MONETARY ECONOMICS NOTES

Chapter 1 – Introduction

What is the Taylor Rule 1980?

According to Taylor, monetary policy stabilizes when the nominal interest rate is higher/lower than the
increase/decrease in inflation. Thus, the Taylor rule prescribes a relatively high interest rate when actual
inflation is higher than the inflation target.

Financial Markets

Financial markets are markets in which funds are transferred from people and firms who have an excess of
available funds to people and firms who have a need of funds.

In short: demand and supply of special good, that is money or financial instruments.

The Bond Market and Interest Rates

• A security (financial instrument) is a claim on the issuer’s future income or assets.

• A bond is a debt security that promises to make payments periodically for a specified period of time.
• An interest rate is the cost of borrowing or the price paid for the rental of funds.

Nominal Interest Rate

Is the stated interest rate on a financial product, such as a loan or bond, without adjusting for the effects of
inflation or compounding.

Real Interest Rate

Is the nominal interest rate adjusted for the effects of inflation. It reflects the actual purchasing power or
real return on an investment after accounting for changes in the price level of goods and services.

Real Interest Rate=Nominal Interest Rate−Inflation Rate

The Stock Market

• Common stock represents a share of ownership in a corporation.

• Share of Stock is a claim on the residual earnings and assets of the corporation. ( is a more general
term that can refer to any unit of ownership in a company, including common stock and preferred
stock)

Volatility

Volatility refers to the degree of variation or fluctuation in the price of a financial instrument (such as a
stock, bond, or cryptocurrency) over time. It's a measure of how much the price of an asset tends to deviate
from its average or expected value.

Financial Intermediaries
Institutions that borrow funds from people who have saved and in turn make loans to people who need
funds.

• Banks: accept deposits and make loans

• Other financial institutions: insurance companies, finance companies, pension funds, mutual funds,
and investment companies

Financial Innovation

The development of new financial products and services. Can be an important force for good by making the
financial system more efficient.

E-learning: the ability to deliver financial services electronically.

Financial Crises

Major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures
of many financial and nonfinancial firms.

Why study Money and Monetary Policy?

Money – anything that is generally accepted as payment for goods or services or in the repayment of debts.
Plays an important role in generating business cycles. Recessions (unemployment) and expansions affect all
of us.

Monetary Theory – ties changes in the money supply to changes in aggregate economic activity and the
price level.

Money, Business Cycles, and Inflation

• The aggregate price level is the average price of goods and services in an economy.
• A continual rise in the price level (inflation) affects all economic players.
• Data show a connection between the money supply and the price level: increase in the money supply
may generate inflation.

Money and Interest Rates

• Interest rates are the price of money.

• Prior to 1980, the rate of money growth and the interest rate on long-term Treasury bonds were
closely tied.

Monetary Policy

Is the management of the money supply and interest rates. Conducted in the US by the Federal Reserve
System (FED) and in EU by the European Central Bank (ECB).

Fiscal Policy
Deals with government spending and taxation.

• Budget deficit is the excess of expenditures over revenues for a particular year.
• Budget surplus is the excess of revenues over expenditures for a particular year.
• Any deficit must be financed by borrowing.

The Foreign Exchange Market

Where funds are converted from one currency into another. The foreign exchange rate is the price of one
currency in terms of another currency. The foreign exchange market determines the foreign exchange rate.

Why Study International Finance?

Financial markets have become increasingly integrated throughout the world. The international financial
system has tremendous impact on domestic economies.

Aggregate Output

The most commonly reported measure of aggregate output, the gross domestic product (GDP), is the market
value of all final goods and services produced in a country during the course of a year.

Aggregate Income

The total income of factors of production (land, labor, and capital) from producing goods and services in the
economy during the course of the year, is equal to aggregate output.

Real Versus Nominal Magnitudes

• total value of final goods and services is calculated using current prices, the resulting GDP measure
is referred to as nominal GDP. The word nominal indicates that values are measured using current
prices.
• GDP measured with constant prices is referred to as real GDP, the word real indicating that values
are measured in terms of fixed prices. More reliable measure of economic production.

Aggregate Price Level

Is a measure of average prices in the economy. Three measures of the aggregate price level are commonly
encountered in economic data:

• The GDP deflator (adjust nominal GDP to real GDP)

• The PCE deflator (measure of inflation in the US)
• The Consumer Price Index - CPI (measure of inflation that reflects the average change in prices paid
by consumers for a basket of goods and services over time)

Chapter 2 – Financial Markets

Function of Financial Markets

• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them
securities.
• Promotes economic efficiency by producing an efficient allocation of capital, which increases
production.
• Directly improve the well-being of consumers by allowing them to time purchases better.

