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Neutrality of money The case of Spain (1996-2008)

Enrique Garca Sez

Introduction Theorical frameworks Keynesian frameworks Neoclassical thinking Lucas approach Another point of view: Austrian School Cantillon: self-adjusting mechanism The case of Spain Evolution of interest rate Commercial banks Cajas Mibor M3 Consequences on assets prices: Houses Stock market CPI Balance of payments Conclusion Annex 1

The monetary policy is very concerned with the effects of changes on the money in the economy. Designing the monetary policy we have to take into account the consequences of increases in money supply or decreases on interest rates. The main idea of neutrality of money is that the changes on money has no effects on the main aggregates of the economy like real wages, production, income or productivity. The implications of this concept are very powerful because if money cannot change macroeconomic variables, the monetary policy has no sense. Can the monetary policy increase production? Is there any cost in this case? We will analyse another important question: How does the interest rate affect different economic sectors?

Theorical frameworks
Keynesian framework: Keynes regarded that prices were not flexible and there was much rigidity in the economy. In this regard, the consequences of a monetary shock could be greater than in the case of a flexible economy. A monetary expansion meant a devaluation because the prices mechanism was so slow. Therefore, the monetary policy can decrease unemployment and affect the macroeconomic variables. Keynes also researched the liquidity trap. This concept means that when the interest rate is very low, an increase on money supply has no consequences on the economy. Curiously, in this case money could be neutral in the Keynesian regard. Neoclassical thinking: The neoclassical thinking is based on adaptative expectations. The main implication is that in the long run the output level comes back to the natural output level. The reason is that the ouput level can be increased by a monetary shock, but if policymakers wish to maintain this output level, they have to continue increasing inflation (the first monetary shock is not enough). The reason is that the agents adapt their expectations regarding the new situation and as a consequence the first shock on money supply is not enough for mantaining a greater output than the natural level. The mechanism which correct this disturbance is the increase of the level price which is greater as the disturbance is greater. When the money supply is not increasing, the real output level goes down because of the rising price level. As a result, we have an accelerationist hypothesis of Phillips curve. This framework is consistent with the neutrality of money in the long run, in this regard, money cannot affect macroeconomic aggregates. Lucas approach: The innovation of Lucas is new expectation hypothesis which is based on rationalism. Agents can set up their expectations taking into account all available information.

Therefore, if policymakers announce an expansion of monney supply, agents will set up a higher price expectation. The difference in this case is that the change on the price level is immediate and not gradual (as in the case of adaptative expectations). In this framework, the neutrality of money is not only in the long run, but maybe also in the short run (if the information is available and agents can proccess it). The Lucas model is not so simple, for example, there is a possibility that the agents cannot regard the policymakers intention. Moreover, Lucas analyses the case in which income is increasing and agents don't know if the increase is because of a monetary shock or higher productivity. But the interesting thing for us is the possibility of self-adjusting of all macroeconomic aggregates even in the short run. Another point of view: Austrian School The previous frameworks have in common an important feature: all points of view are mainly regarding macroeconomic aggregates. Therefore, the consequences on partircular features of the economy, effects on different sectors and consum plans are not taken into account while all of that are not reflected on the macroeconomic statistics. The purpose of this study is to analyse some effects of the interest rate on the kinds of investment and contrast it with the Spanish boom. Therefore, we are going to place our attention on the microeconomic effects of a decrease of interest rate. Firstly, in the previous framework (Keynesian, neoclassical, Lucas) a reduction of interest rate would be a positive shock on the investment. It's obvious, because the interest rate is related to the cost of investment, and a decrease of the cost is an incentive for increasing investment. But it is not the only consequence. We set up two kinds of investment projects: (I) investment projects aimed at distant future consum, (II) investment projects aimed at immediate consum. Now, we suppose a reduction of interest rate and we can predict three effects:

Changes on the demand of investment: if we analyse the investment projects with a number of periods n and the discount rate equal to r: NPV = R1/(1+i) + R2/(1+i)2 + + Rn/(1+i)n If the interest rate decreases, the value of assets which have a long useful life increases. This can be proved mathematically (anex 1). Investment projects aimed at distant consum increase their value proportionally more than investment projects aimed at immediate consum. The value of the first type of projects rises relatively more than the second type of projects. Thus, the demand of first projects will increase while the demand of second projects will decrease because agents will have incentives to start more investment projects of (I) instead projects of (II).

