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Money and Financial Markets

PD Dr. M. Pasche
Friedrich Schiller University Jena

Creative Commons by 3.0 license 2015 (except for included graphics from other sources)
Work in progress! Bug Report to: markus@pasche.name

S.1

Outline:
1. Financial Markets
1.1 Overview over Financial Markets
1.2 Interest Rate Theory

2. Theory of Financial Structure


2.1
2.2
2.3
2.4
2.5

Financial Intermediates
Management of Return, Risk and Liquidity
Adverse Selection Problems
Moral Hazard Problems
Efficient Market Hypothesis and its Limits

3. The Money Supply Process


3.1
3.2
3.3
3.4

Function and Measurement of Money


Creation of Central Bank Money
Deposit Creation and the Multiplier
Endogenous Money Supply

S.2

4. Theory of Money Demand


4.1 Keynesian Theory of Liquidity Preference
4.2 Portfolio Theory of Money Demand

5. Central Banking and Transmission of Policy


5.1
5.2
5.3
5.4

Goals of Monetary Policy


Transmission Channels
Targets, Strategies, and Rules
The Taylor Rule on Macro Models

S.3

Basic Literature:

Mishkin, Frederic S. (2012), The Economics of Money,


Banking, and Financial Markets, 10th ed., Boston et al:
Pearson International Edition.

Bailey, Roy E. (2005), The Economics of Financial Markets,


Cambridge: Cambridge University Press.

Bofinger, Peter (2001), Monetary Policy: Goals, Institutions,


Strategies, and Instruments. Oxford: Oxford University Press.

References to more specific literature can be found in the slide


collection.

S.4

Preliminary time schedule (summer 2015):


17.4.
24.4.
1.5.
8.5.
15.5.
22.5.
29.5.
5.6.
12.6.
19.6.
26.6.
3.7.
10.7.
17.7.

ch. 1
ch. 1
(Labor Day)
ch.2
ch.2
ch.2
ch.2
ch.2,3
ch.3
ch.3
ch.4
ch.5
ch.5
ch.5

S.5

1.
1.1

Financial Markets
Overview over Financial Markets

Outline:
1.1.1 Asset Market Classifications
1.1.2 Bond Markets
1.1.3 Loan Markets
1.1.4 Equity Markets
1.1.5 Further Markets
Basic literature:
Mishkin (2012), chapter 2 and parts of chapter 5

S.6

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

(Financial) Asset: Money Financial Assets All Assets


Examples: Currency, checkable deposits, bonds, stock shares,
claims from loan contracts,...
Different assets have different properties:
1. Expected returns (interest rates, dividends, difference in buying
and selling price) an increase in expected returns makes an asset
c.p. more attractive demand will increase
2. Risk (returns may have a variance, possible covariance with other
assets) an increase of risk makes an asset c.p. less attractive
demand will decrease
3. Liquidity (how fast can the asset be sold or used for transactions)
the more liquid the asset is c.p., the more attractive it is demand
will increase

S.7

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

Asset markets: In contrast to goods markets (producer,


consumer) it is possible that an individual or an institution is on
the supply and the demand side.
Economic theory is interested into the questions (e.g.):

How do different types of agents (e.g. banks, non-banks)


structure their balance sheet = how do they behave on the
demand and supply side on the asset markets?

How can the price movements in aggregated markets be


explained?

S.8

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

a) Debt and Equity Markets


Debt:

Contractual agreement, where the borrower pays the holder of


the asset a fixed amount (interest rate) per period until a
specified expiration date (maturity date). The borrowed
amount is returned until (or at) the maturity date.

The maturity of a debt is the time until the expiration date


(short-term < 1 year, long-term > 10 years)

Examples: Consumer loans/credits, mortgages, bonds

Depending on the contract, the borrower can sell the asset,


especially bonds.

S.9

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

Equity:

The buyer of an equity has a claim to share the net income


and the assets of the sellers business. The net income is an
uncertain residual and is often payed as dividends. The
instrument has usually no expiration date, hence the funds are
not returned to the holder of the equity.

Example: Stock shares

The holder of an equity can sell the asset e.g. on the stock
exchange market.

S.10

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

Advantages and disadvantages:


Debt: Regular payments are more or less certain (unless the debitor
stays solvent).
Equity: Residual payments are uncertain. Residual means that the
firm has to pay the debitors (and taxes) first.
Debt: In case of insolvency the creditor has a prior claim on the
remaining assets.
Equity: Secondary claim on remaining assets in case of insolvency.

S.11

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

Advantages and disadvantages: (cont.)


Debt: Holder do not profit from increasing profitability and
increasing firm value since their payments are fixed.
Equity: The holder profits directly by higher dividends and increased
value of their shares.
Debt: Holder has not the right to vote about management issues
and about the distribution of the net income of the firm.
Equity: Holder has these rights.

S.12

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

b) Primary, Secondary and Derivative Markets


Primary Market:

New issues of assets are sold to initial buyers.


Examples: firm sells new stock shares or new bonds to an
investment bank; a bank and a firm sign a loan contract; central
bank issues currencies by open market operations.

Secondary Markets:

Once an asset has been issued it can be traded at the current price.
The transactions are often performed by brokers instead of the asset
holders themselves.
Example: stock exchange, foreign exchange.

Derivative Markets:

Not the assets themselves are traded but other claims related to the
underlying assets, e.g. the right to buy a certain asset to a certain
price within a certain period.
Example: options, futures.

S.13

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

Secondary markets make assets more liquid: contract can be


sold to a current price. Increasing liquidity makes the assets
more desirable.

On secondary markets the price is determined by the flow of


information as well as by expectations of many agents. In
efficient markets price movements reflect the risk-return
performance of an asset due to new information. The
(expected) price on secondary markets may also affect the
price on the primary market.

S.14

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

c) Exchanges and OTC Markets ( secondary markets):


Exchange:

Organized, centralized, regulated trading of assets, high


transparency of bids, asks and price setting, very competitive,
almost arbitrage-free.

Over the counter (OTC):

Decentralized market where the seller sells the assets over


the counter to a buyer. Since OTC dealers are connected by
computer networks, there is also high price transparency and
competitivenes, but much less regulation.

S.15

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.1 Asset Market Classifications

d) Money and Capital Markets:


Money Maket:

Short-term contracts (maturity < 1 year) with high liquidity

Capital Markets:

Long-term contracts (maturity > 1 year, assets without


expiration date like stock shares)

Note, that this definition of a money market differs from the


term as used in macroeconomics where money is defined in a
specific manner.
Sometimes money market = market for central bank reserves
(e.g. interbank market).

S.16

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.2 Bond Markets

Bonds are issued by firms (corporate bonds) or by government


(governmental, treasury, municipal bonds).
Two types of bonds:

Coupon-bond: owner of the bond receives a fixed payment


per year (coupon rate) until the maturity date. At the
maturity date the specified final amount (face vaule, pair
value) is payed. Special case: perpetuity bond without an
expiration date.

Discount bond (zero-coupon bond): There is no coupon


interest rate. The bond is sold to a price below the face value.
At the maturity date the owner receives the face value.

S.17

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.2 Bond Markets

Interest rate i when holding the bond until maturity:


n

P0 =

X
C
F
+
n
(1 + i)
(1 + i)t
t=0

with P0 = bonds price in t = 0, F = face value, C = coupon rate,


n = maturity date.
Expected return r when holding the bond for one period (before
maturity, without discounting):
r=

C + Pt+1 Pt
Pt

where Pt+1 is the expected bonds price in t + 1.

S.18

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.2 Bond Markets

In both formulas there is an inverse relationship between


interest rate/return and the bonds price!

If the interest rate is lower than expected return it would be


profitable for all bonds holders to hold the bond only for one
period and to sell it in t + 1. Therefore, it can be expected
that Pt+1 will fall, which results in a decreasing r .
In the opposite case, the holders would decide to hold the
bond for a longer time (until maturity). The prices in t + 1
will therefore rise until i and r will be equal.

S.19

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.2 Bond Markets

Slope of demand and supply curves:

The demand for bonds is negatively related to the bonds


price but positively related to the interest rate i.

If the interest rate is low and vice versa the bonds price is
high it is more attractive for governments, firms or institutions
to issue bonds to finance their activities. The supply curve
can be assumed to be downward sloped in i. Alternatively, in
the short run the bonds supply can be assumed to be
exogenously fixed.

S.20

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.2 Bond Markets

price

interest
rate

BS

BD

BD
BS
B

S.21

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.3 Loan Markets

Types of loans:
Simple loan: borrowed amount L is paid back plus interest
payment IP at the maturity date n. The interest rate i then solves:
L=

L + IP
(1 + i)n

Fixed-payment loan: borrowed amount is paid back including


interest in fixed payments FP (amortisation plus interest) per
period until maturity date. The interest rate i then solves
L=

n
X
t=1

FP
(1 + i)t

S.22

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.3 Loan Markets

Solvency: ability of the borrower to pay back the loan plus


interest.

Risk: probability distribution for the cases that the borrower is


able to pay back percent of {loan plus interest}; typical
measure for risk: variance.
Example: full return (probability p) versus total loss
(probability 1 p)
Expected return: r = pi + (1 p)(1)
Variance of return: r2 = p(i r )2 + (1 p)(1 r )2
(If p = 1 then r = i and r2 = 0)

S.23

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.3 Loan Markets

Borrower has to provide collaterals. The lender can claim the


collateral in case of insolvency.

In case of mortgages the borrower is not allowed (or it is not


possible) to sell the collateral. The lender has the right to
claim the collateral unless the loan is fully returned.

There is asymmetric information about p before the


contract (adverse selection problem), and after the contract
when the loan is used to finance an uncertain project (moral
hazard problem). See section 2.3 2.4.

S.24

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.4 Equity Markets

Stock shares as the most common type of equities.


An owner of a stock share has

What is the firm value?

Net present value of expected cash flow?


Value of the physical and non-physical assets?

Different models on pricing stock shares


Problems:

claims on the net residual profits


occasionally paid dividends.
claims on the firm value.

Expectations depend sensitively on news flow.


Expectations may be driven by less rational determinants
(moods, herding effects etc.)
Expectations are a source of speculation, speculation may drive
the prices, price movements confirm speculation ( bubbles).

High volatility of stock prices, high risk.

S.25

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.4 Equity Markets

A case for bubbles? (Dow Jones Index)

S.26

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.5 Further Markets

Options:

Option contracts are derivatives.


The holder of an option has the right (not the obligation) to
buy or to sell an underlying asset (e.g. stock shares, bonds,
foreign exchange, oil, crop,...) to a predetermined price until a
defined expiration date.
Buy = call option
Sell = put option
The option itself can be traded. The institution which issues
the option has the obligation to buy/sell the underlying asset
if the holder of an option wishes to exert his right.
The pricing of options is complicated and is not addressed in
this lecture. The volatility of option prices is high. If the right
is not exercised until the expiration date (this can be
rational!) there is a 100% loss for the buyer of the option.

S.27

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.5 Further Markets

Futures:

Future contracts are derivates similar to options.


The main difference is that buyer and seller are obliged to
execute the transaction (and option holder has only the right
to do that).
The date of transaction is determined in the contract.

Why options and futures?


Derivative contracts are like bets when expectations of
buyers and sellers are divergent.
Instrument to incorporate more information into the price
system.
Leverage effect: potential for high profits from speculative
derivative contracts.
Derivatives can be used to hedge risks of the underlying asset.

S.28

1.

Financial Markets

1.1 Overview over Financial Markets


1.1.5 Further Markets

Foreign Exchange Markets:

Foreign exchange/currency are also assets.

Transactions on foreign exchange markets can be caused by


underlying transactions on goods or capital markets (e.g.
change sale earnings into domestic currency, demand for
foreign exchange in order to pay back a loan).

Transactions can also be caused by the expectation that the


demanded foreign exchange will appreciate (speculation).

There are spot markets and future markets for foreign


exchange. The latter can e.g. be used for hedging the risks of
an underlying transaction on the goods market.

S.29

1.
1.2

Financial Markets
Interest Rate Theory

Outline:
1.2.1 Behavior of Interest Rates
1.2.2 Risk Structure of Interest Rates
1.2.3 Term Structure of Interest Rates
Literatur:
Mishkin (2012), chapter 4, 5, parts of chapter 6

S.30

1.

Financial Markets

1.2 Interest Rate Theory


1.2.1 Behavior of Interest Rates

Equilibrium interest rates for bonds changes with demand and


supply on the bonds market:

Demand shifts by Net Financial Wealth (+), expected


inflation (-), changes in expected returns (+), risk (-), liquidity
(+) of bonds (or vice versa in case of alternative assets).

Supply shifts by changed profitability of investment


opportunities (+), expected inflation (+), governmental
activities (deficit spending) (+).

S.31

1.

Financial Markets

1.2 Interest Rate Theory


1.2.1 Behavior of Interest Rates

The role of expected inflation

Real interest rate = nominal interest rate - (expected)


inflation rate (Fisher equation):
i real = i p

Debt contracts specify fixed payments per time interval. The


real value of the payments decreases with inflation. This is
bad for the creditor/lender but good for the debitor/borrower
(distribution effect of inflation).

Holding debt assets becomes less attractive, portfolios are


restructured in favor of alternative assets. This leads to an
increase of the nominal interest rates so that real interest
rates are not affected by monetary variables (Fisher effect).

S.32

1.

Financial Markets

1.2 Interest Rate Theory


1.2.1 Behavior of Interest Rates

B2D

interest
rate

B1D
expected inflation
raises

B2S
B1S
B

Source: Mishkin (2010)

S.33

1.

Financial Markets

1.2 Interest Rate Theory


1.2.1 Behavior of Interest Rates

Source: Mishkin (2010)

S.34

1.

Financial Markets

1.2 Interest Rate Theory


1.2.2 Risk Structure of Interest Rates

Risk: (details in Bailey (2005), chapter 4)

Realized returns are uncertain, they are dispersed around an


(estimated) mean.
Agents can assumed to be risk averse = utility function is
concave in returns: u (r ) > 0, u (r ) < 0.

Risk premium:
Given a return of a risk-free asset A. Which risk premium RP on
the return will be neccessary so that the utility of the uncertain
asset B equals the utility of the risk-free asset A?
A =
A ,

B =
B + ,

E [u(A )] = E [u(B )]

E [] = 0, V [] > 0

A + RP =
B

S.35

1.

Financial Markets

1.2 Interest Rate Theory


1.2.2 Risk Structure of Interest Rates

u(r )

E [u(
A )] = E [u(B )]
RP

S.36

1.

Financial Markets

1.2 Interest Rate Theory


1.2.2 Risk Structure of Interest Rates

The risk premium increases with the risk V [].

In case of fixed-payment debt instruments, risk is determined


by risk of default of the debitor.

Debt assets with higher risk have a higher nominal interest


rate ( spread of interest rates).

The interest rates of more risky bonds are higher than of low
risk bonds e.g. corporate bonds are more risky than US
government bonds, bonds of AAA-rated firms are less risky
than of BBB-rated firms etc..

