Money and Banking

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Money and Banking Mr. Vaughan
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Learning Objectives Part II Nominal Interest
Rate

• After this lecture, you will be able to
• Explain how changes in expected inflation affect
  nominal interest rates in long run.
• Describe how monetary growth affects inflation in
  long run.
• Trace effects of monetary policy on nominal
  interest rate in short run and long run.

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Fisher Equation

• Recall
• Borrowers and lenders care about real interest
  rate.
• But, financial markets set most interest rates in
  nominal terms.
• So, borrowers and lenders must guess about
  inflation rate.

Real Interest Rate Expected
Inflation Nominal Interest Rate
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Guessing Wrong Is Costly!
Debtors Win/Creditors Lose!
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Guessing Wrong Is Costly!
Creditors Win/Debtors Lose!
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Expectations and Nominal Rates

• To avoid losses, debtors and creditors
• use all useful information.
• learn rapidly from mistakes.
• react quickly to changes in expected inflation.
• Implications
• Rational Expectations Random forecast errors
• Changes in inflation expectations move bond
  demand/supply and nominal interest rate rapidly.

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Fisher EquationIn Pictures
Nominal Interest Rate
Bond Demand1
Increase in expected inflation reduces expected
return on bonds and, thus, bond demand.
ia
a
Bond Supply1
Quantity of Bonds ()
Qa
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Fisher EquationIn Pictures
Nominal Interest Rate
Bond Demand1
Increase in expected inflation reduces real cost
of borrowing and, thus, increases bond supply.
ib
b
Bond Supply1
Quantity of Bonds ()
Qb
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Fisher EquationIn Pictures
Q
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Fisher EquationEvidence

• Note Inflation trends explain
• Rising rates before early 1980s
• Falling rates since 1980s
• Rate volatility since 1950s

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But what causes (changes in) inflation?

• Inflation is always and everywhere a monetary
  phenomenon.
• Milton Friedman
• His Point?
• In short run, many factors can boost general
  level of prices
• Only sustained growth in money supply can produce
  sustained rise in prices.

First things first What is money?
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Money in U.S. Economy

• Money Supply Total quantity (dollar volume) of
  assets providing medium-of-exchange services
• Currency Paper bills coins in public hands.
• Checkable Deposits Bank balances depositors can
  access on demand by writing check (demand
  deposits, NOWs)
• Travelers Checks

This functional definition is M1 (narrow money).
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U.S. Money StockTwo Measures
Note - Currency only 10.1 of M2 - Checkable
deposits only 8.5 of M2
M2 is Broad money Better measure for policy,
scientific purposes
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How correlated are Ms?
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Money and InflationQuantity Theory of Money

• Quantity Theory starts with equation of
  exchange

M x v P x y

• M Money Supply
• v Income Velocity of Money
• Average number of times per period each dollar of
  money supply is spent on nominal GDP
• P GDP Deflator / 100 (general price level)
• y Real GDP
• Note
• P x y Nominal GDP
• Equation is tautology (needs assumptions to
  become theory)

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Quantity Theory of MoneyAssumptions

• M Exogenously determined (by government)
• v Not influenced by money (in short run
  relatively stable)
• Determined by real factors such as payments
  technology/institutions, tastes, etc.
• y Not influenced by money (in short run)
• Determined by real factors such as technology,
  factor endowments, societal commitment to
  markets/property rights, etc.

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Quantity Theory of MoneyAssumptions Reasonable?
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Quantity Theory of MoneyImplications of
Assumptions

• Equation of Exchange (rate of change form)
• Note
• If growth in velocity and real output are
  determined exogenously by real factors, then
  changes in prices (only endogenous variable) must
  be determined by changes in money supply.
• Quantity Theory focuses on long run, not short
  run.

