Maturity lt one year.
• Financial institutions, large corporations and
  central banks trading on debt papers through OTC
  for short-term liquidity adjustments.
• Interbank market trading of reserves with
  central bank and having a direct impact on
  short-term interest rates.
• Forms of trading outright Vs repo.
• Repo rate difference between todays selling
  price and tomorrows repurchase price.

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3.1 Note Issuing Mechanisms

• The arrangement to create an independent and
  circulating currency.
• 2 basic considerations (i) How should the
  currency be supplied? (ii) Could the arrangement
  establish the public confidence in the currency?

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Four Schools of Thought

• Bullionist full convertibility into precious
  metal.
• Banking/Real Bill Doctrine trade/economic
  activity ? money.
• Currency strict control of money return to the
  gold standard.
• Free Banking free competition in money issue.
• Exogeneously- Vs endogenously- determined.

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Note-issuing Under Fiat Money System

• Notes issued by central bank or government
  authority (US, UK).
• Notes issued by currency board or commercial
  banks (Macau, Hong Kong, Argentina, Estonia).
• Supply determined by central bank Vs BOP.
• Monetary discretion Vs automatic mechanism.

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Macaus Currency Board System

• Currency board (AMCM) appoints agent banks to
  issue notes.
• Decree Law No. 7/95/M (i) foreign asset back-up
  (ii) foreign currency-exchanged CIs as guarantee
  of note issues (iii) guarantee as part of
  foreign exchange reserves managed by AMCM.
• Decree Law No. 16/95/M strengthens patacas
  status as legal tender and local money.

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Central Bank Vs Currency BoardAdvantages and
Disadvantages

• monetary autonomy if no exchange rate target
  (isolation from external influences)
• full capacity as lender of last resort (LLR)
• max. seigniorage
• no international reserve requirement
• - overissue/credibility
• - exchange rate volatility
• - large regulatory expenses

• restoration or establishment of confidence with
  convertibility assurance
• capturing a certain level of seigniorage
• exchange rate stability if credible
• - loss of monetary autonomy and LLR capacity
• - exchange rate rigidity
• - large reserve requirement

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The Case of Patacas

• One currency for many countries Vs many
  currencies for one country.
• Pataca, escudo and renminbi.
• Creation of pataca on 27 January, 1906.
• Exchange status of pataca nominally pegged to
  escudo before 1977 linked to HKD since 1977
• realignments in 1949 and 1967
• attempts to set the pataca at par with the HKD in
  1978 and 1983
• The survival of MOP
• realization of the local authority and Macaus
  separate entity
• two currencies with different names are
  essentially unified with a fixed rate of exchange
  between them
• seigniorage

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3.2 Monetary Base and Bank Money

• 3 components of money (M) (i) currency issues,
  (ii) bank reserves with central bank and, (iii)
  deposits.
• Monetary base (MB)(i)(ii).
• Bank money (D) (iii), created by the action of
  depositing cash into bank and credit expansion
  under a fractional reserve system
• MB?? multiple expansion of M or D.

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3.4 Theory of Money Multiplier

• Simple money multiplier1/d.
• In Macau, d1-3.
• Does the public hold cash? Do banks hold excess
  reserve? ? money multiplier (1c)/(dec).
• ?m or/and MB?M.
• Stable m enable central bank to control M.
• Could the central bank control m?

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4.1 Definition of Interest Rates

• Interest - amount of money that lenders receive
  when they extend credit.
• Interest rate - ratio of interest to the amount
  lent.
• Measurement - yield to maturity difference
  between present and future values.
• Functions - allocation of resources determinant
  of investment decisions.

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4.2 Nominal Vs Real

• Nominal - rate of exchange for monetary unit
  today and future.
• Real - rate of exchange for resource today and
  future.
• Fisher equation i r pe or r i pe.
• pe a forward looking variable and unlikely to be
  directly measured.
• Fisher effect
• r stable/determined by real factors such as
  productivity of capital and time preference
• pe ? i
• Empirical evidence.