S.37

1.

Financial Markets

1.2 Interest Rate Theory


1.2.1 Behavior of Interest Rates

increasing risk of corporate bonds


interest
rate

B1D

B2D
B1D

interest
rate

B2D
spread

BS
treasury bonds

BS
corporate bonds

S.38

1.

Financial Markets

1.2 Interest Rate Theory


1.2.1 Behavior of Interest Rates

source: Mishkin (2010)

S.39

1.

Financial Markets

1.2 Interest Rate Theory


1.2.1 Behavior of Interest Rates

source: German Council of Economic Experts

S.40

1.

Financial Markets

1.2 Interest Rate Theory


1.2.2 Risk Structure of Interest Rates

Interest rate differentials can furthemore be explained by

different liquidity of bonds or loan contracts: The more


illiquid an asset is, the higher the interest rate must be in
order to compensate this disadvantage.

different income taxes on interest payments: The more the


interest payments are taxed, the higher the nominal interest
rate will be.

S.41

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

Yield Curve:
Describes the term structure of interest rates for bonds of a given
type (with identical risk and liquidity characteristics) or for a
bundle of bonds.

Upward sloping yield curve (normal yield curve): long-term


interest rate above short-term interest rates

Downward sloping yield curve (inverted yield curve): vice


versa

Flat yield curve: same interest rate in short and long run

(Inverted) U-shaped yield curve etc.

S.42

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

interest
rate
normal yield curve
flat yield curve
inverted yield curve

residual maturity in years


(Daily and historical yield curves can be interactively calculated on the ECBs
home page. Estimation on the basis of a bundle of specific bonds, for details
see homepage.)

S.43

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

Stylised empirical facts:


1. Interest rates of bonds with different maturities move jointly.
2. If the short term rate is low it is likely that yield curve is
upwards sloped; vice versa if the short-term rate is high.
3. The upwards sloped yield curve is the typical case.

S.44

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

Expectations Theory

Assume that short-term rate is low. Agents expect increasing


economic activity (productivity, profitability, but also inflation
increase). Therefore the demand for funds to finance
additional investments will increase. The expected interest
rate level will rise (= falling bonds prices). If you buy a
long-term bond today, the expected higher short-term interest
rates in the future have to be reflected in the current
long-term interest rate.

Explains the first two stylised facts but not the third one.

S.45

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

Example: Amount L is invested for two periods.


Question: Buying one long-term contract or two subsequent
short-term contracts?
Rlong = L (1 + i0,2 )2
Rshort = L (1 + i0,1 )(1 + i1,1 )
where ij,k is the interest rate at time j for a k-period contract.
In an arbitrage-free market we have Rlong = Rshort which implies
q
i0,2 = (1 + i0,1 )(1 + i1,1 ) 1
where i1,1 is the expected interest rate. The current long-term
interest rate is the geometric mean of the current and the expected
short-term interest rate in the future.

S.46

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

If expectations are not systematically false, there should be a


correlation between the slope of yield curves and the business
cycle: before a cyclical downturn the yield curve will become flat or
inverted. Before an economic recovery the slope of the yield curve
will rise.
Empirical Literature:
Bernhard, H., Gerlach, S. (1998), Does the Term Structure Predict
Recessions? The International Evidence. International Journal of
Finance and Economics Vol. 3(3), 195-215.

S.47

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

Segmented Markets Theory:

Long- and short-term bonds are no close substitutes.

Investors have different preferences for different maturities.

Bonds are traded in different (segmented) markets.

It seems to be plausible that investors prefer short-term


maturities which would explain the stylised fact 3 but not fact
1 and 2.

S.48

1.

Financial Markets

1.2 Interest Rate Theory


1.2.3 Term Structure of Interest Rates

Liquidity Theory:

Bonds of different maturities are (imperfect) substitutes


expected returns correlate like in expectations theory.

Investors prefer short-term maturities so that short-term


markets are more liquid. Buying a less liquid bond requires a
liquidity premium.

Since this incorporates the expectations theory, all three


stylised facts are explained.

S.49

2.
2.1

Theory of Financial Structure


Financial Intermediates

Outline:
2.1.1 Economic Functions of Financial Intermediates (FI)

Asset Transformation
Reducing Transaction Costs
Risk Sharing
Dealing with Asymmetric Information

2.1.2 Types of Financial Intermediates


Literature:
Mishkin (2006), chapter 2

S.50

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.1 Economic Functions of Financial Intermediates

Indirect Finance
Financial Intermediates:
1.
2.
3.
4.

Provider:
1.
2.
3.
4.

Households
Firms
Government
Foreign

Banks
Mutual Funds
Pension Fonds
etc.

Receiver:
Market
Direct Finance

1.
2.
3.
4.

Households
Firms
Government
Foreign

S.51

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.1 Economic Functions of Financial Intermediates

a) Asset Transformation:
(Note that liabilities of the intermediate = asset of the houshold or firm)

Lot size transformation:


e.g. many small deposits, few large credits

Maturity transformation:
short run liabilities, long-run assets

Risk transformation:
e.g. less risky liabilities, more risky credits (see below)

Liquidity transformation:
high liquid liabilities, less liquid assets

S.52

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.1 Economic Functions of Financial Intermediates

b) Reducing Transction Costs:

FI have economies of scale:


getting information about demanded and provided funds,
assessing risks, bargaining, designing and enforcing contracts,
buying/selling stock shares these tasks can be accomplished
by FI with much lower transaction costs due to specialized
information processing abilities, large transaction volumes,
specific human capital (expertise).

FI have economies of scope:


FI provide additional services like risk diversification,
optimizing portfolios, and consulting. Sometimes these
services need the same infrastructure and the same human
capital. Hence it may reduce cost when one FI provides these
services.

S.53

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.1 Economic Functions of Financial Intermediates

c) Evaluating, Pooling and Allocating Risk:

Risk: e.g. investment projects may fail, borrowers may become


insolvent.

Evaluating risks calculating risk premia.

Reducing the risk by pooling and diversification.

Transforming the risk structure of financial assets.


Examples:

Depositors hold safe asset and receive low interest rates.


Bank provide risky loans with high interest rates (including risk
premia).
Securitization of risky loans and selling them changes asset
structure and re-allocates the risk.

S.54

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.1 Economic Functions of Financial Intermediates

d) Dealing with Asymmetric Information (see 2.3 2.4)

Adverse Selection:

Moral Hazard:

Hidden characteristics of a potential borrower before


contracting.
Borrower knows his risk better than the lender.
If lender offers a contract which is optimal for a borrower with
average risks, this may be unattractive for those with good
risks. This may result in a market failure.
Hidden action of a borrower after contracting.
Borrower takes the money to engage in a prject that is
undesireable for the lender. This reduces the probability for a
successfully returned credit.

FI may mitigate this problem e.g. by screening, collaterals,


optimal design of contracts. Again, they have the resources to
do that with low transaction costs.

S.55

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.2 Types of Financial Intermediates

Depository institutions (banks):


Accept deposits from individuals and institutions as liabilities,
providing loans and mortgages as assets.
Example: Commercial banks, thifts.
Contractual savings institutions:
Accept premiums and contributions from government, firms
and individuals as liabilities, investment in bonds, stocks and
government securities.
Example: life insurance, retirement funds
Investment intermediates:
Selling commerical stocks, bonds or shares as liabilities,
providing business loans and investment in stocks and bonds
as assets.
Example: Finance companies, private equity funds

S.56

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.2 Types of Financial Intermediates
Type of FI
Depository Institutions
Commercial Bank
Saving/loan associations
and mutual saving banks
Contractual saving Institutions
Life Insurance Companies
Fire/Caaualty Insur. Comp.
Pension funds
Gov. retirement funds
Investment Intermediates
Finance Companies
Mutual Funds
Money market mutual funds

Primary Liabilities

Primary Assets

Deposits

Loans, mortgages,
bonds
Mortgages,
consumer loans

Deposits

premiums
premiums
employer/employee
contributions
employer/employee
contributions

Bonds, mortgages
bonds, stocks
bonds, stocks

commercial papers,
stocks, bonds
issued shares
issued shares

loans

Value

12,272
1,518
4,798
1,337
5,193

bonds, stocks
2,730

bonds, stocks
money market instr.

(US Data 2008 , Bill. Dollar; source: Mishkin (2010), Tables 3 and 4, data from Federal Reserve)

1,910
6,538
3,376

S.57

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.2 Types of Financial Intermediates

Non-bank Financial Intermediaries (NBFI) are sometimes called


shadow banks

Risk originators:

Risk bearers:

Depository institutions (commercial bank 6 NBFI)


Broker dealer (investment banks)
Finance companies
Managed funds (insurance companies, retirement funds etc.)
Institutional investors (mutual funds, money market funds,
hedge funds)

Special Purpose Vehicles (intermediary institution for the


securitization process)

Poschmann, J. (2012), The Shadow Banking System Survey and Typological


Framework. Global Financial Markets Working Papers No.27, Jena/Halle.

S.58

2.

Theory of Financial Structure

2.1 Financial Intermediates


2.1.2 Types of Financial Intermediates

Why do NBFI exist?

Specialisation on transactions where no deposits are involved.

Financial intermediation combination with different private


goods (e.g. insurance).

Regulatory arbitrage: Banks are highly regulated, but


shadow banks are much less regulated they can do risky
investments to less costs. But: no access to short-run central
bank liquidity and safety nets like deposit insurance.

This can utilized also by banks e.g. by securitization and


selling the claims from loans to NBFI.

S.59

2.
2.2

Theory of Financial Structure


Portfolio Selection and the Management of Return, Risk and Liquidity

Outline:
2.2.1 General Principles of Bank Management
2.2.2 Theory of Portfolio Selection
2.2.3 The Value at Risk Approach
Literature:
Mishkin (2010), chapter 10
Bailey (2005), chapter 5

S.60

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.1 General Principles of Bank Management

The Banks Balance Sheet


Assets
Reserves (required, excess)

Cash
Securities/Bonds

firm bonds
governmental bonds

(Checkable) Overnight
deposits
Nontransaction desposits

Loans

Liabilities

industrial
consumer
real estate
inter-bank
other

Other assets
(e.g. physical assets)

Borrowings

Time deposits
Redeemable deposits
(saving accounts)
Inter-bank loans
Central bank loans
Other

Bank Capital / Net Worth

S.61

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.1 General Principles of Bank Management

a) Liquidity Management

Inflows are stochastic (e.g. risk of non-repayment of


debt/interest rates), outflows are stochastic (e.g. sudden
deposit withdrawals) need for liquid assets like cash or
reserves.
If there are not enough liquid assets, the bank needs expensive
overnight loans, or has to sell other assets (fire sales), or it
becomes illiquid.
Problem: If customers receive a signal of possible liquidity
problems, they wish to draw their deposits. This enforces the
liquidity problem and may induce bankruptcy (bank run
equilibrium, see Diamond/Dybvig model).
Given a probability distribution of inflows and outflows on the
liability side, the asset side should consist of enough liquid
assets to meet the obligations to the depositors and creditors.

S.62

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.1 General Principles of Bank Management

Excourse: Interbank market

Most transactions are deposit transfers from bank A to bank B.


Bank A is then in need for liquid reserves while bank B has excess
liquidity.

Interbank market for clearing the demand and supply of liquid


reserves by short-run interbank loans (often called money market).

The money market interest rate is the primary operative goal of the
central bank policy.

What happens if banks do not supply excess liquidity on the


interbank market, e.g. because of distrust to other banks or fear of
liquidity distress? increased central bank loans; central bank aims
to avoid liquidity problems in the banking sector.

Financial crisis 2008/2009 (and also later): drastically increased


central bank loans but also drastically increased excess reserve
holding at the central bank.

S.63

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.1 General Principles of Bank Management

b) Asset Management

Management of risk and return of the assets. Investing into a


mix of risky and riskless assets with the highest expected
utility (portfolio approach). But: portfolio approach requires
assumption of risk aversion which is empirically questionable.
Restrictions to asset management:

Liquidity considerations: The need for sufficient liquiditiy is a


restriction for asset management.
Capital regulation (Basel II/III): value of rsiky assets is risk
weighted, capital requirements for these risk weighted assets.
This prevents from holding too many too risky assets.
Incentive for securitization

S.64

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.1 General Principles of Bank Management

Excourse: Securitization

Illiquid assets like loans are pooled to a specific portfolio.


This portfolio is transferred to an entity called Special
Pupose Vehicle (SPV).
The SPV securitizes this portfolio and issues rated Asset
Backed Securities e.g. to funds, and receives liquid assets in
exchange which are transferred back to the bank.
From the banks perspective, and illiquid asset is therefore
transformed into a liquid asset. The risk of the underlying
securities is transferred to the fund (and fund share holders).
Although the amount of issued risky loans is the same as
before, the bank has a better loans/capital ratio.
Different types of securitization and ABS (not to be discussed
here).

S.65

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.1 General Principles of Bank Management

c) Liability management

Deposits are not given and not the only source of funds.
Decision how to aquire which types of liabilities.
Differences of liabilities:

Hows fast could an additional liability be aquired?


Probability of outflows
Differences in maturity
Costs = interest rates (e.g. for time deposits, for inter-bank or
central bank loans)

Development of new financial instruments (e.g. certificates of


deposits (CD) which are similar to bonds)

S.66

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.1 General Principles of Bank Management

d) Bank Capital Management

Most assets have risks: Credits may fail, bonds prices may fall.
Hence, the value of the asset side is under risk of being
depreciated.

With a certain probability the losses of the asset side may


exceed the bank capital: the bank becomes insolvent.

Trade-off: More risky investments enlarge c.p. the return on


equity capital, but also the risk of insolvency!

This is regulated by Basel II / III (see above)

S.67

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

Outline of Portfolio Theory


(Bailey (2005), chapter 5)

We address the case of two risky and one risk-free asset.


Risky means, that the returns are stochastic.

Notation:
i
12
ii
ai
r0

expected return of risky asset i = 1, 2


covariance between the returns of asset 1 and 2
variance of returns of asset i = 1, 2
P
proportion of portfolio invested in asset i, i ai = 1
return of the risk-free asset

S.68

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

a) The portfolio P of risky assets


We have
P =

P2

XX

ai i

(1)

ai aj ij2

(2)

In case of two risky assets the proportion a1 (obviously a2 = 1 a1 )


determines the expected return and the variance of the portfolio.

S.69

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

b) Efficiency Frontier

In case of more than two risky assets the convex set of


proportions a1 , ...an define a convex set of
(P , P2 )-combinations.

Most of these combinations are inefficient, since there exist


many portfolios with the same P but different P2 .

In the first step, the efficiency frontier has to be derived by


minimizing P2 (overP
ai = 1, ...n) under the constraints of
given P =
P and i ai = 1

In case of two risky assets, this step is not necessary since ai


determines a unique (P , P2 )-combination.