Changes to the discount rate: a reduction of discount rate has a consequence on the rise of the value of all investment projects broadly. We have observed that the demand of some projects decreases but this effect can be compensated by the increase on the value of project. Therefore, we have projects whose effects are compensated and projects whose effects are in the same direction.

The third effect is provided by the first two effects. Some projects (I) are more attractive compared to others. The change on the relative profitability of the investment plans will foster a new allocation of inputs or production factors. Entrepeneurs who are involved in the first kind of investment can compete better than firms which are involved in the second kind of projects because their projects have increased their own profitability. The consequence is that an important quantity of resources or inputs will go from some investment plans to the investment plans which are more profitable after the reduction of interest rate. In this proccess, we can expect rises on the inputs prices. Obviously, when some entrepeneurs want to extract inputs for their investment they have to pay more, in this regard, the demand for inputs has increased.

These elements are immediate consequences of a reduction of interest rate. This point of view is based on the micro analysis and the effects on the different kinds of investment. The implications are clear: investment projects of the first kind will be expanded more rapidly than investment projects whose effects will be compensated. We have to emphasize that the projects which are aimed at distant future are risker because the far future is more uncertain than the near future. The question is: Can these investment projects succeed in the future? If the situation of low interest rate is transitory, can these projects succeed when the interest comes back to higher rates? We have to emphasize that many of these risk projects are discounting so many periods that a change on the situation of interest rate could affect seriously to the success of these investment projects. Is the interest rate sustainable all the time? These questions and others must be considered. Cantillon: self-adjusting mechanism: We are assuming that there is not foreign trade in the economy as we are analysing the whole economy. But the existence of foreign trade has consequences on prices and an open economy performs different to a closed economy. Specifically, a monetary expansion has different effects on different goods because there are goods which are exchanged in the world economy and goods whose market is more closed. In the first case, the growth of money supply fosters the imports and decreases the exports of those goods. However, the second case we will observe the effects of expansion on the price, since importing thes goods is not possible, and the increase of demand will push up the price. The next story (Spain 1998-2010) is consistent with the Cantillon framework. A good example of good which cannot be exchanged in the international trade is housing. If the demand for housing is increased in a country or a zone, the foreign entrepeneurs cannot provide built houses from abroad. They have to produce the new buildings in that country as houses cannot be moved. Therefore, we have goods which are very sensitive to the interest rate and cannot be imported or exported: housing.

The case of Spain 1998-2010

We are going to observe the consequences of a reduction on interest rate in the Spanish economy from the entry to the Euro Area to the financial crisis in 2008. The evolution of

interest rate, the housing bubble, the evolution of private and public debt, etc are interesting signs of the effects of monetary policy. If the data is consistent with our framework we will observe that the housing construction has expanded greater than the common rates. Not only that, after the financial crisis these will be the sectors most affected by the recession. The reason is that these economy sectors are the best example of investment aimed at distant future because houses and infrastructure (railroad, airports, roads) construction need great initial resources and they are aimed to distant future. The reduction of interest rates affects more in this case than others. We have observed that the value of assets which have a long useful life increases, and houses or assets in the stock market can be a good example of this. The useful life of a house could be more than 40 or 50 years and in the case of railroads or airports we can estimate more than 40 years. Enterprises shares also have a broad horizon when buyers want assets for the long run. What happens after a financial crisis with these economic sectors? Interest rate Spain was a country which had high interest rates around 12% - 15% in the eighties. Its own currency was the peseta and the foreign credit facilities were limited because of the currency risk. When Spain was integrating to the European Monetary System the Spanish commercial banks could borrow more easily as the currency risk was disappearing (people assumed that the European Monetary System would be stronger). As a result, in the late nineties, interest rates fell from environ 12% to environ 3%. This is a very big drop which represents a reduction of 75%. The next picture shows the evolution of the main indicators in the financial system in Spain from 1996 to 2011. Firstly the interest rate of commercial banks and Cajas for loans, and after, the Mibor which is the interest rate on the interbanking system in Spain (is closed to the Euribor).

