Set 6 - Monetary Policy and The Financial System

Introduction Financial System Money Eurosystem Price Stability Transmission Mechanism Monetary Policy
Economics 2: Macroeconomics
Set 6: Monetary Policy and the Financial System
Nordhaus and Samuelson, Economics 19e,
Chapter 23 & 24
Dr. Christoph Bierbrauer

Professorship for Economics
Cologne Business School
Winter Term 2016/2017
1/ 90 Economics 2: Macroeconomics
created by: Christoph Bierbrauer
Financial System
The financial system enables the transfer and efficient

allocation of money between savers (investors) and
borrowers. By channeling money to the most profitable
investment projects, the financial system enables and
contributes to economic growth
Moreover, by enabling money transfers between buyers

and sellers, the financial system facilitates trade and
transactions in markets for goods and services
Central Banking
We survey strategies and instruments that enable monetary

policy to affect the real economy
The overwhelming objective of monetary policy in Europe

is to maintain stable and low inflation rates. Other
possible objectives of monetary policy include stabilizing
output, creating employment and/or targeting a particular
exchange rate
Monetary transmission mechanism; interaction between

the central bank and the rest of the economy to determine
interest rates, financial conditions, aggregate demand,
output and inflation
Financial System
Supply and demand in the markets for goods and services as
well as savers and borrowers all are linked together through
the financial system which enables
• individuals to transform specific labor inputs into
consumption and investment goods
• the exchange of goods
• borrowing and lending
The major part of the financial system is composed of for-profit

entities such as banks and insurance companies. However,
public institutions like the Eurosystem, national central banks
and regulatory bodies such as Bafin are crucial for ensuring an
efficient and stable financial system
Financial System: Markets
The financial system encompasses institutions that carry

out financial decisions of households, businesses and
governments
These participate in various financial markets, e.g.:

• Money market
• Markets for interest-bearing assets such as bonds
• Stock markets
• Foreign exchange markets
Financial Markets, cont.
Transactions take place in financial markets. These

function like any other market, except for the fact that
financial assets such as stocks, bonds or currencies are the
traded goods - these assets are mainly of intangible
character
Financial intermediaries represent institutions that

provide financial services. Commercial banks are the most
prominent example. However, insurance companies,
investment funds and hedge funds are other examples of
financial intermediaries
Functions of the Financial System: Flow of Funds
Source: ECB
Money and finance enable households and firms to borrow from and lend to
each other if their cash income does not match their desired spending
Financial assets
Financial assets are monetary claims by one party against

another party, e.g. bank deposits, public or private bonds
and stocks. In general, financial assets are claims that derive
their value from ownership of other tangible and/or
intangible assets
• Nominal assets; the payment is fixed in euro terms

(bonds)
• Equities; claims on residual flows (e.g. common shares)
Fiancial Assets: Asset to GDP Ratio 2000
Source: db research
Source: db research

Source: db research

Source: db research

Major Functions of the Financial System
Transfer of resources across time, sectors and regions: Allows

and facilitates investment being devoted to its most productive
uses
Management of risks: E.g. insurance companies spread risks by

pooling differnt risks together
Pooling and subdivision of funds: Small amounts of money

provided by individual savers and investors are pooled in order to
provide funds for large and/or risky investment projects
Clearinghouse function: Facilitation of transactions between

payers (buyers) and payees (sellers), e.g. bank transfers, payment
by check or credit cards

Financial Instruments or Assets
Saving accounts: Deposits at banks or credit institutions,

guaranteed by deposit protection schemes (no government
guarantee), that have a fixed-Euro principal value and
interest rates which are determined by short-term market
interest rates
Credit market instruments: Euro-denominated obligations

of government or private entities. German government debt
serves as the risk-free Benchmark for the Euro Area.
Other credit market instruments with varying degrees of
risk, are mortgages or corporate securities

Financial Instruments or Assets, cont.
Common stocks: Equity, ownership rights to companies in

particular their residual flows
Money market funds and mutual funds: Funds that hold

nominal euro amounts in either short-term assets or stocks
and are subdivided into fractional shares as to facilitate
buying by smaller investors
Financial derivatives; Forms of financial instruments

whose values are based or derived from the values of other
assets.
The most important asset owned by most people: Their

housing

Wealth and Assets: Private Households in Germany
Wealth: In 2010, German citizens holding a net wealth of

Euro 261 000 or more were among the top 10% in terms of
wealth distribution.
On average a single member of this group possesses Euro
639 000 - the average in the overall population was about
Euro 115 000. A net wealth of Euro 1 million or more was
owned by approximately 1% of Germany’s population
More than 60% of the overall net wealth of Germans is

invested in real estate - their home is their most important
asset
Source: Institut der deutschen Wirtschaft Koeln e.V.