S.70

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

The shape of the efficiency frontier EF depends on the covariance


2
(1 2 = 12
/(1 2 ) is the correlation coefficient).
P
with 12 = 1
F

Asset 1

with 12 (1, 1)

with 12 = 1
Asset 2

S.71

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

c) Optimal portfolio without a risk-free asset

From the set of efficient portfolios choose the optimal


portfolio wich maximizes the utility function.
Mean-Variance-Approach:
X
max E [u(rP )] = P P2
with
ai = 1
ai

with > 0 as the degree of risk aversion.


Note: This is a special type of utility function. From a theoretical
point of view it is not necessary that the preferences can be
represented by a utility function of this type.

In a (P , P )-diagram the indifference curves are upwards


sloped. The tangential point (R) of the indiffrenece curve with
the efficient portfolio frontier is the solution of the
optimization problem.

S.72

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

indifference curves
P
Asset 1

R
optimal portfolio without
a risk-free asset

Asset 2

S.73

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

d) Optimal portfolio with one risk-free asset

The riskless asset has a return r0 and zero variance.

The risky portfolio Z is a mix of two risky assets with

Z = Z 1 + (1 Z )2

(3)

2
Z2 = 2Z 12 + (1 Z )2 22 + 2Z (1 Z )12
q
Z = 2Z 12 + (1 Z )2 22 + 2Z (1 Z )12

(4)
(5)

where Z has to be determined in an optimal way. The


resulting portfolio Z must lie on the efficiency frontier.

S.74

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

If portfolio Z is mixed with the riskless asset (share P ). The


resulting portfolio P has the properties:
P = P r0 + (1 P )Z
P2

P )2 Z2

= (1
q
P = (1 P )2 Z2 = (1 P )Z

(6)
(7)
(8)

Thus, the risk and return of P is a linear combination of Z


and the riskless asset.

S.75

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

In a (, )-diagram we can therefore write


(see also the figure):
P = r0 + bP


Z r 0
P
= r0 +
Z

r0

(9)
(10)

Asset 1
(Z = 1)

r0
(Z = 0)
Asset 2

S.76

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

How to determine the risky portfolio Z ?

Note, that an optimal portfolio P will be a tangential pont of


the indifference curve with the linear function (9).

Every point on a steeper linear function (9) dominates the


points on a flatter linear function since we obtain a higher
return with the same standard deviation.

Therefore, we maximize the slope b = (Z r0 )/Z with


respect to Z under the condition that Z , Z are defined
according to (3) and (5). This guarantees that Z lies on the
efficiency frontier.

Obviously, Z must be a tangential point on the efficiency


frontier!

S.77

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

max b =
Z

Z =

Z r 0
Z

s.t. (3), (5)

(1 r0 )2 (2 + r0 )12
(1 r0 )2 + (2 r0 )1 + 2r0 12 (1 + 2 )12

Now the optimal risky portfolio Z is determined. The linear


equation (9) with Z (and henceforth b ) is called Capital
Allocation Line (CAL).
Now, the optimal mix between Z and the riskless asset is
determined as usual as the tangential point of the indifference
curve with the CAL. The solution depends on the degree of
risk aversion. But it is remarkable, that irrespective to the
individual risk aversion, all rational investors will choose the
same risky portfolio Z (Tobin separation).

S.78

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

capital allocation line


Asset 1
Z

r0

Asset 2

S.79

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

capital allocation line


Asset 1
Z
P

optimal portfolio with


two risky assets and
one risk-free asset

r0

Asset 2

S.80

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.2 Theory of Portfolio Selection

Limitations:

Risky assets have to be backed by capital.

The bank needs a certain liquidity of their assets. Liquidity is


not addressed in the portfolio approach (see below).

Banks have to hold specific securities in order to have access


to Central Bank credits.

These things are constraints to the Portfolio Approach.

Empirically seen, there is not much risk aversion.

S.81

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.3 The Value at Risk Approach

Now we turn back to solvency and liquidity management


considerations.

Once, the optimal portfolio is determined, the value of the


assets is uncertain: Bad loans have to be depreciated, the
bonds prices may fall the value of the assets is a stochastic
variable.

For a given period (e.g. 1 month) it is possible to construct a


probability distribution F for the losses of value (where
negative losses are gains).

Assume that the bank management (or the regulation


authority) wishes that in the given period the bank stays
solvent with a probability of 1 %. Then the upper -fractil
of the distribution F denotes the (tolerated) losses the VaR
benchmark which can be expected with probability of %.

S.82

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.3 The Value at Risk Approach

% tolerated loss
(1 )%
0

VaR

loss

S.83

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.3 The Value at Risk Approach

In order to stay solvent the bank has to keep bank capital


which covers (at least) the VaR benchmark, for example
BC VaR1% . Staying solvent means that the obligations to
the depositors can be fulfilled.

If VaR is determined, then r denotes the percentage of the


asset volume A which will be lost with probability :

VaR = r A
BC
r
A

Example: If = 0.01 and r0.01 = 0.15 then 15% of the asset


volume are lost with probability of 1%. If BC r0.01 A then
losses which exceed bank capital (insolvency) have a
probability less than 1%.

S.84

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.3 The Value at Risk Approach

Applying VaR to Liquidity Management:

Consider a liquid asset (e.g. excess reserves), while the


deposits D are stochastic. The banks liquidity management
should ensure that the bank stays liquid when depositors wish
to draw their deposits.

The VaR approach can also be applied to this task: Let G be


the pobability distribution of daily deposit net outflows (where
negative outflows are net inflows). Then is the probability
that the outflows exceeds the liquid excess reserves and the
bank gets into liquidity troubles.

Similar to the BC /A = r ratio in case of solvency we have a


ratio r of excess reserves and deposits to ensure liquidity with
a probability of percent.

S.85

2.

Theory of Financial Structure

2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
2.2.3 The Value at Risk Approach

It has to be noted that the VaR approach to liquidity is an


additional constraint for the portfolio management: The
share of the most liquid asset (here e.g.: excess reserves) is
determined by the degree of risk aversion of the bank but is
also restricted by the VaR approach.

Summing up: The bank makes simultanous decisions about


the volume and the structure of the asset and the liability side.

S.86

2.
2.3

Theory of Financial Structure


Adverse Selection Problems

Outline:
2.3.1 Introduction
2.3.2 How Adverse Selection Influences Financial Structure
2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals
2.3.4 What Stylized Facts are Explained by Adverse Selection?
Literature:
Mishkin (2006), chapter 8
Wolfstetter, E. (1999), Topics in Microeconomics, chapter 9

S.87

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.1 Introduction

Information Asymmetries:

Principal: offers contract, lack of information


Agent: signs contract, private information

Before contracting: hidden characteristics adverse selection

buying shares or bonds of a firm characteristics are not


known to the buyer
providing a loan to a borrower with unknown ability to pay
back the loan (credit risk)

Principals decision is based on expectations about agents


characteristics
expectations are built on information
limited possibilities to reveal the unknown characteristics
Pooling vs. Separating equilibria

S.88

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

After contracting: hidden action moral hazard

Agent uses the funds for financing projects which are more
risky than announced to the principal, or he reduces the
managerial effort because this might enhance his benefits.

Principal cannot observe this, but he can expect that there is


an incentive for moral hazard.

Optimal design of the contract in order to mitigate or avoid


MH.

S.89

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Markets for Lemons

Akerlof, G.A. (1970), The Market for Lemons: Qualitative


Uncertainty and the Market Mechanism. Quarterly Journal of
Economics Vol. 84, 499-500.

Wolfstetter, E. (1999), Topics in Microeconomics. (Chapter


9.2.1)

Nobel Prize 2001 to George A. Akerlof, A. Michael Spence, Joseph


E. Stiglitz for their analyses of markets with asymmetric

information.
Foundation of market imperfections or market failures due to
information asymmetries.

S.90

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

The original version: Market for used cars

Cars have a different quality q (from very good q = b to


bad q = 0, bad cars = lemons)

The seller is privately informed about the quality q [0, b].

The seller will accept any price p q.

The buyer is willing to pay any price p q with > 1.

For any given q there exists a price [q, q] where buyer and
seller mutually benefit from the deal.

But: The buyer is not able to observe q


building expectations E [q].

S.91

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Assume that the quality q is uniformly distributed on [0, b]. This is


known by the buyer. For any used car the expected quality is hence
E [q] = b/2. Therefore
p(E [q])

b
2

Two cases:

Case 1: 2. Then the buyer is willing to pay p b and all


cars will be sold.

Case 2: 1 < < 2. Then the market breaks down!

S.92

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Market breakdown:

For < 2 the buyer will never pay p = b.

No high quality cars (q = b) will be sold. They can be removed


from the interval (e.g. q [0, b ]).

This can be anticipated by the buyer. The expected average quality


decreases (e.g. E [q] = (b )/2).

The willingness to pay also decreases.

The remaining best quality cars leave the market.

and so forth... (race to the bottom)

S.93

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Or in another way:

Assume an arbitrary merket price p > 0. Obviously there are


only sellers i the market with qi [0, p]. The average quaility
is hence E [q] = p2 .

This is known by the buyers. The are willing to pay maximum


p(E [q]) = /2 p.

For < 2 this is lower than the market price and no deal
comes about.

S.94

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Financial Markets:

Firm needs funds to finance a risky project. Assume that the


firm demands for a loan L.
The firm is willing to pay an interest rate iL which does not
exceed the expected return of the project r .
The bank will provide the loan L when the interest rate covers
at least the interest rate for a secure asset iS plus the risk
premium RP.
Assume that the loan is either returned successfully with
probability 1 p or it fails completely with probability p. The
minimum risk premium is therefore:

L(1 + iS ) = L(1 + iL )(1 p) + 0 p


p
RP = iL iS =
(1 + iS )
1p

(11)
(12)

S.95

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Problem: p is private information of the firm!


Offering a loan contract with an interest rate iL (incl. risk
premium) based on the expected probability E [p] taken from
a prior distribution of risks.
Typically the expected return and the risk of investment
projects are positively correlated. Firms with profitable low
risk projects with
r < iS +

E [p]
(1 + iS )
(1 E [p])

will not have in incentive to sign a loan contract!


The remaining projects are hence more risky which leads to
an increase of E [p] a similar mechanism as in the market
for lemons example applies.

S.96

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Credit Rationing:
Adverse Selection Effect: With an increasing interest rate more and
more good (= low risk) projects leave the market and the expected
risk increases:
dE [p(iL )]
>0
E [p] = E [p(iL )],
diL
Profit maximizing bank: (L given)
max = (1 E [p(iL )])(1 + iL )L
iL

dE [p(iL )]
d
=
(1 + iL )L + (1 E [p(iL )])L = 0
diL
diL
iL

(1 E [p(iL )])
dE [p(iL )]
diL

dE [p(iL )]
diL

(13)
(14)
(15)

S.97

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

What are the consequences?

The profits do not monotonously increase with market interest


rate iL .

If loans demand increases, there is not neccessarily a


Walrasian adjustment of the equilibrium interest rate!

The demand side of the loans market will be rationed.

Existence of rationing equilibria.

The notional plans of the firms cannot be fulfilled


spillover to other markets

e.g. markets for bonds or equities to finance the project


e.g. markets for investment goods

S.98

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

LS
rationing
LD

iL

iL

S.99

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.2 How Adverse Selection Influences Financial Structure

Literature:

Stiglitz, J., Weiss, A. (1981), Credit Rationing in Markets


with Imperfect Information. American Economic Review 71,
393-410.
Greenwald, B., Stiglitz, J., Weiss, A. (1984), Information
Imperfections in the Capital Market and Macroeconomic
Fluctuations. American Economic Review 74, 194-199.

Note:

The problem of rationing may be (partially) overcome e.g. by


collaterals.
The problem may also occur in bonds and stock markets: the
price which the buyer is willing to pay reflects his uncertainty
about the risk type of the firm!

S.100

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

There are different ways how to solve or to alleviate the problem:

Providing better information = decreasing information


asymmetry

Screening: The less informed agent has an incentive

to collect information by himself


to buy additional information supplied by other agents
to provide different contracts with self-selection effects

Signalling: The privately informed agent has an incentive to


provide a trustworthy (costly) signal about his characteristics.
Governmental Regulation

Collateral and Net Worth


The information asymmetry is not neccessarily resolved but
has minor consequences since in case of a failed project the
return of the loan is backed.

S.101

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Screening by collecting information

High information costs, especially for lenders with low


expertise.
Bank as a financial intermediate with expertise and specialized
human capital reduces such information costs:

Multiple lender of funds bank deposits


Bank is pooling the risks and guarantees the depositor an
interest rate
Screening costs of multiple non-specialized lenders are reduced
and transferred to the bank
The bank as the intermediate lender faces a lower information
asymmetry

The existence of a professional banking system is a


prerequisite for a working credit market.

S.102

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Screening by buying information provided by others

Rating agencies (e.g. Standard & Poors, Moody): (large)


borrowers are rated according to a standardized scale (see
Mishkin (2006), chapter 6, p.123)
In Germany: SCHUFA (Schutzgemeinschaft f
ur allgemeine
Kreditsicherung)

Problems:

Free-rider problem since information is a non-rival good.


Once, when information is made public, there is no incentive
anymore to pay for it.
How trustworthy is that information? RA typically payed by
the better informed party. Less informed party is not able to
asses the reliability of the information Moral Hazard
problem.

S.103

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Screening and self-selection (separating equilibrium):

High/low risk investors with probabilities of default pH > pL where


pj is private information.

Bank offers two types of contracts: (iL , CL > 0) and (iH , CH = 0).

For a high risk investor it is more likely that he will have to pay the
collateral. Both investors compare the expected costs:
(1 pj )iL + pj CL (1 pj )iH
iH iL
pj

1 pj
CL
Since the l.h.s. is larger for the risky investor, there exists
combinations of (iL , iH , CL ) where the inequality sign is different for
both investor types.

Investors will choose different contracts and therefore reveal their


type (separating equilibrium)!

S.104

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Governmental Regulation:
If investors need financial funds, e.g. by demanding credits or
selling bonds or stocks, they can be forced by law to provide some
information to reduce the information asymmetry. E.g.

adhere standard accounting principles

providing information about the balance sheet and other


(financial) indicators like sales, earnings, assets

in case of stock markets: publish relevant informations


regularly; annual meeting of shareholders etc.

S.105

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Signalling:

A firm with a low risk project has an incentive to provide a


signal so that the lender is informed about the low risk.
If signalling should make sense...
(a) the signal must be costly
(b) there must exist signals that are too expensive for a high risk
firm but not too expensive for low risk firms
discrimination is possible.

Otherwise high risk firms have an incentive to imitate the


signal so that signalling provides no information (pooling
equilibrium).

S.106

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Signalling means building reputation. Reputation signals (e.g.):

Loans have been successfully returned in the past.

Projects are financed also with equity capital.

Firm provides voluntarily more sensitive information than


required by law.

Firm has valuable assets ( similar to collaterals).

This may be a problem for new and small firms.

S.107

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Collaterals:

In case of failure of the investment project the investor has


other assets which can be sold to meet the debt obligations.