Data from European Central Bank (ECB)

The immediate consequence was the growth of money supply. The financial institutions enjoyed this abundance of credit and this shows up in the next picture:

Data from European Central Bank (ECB)

The money supply grew in Spain too much rapidly with rates betwen 10% - 17% until 2008. The rates are higher than the rates in the Euro area where the money supply increased to rates below 10%. Therefore, since 1996 Spain had a very important monetary expansion and this ended in the world financial crisis in 2007. In this period of time, the cost of borrowing went down and the growth of credit increased rapidly. Consequences on assets prices: In the framework which we have set up in the first part, we expect that the demand of assets for a long useful life has increased more than other assets. In the first case we have two examples: houses and stock markets. For the second case we have the consumer prices index(CPI). Houses prices The housings prices average betwen 1998-2011 increases by 193%. We are taking in account the bubble effect which is very important in this asset. The bubble effect is a consequence of strong rises on the assets price and this effect is clearer in the last years of the bubble e.g 2005 o 2006.

Data from AHE (Asociacin de hipotecas espaola)

The rise for the demand in houses fostered the construction of new houses and this shows up in the same period of time:

Data from Ministerio de Fomento de Espaa

In 1996 the construction branch built 322073 new houses, a quantity which doubled in six years (617126 in 2002). We are observing an incredible expansion of housing market from 1996 to 2007 which finally reached the peak in 2006 with almost 1 million of new houses, a quantity higher than the construction of new houses in the whole of Germany, France and Britain. The stock market We consider that enterprises shares are assets with a long useful life because the discount is given by the next formula: NPV = R1/(1+i) + R2/(1+i)2 + + Rn/(1+i)n In this regard, the discounted periods of time are many, and many people buy these assets for 20, 30 years. Although the buyers are purchasing these assets for the short run (2, 3 years), the asset continue being a long useful life asset because these buyers have the belief that the bought shares will be increase in value in two years. There is no doubt that the shares of firms can have a useful life of infinite time. The next picture show us the evolution of the stock market in Spain (Ibex35):

Data from Invertia (

The first regard is that the evoluiton of index is guided by the evolution of interest rate. When the interest rate falls the index expands and vice versa. But the evolution of the index involves the size of earnings, the situation of enterprises, etc. To measure the price of assets we have to look at the PER (Price Earnings Ratio), which measures the shares prices as PER tell us the willingness to pay for future earnings.

16 Tipos de inters a 10 aos (%) 14 12 10 8 6 4

Tipos de inters 10 aos PER Espaa

34 30 26 PER
105.00 4.60 88.02 3.50

22 18 14 10

2 6 01-9111-9109-9207-9305-9403-9501-9611-9609-9707-9805-9903-0001-0111-0109-0207-03 Data from IESE (Pablo Fernndez)

This picture shows us the relationship betwen interest rate and PER (1991-2003). The relationship is negative, when the interest rate goes down the PER of IBEX35 reacts by going up. However, when the interest rate goes up (1993-1995) the PER of stock market falls. The most important rise of PER begins in 1996, which is the date which we have established the start of monetary expansion in Spain. CPI The next step is to compare the previous cases with the evolution of consum prices. We can observe in the next two tables that the rates of growth of annual average are lower than the house prices or the stock market prices. The CPI is an average of many kinds of goods which means that there are prices below and above these rates. The disparitties are significant:

1992 = 100

135.70 3.60

131.00 3.40

126.70 2.30

123.80 1.80

121.60 2.00

119.20 3.60

115.10 4.70

110.00 4.70


Annual average Growth of annual average

Data from INE (Instituto Nacional de Estadstica)

2006 = 100

108.59 1.80

106.67 -0.30

106.98 4.10

102.79 2.80

100.00 3.50

96.60 3.40

93.46 3.00

90.70 3.00


Annual average Growth of annual average

Data from INE (Instituto Nacional de Estadstica)

The increases on the CPI are much lower than the increases on house prices. While the CPI is growing by 3% in 2003 the price of m 2 of houses is growing by 18.39% at the same time. The remaining years the disparities are also great:


2005 House prices

/m2 (average) Growth of annual average 1685.40 15.72

1456.20 15.72

1230.30 18.39

1051.70 17.00

930.30 13.00

856.20 7.96

780.30 9.72


Data from AHE (Asociacin de hipotecas espaola)