Structure of Financial Markets

• Debt and Equity Markets

➢ Debt instruments (maturity)
➢ Equities (dividends)
• Primary and Secondary Markets
➢ Investment banks underwrite securities in primary markets.
➢ Brokers and dealers work in secondary markets.
• Exchanges and Over-the-Counter (OTC) Markets
➢ Exchanges: NYSE, Chicago Board of Trade
➢ OTC markets: Foreign exchange, Federal funds
• Money and Capital Markets
➢ Money markets deal in short-term debt instruments.
➢ Capital markets deal in longer-term debt and equity instruments.

Characteristics Money Market

• Trading of short-term assets

• Maximum tenure- usually 365 days
• Wholesale transactions
• High liquidity
• Low risk
• Low earning

Internationalization of Financial Markets

 • Foreign Bonds: sold in a foreign country and denominated in that country`s currency.
• Eurobond: bond denominated in a currency other than that of the country in which it is sold.
• Eurocurrencies: foreign currencies deposited in banks outside the home country.
• World Stock Markets: help finance corporations in the United States and the U.S. federal government.

Function of Financial Intermediaries

Indirect Finance (financial intermediates)

• Lower transaction costs (time and money spent in carrying out financial transactions)
➢ Economies of scale
➢ Liquidity services
• Reduce the exposure of investors to risk.
➢ Risk sharing (asset transformation)
➢ Diversification
• Deal with asymmetric information problems
➢ Adverse Selection (before the transaction): try to avoid selecting the risky borrower by
gathering information about them.
➢ Moral Hazard (after the transaction): ensure borrower will not engage in activities that will
prevent him/her to repay the loan.

Types of Financial Intermediaries

Regulation of the Financial System

▪ To increase the information available to investors

▪ To ensure the soundness of financial intermediaries (restrictions on entry; disclosure of information;
restrictions on assets and activities, deposit insurance; …)
Regulation in Europe

The Central Bank

Chapter 3 – Money

Money (a stock concept) is different from:

• Wealth: the total collection of pieces of property that serve to store value
• Income: flow of earnings per unit of time

Functions of Money
 • Medium of Exchange: Eliminates the trouble of finding a double coincidence of needs (reduces
transaction costs) and promotes specialization.
➢ be easily standardized.
➢ be widely accepted.
➢ be divisible.
➢ be easy to carry.
➢ not deteriorate quickly.
• Unit of Account: Used to measure value in the economy and reduces transaction costs.
• Store of Value: Used to save purchasing power over time, and it is the most liquid of all assets but
loses value during inflation.

Evolution of the Payments System

• Commodity Money (valuable, easily standardized, and divisible commodities)

EX: precious metals, cigarettes
• Fiat Money (paper money decreed by governments as legal tender)
• Checks (an instruction to your bank to transfer money from your account)
• Electronic Payment (EX: online bill pay)
• E-Money (electronic Money)
EX: Debit card, E-cash

Will Bitcoin Become the Money of the Future?

It is a type of electronic money created in 2009 and it is created by decentralized users when they use their
computing power to verify and process transactions. Although Bitcoin functions as a medium of exchange, it
is unlikely to become the money of the future because it performs less well as a unit of account and a store
of value.

Measuring Money

Monetary aggregates (using the concept of liquidity):

➢ M1 (most liquid assets) = currency + traveller’s checks + demand deposits + other checkable deposits
➢ M2 (adds to M1 other assets that are not so liquid) = M1 + small denomination time deposits + savings
deposits and money market deposit accounts + money market mutual fund shares

Chapter 4 – Interest Rates

Present Value

A dollar paid to you one year from now is less valuable than a dollar paid to you today because can earn
interest and become $1×(1+i) one year from today.

Credit Market Instruments

▪ Simple Loan
▪ Fixed Payment Loan
▪ Coupon Bond
▪ Discount Bond

Yield to Maturity

The interest rate that equates the present value of cash flow payments received from a debt instrument with
its value today. For simple loans, the simple interest rate equals the yield to maturity.

Fixed-Payment Loan

The same cash flow payment every period throughout the life of the loan.