Borrower must prove that he has such collaterals before


signing the credit contract.

Credit contract includes the obligation that the collateral


must not sold until the credit is returned successfully.

Cedit contract includes that lender automatically becomes the


owner of an asset in case of a credit failure.

In some contracts, the lender has property rights on the asset


which is financed by the credit. These property rights are
returned to the borrower in case of a successfully returned
credit mortgages (e.g. in case of housing)

S.108

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Collaterals C lower the risk premium:

L(1 + iS ) = L(1 + iL )(1 p) + pC


p C
p
(1 + iS )
RP = iL iS =
1p
1p L

(16)
(17)

with C = arg max{0, (1 + iS )L}. In case of C = L(1 + iS ) there is


no credit risk for the lender anymore.
Problems:

Providing collaterals and liquidation is costly (e.g. opportunity


costs).

The access to collaterals is limited (e.g. start-up companies).

The value of collaterals may be uncertain (see the housing crisis in


the U.S. dramatic decrease of house prices = decrease of the
value of collaterals)

S.109

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals

Literature on Collaterals:

Bester, H. (1985), Rationing in Credit Market with Imperfect


Information. American Economic Review 75, 850-855.

Besanko, D., Thakor, A. V. (1987), Collateral and Rationing:


Sorting Equilibria in Monopolistic and Competitive Credit
Markets. International Economic Review 28, 671-689.

S.110

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.4 What Stylized Facts are Explained by Adverse Selection?

1. Credit and loans are an importnat source of financing business

One could think that there is an incentive for a firm to finance


their business primarly by selling equities (e.g. stocks), since
the stock owner only have claims on the residual profit.

Due to information asymmetries about risky business projects


the owner of financial funds prefer to buy assets with a lower
risk like bonds, or to buy risk-free assets like time deposits
which are used by the financial intermediates to provide
credits.

Financial intermediates have lower costs to achieve


information about the risky business.

S.111

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.4 What Stylized Facts are Explained by Adverse Selection?

(Source: Mishkin (2006), p.171)

S.112

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.4 What Stylized Facts are Explained by Adverse Selection?

2. Indirect Financing via Intermediates (like banks) is much more


important than Direct Financing

The same argument applies

3. The financial system is one of the most regulated sectors in the


economy.

Regulation is needed to alleviate the problems of information


asymmetries.

S.113

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.4 What Stylized Facts are Explained by Adverse Selection?

4. Large well-established firms have a more easy access to financial


funds than small or new firms.

Large firms have more expertise as well as more economies of


scale to provide detailed information.
Only large firms are rated by rating agencies.
Well-established firms have built up reputation.
Large firms can provide much more collaterals.

5. Collaterals are a prevalent ingredient of loan contracts for firms


and households.

Collaterals lead to a drastic decrease of risk premiums what


alleviates the adverse selection effect.
Combining different interest rates and collateral requirements
may lead to self-selection (separating eqilibrium).

S.114

2.

Theory of Financial Structure

2.3 Adverse Selection Problems


2.3.4 What Stylized Facts are Explained by Adverse Selection?

Excourse: Microfinance in Developing Countries

Many small businesses with small amounts of required loans.

Typically no collaterals!

Consequently, extremely high interest rates for private lending or no


access to capital.

Idea:

Bundling several borrowers to a group (group lending). Every


group member is liable for all repayments screening and
monitoring task is partially shifted to the borrowers.

Self-selection of reliable lenders, incentive to monitor the efforts


in creating profitable business.

Repayment scheme which incentivices monitoring. Short-run


opportunistic behavior will reduce likelihood of loan prolongation or
future loans.

However: Could lead to severe social pressure within a group.

S.115

2.
2.4

Theory of Financial Structure


Moral Hazard Problems

Outline:
2.4.1 Introduction into Principal-Agent-Problems
2.4.2 How Moral Hazard Affects the Choice Between Debt and
Equity
2.4.3 Solving Moral Hazard Problems
2.4.4 What Stylized Facts are Explained by Moral Hazard?
Literature:
Mishkin (2006), chapter 8
Wolfstetter, E. (1999), Topics in Microeconomics. Cambridge University
Press, chapter 11

S.116

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.1 Introduction into Principal-Agent-Problems

General Structure:

Principal offers a contract to the agent.

The payoff depends on the unobservable behavior of the agent


as well as on stochastic variables.
Examples

Employer-employee relationship: The outcome for the employer


depends on the unobservable effort of the employee.
Borrower-lender relationship: The risk of debt failure depends
on the project choice of the borrower (high risk or low risk)

The agent has an incentive to exploit the unobservability of


his choice in order to maximize his own utility instead of
making decisions in accordance to the preferences of the
principal (= moral hazard). This can be anticipated by the
pricinpal.

S.117

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.1 Introduction into Principal-Agent-Problems

(uP1 , uA1 )
high effort
A
low effort

random
variable

(opportunism)

P
equity contract

accept
(uP2 , uA2 )
reject
(
uP , uA )

S.118

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.1 Introduction into Principal-Agent-Problems

(uP1 , uA1 )
low risk project
A
risky project

random
variable

(opportunism)

P
debt contract
(low risk premium)

accept
(uP2 , uA2 )
reject
(
uP , uA )

S.119

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.1 Introduction into Principal-Agent-Problems

The principal is (at the best case) able to observe the


outcome of the agents deicion, not the decision itself =
hidden action (except for monitoring).

In some cases it is possible to conclude from the outcome to


the underlying actions of the agent (revelation), in other cases
this is not possible (non-revelation).

Therefore, the contractual payments can depend on the


outcome but not on the behavior of the agent.

S.120

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.1 Introduction into Principal-Agent-Problems

low effort or low risk


high effort or high risk

reveal

not reveal

reveal

low effort or low risk


high effort or high risk

not reveal

S.121

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.1 Introduction into Principal-Agent-Problems

Two types of Moral Hazard problems:

Agent = manager: In case of equity contracts the agent tends


to reduce his effort, since the equity holder benefits from the
returns due to his efforts. In case of a debt contract, the
lender receives fixed payments, and the agent has an incentive
for high efforts since he benefits from the increasing expected
return.

Agent = investor: In case of debt contracts the agent tends to


invest into too risky projects than negotiated with the
lender. The reason is that in case of negative returns of the
project the debt fails = the lender also carries the risk. The
risk of the agent, however, is limited.

How to construct a financial contract which incentivices the


agent to decide according to the principals preferences?

S.122

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.2 How Moral Hazard Affects the Choice Between Debt and Equity

Contracting in the presence of Moral Hazard:

The financial contract regulates how the (stochastic) return


and how the risk is allocated to the principal and the agent
(risk-return-scheme).

Each type of a risk-return-scheme incentivices a certain


behavior of the agent.

The principal anticipates the incentive structure of the agent.


He proceeds in two steps:
1. What is the optimal risk-return-scheme which incentives the
agent to choose a certain project or a certain effort level?
2. Which risk-return-scheme maximizes the utility of the
principal?

S.123

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.2 How Moral Hazard Affects the Choice Between Debt and Equity

Two extreme cases:

Fixed payments (= low risk) for the agent,


residual return (= high risk) for the principal
Examples: fixed wages in case of employer-employeerelationships; shareholder and fixed payed manager of a firm

Residual returns for the agent,


fixed payments for the principal
Example: premium wages for employee and fixed return for
the employer; fixed interest payments for the bank, residual
return for the investor

S.124

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.2 How Moral Hazard Affects the Choice Between Debt and Equity

A note on guarantees (suretyship):

Guarantees from third parties (like government) reduces the


risk of the lender in case of a credit failure.

The lender has a bias towards financing too risky projects.

Similar to Moral Hazard effects in case of insurances.

Example: bank crisis in 2008 if large banks could expect


that in case of insolvency there will be a governmental bailout
they might be less cautious in buying risky assets.

S.125

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.3 Solving Moral Hazard Problems

Equity Markets:
a) Monitoring:

Providing information about the decisions of the investor and


their consequences for earnings and profits. Thus, the actions
are less hidden.

This is costly!

Legal constraints.

If there are many principals, a free-riding problem arises.

S.126

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.3 Solving Moral Hazard Problems

b) Governmental Regulation:
Same argument as in case of adverse selection (see above).
c) Co-determination of management decisions
This is only possible in case of financial intermediation: Financial
funds are given to a FI (e.g. an investment corporation) that buys
equities of a firm but also participate in the management.

S.127

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.3 Solving Moral Hazard Problems

d) Manager contracts
If managers are payed according to the impact of their decisions on
the firm value (e.g. by stock options), it could be expected that
they have similar preferences than other holders of equity shares.
e) Mixing with debt contracts
Similar effect: The lender receives fixed payments, the agent
receives the residual profit. He will show more effort and choose
projects according to his risk preferences.

S.128

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.3 Solving Moral Hazard Problems

Especially in loan markets:


a) Net Worth
Sum of assets minus liabilities = Net Worth. A failure of the
project (negative returns) reduces the agents own net worth.
Hence agent has incentive to choose projects with proper risk
insetad of exploiting the moral hazard effect and shifting the risk of
loss to the lender.
b) Collaterals
Most debt contracts contain covenants to keep some valuable
collaterals. In case of debt failure the lender can claim these
collaterals. This works similar to the net worth effect (see above).

S.129

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.3 Solving Moral Hazard Problems

c) Provision of information / Monitoring


The debt contract contains covenants that the borrower must
provide (regularly) information about his activities. There may be
contractual penalties in case of verified false information.
d) Financial intermediation
Restrictions in contracts must be monitored and enforced.
Intermediates can do this more effectively and with lower
transaction cost than an individual lender.

S.130

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.3 Solving Moral Hazard Problems

Summary:

Moral Hazard (MH) arises in both, equity and debt contracts.

MH may result in (a) too low effort of the agent, (b) choosing
too risky projects.

Financial contracts should be designed in an incentive


compatible way, i.e. that agents utility maximizing decisions
are compatible with the preferences of the principal. This is
not always perfectly possible.

Financial intermediates have better possibilities to alleviate


the MH problem.

S.131

2.

Theory of Financial Structure

2.4 Moral Hazard Problems


2.4.4 What Stylized Facts are Explained by Moral Hazard?

1. Credit and loans are an importnat source of financing business


2. Indirect Financing via Intermediates (like banks) is much more
important than Direct Financing
3. The financial system is one of the most regulated sectors in the
economy.
5. Collaterals are a prevalent ingredient of loan contracts for firms
and households.
6. Debt contracts are typically complicated and contain many
restrictions on the behavior of the borrower.

S.132

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

We leave the theory of financial intermediation and turn to


secondary markets where financial assets are valued by market
participants.

Mishkin, Frederic S. (2012), The Economics of Money,


Banking, and Financial Markets, 10th ed., Boston et al:
(chapter 7)

Malkiel, B.G. (2003), The Efficient Market Hypothesis and Its


Critics. Journal of Economic Perspectives 17(1), 59-82

S.133

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Study of behavior of stock prices by L. Bachelier (1900):


random character of stock prices.
E. Fama (1960ies):
Started as a technical analyst: trying to find patterns in
past data which enables investor to predict stock prices
But: Random Walk successive price changes are
independent
interpreted RW as an indicator that all relevant information is
processed efficiently!

S.134

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Idea:

If we could predict in t from available information that price


pt+1 will exceed pt then it would be rational for all
participants to buy in t (speculation). Thus, pt will
instantanously increase until the level pt+1 so that pt is the
best predictor for pt+1 .

Thus speculation is seen as an acrtivity making markets


informationally efficient.

S.135

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

An efficient market is defined as a market where there are a large


number of rational profit-maximizers actively competing, with each
trying to prdict future market values of individual securities, and
where important current information is almost freely available to
all participants [...] on average, competition will cause the full
effects of new information on intrinsic value to be reflected
instantanously in actual prices. (Fama 1965)

S.136

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Informational no-arbitrage: a further analysis is useless

Not possible to beat the market (generate excess returns)

Consistent with the Rational Expectations Hypothesis

S.137

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Lot of empirical work in late 1980ies. Resume in Fama (1970,


Journal of Finance), elaborated EMH in three forms:

Weak efficiency: prices fully reflect all information from past


data (technical analysis cannot have any advantages); no
systematic market inefficiencies which could be exploited.

Prices should follow Random Walk testable hypothesis

Mixed evidence: main problem is the momentum effect


(persistence of temporary trends); episodes of euphoria and
glooms.

Example: Pesaran, M.H. (2010), Predictability of Asset


Returns and the Efficient Market Hypothesis. CESifo Working
Paper No. 3116.

S.138

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Semi-strong efficiency: prices fully reflect all information


from past data and all current information which is publicily
available.

New informations which are relevant for fundamental value of


the asset is incorporated in the prices immediately.

Returns from an asset: general market moves versus individual


(residual) component. Which infiormations drive the residual
component? E.g.: announced stock splits, quarterly earnings
reports, issuing new stock shares, other relevant information

Mainly empirical support of semi-strong efficiency.

S.139

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Strong efficiency: same as semi-strong but also incorporating


private information of market participants.

However: in most legislations this is forbidden (insider trade).

Not much evidence for strong efficiency.

S.140

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Implications of EMH:

Only surprising news are moving the market (very quickly).


Published information which has been anticipated already,
does not move the prices.

Dont trust hot tips (either forbidden insider trades, or


useless)

S.141

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Critique:

Micro-perspective:
Bounded rationality, various cognitive biases which prevent
even sophisticated people to make statistically correct
predictions (e.g. over-confidence, distorted risk-perception
Herding behavior, irrational exuberance.
Behavioral Finance (e.g. Robert Shiller)

Macro-perspective:

Bublles and crashes; global financial crisis

(Note: Eugene Fama and Robert Shiller as well as Lars Peter Hansen won 2013
the Nobel Prize in Economics....)

S.142

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

However:

Fama argues that bubbles do not exist: a theory which


defines and explains bubbles should be able to predict them.
As long as there is no such a theory there is no reason to
believe in bubbles. They are seen as an ex post attribution
of an observed rapid price decline.

Detection of a bubble requires that we know something


about the fundamental value. According to EMH, all
relevant information about this is already included in the price.
Thus a sudden crash could be explained by the occurence of
new (even small) information triggering the expectations.

Problem of self-reference of (rational) expectations:


expectations about future fundamental firm value
fundamental firm value: net present value of future expected
cash flow.

S.143

2.

Theory of Financial Structure

2.5

Efficient Market Hypothesis and its Limits

Joint Hypothesis Problem:

To test efficiency, the modeler has to consider all relevant


information which is necessary to compute the best
prediction.

If test does not reject EMH, we cannot reject that market


participants are doing the same as the modeler (EMH is not
rejected 6= proven as true).

If test rejects EMH, than this shows that the underlying model
is not completely specified (e.g. the modeler did not use all
the information which the market participants have used).

Therefore, EMH is not testable

S.144

3.

