1. Chapter 2 of Cecchetti Money and the Payments System

2. Money  Money is an asset that is generally accepted as payment for goods and services or repayment of debt. 1.A means of payment. Transferability Information 2.A unit of account Allocation of resources Relative prices 3.A store of value Liquidity

3. Example: Island Economy Farmer Gold MinerBlacksmith Teacher 1M florins 1M oz gold CENTRAL BANK “M”=million

4. Example: Island Economy Central bank declares it stands ready to redeem 1 florin for 1 ounce of gold from anyone at any time. Balance Sheet of Central Bank ASSETSLIABILITIES Gold: 1M flCurrency: 1M fl

5. Example: Island Economy Farmer Gold MinerBlacksmith Teacher 1M florins 1M oz gold CENTRAL BANK “M”=million florins food florins food lectureflorins services florins gold

6. Example: Island economy Assume no banking system  No bank deposits Money supply is completely in the form of currency Money supply = 1,000,000 fl

7. Example: Island Economy Farmer Gold MinerBlacksmith Teacher florins Commercial Bank

8. Initial Purpose:  Keep florins safe Why not loan some of those florins out? Commercial Bank Balance Sheet ASSETSLIABILITIES Currency 1M flDeposits 1M fl

9. Example: Island Economy Bank Reserves: liquid assets held by banks to meet demands for withdrawls from investors. Central Bank mandates bank must hold some fraction of florins in vaults called reserves.

10. Example: Island Economy Reserve deposit ratio = currency/deposits Assume required reserve deposit ratio = 20% Commercial Bank loans out 80% of deposits  800,000 fl  These are deposited back in the bank

11. Example: Island Economy Commercial Bank Balance Sheet ASSETSLIABILITIES Currency 1,000,000 flDeposits 1,800,000 fl Loans 800,000 fl ----------------------------- Total 1,800,000 fl 1,800,000 fl Reserve deposit ratio = 1/(1.8) = 60% Only need.20  1,800,000 =360,000 fl Can loan out 1,000,000 – 360,000 = 640,000 fl Deposited back in bank

12. Example: Island Economy Consolidated Balance Sheet of Banks ASSETSLIABILITIES Currency 1,000,000 flDeposits 2,440,000 fl Loans 1,440,000 fl ----------------------------- Total 2,440,000 fl 2,400,000 fl Reserve deposit ratio = 1/(2.4) = 42% Only need.20  2,440,000 =488,000 fl Can loan out 1,000,000 – 488,000 = 512,000 fl Does this just go on forever..... ?

13. Example: Island Economy Equilibrium is achieved when Currency/deposits = 0.20 1,000,000/deposits = 0.20 1,000,000/0.20 = deposits 5,000,000 = deposits

14. Example: Island Economy Equilibrium ASSETSLIABILITIES Currency 1,000,000 fl Deposits 5,000,000 fl Loans 4,000,000 fl ----------------------------- Total 5,000,000 fl 5,000,000 fl Reserve deposit ratio = 1/5 = 20%

15. Money Supply Banks have effect on the money supply Bank Deposits  Very liquid, can be used for transactions  Are counted as part of the money supply In example, no cash is held by public  Money supply = total deposits Risk of bank runs

16. Measuring Money Different Definitions of money based upon degree of liquidity. Federal Reserve System defines monetary aggregates: measures of money

17. Monetary Aggregates Link to Current Data

18. Growth Rates in Monetary Aggregates

19. Money and Inflation 1990-2000 1960-1980 M2 Growth Rate and CPI Inflation Rate 2 years later.

20. Changes in Rates Chapter 6 of Cecchetti

21. Fluctuations of 1-year T-bond Rate 1-month T-bill Rate: 1953-2007

22. Bond Demand and Supply From perspective of primary market  Market in which firms issue debt, sell to investors  Suppliers: Firms and Government  Demanders: Investors Looking at secondary market, does not allow us to investigate firm behavior  Market in which investors buy and sell bonds among themselves

23. Supply And Demand Curves Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0% Supply Demand

24. Suppliers We could actually have two supply curves  Government  Firms Factors that impact one sector may not impact the other Government and Corporate rates are connected.