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4.3 Types of Interest Rates

• Prime rate/best lending rate for most
  creditworthy customers.
• Deposit rate not necessarily market-driven MAB
  indicative rates for 7-day and saving deposits in
  Macau.
• Interbank rate MAIBOR (1M, 3M, 6M).
• Bond rate benchmark Pb R/i.
• Policy rate discount rate, interbank target rate
  (e.g. Fed funds target rate).

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4.4. Determination a. Classical Economists

• i price paid for the use of capital.
• I demand for capital and
• S supply of capital ? I(i) S(i).
• Demand for/supply of waiting (postponing
  consumption).
• i determined by the market, not the authorities.

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(b) Keynes

• ireward of not-hoarding cash (parting with
  liquidity), rather than reward of not-spending.
• People hold cash/money or bonds.
• M/PL(y,i).
• If M/PgtL ? buying bonds ? Pb ? ? i?.
• Effect of y changes effect of M changes and
  Friedmans critic.
• i ?? iltmec ? I? until imec.

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(c) Loanable Funds Theorists

• A synthetic approach.
• Supply - willingness to lend (purchase of
  financial claims)
• demand - borrowings (issue of financial claims).
• Supply of loanable funds affected by Ms
  (exogenous), savings (vely related to i),
  government budget surplus (exogenous), foreign
  lending and money hoarding (-vely related to i).
• Demand for loanable funds determined by
  government, business, consumer and foreign
  borrowings.
• Supply and demand ? i.

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4.5 Term Structure of Interest Rates

• Definition Relation among interest rates on a
  particular financial instrument with different
  terms to maturity.
• Question Why do interest rates of an instrument
  with different terms to maturity vary?

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(a) Expectations Hypothesis

• S-T interest rates vary over time.
• Instruments of different maturities are prefect
  substitutes.
• int it E(it1) .. E(itn-1)/n.
• Expecting rising S-T rates?upward sloping yield
  curve expecting falling S-T rates ?inverted
  yield curve.
• Implied future rate.

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(b) Segmented Markets Theory

• Instruments of different maturities not
  substitutable.
• Desired holding period ? demand for instrument of
  matching maturity.
• Different liability maturities ? supply of
  instrument of matching maturity.
• Separate markets, different SS/DD conditions
  (e.g. investment banks in S-T market, insurance
  companies in L-T market) ? varied rates for
  different terms of maturity.

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(c) Preferred Habitat Theory

• Expectations premium reflecting supply and
  demand conditions.
• Instruments with different terms of maturity are
  substitutes, but not prefect substitutes.
• int it E(it1) .. E(itn-1)/n knt,
  where k (term premium) can be ve or -ve.

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(d) Liquidity Premium Theory

• Similar to Preferred Habitat Theory, with k
  always of ve sign due to increased market risk
  for longer term securities.
• k a positive function of the term to maturity.
• (c) and (d) most popular for interpreting yield
  curves and future interest rates.
• Cases (i) steeply rising yield curve? (ii)
  moderately steep yield curve? (iii) flat yield
  curve? (iv) inverted yield curve?

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4.6 Risk Factor of Interest Rates

• Relation among interest rates with same term to
  maturity.
• Default risk (unable to pay interest /face
  value) yield with default risk benchmark yield
  risk premium risk premium determined by credit
  rating/supply of funds.
• Liquidity risk (how widely the instrument being
  traded) risk premiumdefault liquidity.
• Tax treatment exemption ? lower i.

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5.1 The Balance Sheet Liab.

• Demand deposits non-interest bearing subject to
  reserve requirement M1 component lowest cost of
  bank funds.
• Non-transaction deposits (savings, notice, time)
  interest bearing subject to reserve requirement
  M1/M2 components.
• Public sector deposits non-monetary liabilities
  a significant value compared with other types of
  deposits.
• Borrowings from central bank (discount window),
  large corporation (Repo) and interbank market
  focusing on interbank market in Macau (foreign
  currency transactions gt pataca transactions).
• Capital (share capitalretained earnings) minor
  source of funds in banking less than 4 of total
  asset value in Macau.