The Money Supply Process

3.1

Function and Measurement of Money

Outline:
3.1.1 Functions
3.1.2 Monetary Aggregates
3.1.3 Other Definitions of Money
Literature:
Bofinger (2001), chapter 1
Mishkin (2010), chapter 3

S.145

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.1 Functions

Money is what money does. Money is defined by its

function. (J. Hicks 1976)


Functions:

Medium of Exchange

Unit of Account

Store of Value

S.146

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.1 Functions

Medium of Exchange:

Without money each good can possibly exchanged with each


other good (bartering). Hence we have for n goods n(n 1)/2
exchange relations = relative prices.

Finding a transaction partner with symmertic exchange wishes


(A: books whiskey, B: whiskey books) is extremly
expensive transaction costs. Since there are numerous
possibilities to exchange goods over several edges (e.g.
books butter cutting hair whiskey) there are extreme
high information costs to find the best exchange relation.

Money as a generally accepted medium of exchange leads to a


dramatic decrease in transaction costs (only n money prices).

S.147

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.1 Functions

Unit of Account:

Money as a numeraire: Money prices makes comparisons very


easy (what is cheap, what is expensive?), hence money
reduces information costs.

Money as a precondition for accounting systems: A general


unit enables accounting systems like balance sheets to measure
the financial wealth or current accounting systems to measure
the inflow and outflow of money and eranings per period.

S.148

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.1 Functions

Store of Value:

Receiving money (instead of goods or services) enables the


money holder to buy goods and servies to an arbitrary time.
His purchaising power is conserved.

If the disposition of the agent changes over time, the stored


money can be used for varying expenditures concept of
liquidity, money as the asset with the highest degree of
liquidity.

The possibilities for intertemporal decisions (like savings in t0


for additional production and consumption in t1 ) increase
dramatically with such a store of value.

Problem: Inflation! Money may be substituted by real assets.


This function of money is fulfilled by another asset.

S.149

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.1 Functions

The functions define money in an abstract manner.

There are different forms of apparance of money (financial


assets) like currency, deposits, time deposits, checks etc.

It is reasonable to define collections of financial assets which


are called monetary aggregates.

S.150

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.2 Monetary Aggregates

M1 =
M2 =

M1

M3 =

M2

+
+
+
+
+
+

currency in circulation
overnight deposits
deposits with an agreed maturity of up to two years
deposits redeemable at notice of up to three months.
repurchase agreements
money market fund shares
debt securities with a maturity of up to two years

S.151

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.2 Monetary Aggregates

Monetary aggregates in 02/2014 (Bill. Euro)


(source: ECB):
currency in circulation
overnight deposits
deposits mat. < 2 years
red. deposits < 3 months
repos
money market fund shares
debt sec. < 2 years

919
4574
1663
2117
130
427
87

M1= 5493
M2= 9273

M3= 9918

S.152

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.2 Monetary Aggregates

(Source: ECB)

S.153

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.2 Monetary Aggregates

(Source: ECB)

S.154

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.2 Monetary Aggregates

S.155

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.3 Other Definitions of Money

Definition by the transmission mechanism

There are different transmission theories on how monetary


shocks affects the real sphere or the inflation rate.

Take a transmission theory: monetary aggregate M then


includes all financial assets which are consistent with the
transmission theory.

Advantage: If the transmission theory is true, the aggregate


M is a good intermediate goal for monetary policy.

Problem: If M is defined in this way then the underlying


transmission theory can not be falsified. It is a tautology.

S.156

3.

The Money Supply Process

3.1 Function and Measurement of Money


3.1.3 Other Definitions of Money

Econometric definition

There are diffreent theories of money demand. In the long run


it can be assumed that the money market is in equilibrium,
i.e. money equals money demand.

Take a theory of money demand. Money includes then all


financial assets which are demanded by the agents (example:
Keynes theory Ld (Y , i)). Statistical regression then decides
whether a type of financial asset is significant to explain
money demand.

Advantage: The definition of money is based on an economic


theory rather than being arbitrary or a matter of convention.

Problem: If M is defined in this way, the underlying money


demand theory can not be falsified.

S.157

3.
3.2

The Money Supply Process


Creation of Central Bank Money (Money Base)

Outline:
3.2.1 Balance Sheets of the Financial Sector
3.2.2 Basic Operations of the Central Bank
3.2.3 Overview: Policy Instruments
Literature:
Bofinger (2001), chapter 3.1-3.3
Mishkin (2010), chapter 15, parts of chapter 16
ECB (2004), The Monetary Policy of the ECB (downloadable)
McLeay, M., Radia, A., Ryland, T. (2014), Money creation in the modern
economy. Bank of England, Quarterly Bulletin 2014 Q1

S.158

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.1 Balance Sheets of the Financial Sector

central banks balance sheet (simplified)


Assets
Liabilities
Foreign reserves F
Currency (C )

Loans to commercial
banks (Lc )

Deposits of commercial
banks (reserves) (R)

Securities (S cb , B)
(e.g. bonds)

Other Liabilities
Net Worth

Monetary Base M0 = C + R

S.159

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.1 Balance Sheets of the Financial Sector

commercial banks balance sheet (simplified)


Assets
Liabilities
Reserves (R)
Loans:
= required reserves
central bank loans (Lc )
+ excess reserves
inter-bank loans

Loans (L):
inter-bank loans
commercial loans
reals estate

Deposits of non-banks (D):


overnight deposits
time deposits
saving deposits

Bonds/Securities (B):
Cash items
Other assets

Other debt instruments

Bank Capital/Net Worth (BC )

S.160

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.2 Basic Operations of the Central Bank

Central bank can create money M0:

non-borrowed reserves: purchasing securities like bonds on the


security market: S cb or B > 0
borrowed reserves: providing a loan to a commercial bank:
Lc > 0

Since there is a inter-bank market for (borrowed) reserves, the


main central bank loans are also called open market
operations.
Furthermore, banks could borrow reserves overnight
standing facilities.

S.161

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.2 Basic Operations of the Central Bank

Case 1: Central bank buys a security from a commercial bank


central bank
Assets
Liabilities
B = 100 R = 100

commercial bank
Assets
Liabilities
B = 100
R = 100

With the additional reserves the commercial bank is able to


provide additional loans to the non-bank sector or to buy
other assets.

This is a restructuring of the banks portfolio. The bank will


do this only if it is profitable.

S.162

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.2 Basic Operations of the Central Bank

Similar accounting records (e.g.):

Central bank buys securities from a commercial bank and pays


with currency: S cb = C .

Central bank buys foreign reserves from a non-bank and pays


with currency: F = C .

etc. (see Mishkin (2010) for examples)

Reserves may be changed into currency and vice versa


(no effect on M0):
R = C

S.163

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.2 Basic Operations of the Central Bank

Case 2: Central bank loan to a commercial bank


central bank
Assets
Liabilities
Lc = 100 R = 100

commercial bank
Assets
Liabilities
R = 100 Lc = 100

Again, with the additional reserves the commercial bank is


able to provide additional loans to the non-bank sector or to
buy other assets.

This extends the commercial banks balance sheet and shifts


the debt/equity ratio of the liability side.

S.164

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.2 Basic Operations of the Central Bank

Some characteristics of the central bank loans:

The commercial bank has to pay interest rates. These interest


rates are the primary policy instrument.

The loan contract has typically a maturity of one week or


three months (open market operations), or it is an
overnight loan (standing facilities). In times of financial
distress there are also long-term contracts.

The banks must provide securities = function of a collateral.

When the loan is returned at the maturity date, the monetary


base M0 decreases reverse accounting record.

S.165

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

Overview over ECB policy instruments:


1. Reserve requirements: The bank must hold a part of their
deposits as reserves. There is a need to borrow liquidity from the
central bank.
2. Open Market Operations: The central bank provides liquidity to
the banks while the banks provide specified securities; tender
procedures.
Main operations: interest rates weekly adjusted; maturity 1
week
Long term-operations: interest rates monthly adjusted;
maturity three months.
Structural and fine-tuning operations: also definitve purchases
and sales of securities are possible.
3. Standing Facilities:
Short-run (overnight) loans
Overnight deposits

S.166

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

Reserve requirements:

Liabilities with positive reserve ratio:

Deposits (including overnight deposits, deposits with an agreed


maturity up to two years and deposits redeemable at a period
of notice of up to two years)
Debt securities issued with a maturity of up to two years

Liabilities with zero reserve ratio

Deposits (including deposits with an agreed maturity of over


two years and deposits redeemable at a period of notice of
over two years)
Debt securities issued with a maturity of over two years
Repurchase agreements

S.167

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

(source: ECB (2004))

S.168

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

Market for (borrowed) reserves:

Supply of liquid excess reserves e.g. in case of inflowing


deposits.

Demand for liquid reserves e.g. in case of outflowing deposits


or expansion of loans.

Collateralized and non-collateralized borrowing.

Interbank (money) market interest rate: e.g. EONIA (Euro


Overnight Index Average)

Since interbank loans and central bank loans are close


substitutes, the central bank has a strong impact on the
money market rate, and it determines the circulating reserves.

Fixed reserve supply and aggregated net demand for


reserves.

S.169

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

Stylized market for (borrowed) reserves:


(i cb = discount rate, i M = market interest rate)

interest
rate
i cb

supply (cb)

iM
demand

reserves

S.170

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

Effects of monetary policy on borrowed reserves and interest rates:


interest
rate

Changing the
discount rate

interest
rate

reserves

Outright purchases
of securities

reserves

S.171

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

How to respond to a increasing demand for reserves?


interest
rate

full accomodation
(goal: stable i)

interest
rate

reserves

no accomodation
(goal: stable M0)

reserves

CB cannot fully control both, interest rate and M0. Most CB use
interest rate as operational target, thus they accomodate demand for M0.

S.172

3.

The Money Supply Process

3.2 Creation of Central Bank Money (Money Base)


3.2.3 Overview: Policy Instruments

(source: Deutsche Bundesbank)

S.173

3.
3.3

The Money Supply Process


Multiple Deposit Creation and the Multiplier

Outline:
3.3.1 The Money Multiplier
3.3.2 Determinants of the Multiplier
3.3.3 Objections against Static Multiplier Analysis
Literature:
Bofinger (2001), chapter 3.4
Mishkin (2010), chapter 16

S.174

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.1 The Money Multiplier

Monetary aggregat M1 defined as


M1 = C + D

(18)

with C as currency and D as deposits.

The monetary base, controlled by the central bank, ist


defined as
M0 = C + R
(19)
where R are the reserves with
R = RR + ER = r D + ER

(20)

where RR are the required reserves and r is the required


reserve ratio. ER are the excess reserves.

S.175

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.1 The Money Multiplier

Behavior of the non-bank public:


People have certain transaction customs. They wish to hold
currency and deposits in a certain ratio (= assumption)
c=

C
D

C = cD

(21)

Behavior of commercial banks:


Due to liquidity considerations they hold excess reserves as a
high liquidity risk-free asset (as a reaction to expected deposit
outflows). The ratio of excess reserves and deposits are
assumed to be
e=

ER
D

ER = eD

(22)

S.176

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.1 The Money Multiplier

Inserting (21 ) and (22) into (18) and (19) we have:


M0 = cD + rD + eD = (c + r + e)D

(23)

M1 = cD + D = (1 + c)D

(24)

Solving (23) to D and inserting into (24) we have the money


multiplier
1+c
M0
r +c +e
M1
1+c
=
m
M0
r +c +e
M1 =

(25)

From (23), the deposit multiplier is


D
1
=
M0
c +r +e

(26)

S.177

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.2 Determinants of the Multiplier

Required reserve rate r : fixed by the central bank; negative


correlation with the money supply.

Currency/deposit ratio c: depends on the behavior of


non-banks; negative correlation with the money supply (the
change of the denominator is relatively large compared to the
change of the numerator).

Excess reserves/deposit ratio e: depends on bank behavior ;


negative correlation with the money supply.

What drives c and e?

S.178

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.2 Determinants of the Multiplier

Excess Reserves are an asset with low return, no risk, and high
liquidity. Bank holds excess reserves e.g. to meet deposit
outflows or, generally, to avoid illiquidity.

If the interest rate (for bonds and/or loans) increases, the


opportunity costs of holding excess reserves increas. Hence,
the excess reserves are negatively correlated with i.

Excess reserves can be borrowed to other banks (inter-bank


market). This depends primarly on trust, and also on the
difference between money market rate and central banks
deposit rate.

Normally, excess reserves do not play a major role, the effcts


on the multiplier are small.
Exception: Financial crisis 2008/2009 sharp increase of E !

S.179

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.2 Determinants of the Multiplier

(Source: Mishkin (2006), p.381)

S.180

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.2 Determinants of the Multiplier

(Source: ECB)

S.181

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.2 Determinants of the Multiplier

For the determination of c we have no theory about payment


customs.

Further determinants of M1 = m M0:

The money base M0 changes according to

the central banks activities on the security market


(purtchasing/selling securities S cb )
the demand for central bank loans Lc

The major policy instrument is Lc . Central bank can reduce


deposit rate but cannot force banks to demand Lc . They can
also not completely refuse to provide Lc in case of strong
liquidity needs market interest rate would increase, losing
control over the interest rate.

S.182

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.3 Objections against Static Multiplier Analysis

The static multiplier approach M1 = m M0 suggests that the


central bank is able to determine money supply. However, there are
some objections:

The approach suggests that the multiplier process is initiated by the


central bank, not by the demand for loans (deposits). However,
credit demand initiates the demand for M0 which is then
accomodated by the CB.

It is assumed that additional reserves are transformed into


additional credits. But credit supply and demand behavior is not
founded by microeconomic reasoning. Thus, you cannot push M
by an increase of M0.

The determinants c, e are assumed to be fixed in the multiplier


process. But the behavior of banks and non-banks may change
because the multiplier process takes place since it affects e.g.
interest rates and liquidity positions. Furthermore, if a monetary
impulse has real effects (e.g. Y increases) then this has a feedback
on credit demand.

S.183

3.

The Money Supply Process

3.3 Multiple Deposit Creation and the Multiplier


3.3.3 Objections against Static Multiplier Analysis

S.184

3.
3.4

The Money Supply Process


Endogenous Money Supply

Outline:
3.4.1 Bofingers price theoretic model
3.4.2 The Bernanke/Blinder approach
3.4.3 Outline of an integrated model
Literature:
Bofinger (2001), chapter 3.4
Bernanke, B., Blinder, A.S. (1988), Credit, Money, And Aggregate
Demand. American Economic Review, Papers And Proceedings Vol.78,
435-439.
Palley, T.I. (2002), Endogenous Money: What It Is And Why It Matters.
Metroeconomica Vol. 53, 152-180.

S.185

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Simplified version of the Bofinger model Basic Ideas:


The multiplier approach provides no microeconomic foundation
neither of the banks credit supply nor of the credit demand. This
foundation should be (partially) provided.

The loan interest rate (price) coordinates supply and


demand of credits.

In order to provide credits the bank needs reserves.

The equilibrium interest rate on the credit market determines


the banks demand on the market for (borrowed) reserves.