Wealth and Assets: Family Homes
Approximately 90% of the wealthy are house owners, on

average just about 40% of the Germans owe their homes

Main Financial Assets in the Euro Area 2009

Risk and Return
Based on the considerations in Set 3, we know that assets

are characterized by the
• rate of return and
• implied risk
In general, the riskiness of an asset is measured by variance,
i.e. the standard deviation of its marketable value. Based on
the lectures on microeconomics (set 10), we know that
households prefer high rates of return and low risks
Risk-aversion: The disutility from losing a particular

payment is greater than the utility from gaining the same
amount of money. Risk-averse behavior is implied by the
assumption of diminishing marginal utility

Risk and Return on Major Investments, 1926-2005

Bubbles and Crashes
In general, private investors can be divided in two

categories:
Fundamental analysis tries to identify the intrinsic value of

a company. A popular approach is to look at dividend
payments as a perpetuity which determine the value of a
company
Market psychologists attempt to read the believes of

market participants; e.g. the strategy to buy when the
market rises and to sell when prices decrease

Efficient Market Theory
An efficient market is one of which all new information is

quickly understood and immediately incorporated into
market prices by market participants
The theory of efficient markets holds that market prices

contain all available information. It is not possible to make
profits by acting on old information or on patterns of past
price changes. Returns on stocks will be primarily
determined by their riskiness relative to the market

Money’s Functions
• Medium of exchange
• Unit of account
• Store of value
The cost of holding money is the interest forgone from

not holding other assets. That cost is usually very close to
the short-term interest rate

Sources of Money Demand: Transactions Demand
Transactions demand for money: In general, households

receive discrete payments and spend their money
continuously in order to consume goods and services
Example: A typical household receives its wage payment

once a month and is subsequently spending fractions of its
income, every day, up to the next pay day. Thus, households
require some money every day. Their particular demand
depends on nominal prices and is affected by current
nominal interest rates

Sources of Money Demand: Asset Demand
Asset demand for money: Money may serve as a store of

value. However, in normal times storing wealth in
banknotes is not very attractive as it involves costs in terms
of interest forgone. Moreover, money has no inherent value
such as gold or other forms of physical storage
The most important motivation to hold money is

meeting the transaction demand. In general, we observe
little or no asset demand if i > 0

Money: Medium of exchange
Money serves as the commonly accepted medium of

exchange
A world without a commonly accepted medium of exchange

and n goods features
n(n − 1)
(1)
2
possible ways to barter these goods in one-to-one trades
which would require a ”double coincidence of wants”
Money serves as the Numeraire, the unit of account that

assigns each good a particular numerical value

Definitions of Euro Area Monetary Aggregates
M1 comprises currency in circulation and overnight deposits, which can

be immediately converted into currency or used for cashless
payments
M2 includes, in addition, deposits that can be converted into
components of narrow money, although some restrictions may
apply, such as the need for advance notification, penalties and fees
M3 includes M2 and certain marketable instruments issued by the
resident MFI sector. A high degree of liquidity and price certainty
make these instruments to close substitutes of deposits. As a result
of their inclusion, broad money is less affected by substitution
between various liquid asset categories than narrower definitions of
money and therefore more stable
In the Euro Area, M3 serves as the most important indicator for the
amount of money in circulation

Definitions of Euro Area Monetary Aggregates, cont.