?M ?v ?P ? y
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Quantity Theory of MoneyU.S. Evidence
Period Money (M2) Growth (Average) Velocity Growth (Average) Inflation Rate (Average) Real GDP Growth (Average)
(1) 1959Q1 - 1983Q4 8.4 0.1 4.8 3.6
(2) 1983Q4 - 2008Q4 5.5 0.1 2.5 3.0
Notes All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures Notes All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures Notes All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures Notes All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures Notes All Series Seasonally Adjusted, Averages of Annualized Quarterly Figures
Source U.S. Department of Commerce, Board of Governors of Federal Reserve Source U.S. Department of Commerce, Board of Governors of Federal Reserve Source U.S. Department of Commerce, Board of Governors of Federal Reserve Source U.S. Department of Commerce, Board of Governors of Federal Reserve Source U.S. Department of Commerce, Board of Governors of Federal Reserve
NOTE Money growth and inflation lower in period
(2)!
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Quantity Theory of MoneyCross-Country Evidence

• Note
• Each point represents 30-year average annual
  money growth and 30-year average annual inflation
  
• All points lie near/on 45-degree line.

Source McCandless and Weber, 1995
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Proximate Cause of InflationExcessive Monetary
Growth

• Excessive Growth of Money Supply

Faster than economys long-run real growth rate
Excessive Spending on Goods and Services
Long-Run Real Growth 3.3
Inflation
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Money Growth and InflationU.S. Evidence
Average Annual Rates United States 1959Q1-2008Q4

• Money Supply (M2) Growth 7.0

Inflation 3.7
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Money and Nominal Rates Cross-Country Evidence
Monetary growth gt Inflation gt Nominal Interest
Rates
Note Each point represents average annual money
growth and average annual inflation
(circle/square represents average values for one
country, 1961-1998).
Source Monnet and Weber, 2001
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Money and Nominal RatesCross-Country Evidence
Note Each point represents average annual money
growth and average annual inflation
(circle/square represents average values for one
country, 1961-1998).
Source Monnet and Weber, 2001
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Money and Nominal Rates U.S. Evidence
Monetary growth gt Inflation gt Nominal Interest
Rates
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Money and Nominal Rates Short Run

• Fed implements monetary policy by
  purchasing/selling Treasuries.
• Transactions are called open-market operations.
• Open-market purchases increase bank reserves and
  reduce bond supply.
• Open-market sales reduce bank reserves and
  increase bond supply.

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ExampleFed in Action
Nominal Interest Rate
Bond Demand1
Suppose Fed buys Treasuries in open market. Bond
supply will fall, and nominal interest rate will
fall.
Quantity of Bonds
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Why ConductOpen-Market Operations?

• Fed buys and sells Treasuries to stabilize
  economy.
• Weakening economy Fed buys Treasuries to lower
  interest rates and stimulate economy.
• Overheating economy Fed sells Treasuries to
  raise interest rates and slow economy.

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Art of Central Banking

• Balancing short-run goals of monetary policy (a
  stable, high-growth economy) with long-run goals
  (low inflation) is challenging.
• High inflation and nominal interest rates of
  1970s were due to excessive focus on short run.

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Putting It All TogetherLinking the Long and
Short Run

• Does easy money lower nominal interest rate?
• Short run
• Open-market purchases lower nominal interest
  rate.
• Long run
• When economy perks up, nominal rate starts
  rising.
• If monetary stimulus is excessive, inflation
  starts rising.
• Bond demanders/suppliers adjust inflation
  expectations, further raising nominal rate.

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Putting It All TogetherLinking the Long and
Short Run

• Does easy money lower nominal interest rates?

Nominal Interest Rate
Time
0
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You try it!
Year Average3-MonthT-Bill Rate Year Average3-MonthT-Bill Rate
1978 7.2 1993 3.0
1979 10.0 1994 4.3
1980 11.5 1995 5.5
1981 14.0 1996 5.0
1982 10.7 1997 5.1
Why were nominal rates lower in later period?
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You try it!
Money growth and inflation were lower!
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Questions over
Money and Banking Mr. Vaughan