The central bank can accomodate the reserve demand or it


can change the discount rate for borrowed reserves. Hence the
discount rate affects the credit supply function.

S.186

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Simplified banks balance sheet: rD + L = D + Lc


Simplified central banks balance sheet: Lc = rD
In the simplified version there is no currency, therefore
M1 = D and M0 = R = rD and therefore m = 1/r .
The multiplier relation is then D = mLc .

The loan supply is derived from a profit maximizing calculus:


max = iL ic Lc L2
L

(27)

where the term L2 describes the increasing risk of debt failures.


When required reserves R = rD are subtracted from the balance
sheet and applying D = mLc , we have the multiplier:
L = Lc + (1 r )mLc = mLc

(28)

S.187

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Solving (28) to Lc = 1/m L and inserting into the profit function


the maximizing calculus (27) leads to credit supply function
L = L(i, ic , ) =

1
(i ic /m)
2

(29)

which depends positively on i and negatively on ic and .


On the other market side we have a decreasing credit demand
function LD (i, y ) with LD /i < 0 and LD /y > 0.
The equilibrium L(i , ic , ) = LD (i , y ) determines the
equilibrium interest rate i = i (ic , , y ).

S.188

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Now we turn to the demand for reserves:


Taking the optimal loan supply (29) and substituting L into (28)
we obtain the optimal reserve demand:
Lc (i, ic , ) =

1
(i ic /m)
2m

(30)

which is a linear decreasing function of ic . It is parametrized by the


equilibrium interest rate on the credit market.

S.189

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

The Bofinger model:


i

credit market
L(i, ic , )

interest rate
relation
LD (i, y )
L

ic
demand for
borrowed reserves

L = mLc
(multiplier)
Lc

S.190

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Interpretation:

Upper right: The credit market with upward sloping credit


supply function (29) and a linear cerdit demand function.

Lower right: The multiplier relation translates the desired


level of loans L into the level of required reserves which are
neccessary to create deposits to finance these loans.

Lower left: The demand for borrowed reserves Lc (eq. (30)).

Upper left: The market equilibrium interest rate i is an


implicit function of the discount rate ic . In case of linear
functions also this relationship is linear.

S.191

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Case 1: Central bank increases the discount rate ic


i

L(i, ic2 , )
L(i, ic1 , )

LD (i, y )
ic

ic2

ic1

Lc

S.192

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Case 2: The demand for loans increases, central bank does not adapt ic
i
L(i, ic , )

LD (i, y2 )
LD (i, y1 )
L

ic

Lc

S.193

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

For an extensive analysis (e.g. the case of fluctuating credit


demand) see Bofinger (2001), chapter 3.4 and appendix

The model has implications for the macroeconomic IS-LM analysis:

Demand shocks on the credit market may lead to a reaction


of the central bank. Depending on their primary goals
(stabilizing the interest rate vs. stabilizing the money base)
different types of LM curves occur.

If the central bank does not respond to the demand shock, an


increasing y leads to an increasing credit demand and thus to
a monetary expansion. In the traditional IS-LM analysis this is
not the case Money creation is (partially) demand driven.

S.194

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Increasing income Y1 Y2 leads to a right-shift of money demand


(credit demand) and hence to a shift of the demand for borrowed
reserves.

Case 1 Money volume targeting: Central bank will keep


the money volume on the same level. It has to increase the
discount rate. This leads to a left-shift of the credit supply
curve. The LM curve will be steep.
Case 2 Discount rate targeting: Central bank will keep
the discount rate on the same level. Hence it will provide more
central bank loans and the money volume increases. The LM
curve will be more flat (positively sloped).
Case 3 Loans rate targeting: Central bank will keep the
interest rate on the loans market on the same level. It will
fully accomodate the additional money demand by decreasing
the discount rate. The LM curve will be horizontal.

S.195

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

L(i, ic )
i
L(i, ic )

LM (case 1)

LD (i, Y2 )
LD (i, Y
ic

ic

ic

1)

Y1
L
money volume targeting

Y2

Lc

S.196

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

i
L(i, ic )
LM (case

LD (i, Y2 )

discount rate targeting

LD (i, Y1 )
ic

ic

Y1

Y2

Lc

S.197

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

i
L(i, ic )
L(i, ic )

LM (case 3)

LD (i, Y2 )

interest rate targeting

LD (i, Y1 )
ic

ic ic

Y1

Y2

Lc

S.198

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

LM (case 1)
LM (case 2)

Y1

Y2

S.199

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.1 Bofingers price theoretic model

Dont confuse these LM curves with the LM curve of the


standard Keynesian IS-LM model. The latter assume a fixed
M, determined by the central bank. This is only a very special
case in the Bofinger framework.

For most LM curves in this framework there is no fixed (but


an endogenously determined) money supply.

S.200

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.2 The Bernanke/Blinder approach

Assume that the commercial banks balance sheet is


rD
+ E} +L + B = D
| {z
R

E + L + B = (1 r )D

where B are bonds. The is no currency C and no central bank


loans Lc . The central bank determines the money base R by
purchasing or selling bonds.
The acitivity of the bank is to choose an appropriate portfolio
structure of the asset side.

S.201

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.2 The Bernanke/Blinder approach

The asset side contains two risky assets L and B, and a risk-free
asset E . The structure of the portfolio is given by:
E (i) = E (i)(1 r )D
L(i, ) = L (i, )(1 r )D
B b (i, ) = (1 E (i) L (i, ))(1 r )D
{z
}
|
B (i,)

where i is the interest rate of the bonds, ane is the interest rate
of loans.
The portfolio share L [0, 1] depends positively on , negatively
on i, and vice versa for B , E depends negatively on i.

S.202

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.2 The Bernanke/Blinder approach

The reserves of the commercial bank are


R = rD + E = rD + E (i)(1 r )D = (r + E (i)(1 r ))D (31)
Hence the money multiplier is
1
D
= m(i) =
R
r + E (i)(1 r )
The multiplier depends on the banks portfolio considerations and
is endogenously determined by the bonds interest rate i. Note,
that i is determined on the bonds market and that the central
bank is an agent on the bonds market.

S.203

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.2 The Bernanke/Blinder approach

The equilibrium on the credit market is determined by


Ld (i, , y ) = L = L (, i)(1 r )D
It is assumed that non-banks also hold a portfolio of bonds and
money so that the loan demand is determined by i (+) and (-).
Money supply is given by the multiplier D = m(i)R while the
money demand follows the standard assumptions D d (i, y )
(positive dependency on y and negative dependency on i).

Money market equilibrium is given by (LM curve)


D d (i, y ) = m(i)R

S.204

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.2 The Bernanke/Blinder approach

Comparison:
Bofinger model:

only borrowed reserves = discount rate policy

banks have only loans as an asset, no portfolio approach

Fixed multiplier, but an endogenously determined money base

Bernanke/Blinder model:

only non-borrowed reserves = open market operations on the


security market

banks use a portfolio approch to determine their portfolio which


contains loans, bonds, and excess reserves

Exogenously determined money base, but an endogenously


determined money multiplier

S.205

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.3 Outline of an integrated model

Remind the stylized balance sheet of a bank:


Assets
Reserves (required, excess)

Liabilities
Deposits

Cash

Inter-bank loans

Securities/Bonds

Central bank loans

Loans to non-banks

Other debt instruments

Inter-bank loans

Bank Capital / Net Worth

S.206

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.3 Outline of an integrated model

Bank decides about

structure of the asset side


structure of the liability side
size of the balance sheet

Decisions depend on expected returns, risks, and liquidity of


assets, as well as the interest rates to be paid for deposits,
interbank and central bank loans (costs).

Decisions are made under constraints such like Basel II/III.

S.207

3.

The Money Supply Process

3.4 Endogenous Money Supply


3.4.3 Outline of an integrated model

Deposits are created by new loans.


Hence, the loans supply and demand determines the loans
interest rate and the loan (deposit) volume.
The central bank influences (not: determines) this process by
the conditions for borrowing reserves, amount of
non-borrowed reserves, the required reserve rate: The
elasticity how loan supply depends on these monetary policy
variables, depends also on other endogenous variables.
The central bank has to respond to changes e.g. on the loans
market and to changed reserve demand. Central banks role in
a phase of financial distress.
Increased role of non-bank financial intermediates (shadow
banks) might change the transmission of monetary policy
and even the ability of the central bank to affect the liquidity.

S.208

3.
3.4

The Money Supply Process


Endogenous Money Supply

Some Implications:

Monetary policy has some impact on the money supply but


does not control it. Monetary expansion is primarly
determined by the money demand of the private sector (and
the government).

If money is created according to the money demand, it is


questionable to construct a money market equilibrium
(supply = demand) like the LM curve.

Inflation by monetary expansion is therefore not only a matter


of a wrong central bank policy but a consequence of
massive credit expansion e.g. by governmental debt. Success
of monetary policy depends also e.g. on fiscal discipline.

S.209

4.
4.1

Theory of Money Demand


Keynesian Theory of Liquidity Preference

Outline:
4.1.1 Transaction Motive
4.1.2 Money as an asset
4.1.3 Precautionary Motive
4.1.4 Evidence
Literature:
Mishkin (2006), chapter 22
Bofinger (2001), chapter 2

S.210

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.1 Transaction Motive

Money is used for transaction purposes:


X
Mv =
pi ti
i

with M = money (stock variable), v = velocity, pi , ti as the


prices and the quantities determining transaction i in the
period (flow variable).

Since there is no statistical data about all transactions, we use


the price index P and the real income Y as a proxy:
Mv = PY

M
v =Y
P

Mr v = Y

(32)

The velocity v is a matter e.g. of payment customs. Eq. (32)


is called the quantity theory of money.

S.211

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.1 Transaction Motive

Income velocity of M3 in Euro area:

(Source: Brand, C., Gerdsmeier, D., Roffia, B. (2002), Estimating the Trend of M3 Income Velocity Underlying the
Reference Value for Monetary Growth. ECB Occasional Papers No. 3)

S.212

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.1 Transaction Motive

If money is primarly needed for transactions, the demand for


money is (so called Cambridge form)
Md =

1
PY = kPY
v

or in real terms
Md
LT (Y ) = kY
P

(33)

This is the only motive in classical (pre-Keynes) economics.

While the quantity theory (32) is a pure definition (and hence


always true), the Cambridge form (33) is interpreted as a
behavioral hypothesis.

S.213

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.2 Money as an asset

Keynes assumes that agents could choose to hold either


money or bonds as a financial asset.

Money: No return, no risk


Bonds. Positive return, positive risk

Assume that bonds have no maturity date and are held for
only one period (no discounting).

Agents are assumed to be risk-neutral = they decide only


according to expected return.

S.214

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.2 Money as an asset

Bt
e
Bt1
C

price of the bond in t


expected price in t + 1
regular coupon rate payments

The effective interest rate is defined by


C
C
Bt =
it =
Bt
it
Holding the bond for one period is profitable if
e
= C + Bt+1
Bt > 0
C
C

C+ e >0
it+1
it
1
1

1+ e >0
it+1 it

it >

e
it+1
= ic
e
1 + it+1

S.215

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.2 Money as an asset

For it > i c there are positive returns from holding the bond,
and negative returns in case of it < i c .

e
Depending on individual expectations it+1
the agent will hold
financial wealth either in bonds or in money.

Similar calculations can be made for the case that money (e.g.
deposits) have a positive interest rate.

e
Different individuals have different expectations it+1
and
c
hence different i . If market interest rate falls, more and more
individual critical interest rates are undercut, and more and
more individuals sell bonds and hold money instead.

S.216

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.2 Money as an asset

individual demand

aggregated demand

ic

LS

LS

S.217

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.2 Money as an asset

The money demand from the asset motive


(or as Keynes said: speculation) is:
Ls = Ls (i),

dLS
<0
di

Note:

The money asset LS is limited by the financial wealth: LS in


case of money is the unique asset type for all individuals.

If you consider other alternatives than bonds (e.g. time


deposits), there is a dependency on multiple interest rates.

Instead of interest rate it may be plausible to use real interest


rates since LT , LS are real values.

S.218

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.2 Money as an asset

Bringing both motives together, we have the money demand


L = L(Y , i),

with

L
L
> 0,
<0
Y
i

Defining the velocity by


v=

Y
Y
=
r
M
L(Y , i)

Keynes liquidity preference theory can be interpreted as the


Cambridge approach with an endogenous velocity:
L=

1
Y = k(Y , i)Y
v (Y , i)

S.219

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.3 Precautionary Motive

Money is hold to make unexpected transactions = to avoid


illiquidity in case of neccessary unexpected transactions.

Money holder faces opportunity costs i.

Also from this motive we have a dependency from


Y (+) and i (-):
LP = LP (Y , i)

Original Keynesian idea: liquidity preference (hording) as a


response to fundamental uncertainty because liquidity can be
transformed in everything if the economy evolves in an
unperceived way, and if people lack knowledge to form reliable
expecattions about that.

S.220

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.4 Evidence

Empirical Evidence:
Since the money demand reflects plans which are not
observable, it is assumed (!) that the money market is always
sufficiently close to the equilibrium, i.e. that real money
circulation is a good proxy for the money demand.
For M r = L(Y , i) we assume a log-linear form like
ln Mtr = 0 + 1 ln Yt + 2 it + t

where 0 , 1 , 2 are coefficients to be estimated, and t is a


serially uncorrelated stochastic variable.
Derivation with respect to time t shows that
dM r Y
d ln M r /dt

1 =
d ln Y /dt
dY M r
is the income elasticity of money demand, while 2 is the
semi-interest rate elasticity of money demand.

S.221

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.4 Evidence

Questions:

Which monetary aggregat? (M1, M2, M3)

Which income? usually real GDP

Which interest rate? usually bond interest rates;


short term, long term interest rates?

Regression analysis; cointegration

S.222

4.

Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference


4.1.4 Evidence

Some results (details in Bofinger (2001)):

Positive income elasticity (some studies: near 1)

Negative interest rate elasticity (but mostly small)

In Europe more or less stable parameters, in USA not stable


(eventually due to financial innovations)

Large monetary aggregates do not depend on short term


interest rates.

S.223

4.
4.2

Theory of Money Demand


Portfolio Theory of Money Demand

Outline:
4.2.1 Money and Bonds in a Portfolio Equilibrium
4.2.2 Effect of Interest Rate Changes
Literature:
Bofinger, Peter (2001), Monetary Policy: Goals, Institutions, Strategies,
and Instruments. Oxford: Oxford University Press.
Thompson, N. (1993), Portfolio Theory and the Demand for Money.
Hampshire.

S.224

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.1 Money and Bonds in a Portfolio Equilibrium

Keynes Speculation Motive:

Risk Neutrality

e
only it+1
(expected mean) is relevant

(0, 1)-decision between money and bonds

Mixture of money and bonds in a population with


heterogenous expectations.