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Assets Customer Interbank Loans

• Major use of funds and source of profit.
• Over 99 domestic loans to private sector in
  Macau.
• Mortgage, construction and trade finance the
  largest items of domestic credit to firms
  individuals.
• Active lending to external customers.
• Domestic interbank market relatively inactive
  with interbank loans accounting for only 6 of
  claims on monetary institutions claims on AMCM
  (MBs) the lions share .
• Active offshore activity reflects in the large
  claim on banks abroad which is very much larger
  than domestic interbank lending.
• Other claims on banks include cheques in
  collection process and deposits with other banks.

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Other Assets

• Financial investments interest earning
  securities mainly foreign investments due to
  strong offshore activity and negligible domestic
  financial market.
• Reserves deposits with the AMCM and vault cash
  excess reserve/required reserve ratio is 20-30
  accounting for less than 2 of total asset (low
  cost to banks).
• Sundry assets such as real estate, furniture and
  supplies.

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5.2 Asset and Liability Management

• John Bond (1998) suggests 5 criteria to evaluate
  bank performance.
• Income growth gt cost growth.
• Income/cost ? 2.
• Net income growth gt risky asset growth.
• Non-interest income/operating profit ? 0.5.
• Balanced loan portfolio.
• Overall, how to max. profit in a prudent manner?

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5.2.1 Asset Management

• A balance between interest income and default
  risk.
• A balance between reserve holding and liquidity
  risk.
• In practice
• screening of loan cases
• specialization
• enforcement of restrictive covenants
• direct equity holding
• collateral
• credit rationing

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5.2.2 Liability Management

• Stable and low-cost funds.
• Capital insignificant.
• Deposits.
• Interbank loans.
• Negotiable CDs.
• Loans from central bank.
• Macau domestic liabilities concentrated on
  deposits and foreign liabilities concentrated on
  interbank loans.

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5.2.3 Interest Rate and Portfolio Adjustment

• Asset/liability types
• rate sensitive/non-sensitive (floating Vs fixed)
• maturity (re-pricing time)
• Adjusting the combination according to
  expectations about the trend of i.
• i expected to fall/rise
• rate sensitive asset/liab., more or less?
• maturity of asset/liab., lengthen or shorten?

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5.3 Risk to Bankers

• Credit risk
• Country risk
• Market risk
• Interest rate risk
• Liquidity risk
• Operational risk
• Legal risk
• Reputational risk

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Credit Risk

• Default
• loans (incl. investment in debt paper)
• off-balance sheet exposures
• Loan granting (objective sound principles,
  written lending policy, loan approval
  administration procedures, database of every loan
  case).
• Loan quality incl. provision (periodic review on
  repayment, strength of guarantees collateral
  value).
• Concentration alarm (restricting exposures to
  single borrowers or groups of related borrowers,
  particular industries, economic sectors or
  geographical regions).
• Prevention of abuse of connected lending (fair
  terms conditions, limit, special
  capital/collateral requirements).

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Country, Market, Interest Rate and Liquidity Risks

• Country cross border exposures incl. transfer
  risk.
• Market exposures in financial markets
  (securities, forex, commodities).
• Interest rate adverse movements.
• Liquidity failure to accommodate decreases in
  liab. or to fund increases in assets.
• Clear cut policy and control, appropriate
  reserves or capital cushion, powerful monitor
  system, sufficient diversification, contingency
  plan.

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Operational, Legal and Reputational Risks

• Operational breakdown in internal control and
  corporate governance system.
• Legal inadequate or incorrect legal advice or
  documentation.
• Reputational operational failures, failure to
  comply with laws and regulations.
• Effective internal control and auditing
  procedures, insurance and contingency plans,
  professional management.

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5.4 Clearing and Settlement

• For transactions of cheques, interbank funds,
  foreign exchange and securities.
• Payment and delivery actions.
• Centralised clearing house Vs bilateral clearing
  (Macau 1983, HK 1981).
• Significance
• large value
• chain effect
• key infrastructure for financial investments and
  development
• Risks arisen from all kinds of risks discussed in
  5.3 and Herstatt risk.
• RTGS solution proposed by G-10 central banks
• continuous, individual without netting debits
  with credits
• intraday finality of settlement across the book
  of central bank
• queued if without sufficient credit balance

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5.5 Deposit Insurance

• Run by a government agency, e.g. FDIC in the US.
• Premiums calculated as a percentage of the
  insured deposits paid by banks.
• Mostly customer deposits, some also cover
  interbank and foreign currency deposits.
• Focus on small-valued deposits, e.g. up to
  US100,000 in the US.
• IMF-suggested benchmark of coverage twice per
  capita income.