Coupon Bond

Using the same strategy used for the fixed-payment loan. When the coupon bond is priced at its face value,
the yield to maturity equals the coupon rate. The price of a coupon bond and the yield to maturity are
negatively related. The yield to maturity is greater than the coupon rate when the bond price is below its
face value.

Perpetuity

A bond with no maturity date that does not repay principal but pays fixed coupon payments forever.

Discount Bond

The yield to maturity equals the increase in price over the year divided by the initial price. As with a coupon
bond, the yield to maturity is negatively related to the current bond price.

The Distinction Between Interest Rates and Returns

Rate of return: The payments to the owner plus the change in value expressed as a fraction of the purchase
price.

• The return equals the yield to maturity only if the holding period equals the time to maturity.
• A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to
maturity is longer than the holding period.
• The more distant a bond`s maturity, the greater the size of the percentage price change associated
with an interest-rate change.
• The more distant a bond`s maturity, the lower the rate of return the occurs as a result of an increase
in the interest rate.

Maturity and the Volatility of Bond Returns: Interest-Rate Risk

• Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose time to maturity matches the holding period.

Fisher Equation

When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend. The
real interest rate is a better indicator of the incentives to borrow and lend.

Chapter 12 – Financial Crises

Global: The European Sovereign Debt Crisis 2007-2009

The increase in budget deficits that followed the financial crash of 2007-2009 led to fears of government
defaults and an increase in interest rates. The sovereign debt, which began in Greece, moved on to Ireland,
Portugal, Spain, and Italy. These events continue to threaten the viability of the Euro.

Causes of the financial crisis:

▪ Financial innovations emerge in the mortgage markets.

▪ Housing price bubble forms
▪ Agency problems arise.
▪ Information problems surface
▪ Housing price bubble bursts

Effects of the financial crisis:

 ▪ After a sustained boom, housing prices in the U.S. and other countries (such as Ireland or Spain)
began a long decline, starting in 2006.
▪ rise in defaults on mortgages and a deterioration in the balance sheet of financial institutions.
▪ caused a run on the shadow (parallel) banking system.
▪ the unemployment rate shot up.

Origins: U.S. financial markets

FYI Collateralized Debt Obligations and Credit Default Swaps

Collateralized debt obligations (CDOs) are credit derivatives that purport to redistribute the risks involved in
lending.

Credit default swaps are also credit derivatives. They are derivative contracts that allow the parties to
exchange (swap) risks linked to cash flow payments. A CDS seller commits himself/herself to compensate the
buyer (lender) in the event of a default by a buyer (lender)'s client (borrower).

Government Intervention and the Recovery

Short-term Responses and Recovery:

o Financial Bailouts: In order to save their financial sectors and to avoid contagion, financial support
was provided by many governments to bail out banks, other financial institutions, and even the so-
called “too-big-to-fail” firms that were severely affected by the financial crisis.
o Fiscal Stimulus Spending: To boost their individual economies, most governments used fiscal stimulus
packages that combined government expenditure and tax cuts.

Long-term Responses:

o global leaders looked to building a more stable and robust global financial system (implementing
sound macroeconomic policies; enhance their financial infrastructure; develop financial education
and consumer protection rules)
o At the international level: proactive globally binding supervision; financial market discipline
enforced; systemic risk managed)

What is a Financial Crisis?

Occurs when there is a particularly large disruption to information flows in financial markets, with the result
that financial frictions increase sharply, and financial markets stop functioning.

Dynamics of Financial Crises

• Stage 1: Initiation of a financial crisis (credit boom and bust; asset-price boom and bust; increase in
uncertainty)
• Stage 2: Banking Crisis
• Stage 3: Debt Deflation

The Great Depression 1929-1941

This event was brought on by:

o Stock market crash

o Bank panics
o Continuing decline in stock prices
o Debt deflation

FYI The LIBOR Scandal

LIBOR stands for “London Interbank Offered Rate”. It is an indicator of the cost of short-term money on the
inter-bank market, calculated daily by Thomson-Reuters on the basis of reports by a sample of large banks.

Future Regulations and Policy Areas at the International Level

• more radical overhaul of the financial supervisory and regulatory system at the international level.
• help decrease the risks of regulatory arbitrage, through which financial actors take advantage of
loopholes in national regulatory systems.
• Bilateral and multilateral supervisory coordination
• Collective supervisory cooperation
• Self-discipline (avoid the irresponsible and unethical behaviour of bankers)

Chapter 14 – Central Banks

Origins of the Central Banking System

Rising global trade increased the volume of international payments in the seventeenth century, hence the
need to create more central banks throughout Europe. The founding of the Bank of England (BoE) in 1694
marks the de facto origin of central banking.