Portfolio Approach:

Risk Aversion

e
the distribution of it+1
is relevant

each individual mixes money and bonds

S.225

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.1 Money and Bonds in a Portfolio Equilibrium

Let i be the expected return from holding a bond, and B2 is


the variance of these returns.
The Financial Wealth of an individual is composed of money
and bonds: FW = M + B. Let l = M/FW be the fraction of
money in the portfolio, while 1 l = B/FW is the fraction of
bonds.
Expected return and standard deviation of a portfolio unit is
then
(l) = l 0 + (1 l) i

(34)

(l) = (1 l)B

(35)

Solving (35) to 1 l and inserting into (34) gives the linear


restriction

=i
(36)
B

S.226

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.1 Money and Bonds in a Portfolio Equilibrium

We have a utility function u(, ) with the standard


properties for a risk-averse agent. The indifference curve in
the (, )-space are increasing and convex (see figure).

Maximizing utility with respect to l conditional to the linear


constraint (36) gives the tangential solution
u/
i
=
u/
B
(see figure)

Thus, for a given (i, B ) the optimal portfolio structure is


determined.

S.227

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.1 Money and Bonds in a Portfolio Equilibrium

=i

(1 l)
l
1

(1 l) =

S.228

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.2 Effect of Interest Rate Changes

What happens if the interest rate increases from i0 to i1 ?

= i1

= i0

income effect
substitution effect

(1 l)
l0 l1
1

(1 l) =

S.229

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.2 Effect of Interest Rate Changes

The result depends on the income and the substitution effect!


dl
Typical result: di
< 0 dM
di < 0
i

S.230

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.2 Effect of Interest Rate Changes

Substitution effect:

An increasing it makes bonds more attractive relative to money:


Portfolio will be restructured in favor of bonds. This effect is
unambigous (l decreases, see figure).

Income effect:

An increasing it shifts the expected profits with given standard


deviations upwards, or shifts the risks downwards with given profits.
According to the preferences, this leads to an adaption of the
portfolio where the direction is ambigous: l might decrease or
increase. If it increases, it might outweight the substitution effect or
not.

In the figure we assumed that the income effect increases l but does
not outweight the substitution effect.

S.231

4.

Theory of Money Demand

4.2 Portfolio Theory of Money Demand


4.2.2 Effect of Interest Rate Changes

The total effect is henceforth:


M(i) = l(i)FW ,

dl
dM
= FW
di
di

Note, that money demand depends on Financial Wealth!

Adding a transaction motive gives:


M(Y , i) = l(Y , i)FW

l
>0
Y

S.232

5.
5.1

Central Banking and Transmission of Policy


Goals of Monetary Policy

Outline:
5.1.1 Social Welfare and Inflation
5.1.2 Social Costs of Inflation
5.1.3 Operationalization of the Inflation Goal
Literature:
Mishkin (2006), chapter 18, 26
Bofinger (2001), chapter 5

S.233

5.
5.1

Central Banking and Transmission of Policy


Goals of Monetary Policy

Goals versus Targets:

Ultimate goals like social welfare or low inflation could


not directly affected by monetary policy tools.

It is assumed (based on macroeconomic theory on


transmission channels) that intermediate targets have an
influence on the goals Example: Monetary aggregates M1,
M2, M3, loans volume, interest rates, inflation expectations.

Also the intermediate targets could not be accomplished


directly. It is assumed that they depend on operating targets
or instrument targets. These targets are close to the policy
tools. Example: reserves, monetary base M0, interest rate for
borrowed reserves.

Policy tools operating targets intermediate targets goals

S.234

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.1 Social Welfare and Inflation

Ultimate goal social welfare

E.g. high employment, economic growth, price stability

Conflicts among the goals, e.g. price stability and low


unemployment (short run Phillips curve)

In many models maximizing welfare means minimizing a loss


function (= maximizing loss), e.g. like
P
target )2 u 2 ,
L = (P

>0

with u as the unemployment rate, or


P
target )2 (Y Y pot )2
L = (P
with Y pot as the potential output.

S.235

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.1 Social Welfare and Inflation

Reasons why most central banks are primarly focussed


on the inflation goal (price stability):

Rational Expectations and Commitment problems

Policy Assignment

Long-term orientation of the policy

S.236

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.1 Social Welfare and Inflation

Rational Expectations and Commitment problems:


Barro, R.J., Gordon, D.B. (1983), Rules, Discretion, and Reputation in a

Model of Monetary Policy. Journal of Monetary Economics 12, 101-122.

Assume a central bank which announces the goal of zero inflation.


It is always possible that the central bank is able to realize the goal.

If the public is believing this zero inflation goal, they incorporate


these expectations in their dispositions, e.g. wage contracts.

By doing so it is no longer optimal for the central bank to achieve


zero inflation. Their policy is hence time-inconsistent. It will exploit
the low inflation expectations by choosing a positive inflation rate
and positive real effects on output and employment.

Rational agents will anticipate this time-inconsistency and not


believe the zero inflation goal.

The only time-consistent optimal inflation rate is positive.

Rule-binding to zero inflation better than discretion.

S.237

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.1 Social Welfare and Inflation

Policy Assignment:

Tinbergen rule (Jan Tinbergen, 1903-1994): In a framework


of conflicting goals you need as many (linearly independend)
instruments as you have goals. These instruments are
assigned to the goals.

Monetary Policy assigned to the inflation goal, since money


is assumed to be neutral in the long run.

Fiscal Policy assigned to the output goal.

(However, requirements of the Tinbergen model are rarely met.)

S.238

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.1 Social Welfare and Inflation

Long-term orientation:

Many macroeconomists agree (with except for e.g.


Post-Keynesian macroeconomists) that in the long run
inflation is a monetary phenomenon, and monetary policy is
not able to affect real decisions. Real economic processes
depend in the long run only on relative prices rather than on
the price level.

Achieving a low inflation level is assumed to be good for


allocation efficiency and growth.

S.239

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.1 Social Welfare and Inflation

From the ECBs statute (chapter II, article 2):


To maintain price stability is the primary objective of
the Eurosystem and of the single monetary policy for
which it is responsible. This is laid down in the Treaty
establishing the European Community, Article 105 (1).
Without prejudice to the objective of price stability,
the Eurosystem will also support the general economic
policies in the Community with a view to contributing to
the achievement of the objectives of the Community.
These include a high level of employment and
sustainable and non-inflationary growth.

S.240

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.2 Social Costs of Inflation

Transaction costs for price changes (menu costs)

Confusion about absolute and relative price changes distorts


the allocation (loss of efficiency), i.e. there is no perfect
anticipation which part of a single price change is due to
inflation.
Biases in fixed-payment-contracts: disadvantage for the
receiver, since the real value of the payment is reduced.

fixed wages
retirement pensions
debt contracts (!)

Bias in the distribution of financial wealth, and


Distortion of intertemporal allocation
Solution: Indexed contracts (in most cases not allowed since this
would accelerate inflation)

S.241

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.2 Social Costs of Inflation

Inflation and taxation

Cold Progression (nominal increase in income leads to


increasing tax rates)

Inflation tax: Inflation reduces real net interest rates

Fisher equation: i = r + p
(nominal interest rate = real interest rate + inflation rate)
After taxation with tax rate t:

rN = (r + p)(1 t) p
rN > 0

r>

t p
1t

Inflation reduces the incentive to invest.


0

S.242

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.2 Social Costs of Inflation

Money loses its function as a store of value: Inflation raises


the opportunity costs of holding money.

Sub-optimal level of holding money. Other assets serve as a


substitue for storing purchasing power, e.g.
foreign currency ( depreciation of domestic currency),
real estate or gold ( with accompanying price effects)
This distorts the portfolio structure.
Some negative aspects occur only in case of unanticipated
inflation. However, the higher the inflation rate, the higher is the
volatility.

S.243

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.2 Social Costs of Inflation

Positive effects of inflation?

Some negative effects are alleviated when the inflation rate is


stabilized because the effects of inflation could be anticipated
and taken into consideration (e.g. in contracts).

Since nominal wages have downward rigidity, inflation helps


to make real wages to become more flexible.

Allowing for small positive inflation rates means that


monetary policy can be used for short-run real effects.

S.244

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.3 Operationalization of the Inflation Goal

Price index:

Two common concepts:


Laspeyres-Index PL and Paasche-Index PP
Pn
Pn
t t
pit qi0
i=1 pi qi
i=1
P
,
P
=
P L = Pn
P
n
0 0
0 t
i=1 pi qi
i=1 pi qi

where pij is the price of good i in period j (with j = 0 as the


base period) and qij as the quantity share in the basket.

The shares qij may be adjusted according to the consumer


behavior of typical houshold.
Different price indices e.g. for consumer prices. In Europe:
HCPI (Harmonized Consumer Price Index) according to the
Laspeyers concept, and the GDP-deflator according to the
Paasche concept.

S.245

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.3 Operationalization of the Inflation Goal

Inflation target of the ECB:


... narrow below 2% of an increase of the HCPI.
Why not zero inflation?

The HCPI (as all Laspeyres indices) overestimates inflation.

Allowing for small positive inflation rates allows for using


monetary policy in the short run for other goals.
could not exactly be achieved (stochastic effects)
Since P
and deflation causes more welfare losses than inflation a small
positive rate minimizes the expected losses.

S.246

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.3 Operationalization of the Inflation Goal

expected loss

loss

p
p

S.247

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.3 Operationalization of the Inflation Goal

Biases in the inflation index:

Quality bias (example: computer)

New goods bias (example: consumer electronics)

Relative price changes lead to substitution effects which are


not incorporated in the fixed qi0 .

There is not a single price for a good but a price dispersion;


while pij reflects an average price, consumer tend to choose
low price offers.

S.248

5.

Central Banking and Transmission of Policy

5.1 Goals of Monetary Policy


5.1.3 Operationalization of the Inflation Goal

Excursus: On the economically correct measure of inflation


Alchian, A.A., Klein, B., (1973), On a correct measure of inflation.

Journal of Money, Credit and Banking 5(1), 173-191.

All known indices are based on a standardized basket of goods (e.g.


HCPI index for a representative household) or the basket of goods
which have been produced in a period (GDP deflator).

The logic of saving/investing is that you can produce consumption


goods in the future. The expectation of future prices are hence the
basis for saving/investment decisions.

The net present value of accumulated savings (capital stock) = the


price of the asset stock reflects the value of future consumption.

To measure not only the loss of real wealth of present


(consumption) goods but also of future goods a price index should
primarly be based on asset prices.

These issues are actually discussed in monetary policy.

S.249

5.
5.2

Central Banking and Transmission of Policy


Transmission Mechanisms (Channels)

Outline:
5.2.1 Basic Problems: Limited Knowledge, Lags
5.2.2 Quantity Theory as a Black-Box Approach
5.2.3 Interest Rate Channels
5.2.4 Credit Channels
5.2.5 Expectation Channels
Literature:
Mishkin (2006), chapter 26
Bofinger (2001), chapter 4

S.250

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.1 Basic Problems: Limited Knowledge, Lags

There exist different causal relationships between policy


instruments, intermediate targets and final goals.

Some of them are complementary, some may have


countervailing effects.

The magnitude of effects depend on the value of exogenous


and endogenous variables.

The effects occur with time lags (timing of monetary policy,


role of forecasts).

The causal relationships are controversially discussed in theory


(e.g. Are prices sticky? Do reserves determine lending or does
lending determine reserves? Are investments limited by credit
rationing?).

S.251

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.1 Basic Problems: Limited Knowledge, Lags

Monetary Policy Art or Science? (O. Blanchard 2006)


Der Transmissionsprozess der Geldpolitik ist trotz intensiver
theoretischer und empirischer Forschung weiterhin nur l
uckenhaft
bekannt. (O. Issing 1995)
Transmission channels might change because of:

new financial products and intermediaries

increasing gloval integration of financial markets

changed behavior of banks due to regulation

specific economic situations (e.g. ZLB)

S.252

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.1 Basic Problems: Limited Knowledge, Lags

(Mishkin (2006), p.619)

S.253

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.1 Basic Problems: Limited Knowledge, Lags

S.254

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.2 Quantity Theory as a Black-Box Approach

Quantity Theory:

M v =P Y
+ v = P
+ Y

M
+ Y
m
+ M0 + v = P

Forecasting: m,
v , Y
(e.g. close to zero)
Goal: P
Target: M0

Idea: M used for transactions in goods market Y D P


Price level changes determined by excess demand Y D Y .
It is not clear how the money affects the aggregated demand
(black box).

S.255

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

In the standard IS-LM framework it is


assumed that the central bank determines
(via fixed multipliers) the money volume.
This induces a shift of the LM curve. An
(e.g.) excess supply of money leads to an
excess demand of bonds. Hence the bonds
price increases and the interest rate falls:
policy M i I (i) Y D .

LM
LM

IS
Y

However, (a) CB does not determine M (endogeneity of M), (b) most


CB consider i as the operating or intermediate target rather than M,
thus i could be seen as a policy instrument.

S.256

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

The central banks discount rate c affects the market for


borrowed reserves (Lc ).

This affects the banks loans supply, and other dispositions


about the banks balance sheet structure and size.

Effects on bonds interest rates i, stock prices, and loan


interest rate . Portfolios are hence restructured.

In case of outright purchases of securities, there is an


immediate effect on the bonds price interest rate i.

Interest rate channels consider the effects of changing interest


rates on the aggregated demand.

S.257

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

a) The standard interest rate effects

Demand for investment goods:

investors calculate whether to invest into a physical investment


project I or into bonds. Aggregated investment demand
depends on real interest rate:
i I (i pe , ) Y d ...
investors have to finance the physical investment projects by
bank loans:
I (, ) Y d ...

Demand for (durable) consumption goods, financed by loans:


C (, ) Y d ...

S.258

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

b) The Tobin-q-effect

Firms hold a portfolio with different assets, especially physical


assets. They finance these assets by debt and equity.

The market value of a firm (MVF ) reflects the discounted


flow of expected returns from the asset side.

If there is a new enterprise = a new need for production


capacities, then it has to calculated whether
(i) it is more profitable to buy an existing firm (price = MVF )
or
(ii) to buy/produce new capital goods (price = costs for
financing capital goods, CC )

S.259

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

Let R be the return from the new enterprise. Then the


effective return depends on the cases (i) and (ii):
R
r(i) =
MVF
R
r(ii) =
CC
The demand for new investment goods requires r(ii) > r(i) or
(in Tobins concept)
r(ii)
MVF
>1
(37)
=
q=
r(i)
CC

CB policy affects financing costs for capital as well as the


stock prices = market value of firm. An expansive policy leads
to lower interest rates and higher stock prices due to portfolio
rearrangements increase of Tobins q stimulates
investments aggregated demand.

S.260

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

c) Exchange rate channel

If the domestic interest rate increases the domestic currency


becomes more attractive than foreign currencies. A change in
the interest rate differential leads to a change in the exchange
rate e:

i increases domestic currency is appecreiated (c.p.)


i decreases domestic currency is depreciated (c.p.)

The exchange rate affects exports and imports and hence the
trade balance NX = Ex Im which is a part of the
aggregated income.
i e NX (e) Y d

S.261

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

d) Wealth effects

Monetary policy may have an effect on bonds and stock


prices. An increase in bonds/stock prices leads to an
increasing nominal level of financial wealth FW .