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Types and Objectives

• To protect the interest of small depositors
  (rumour-sensitive mass).
• To safeguard the stability of the banking system.
• Favourable US experience between the 1930s and
  the early 1980s and banking crisis in HK in the
  1960s.

• Fund-based Vs ex post levied.
• Voluntary Vs compulsory.
• Flat premium Vs risk-adjusted premium.

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Options for Insurer under Bank Failure

• Direct payoff
• Purchase and assumption
• Indirect payoff (assumption only)
• Direct assistance (too large to fail)

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The Development

• Explicit DIS for over 60 countries.
• Compulsory system the majority.
• US the first country to enact DIS (1934).
• Becoming popular since the 1960s.
• Thousands of bank failure in the US in the late
  1980s and early 1990s
• a financial burden
• an effective tool?
• a contributor to the problem?

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Problems of Deposit Insurance

• CDs and interbank credits not sufficiently
  covered.
• Adverse selection for voluntary system cross
  subsidization for statutory system.
• Moral hazard for both banks and depositors.
• Agency problems of DIS staff.
• Delayed compensation effect.

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The Best Practices and Recent Trends

• Incentive compatible
• inducing all economic agents affected by the
  scheme to keep the financial system sound
• inclusion open only to those depository
  institutions that are well regulated and
  supervised
• Rise of risk-adjusted premiums.
• Shifting towards compulsory schemes.
• Domination of funded DIS.
• Access to back-up funding from the government.
• Higher coverage in poor countries.
• Increasingly limiting the coverage
• coverage per depositor, rather than per account
• interbank and foreign exchange deposits excluded

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Rebuke to DIS

• Bank runs on insolvent banks Vs systemic crisis
• Necessary and sufficient conditions for banking
  stability
• lender of last resort to massively withdrawn but
  solvent banks
• effective and credible system of prudential
  supervision
• transparency and information disclosure

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Banking Crisis

• Insolvent banks
• asset value lt liability value
• loan loss gt reserves capital
• other risks to bankers
• Systemic crisis and the failure of sound banks.
• Costs
• rescue operations
• speculative attack against the domestic currency
• More than 30 systemic crises since the 1980s
  over 70 in developing countries.
• Signals
• weak macroeconomic environment
• massive outflows of funds
• structural characteristics

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Policy Options for Strengthening Banking Systems

• Banking Crises in Emerging Economies (Goldstein
  and Turner 1996).
• Reducing volatility.
• Defending against lending booms, asset price
  collapse and surges in private capital flows.
• Reducing liquidity/maturity/currency mismatch.
• Preparing better for financial liberalization.
• Reducing government involvement and connected
  lending.
• Strengthening the accounting, disclosure and
  legal framework.
• Improving incentives for bank owners, managers,
  creditors, and for bank supervisors.
• Preventing the exchange rate regime from
  compromising crisis prevention/management.

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6.1 The Origin of Central Banks

• The first central bank in the world - BOE in 1694
• finance government expenditure in exchange for
  the right to issue paper money
• clearing and settlement for banks
• Financial crises in the 1800s
• lender of last resort
• many western countries have followed the British
  model since the late 1800s
• Post WWI
• international financial summit in 1920

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6.2 Functions of Central Banks Conduct of
Monetary Policy

• Issue of legal tender, control of money supply
  and short-term interest rate, regulation of
  exchange rate.
• Objectives financial stability, price stability,
  full employment, sustainable economic growth.
• Neither too much nor too little money is
  created.
• AMCM under Decree Law No. 14/96/M
• to monitor internal monetary stability and the
  external solvency of the local currency, ensuring
  its full convertibility.
• to monitor the stability of the financial
  system.