To avoid the risk of power concentration, the structure of the Federal Reserve System, which was established
in 1913, was designed to distribute power over 12 regional Federal Reserve banks and remained privately
owned by its member banks.

Who Should Own Central Banks

Arguments for public ownership:

▪ Central banks act in the ultimate public interest

▪ Private ownership bias central banks toward self-serving profit-making interests, hence increasing
risk-taking and balance sheet troubles.
▪ The global financial crisis highlighted concerns that the profit-making target of private shareholders
could hamper them from saving the financial sector during financial crises.

Arguments for private ownership:

 ▪ guarantees central bank Independence.
▪ restricts the distribution of dividends per share.
▪ private owners are required to recapitalize the central bank in the case of losses which lifts this
burden off the fiscal budget.

Central banks have taken on increasing responsibilities which required more independence from fiscal
authorities and political institutions.

European Central Bank (ECB)

Created to handle the transitional issues of the nations that comprise the Eurozone (economic and monetary
union that have adopted the euro as their currency). The three main objectives are:

• maintain price stability in the economies of the EU (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.

Eurosystem

Comprises the ECB and the NCBs (National Central Banks) of those EU member states that have adopted the
euro.

European System of Central Banks (ESCB)

Since not all of the EU member states have adopted the

euro, the ESCB was established alongside the
Eurosystem to comprise the ECB and the NCBs of all EU
member states whether or not they are members of
the Eurozone.

Decision-Making Bodies of the ECB

• The Governing Council (main decision-making

body, responsible for formulating monetary
policy to maintain price stability in the euro
area)
• The Executive Board (responsible for the day-
today operations and management of the ECB
and the Eurosystem)
• The General Council (encourage cooperation
between the National Central Banks of the
member states of the EU; also performs
important advisory functions)

The Federal Reserve System (Fed)

Is one of the largest and most influential central banks in the world. Is an independent entity that is privately
owned by its members banks. Supervises and regulates the nation`s financial institutions and simultaneously
serves as their banker.

• The Federal Reserve Board of Governors (FRB) which mainly assumes regulatory and supervisory
responsibilities over member banks.
• The Federal Open Market Committee (FOMC) convenes eight times a year to decide on the interest
rates and monetary policy.

Comparing the ECB and the Fed

Both are entities that bins a number of regional central banks together, both are independent institutions
with a decentralized structure. The ECB supports political independence and makes monetary policy
decisions independent from political authorities. The Fed is highly independent os the government and
reports to the Congress.

Important differences between both:

o The primary objective of the ECB is to achieve price stability, and Fed is to deliver price stability and
consequently to support the macroeconomic objectives including those for growth and employment.
Fed ignores the temporary effects of price changes since it considers unemployment to be a much
bigger priority.
o The monetary operations of the Euro System are not centralized but conducted by the National
Central Banks while monetary operations are centralized in the Federal Reserve System.
o The ECB is not involved in supervisions and regulation of financial institutions as these tasks are left
to the individual countries in the European Monetary Union, while the Federal Reserve is involved in
these areas.
o In financing fiscal budget deficits, the Fed buys government bonds outright, while the ECB accepts
them as collateral for new loans to the banking system.

The Bank of England

As the UK is not a member of the euro area, the BoE makes its monetary policy decisions independently from
the ECB. The Banks’s Monetary Committee (MPC) is responsible for conducting monetary policy.

Interest Rates is the main policy tool that the BoE uses for controlling growth.

Brexit and the BOE

Brexit will have economic and financial repercussions on the UK. These repercussions depend on the kind of
future relationship that the UK will develop with the EU.

Structure and Independence of Central Banks of Emerging Market Economies

Emerging markets economies (EMEs): are economies of Asia, Latin America and Eastern Europe that are
growing rapidly and experiencing booming industrialization and increased exports. Central Banks of EMEs
assume a more complex role in comparison to their counterparts in industrial nations.

Should Central Banks be Independent?

The case for Independence:

o The public generally distrusts politicians in regard to making politically motivated decision and their
lack of expertise in conducting monetary policy.
o This tends to lead to a political business cycle, in which these expansionary monetary policies are
reversed after the election to limit inflation, thus leading to booms and busts in the economy.