Therefore, the evolution of prices is not homogeneous, some prices grow more than others. For example, some prices are going down in this period of time like clothes. There are many reasons for the movement of prices and the interest rate is not the only one. But, the cost of borrowing is decisive in the case of assets with a long useful life which require important initial investment. In this point we can explain that this phenomenon is related with the selfadjusting mechanism, goods prices which are in an open economy will not change as other goods (clothes). Balance of payments (2007, 2008) Another consequence of this proccess is the rising debt of the private sector betwen 1996 and 2008. The monetary expansion fostered a very strong current account deficit in Spain. The next table summarizes the main data about the balance of payments in 2007 and 2008:
Balance of Payments

Current account
Trade in goods Trade in services Income + profits Transfers

Capital account Current account+capital

2007 -96836.1 -80423.2 21517.7 -28697.2 -9233.5 3353.4 -93482.7

2008 -98291 -78587.2 22923.4 -32284.7 -10342.5 5297.9 -92993.1

Data from Banco de Espaa (Bank of Spain)

The current account deficit was 9.19% and 9% of GDP in 2007 and 2008. This means that the Spanish economy had a very strong financing requirement above 90000 millions. This is another consequence of the low interest rate in Spain. Many years the real interest rate was negative (not like other countries of EU), as a result the private sector is so much indebted as a decrease of the cost of borrowing gave the incentives to borrow more and save less. Therefore, the Spanish economy will face to big liabilities in the next years with many problems, as many investments failed after the financial crisis. All of these facts are consistent with the Cantillon framework. Some goods prices increased (inflation), on the other hand, other prices remained stable but imports rose and exports reduced. The growth of money supply had as a consequence inflation and a balance of payments with deficits. The story finished in 2008.


Coming back to the start, is money neutral? If we look at the aggregate data it is possible that we don't discover all the phenomenons which we have observed in this exercise. But we have showed that we cannot ignore some endogenous proccesses which are consequences of the change on interest rates. The change on the trade off betwen present consum and future consum is not neutral, this phenomenon changes the relative prices between some goods, specifically goods for the future consum against goods for the present consum. This proccess guides the entrepeneurs and ressources to produce more goods for the future consum with big initial investment. Ten years after, an important quantity of ressources are aimed at the construction and the auxiliary industries to the construction has expanded. Many workers are specializing in industries around construction and they are not able to use their human capital in other industries. Construction of houses have shrunk strongly and there is an allocation ressources problem, Spain doesn't need so many construction workers. All of this capital is now devalued capital as capital is not homogeneus, but heteregenous. All of this has a consequence in that Spain is less competitive in the world economy. The main question now is: is the expansive monetary policy sustainable continuously? And this is the key, because if the monetary expansion is sustainable there is no problem, but if the expansion of money supply is not sustainable we have to conclude that this policy fosters the expansion of some sectors and a bad allocation of ressources. While Spain suffers the hang over: an unemployment of 23% in 2011 an a country so much debted.

Anex 1:
The next example show us that the investment projects with more periods of time are more sensitive to the discount rate. We have two investment projects: NPV 1 = 5000/(1+i) + 5000/(1+i)2 + 5000/(1+i)3 + 5000/(1+i)4 NPV 2 = 9000/(1+i) + 9000/(1+i)2 We are going to calculate the NPV with different discount rates:

Discount rate NPV project 1 NPV project 2 11.80% 15250 15250 5% 17729.75 16734.69 2% 19038.64 17474.04
The first investment plan increases more the NPV when the interest rate falls because it has more cash flows periods. In the first case, when the discount rate goes dow from 11.80% to 2%, the NPV 1 is increasing by 24.8%, while the NPV 2 is increasing by 14.05%. If we calculate the NPVs with greater discount rates, we have the same effect but in the opposit direction. If we take into account projects with more cash flows the effect is greater. Therefore, the temporal horizon is very important for the profitability of investment when the interest rate is changing.

J.M. Keynes (1936). General Theory of employment, interest and money Fiedrich A. Hayek. (1931). Prices and production Robert E. Lucas (1970). Expectations and the neutrality of money. Mario Rizzo and Gerald O'Driscoll (1985). The Economics of time and ignorance Adrin Ravier (2010). En busca del pleno empleo Richard Cantillon (1755). Essai sur la nature du commerce Alberto Recarte (2008). Informe Recarte Database from Banco de Espaa (Bank of Spain) Database from European Central Bank Database from AHE (Asociacin de hipotecas espaola) Database from IESE