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Banker to the Government

• Expenditure payments and revenue receipts through
  Treasurys account with central bank.
• Financing short-term, seasonal funding needs.
• Managing debts and reserves.
• Financial adviser.
• Representative in international monetary
  organizations such as IMF/World Bank.
• AMCM
• to advise and assist the Chief Executive in
  formulating and applying monetary, financial,
  exchange rate and insurance policies.
• to exercise the functions of a central money
  depository and mange the territorys currency
  reserves and other foreign assets.

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Prudential Supervision of Banks and Financial
Market Regulation

• On-site/off-site examination on the quality of
  deposits and loans, the amount of capital and the
  quality of management.
• Implementation of banking ordinances.
• Issue policy directives in relation to bank
  operations.
• Oversee the operation of financial markets to
  ensure market integrity and protect investors.
• Receive complaints from and educate bank
  customers.
• AMCM
• to guide, co-ordinate and oversee the monetary,
  financial, foreign exchange and insurance
  markets, ensure their smooth operation and
  supervise the actions of those operating within
  them according to the terms established in the
  regulatory statutes governing each respective
  area.

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Banker to Banks and Others

• Clearing, settlement and fund transfers.
• Lender of last resort.
• Development of financial system and
  infrastructure.
• Research.
• Macau
• Clearing House managed by MAB, but settlement
  still made across banks accounts with AMCM
  (Interbank Liquidity Account Service since
  2/12/1999)

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Do We Need Central Banks?

• Friedmans critic in Hong Kong (1993).
• The conduct of monetary policy aims at
  establishing a monetary anchor by discretion, but
  the achievement is far from satisfactory in many
  instances.
• Suggestion to fix a stable growth of monetary
  base consistent with economic growth free
  banking ? central bank replaced by a computer.
• Unnecessary lender of last resort
• moral hazard
• too big to fail
• If banks go bad, it is best that they fail
  earlier and not later.

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6.3 Balance Sheet of Central Banks Assets

• Securities
• largest item of interest-earning assets
• primarily domestic Treasury securities
• reflecting OMO
• missing in Macau, though AMCM extending
  short-term credits to the public sector
• Discount loans
• interest earning loans to banks through the
  discount window
• missing in Macau
• Foreign assets
• gold, silver, forex, financial investment abroad,
  SDR issued by IMF
• BOP adjustments
• Cheques in process
• Sundry assets

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Liabilities

• Currency outstanding
• currencies in the hands of the public
• CIs in Macau
• Bank reserves
• deposits with central bank and vault cash
• required reserves and excess reserves
• Public sector deposits
• Treasury payments
• deposits drawn out from the banking system
• Foreign and other deposits
• non-bank and foreign central banks deposits
• central banks borrowing from foreign
  institutions
• Deferred-availability cheque items
• Capital accounts and sundry liabilities

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6.4 Central Bank Independence

• How free is the central bank from the
  Administration and Legislation?
• Factors
• appointment of major executive and board members
• source of finance
• the power
• transparency
• The case for independence
• politicians short-sighted (inflation bias,
  political business cycle, central bank-financed
  deficit)
• empirical evidences
• The case against independence
• undemocratic (check and balance, performance)
• monetary and fiscal policy coordination

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7.1 Classical Model

• Dominant school from 1770s-1930s.
• Oral tradition of Cambridge macro-economics on
  money.
• Self-regulating economic system.
• Flexible wage system ensures full employment.
• Supply creates its own demand (i as an adjusting
  variable).
• Quantity theory of money, MVPY
• Y, V constant ? monetary neutrality
• Cambridge equation (behavioural version of the
  quantity theory), MdkPY
• economic agents hold some fraction of their
  nominal income as money (transactions motive and
  precautionary motive)
• If MsMo (fixed), Y interpreted as AD ? downward
  sloping AD schedule (AD (Mo/P)(1/k))
• M? ? AD? ? P? and Y unchanged (monetary
  neutrality)