According to the Pigou effect a higher financial wealth FW


stimulates the consumption demand (shift in the
intertemporal consumption/saving decision in favor of
consumption because FW is kept on an optimal level).

stock/bonds prices FW C (FW , ) Y d

S.262

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.3 Interest Rate Channels

Remarks:

The strength of the interest rate channels depend on the sensitivity...


(a) ...how portfolio depend on changes in relative prices. Also
liquidity and other considerations may be important for the
portfolio structure.
(b) ...how sensitive demand depends on interest rates and wealth
effects. In a recession the investment behavior is more
determined by pessimistic expectations rather than interest
rates.

Change/Reduction of the discount rate...


(a) ...only has an effect when it is not significantly larger than the
money market interest rate. The behavior of agents on the
money market then determines the effectiveness of policy.
(b) ... is only possible if it is larger than zero negative lending
rates?

S.263

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.4 Credit Channels

Basic idea:

In contrast to interest rate channels which depend on changes


in relative prices and portfolio rearrangements, the credit
channels are related to the volume of lending acrtivity.

Therefore the commercial bank sector (financial


intermediates) plays a central role.

S.264

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.4 Credit Channels

a) Bank lending channel

The idea is that an expansion of reserves stimulates the


multiplier process: deposits and loans supply increases.
Consumption and investments which have to be financed by
loans should then be stimulated because it is easier to get
loans (no quantitative restriction)
reserves deposits availability of loans I , C Y d

Even if this process may be accompanyied by a change of the


loans interest rate the focus is on the quantitative effect.

S.265

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.4 Credit Channels

Problem:

The demand for loans depends on


the loans interest rate, the income,
and eventually on the bonds
interest rate (Ld (, i, y )). It is not
reasonable to argue why a credit
expansion should take place, since
an increase in reserves does not
directly affect the loans demand.
If the bonds interest rate i
decreases, this may induce a
contractive effect on the loans
demand (bonds and loans as
substitutes). As a result the effect
on loans is unclear (see figure).

L(1c )
L(2c )

c i

Ld (i2 )

Ld (i1 )
L

S.266

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.4 Credit Channels

Another justification:

Assume that there are


rationing effects due to
adverse selection. Some firms
do not receive loans and there
is no tendency to adapt interest
rates to the market equilibrium.
An expansion of reserves shifts
loans supply function so that
without changes in the interest
rate the loans volume
increases by alleviating the
rationing effect.

L(1c )
LL(2c )

rationing
Ld
L

S.267

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.4 Credit Channels

b) Balance Sheet Channels

The channel is based on the adverse selection and moral


hazard effects. These effects lead to credit rationing. The
rationing effect can be alleviated e.g. by collaterals, net worth,
and own capital.

Since monetary policy has an effect on stock prices, this also


affects the value of collaterals and net worth. Furthermore the
ratio between the value of debt and the value of equity + net
worth changes.

This leads to a lower rationing effects and hence credit


expansion.

stock/bonds prices adverse selection/moral hazard


lending I Y d

S.268

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.4 Credit Channels

c) Cash Flow Channels

Monetary policy affects the interest rates to be paid in debt


contracts. Lower debt payments = higher cash flow, more
liquidity. This works similar as in the balance sheet channel:
The soundness of the firm increases and the rationing effect is
alleviated.

d) Liquidity effect

Increasing nominal financial wealth by increasing stock prices


reduces the likelihood of financial distress. The soundness of
the household/firm is improved. Hence it is easier to receive a
loans contract.

S.269

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.4 Credit Channels

Remarks:

Several channels depend on the effect on stock prices as well


on the bonds interest rate (and hence the bonds prices).

Expansive monetary policy leads to higher asset prices which


serve as a channel for the effects of monetary policy on the
real sphere (see ECB transmission scheme).

But higher nominal asset prices are asset price inflation!


Inflation is measured usually in terms of the price for
(consumption) goods and services. Asset price inflation may
also be a source of a loss of efficiency and welfare.

If asset prices properly reflect the discounted net revenues, an


increase in asset prices due to monetary policy implies higher
expected future prices (= inflation in the future).

S.270

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.5 Expectation Channels

Prices and wages are more or less rigid in the short run:

Transaction/menu costs of price changes


Negotiation costs (wage contracts) long-term contracts
Uncertainty whether costs and/or demand has changed
systematically or due to stochastic fluctuation

If monetary policy affects demand, it has effects on quantities


but almost no price effects in the short run.

Downward sloped short run Phillips curve (see section 6)!

S.271

5.

Central Banking and Transmission of Policy

5.2 Transmission Mechanisms (Channels)


5.2.5 Expectation Channels

What happens when these future price changes are expected


(expected inflation)?

Forming expectations: static, extrapolative, adaptive, rational


expectations.

Economic agents will incorporate their inflation expectations


into their contracts.

The expectation augmented Phillips curve shifts. The real


effects of monetary policy decrease (to zero).

Hence, monetary policy aims to keep inflation expectations on


a low level!

The central bank policy has to be credible! All changes in


policy variables may induce changing inflation expectations.

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5.
5.2

Central Banking and Transmission of Policy


Transmission Mechanisms (Channels)

Some empirical findings:


Recent findings on monetary policy transmission in the euro
area, ECB Monthly Bulletin, October 2002, pp.43-53

Monetary policy works; no real effects in the long run.

Difficult to decompose the transmission effects.

Significant interest rate effects on investments, also cash flow


and liquidity effects play a (minor) role; less evidence for bank
lending channels.

After financial crisis and European debt crisis (Euro crisis)


it is highly questionable whether transmission channels work
in th same way!

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5.
5.3

Central Banking and Transmission of Policy


Targets, Strategies, and Rules

Outline:
5.3.1 Which targets to choose?
5.3.2 Targeting the money volume
5.3.3 Targeting the exchange rate
5.3.4 Inflation Targeting
5.3.5 The Taylor Rule
Literature:
Mishkin (2006), chapter 18, 21
Bofinger (2001), chapter 8

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.1 Which targets to choose?

Since the final goals could not be achieved directly by


monetary policy there is a need for intermediate and
operational targets.

These targets should have the following properties:

Measurability
Controllability
Predictive effects on the goals (this depends on the adopted
transmission theory)
Not too long delays of the effects

Targets may also be referred to as indicators

Monetary policy should be reliable and transparent. The


strategy is not to design an optimal monetary policy based
on very complicated transmission models, but to find good
performing simple rules.

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.1 Which targets to choose?

Operating targets:

Intermediate targets:

money market rate


interest ratess (loans, bonds) and their structure
money volume (M1, M2, M3)
exchange rate
output gap

Final target:

Price level target or inflation rate target?

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5.3 Targets, Strategies, and Rules


5.3.1 Which targets to choose?

Intermediate targets may be conflicting!


Remind the price-theoretic model by Bofinger:

Targeting the loans interest rate


then the loans volume = money volume changes.

Targeting the loans volume


then the loans interest rate changes.

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.1 Which targets to choose?

Price level target or inflation rate target?

Price level target: pt (example: pt = p )

Inflation rate target: p (example: p = 0)

Both targets are equivalent in case of perfect controllability!

Differences occur in case of imperfect control (control errors)

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5.3 Targets, Strategies, and Rules


5.3.1 Which targets to choose?

Evolution of the price level with a fixed inflation rate p in


continous time:

pt = e p t p0

ln pt = ln p0 + p t

In one time step with realized inflation rate pt = p + t :


ln pt+1 = ln pt + pt

ln pt+1 = ln pt + p + t

and the control error t has the property E [t ] = 0, Var [t ] > 0


and it is serially uncorrelated. How to respond to these errors?

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.1 Which targets to choose?

Inflation rate goal p = 0: Price level follows a Random


Walk, since the control error is neutral there is no need to
adapt policy measures:
ln pt+1 = ln pt + t

Price level goal p : Random deviations from the price level


lead to adaptions of the policy measures:
ln pt+1 = ln pt + (ln p ln pt ) + t ,

(0, 1)

Result of control errors:

Price level is more volatile in case of inflation goal

Inflation rate is more volatile in case of a price level goal

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

The monetary policy of the Deutsche Bundesbank (before


the monetary union) was primarly based on money volume
targets.
Possible in a regime of flexible exchange rates (after Bretton
Woods)
Stable demand for money L(y , i), that means stable
functional form and parameters. This has empirically proven
to be the case for M3.
Stable relation between interest rate i and the target M: Since
changes in interest rates lead to a restructuring of assets (e.g.
overnight deposits, time deposits etc.), M1 and M2 seem to
be too volatile. The Deutsche Bundebank had chosen M0
(1974-1988), and later M3 (from 1988-2001).
and goal P
in the long run.
Stable relation between target M

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5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

In accordance to quantity theory we have the


potential formula
+ v trend = P
goal + Y pot
M3
where Y pot is the (estimated) production potential. The
monetary policy has been oriented on the long run growth
path.

The current velocity v depends on the busniness cycle


(increasing in boom, decreasing in recession). An orientation
on the trend of v means that the policy does not respond to
business cycles.
as the unavoidable inflation rate is 1-2 %.
The goal P

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

is formulated
The targets for M3

for a certain period: e.g. 1 year


= 6% should be
as an average goal (the target e.g. M3
achieved at the end of 1 year, fluctautions within this year
dont matter) or as a permanent goal (the target is controlled
within the period, e.g. every month higher transparency of
the policy)
= 6%) or as a target corridor
as a dot target (exactly M3
= 6% x%). A dot target will be violated with a
(M3
probability of nearly 100%. A broad corridor target will
rarely be violated but is not a meaningful target anymore.

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

Money volume targets have rarely been achieved. Nevertheless, the


Bundesbank policy was successful regarding the final goal.

(Gischer/Herz/Menkhoff (2005), p.308)

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

The relation between the development of M and the development


of the price level P is

very close

in case of very high inflation


in the (very) long run

not very close

in case of low inflation

As remarked above there is also a relation to asset prices (money


used for transactions on asset markets rather than goods markets).

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

The long run relationship between inflation and monetary


expansion is an argument for the neutrality of money.

all 110 countries


Subsamples:
21 OECD countries
14 latin american countries

Correlation with
M0
M1
M2
0.925 0.958 0.950
0.894
0.973

0.940
0.992

0.958
0.993

(Source: McCandless/Weber (1995), Some Monetary Facts, in: Federal Reserve


Bank of Minneapolis Quarterly Review, Vol.19, M.3, pp.2-11)

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

In the short run and/or in countries with low inflation rates the
correlation is not very strong:

(Spahn (2006), p.116)

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.2 Targeting the money volume

(Mishkin (2006), p.10)

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.3 Targeting the exchange rate

This approach may be reasonable for small open economies


with high inflation rates.
Targeting the exchange rate (to a country with low inflation
rate) means to import stability.
The idea is that there exists a relation between the exchange
rate and the price level (PT = price level of tradable goods,
indicates the foreign country):
PT = ePT
P = PT + (1 )PN

(38)
(39)

Hence, the exchange rate e changes with the difference of


inflation rates:
T P

e = P
T

If is large then targeting e 0 leads to similar inflation rate


than in the foreign country.

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.3 Targeting the exchange rate

Another mechanism is based on the interest rate parity : If the


owner of a financial fund has to decide whether to invest in
domesitic or foreign opportunities the no-arbitrage-condition
reads like
i i = eexpected

Monetary policy has to take the depreciation expectations into


consideration. Targeting the exchange rate and thus lowering
eexpected makes domestic capital markets more attractive and
the interest rate is accomodated to i .

Problem: Speculative attacks against the central bank if the


targeted exchange rate is expected to be not fundamentally
justified.

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.4 Inflation Targeting

The idea is that due to the complexity of the transmission


process and the limited knowledge about it the operational
target or the policy instrument should directly respond to
expected deviations of the inflation rate and the targeted
inflation rate:
e P
target ),
i = (P

>0

The central bank is committed to an inflation target. Since


could be estimated from central banks behavior, this policy
rule provides a high transparency.

Problem:

no theoretical considrations about the transmission process


low flexibility

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.4 Inflation Targeting

Inflation targeting has been a successful policy strategy e.g. in New


Zealand, United Kingdom, Sweden, Canada.

(Mishkin (2006), p.503)

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.4 Inflation Targeting

(Mishkin (2006), p.503)

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.5 The Taylor Rule

Taylor, J.B. (1993), Discretion versus Policy Rules in Practice.


Carnegie Rochester Conference Series on Public Policy 9(4),
195-314

The operating target (real money market interest rate i P)


should respond to the equilibrium real interest rate r0 , the
deviation of current and targeted inflation rate, as well as to
the output gap Y Y p .
t + (P
t P
target ) + (Yt Ytp )
ittarget = r0 + P

In case of accelerating inflation the central bank increases the


target rate (by 1 + ). In case of a boom where the output
gap becomes positive the target rate is also increased (by ).

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.5 The Taylor Rule

Taylor (and several others) has shown that the rule is a good
empirical description for the behavior of most central banks. For
target = 2,
the USA Taylor showed that the rule with r = 2, P
= 0.5, = 0.5 is a good predictor for the Fed policy.

(Mishkin (2006), p.430)

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.5 The Taylor Rule

The results for Germany:

(Gischer/Herz/Menkhoff (2005), p.317)

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.5 The Taylor Rule

Operationalizing the Taylor rule:

Inflation is measured e.g. by the HCPI.


Income is measured e.g. by the nominal GDP while the
production potential has to be estimated (e.g. econometric
estimation of a production function).
Targets for the inflation rate and the equilibrium real
interest rate may be theoretically justified.
Different lag structures may be chosen.
An additional goal may be to smooth interest rates. Hence
the Taylor interest rate should not fluctuate too much.
Possible smoothing rule:
itsmooth = ittarget + (1 )it1

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.5 The Taylor Rule

The main advantages:

Very simple and transparent rule.

Combines inflation targeting with anticyclical policy. It


compromises rule-binding with a certain degree of flexibility.

Different macroeconomic views of the transmission process are


compatible with the rule (i.e. it does not depend critically on
a specific macroeconomic paradigm).

Empirically robust description of central bank behavior.

Main problem: How to determine r0 ?

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Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.5 The Taylor Rule

Variants of the Taylor rule:

One problem is that in the original version the central bank


responds to realized (=past) changes in the variables.

Due to lags there is the danger of procyclical results.

It is reasonable that the central bank responds to expected


values instead:
pot,e
e
e
e
t+1
t+1
target ) + (Yt+1
i target = r + P
+ (P
P
Yt+1
)

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5.

Central Banking and Transmission of Policy

5.3 Targets, Strategies, and Rules


5.3.5 The Taylor Rule

Remark:

With given values for Y pot and r the Taylor rule provides a
stable relation between i, Y , and P. Hence the Taylor rule is a
proper replacement of the LM curve in the (i, Y )-diagram.

Course Monetary Macroeconomics.

S.300