The case against Independence:

o Macroeconomic stability can be best achieved if monetary policy is properly coordinated with fiscal
policy. As the government is responsible for the country’s macroeconomic performance, it must have
some control over monetary policy.
o Central banks are not immune from political pressures. Thus, the central bank can pursue a course of
narrow self-interest to increase its power and prestige at the expense of public interest.

Chapter 17 – Taylor Rule

The Price Stability Goal and the Nominal Anchor

Over the past few decades, policy makers throughout the world have become increasingly aware of the social
and economic costs of inflation and more concerned with maintaining a stable price level as a goal of
economic policy.

Nominal Anchor: is a nominal variable, such as the inflation rate or money supply, which ties down the price
level to achieve price stability.

Other Goals of Monetary Policy

• High employment and output stability

• Economic growth
• Stability of financial markets
• Interest rate stability
• Stability in foreign exchange markets

Price Stability Be the Primary Goal of Monetary Policy?

Hierarchical Markets: put the goal of price stability first, and then say that as long as it is achieved other goals
can be pursued.

Dual mandates: are aimed to achieve two coequal objectives: price stability and maximum employment
(output stability)

The Evolution of the Federal Reserve’s Monetary Policy Strategy

The United States has achieved excellent macroeconomic performance (including low and stable inflation)
until the onset of the global financial crisis without using an explicit nominal anchor such as an inflation target.
The goal is to prevent inflation from getting started.

The Fed’s “Just Do It” Monetary Policy Strategy

Advantages: forward-looking behaviour and stress on price stability also help to discourage overly
expansionary monetary policy, thereby ameliorating the time-inconsistency problem.

Disadvantages: lack of transparency; strong dependence on the preferences, skills, and trustworthiness of
the individuals in charge of the central bank.

Lessons for Monetary Policy Strategy from the Global Financial Crisis

• Developments in the financial sector have a far greater impact on economic activity than was earlier
realized.
• The zero-lower-bound on interest rates can be a serious problem.
• The cost of cleaning up after a financial crisis is very high.
• Price and output stability do not ensure financial stability.

Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which
eventually burst. Bubbles are easier to identify when asset prices and credit are increasing rapidly at the same
time.

Criteria for Choosing the Policy Instrument

• Observability and measurability

• Controllability
• Predictable effect on Goals

The Taylor Rule

Estimated using time series and regressions analysis, it is very important to use reliable GDP and inglation
data.
Chapter 20 – Inflation and Money Demand/Supply

Quantity Theory of Money

• Velocity fairly constant in the short run

• Aggregate output at full-employment level
• Changes in money supply affect only the price level.
• The demand for money is not affected by interest rates.

When the money market is in equilibrium:

Budget Deficits and Inflation

Two ways the government can pay for spending: raise revenue (taxes) or borrow (issuing government bonds).

The government budget constraint thus reveals two important facts:

o If the government deficit is financed by an increase in bond holdings by the public, there is no effect
on the monetary base and hence on the money supply.
o If the deficit is not financed by increased bond holdings by the public, the monetary base and the
money supply increase.

Hyperinflation

Are periods of extremely high inflation of more than 50% per month.

Keynesian Theories of Money Demand

Keynes’s liquidity preference theory. Distinguishes between real and nominal quantities of Money. Individuals
hold money for three motives:

• Transactions motive
• Precautionary motive
• Speculative motive

Transactions Motive

Transactions component is proportional to income. Also recognized that new methods for payment, referred
to as payment technology, could also affect the demand for money.

Precautionary Motive

People hold money as a cushion against unexpected wants.

Speculative Motive

people choose to hold money as a store of wealth.

Portfolio Theories of Money Demand

The theory of portfolio choice can justify the conclusion from the Keynesian liquidity preference function that
the demand for real money balances is positively related to income and negatively related to the nominal
interest rate.

Other factors that affect the demand for money:

• Wealth
• Risk
• Liquidity of other assets

Interest Rates and Money Demand

▪ We have established that if interest rates do not affect the demand for money, velocity is more likely
to be constant so that the quantity theory view that aggregate spending is determined by the quantity
of money is more likely to be true.
▪ However, the more sensitive the demand for money is to interest rates, the more unpredictable
velocity will be, and the less clear the link between the money supply and aggregate spending will
be.

Stability of Money Demand

The stability of the money demand function is also crucial to whether the Federal Reserve should target
interest rates or the money supply. If the money demand function is unstable and so the money supply is not
closely linked to aggregate spending, then the level of interest rates the Fed sets will provide more
information about the stance of monetary policy than will the money supply.