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7.2 Keynesian Model

• 1930s Great Depression brought Keynesian
  revolution.
• The General Theory of Employment, Interest and
  Money
• AS always at YF? Demand-determined Y
• AS not determined by the quantity theory of money
  (supply creates its own demand not true), but
  desired expenditures of different sectors of the
  economy (C, I, G)
• i not determined by S and I, but Md and Ms
• classical model at best a long run model, but we
  are all dead in the long run
• Money demand (liquidity preference) function
• bond and money
• speculative demand for money added to
  transactions and precautionary demand, MdMd(Y,
  i)
• downward sloping money demand curve

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7.3 IS and LM

• AD CIGNX cTrc(1-t)y(II-di)GNX
  Ac(1-t)y-di.
• In equilibrium, y Ac(1-t)y-di
  ? diAc(1-t)y-y
  ? diA-y1-c(1-t)
  ? i (A/d) - (y/d)
  1-c(1-t) ? downward sloping
  IS curve.
• Real money demand, L ky-hi.
• In equilibrium, M/P ky-hi
  ? hi ky-M/P ? i (ky)/h-(M/hP) ?
  upward sloping LM curve.

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General Equilibrium

• Both money market and product market in
  equilibrium.
• Slope of LM curve determined by sensitivity of L
  to i (h) and sensitivity of L to y (k).
• Small h and large k ? steep LM curve.
• Shift in LM curve change in M, change in P.
• Slope of IS curve determined by sensitivity of I
  to i (d) and the size of the multiplier
  (1/(1-c(1-t)).
• Small d and small multiplier ? steep IS curve.
• Shift in IS curve change in autonomous
  variables.

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Monetarism

• Inflation is always a monetary phenomenon.
• Monetary policy very effective in raising Y in
  the short run (steep LM curve and flat IS curve),
  but only causes inflation in the long run
  (quantity theory of money works).
• Capacity relation between expectations of price
  and money.
• Goodhart to increase M for 2-3 years sufficient
  to have inflation impacts.
• Supply shock such as union-pushed inflation
• non-monetary?
• reaction of M/P and L
• sustainable if no corresponding increase in M?

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7.4 Monetary Objectives

• The 1st task to conduct monetary policy to set a
  precise objective.
• Most popular ultimate objectives
• low stable unemployment (high or stable
  economic growth)
• low stable inflation (price stability or
  internal monetary stability)
• exchange rate stability (external monetary
  stability)
• Data problem and theoretical compromise ?
  intermediate or proximate objectives.
• Criteria of intermediate targets consistent,
  measurable, timely and controllable.
• Choices of intermediate targets interest rate,
  money supply, credit aggregates, commodity
  prices, gap between short- and long-term interest
  rates.

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Uses of Intermediate targets

• Interest rate
• adjust Ms to changes in Md in order to fix i
• superior target if volatile interest elastic
  Md, unstable money multiplier, stable IS curve
• Money supply
• offset variations in the value of money
  multiplier that cause quantity of money to change
• superior target if stable interest inelastic
  Md, well-defined money supply, volatile IS curve
• Commodity prices leading indicators of
  inflation.
• Credit aggregates supplement to monetary
  aggregates.
• Spread between short- and long interest rates
  stabilising inflation expectations.

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7.5 Monetary Instrument OMO

• Purchase and sale of government securities
  (monetary bills in Macau).
• Impacts on depository institutions reserves and
  short term interest rates.
• Announcement effect moves market expectations.
• Daily operations.
• Outright (changing money supply or interest
  rates) and Repo (removing fluctuations).

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Discount Window, Reserve Requirement and Others

• Discount window
• banks discounting securities to the central bank,
  in exchange for an increase in their reserves
  (borrowed reserves)
• discount rate leading short-term interest rates
• discount rate as a price of reserves (monetary
  base) indirectly influencing money supply
• announcement effect
• Reserve requirement
• in proportion to deposits in the form of deposits
  with central bank or vault cash
• little impact on monetary base, but directly
  affecting the size of money multiplier (hence
  money supply)
• seldom applying the instrument in view of high
  costs to central bank and commercial banks
• acting as a stabiliser of money multiplier and
  hence enable the central bank to control the
  money supply with greater accuracy when engaging
  in OMO
• Moral suasion, margin requirements, direct credit
  control.