Percentage shares of components of M3, 2010

Balance Sheets
A balance sheet is a statement of a firm’s financial position

at a certain point in time. It lists assets (items that the firm
owns) and liabilities (assets that the firm owes)
Each item is listed at its actual market value or its historical

cost. The difference between the value of assets and total
liabilities is called the net worth
The unique feature of a bank balance sheet is an asset

called reserves

Goldsmith Establishments: Balance Sheet
Commercial banking began in England when goldsmiths

started storing gold against receipts. The gold was released
while charging a fee for the safekeeping service
The above balance sheet shows a one-to-one relation

between liabilities and assets: Reserves are therefore 100%
of deposits

100% Reserve Banking
A 100% reserve banking system has a neutral effect on

money and the macroeconomy because it has no effect on
money supply
Paper money issued under a gold standard with 100%

backing by gold
Gold notes replaced demand deposits and served as the

medium of exchange

Fractional-Reserve Banking
Banks soon learned that it is not necessary to keep reserves up to
100% because not all customers came to redeem their gold notes
at the same time. At any point in time, only a fraction of the
reserves were needed to cover actual demand
Assume that reserves are reduced to 10%
A process of deposit, relending and redepositing starts a chain of

expansion of money supply

Fractional-Reserve Banking, cont.
We assume a legal requirement that demands reserves

equal to at least 10% of deposits
The bank lends out 90% of its deposits and keeps 10% in
reserves which in turn end up as a new bank deposit of the
recipient who might use the borrowed amount to invest or
cover other costs
Again, the bank uses 90% of the newly received deposits as

to lend these out to other clients

Final System Equilibrium
We observe an expansion of the money supply:

Total deposits = 1 + 0.9 × 1 + 0.92 × +0.93 + . . . (2)
which implies the final system equilibrium:

Fractional Reserves: Money Multiplier
When banks hold fractional reserves against their deposits, they

actually create money. The total bank money is generally equal to
total reserves multiplied by the inverse of the reserve ratio:
1
Bank money = total reserves × (3)
reserve ratio
The minimum reserve requirement of the ECB was set at 2% at

the start of Stage Three of European Economic and Monetary
Union (EMU) and was lowered to 1% from 18 January 2012
onwards which implies a max. multiplier of 100

Money multiplier in Germany and the Euro Area
Money multiplier in Germany (1980-1999) and Euro Area

(1999-2013)

Eurosystem
On 1 January 1999, the European Central Bank (ECB)

assumed responsibility for monetary policy in the euro area
The transfer of this responsibility from originally 11 national

central banks (18 with the participation of Latvia as of 1
January 2014) to a new supranational institution
represented a milestone in the process of integration
among EU member states
Today, the ECB enjoys a high degree of credibility worldwide

for its sound monetary policy of ensuring price stability in
the euro area

Eurosystem, cont.
The legal basis for the single monetary policy is the Lisbon
Treaty comprising of the Treaty on European Union (TEU)
and the Treaty on the Functioning of the European Union
(TFEU) as well as the Statute of the ECB
The ECB is an institution of the EU (Article 13 of the TEU).

The Eurosystem is made up of the ECB and the NCBs of the
EU Member States whose currency is the euro
Price stability is not only the primary objective of the

ECB’s monetary policy, but also an objective of the EU as a
whole

Objectives for the Eurosystem
Price stability is the most important contribution that

monetary policy can make to achieving a favourable
economic environment
The Treaties establish a clear hierarchy of objectives for

the Eurosystem:
I. Price stability
II. A high level of employment
The exchange rate is not a separate policy instrument, the

Euro area adopted a flexible exchange rate regime

Unique Characteristics of the Euro Area
The euro area is characterized by a unique combination of

centralized monetary policy-making and decentralized
fiscal policy-making
This feature of one monetary policy and many fiscal

policies is at the heart of the institutional set-up which
governs the interactions between monetary and fiscal policy
in the Economic and Monetary Union (EMU)
EMU Member States have to treat their economic policies as

a matter of common concern and coordinate them within
the EU Council (Article 121(1) of the TFEU)

The Maastricht Criteria

The framework is based on clearly specified objectives and a
unambiguous allocation of responsibilities between policy areas.
According to the Maastricht Treaty all countries entering the
monetary union have to satisfy three fiscal conditions:
1. Exchange rate stability defined by the European Monetary
Systems before adopting the euro
2. Price stability, i.e. a maximum inflation rate of 1.5% above
the average of the three lowest national inflation rates
among EU members
3. Sustainable fiscal policy, i.e. the ratio of
• government deficit to GDP is allowed up to a maximum
of 3%
• government debt to GDP is allowed up to a maximum of
60%