25. Supply – A Closer Look Three agents in economy  Government  Business  Households Initial Situation Increased Gov Borrowing

26. Shift in Supply Increase in Government Borrowing Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0% Government Bond Supply Curve

27. Changes in Government Borrowing An increase in Government borrowing  The supply curve shifts to the right  Prices to decrease  Yields to increase A decrease in Government borrowing  The supply curve shifts to the left  Prices to increase  Yields to decrease

28. Shift in Supply Declining Business Conditions Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0% Corporate Bond Supply Curve

29. Changes in Business Conditions An improvement in business conditions  The supply curve to shift to the right  Prices to decrease  Yields to increase A decline in business conditions  The supply curve to shift to the left  Prices to increase  Yields to decrease

30. Shift in Supply Increase in Corp. Tax Subsidies Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0% Corporate Bond Supply Curve

31. Changes in Corp.Tax Subsidies An increase in Corp. Tax Subsidies  The supply curve to shift to the right  Prices to decrease  Yields to increase A decrease in Corp. Tax Subsidies  The supply curve to shift to the left  Prices to increase  Yields to decrease

32. Shift in Supply Increase in Expected Inflation Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0% Corporate/Government Bond Supply Curve

33. Changes in Expected Inflation An Increase in Expected Inflation  The supply curve to shift to the right  Prices to decrease  Nominal Yields to increase A decrease in Expected Inflation  The supply curve to shift to the left  Prices to increase  Nominal Yields to decrease

34. Demand – A Closer Look Three agents in economy  Government  Business  Households Initial Situation Increased Household Saving

35. Shift in Demand Increased Household Wealth Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0%

36. Changes in Household Wealth An Increase in Household Wealth  The demand curve to shift to the right  Prices to increase  Yields to decrease A decrease in Household Wealth  The demand curve to shift to the left  Prices to decrease  Yields to increase

37. Shift in Demand Increase in Expected Stock Return Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0%

38. Changes in Expected Relative Bond Returns An Increase in Bond Yield – Return Alt.  The demand curve to shift to the right  Prices to increase  Yields to decrease A decrease in Bond Yield – Return Alt.  The demand curve to shift to the left  Prices to decrease  Yields to increase

39. Shift in Demand Decrease in Relative Risk of Bonds Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0%

40. Changes in Relative Bond Risk A decrease in Bond Risk – Risk Alt.  The demand curve to shift to the right  Prices to increase  Yields to decrease An increase in Bond Risk – Risk Alt.  The demand curve to shift to the left  Prices to decrease  Yields to increase

41. Example: Crowding Out Increased government borrowing “crowds out” firms from borrowing PriceYield Primary Market for Government Bonds Price Yield Primary Market for Corporate Bonds

42. Shift in Demand Increase in Relative Bonds Liquidity Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0%

43. Changes in Relative Bond Liquidity An Increase in Bond Liq. – Liq. Alt.  The demand curve to shift to the right  Prices to increase  Yields to decrease A decrease in Bond Liq. – Liq. Alt.  The demand curve to shift to the left  Prices to decrease  Yields to increase

44. Shift in Demand Increase in Expected Inflation Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0%

45. Changes in Expected Inflation A Decrease in Expected Inflation  The demand curve to shift to the right  Prices to increase  Yields to decrease An increase in Expected Inflation  The demand curve to shift to the left  Prices to decrease  Yields to increase

46. Expected Inflation Expected inflation shifts both curves Consider a decrease in expected inflation

47. Decrease in Expected Inflation Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0%

48. Decrease in Expected Inflation A decrease in expected inflation unambiguously causes bond prices to rise and yields to fall.

49. Business Cycles Business Cycles can shift both curves  Consider what happens when economy emerges from a recession. Jobs are created, household wealth increases Business conditions improve

50. Economy Emerges from Recession Quantity of Bonds ($ billions) Price 950 5.3% Yield 300 900 850 800 750 200100 400500 11.1% 17.6% 25.0% 33.0%

51. Economy Emerges from Recession During expansions  Wealth increases (demand shifts right)  Business Conditions improve (supply shifts right) Effect could be ambiguous Data shows during expansions  Bond prices decline, yields increase

52. Credit Markets August 28 Relative Risk of U.S. treasuries has dropped. Demand curve shifts right. Prices jump up, yields decline. Relative return of U.S. treasuries is higher. Demand curve shifts right. Prices jump up, yields decline.

53. Credit Markets July 2 Softer inflation causes demand curve to shift right, supply curve to shift left. Both effects cause prices to increase, yields to decrease.