1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich

2 Lecture 7: January 27 Ch. 15, 16

3 Demand for Financial Assets Two financial assets: Government of Canada bond with one year to maturity; US Government Bond with one year to maturity C$ bonds have higher degree of risk and are more illiquid than US$ bonds   represents value of risk and illiquidity Covered interest rate parity condition must hold (with expected E – E(e) – in place of F) adjusted for greater risk and less liquidity of C$ government bonds: –R(1,C) = R(1,US) + (E*(e)-E*)/E* +  –(E*(e)-E*)/E* : expected change in value of C$ –(E*(e)-E*)/E* > 0  C$ expected to depreciate –(E*(e)-E*)/E* < 0  C$ expected to appreciate

4 Demand for Financial Assets Following graph –Horizontal axis: expected rate of return in C$ –E*(e) is assumed to be independent of E*, so the higher is E*, the smaller is the expected change in the value of the C$, and the smaller is the expected C$ return on US Government bond

5 E* R(1,C) [R(1,US) 0,  0, E*(e) 0 ] R0R0 E* 0 1

6 Impact on Exchange Rate Impact on E*: –  R(1,US) –  R(1,C) –  –  E*(e)

7 R(1,C) [R(1,US) 0,  0, E*(e) 0 ] R0R0 1 E* E* 0  R(1,US), , or E*(e) 2 E* 1 R1R1 3E* 2

8 Problems with Model Speed of adjustments – stability, herd effect Variety of assets – different terms to maturity, risks, degree of liquidity, expected returns Transactions costs; differential tax treatment Formulation of expectations –Momentum –Surprises Ignores current account transactions and direct intervention by central bank Determinants of E* -- consider case of financial assets with more than 10 years to maturity

9 Problems with Model Fundamental Problem: –When asset markets in equilibrium, flows = 0  no D/S for currencies –Flows do not = 0: asset markets not in equilibrium  uni- directional capital flows during adjustment period; speed of adjustment to restore equilibrium –To salvage model, need to consider growth in wealth and stock of assets

10 Central Banks Monetary policy conducted by central banks U.S. Federal Reserve –Most important –Created in 1913 Bank of Canada – created in 1935 Riksbank (Sweden) – 1668 Bank of England – 1694 Bank of France – 1800 Bundesbank (Germany) – re-established in 1946 European Central Bank – 1998

11 Traditional Policy Tools Open market operations –Interest rates, liquidity –Quantitative easing –Operation twist Discount rate/fed funds rate; bank rate/overnight interest rate Reserve requirements Moral suasion

12 Money, Interest Rates and Exchange Rates Demand for Money –Opportunity cost –Liquidity –Real income –M D /P = L(R, Y) Supply of Money determined by central bank M S = M D

13 Money, Interest Rates and Exchange Rates Assumptions –Real income constant – not impacted by changes in money supply –Price level constant –Exchange rate expectations constant –Short run Increase (decrease) in M S  decrease (increase) R  depreciation (appreciation) of exchange rate

14 Classical Monetary Theory M(t)*V(t) = P(t)*Y(t) –M: supply of money –V: income velocity of money –P: price deflator for GDP –Y: GDP –V = L(R) Real interest rates matter –%  M + %  V = %  P + %  Y

15 Classical Monetary Theory Short run: –Changes in V depend on changes in R –Price rigidity –Changes in M can affect Y and R

16 Classical Monetary Theory Long run: –Flexible prices –Assume: %  V = k; %  = n (determined by rate of growth in factors of production and multi-factor productivity growth rate) –%  P = %  M + k - n –Assume further that k = 0 and cause-effect runs from the supply of money to the rate of inflation –  inflation a monetary phenomenon –%  P = %  M - n

Canadian Experience M1+M2+Core CPI %6.6%2.1%