Competence of the Eurosystem
Under Article 127(2) of the TFEU, the basic tasks carried out
within the competence of the Eurosystem are the following:
• Definition and implementation of the monetary
policy of the euro area
• Conduct of foreign exchange operations
• Holding and management of the foreign reserves of the
participating EU Member States
• Promotion of smooth operation of payment systems

Financial Stability: A Public Good
In a mixed economy, achieving and maintaining financial

stability is first and foremost the responsibility of market
participants, who are expected to assess and manage their
risks effectively and to bear the financial consequences of
their transactions
Financial stability is deemed to be a public good but

requires an institutional framework to safeguard and
maintain it
The Eurosystem contributes to financial stability by being

the authority in charge of the prudential supervision of
credit institutions and the stability of the financial system

Decision-making Bodies of the ECB
The monetary policy of the ECB is based on a collective

decision-making system (Articles 129 and 132 of the TFEU)
The Governing Council and the Executive Board are the

two decision-making bodies of the ECB which are
responsible for the preparation, conduct and
implementation of monetary policy
The Executive Board of the ECB consists of the President,

the Vice- President and four other members appointed by
the European Council, acting by a qualified majority

Decision-making Bodies of the ECB, cont.

Governing Council of the ECB
The Governing Council of the ECB consists of the six

members of the Executive Board and the governors of the
euro area’s NCBs. Both the Governing Council and the
Executive Board are chaired by the President of the ECB

Governing Council of the ECB, cont.
The responsibilities of the Governing Council are to

• take the decisions necessary to ensure the performance
of the tasks entrusted to the Eurosystem
• formulate the monetary policy of the euro area which
includes taking decisions on intermediate monetary
objectives, key interest rates and the supply of reserves
in the Eurosystem

Executive Board of the ECB
The Executive Board is responsible for the day-to-day business:

• prepares the meetings of the Governing Council
• implements monetary policy and, in so doing,
• gives the necessary instructions to the euro area NCBs

What monetary policy can and what it cannot do
Monetary policy exerts its influence on the economy using

its position as the monopoly supplier of the monetary base
Monetary policy transmission mechanism: The central

bank is able to influence money market conditions and steer
short-term interest rates.
In the short run, a change in money market interest rates
induced by the central bank sets in motion a number of
mechanisms and actions by economic agents, ultimately
influencing developments in economic variables such as
output or prices

Monetary Policy Strategy of the ECB
The monetary policy strategy of the ECB is its general

approach to achieving its primary objective of
maintaining price stability
We will discuss:
• The reasoning underlying the assignment of this
objective to monetary policy
• The key features of the monetary policy transmission
mechanism
• Monetary policy in the AS-AD Framework

Benefits of price stability
Price stability refers to the general level of prices in the

economy and implies avoiding both prolonged inflation
and deflation
Price stability improves the welfare of households by

contributing to achieving high levels of economic activity
and employment

i. If creditors can be sure that prices will remain stable in

the future, they will not demand an ”inflation risk
premium”, according to the Fisher equation
i = r + πe (4)
to compensate them for the risks associated with

holding nominal assets over the longer term. This
increases the efficiency with which the capital markets
allocate resources and thus increases the incentives to
invest

ii. Price stability enables market participants to

disentangle changes in relative prices (i.e.
movements in prices of any individual good or service)
from changes in the general price level. Households
know that movements in prices typically mirror changes
in the ”relative scarcity” of individual goods and
services which result from changes in the supply of, and
demand for, these goods and services. Thus, motivate
the market to allocate resources more efficiently

Benefits of price stability, cont.
iii. Credible maintenance of price stability also makes it

less likely that individuals and firms will divert
resources from productive uses in order to hedge
against inflation, i.e. to stockpile real goods, which is
not an efficient investment decision, and therefore
hinders economic growth

iv. Tax and welfare systems can create perverse

incentives which distort economic behavior. In most
cases, these distortions are exacerbated by inflation or
deflation, as fiscal systems do not normally allow for the
indexation of tax rates and social benefits
v. Inflation acts as a tax on holdings of cash. In an
inflationary environment, households have an incentive
not to use cash as often in order to reduce transaction
costs (so-called shoe-leather costs arise)

vi. Price stability prevents the arbitrary redistribution of

wealth and income that arises in inflationary as well as
deflationary environments, where price trends change
in unpredictable ways (e.g. redistribution effects from
creditors to debtors). The weakest groups of the society
suffer the most from inflation, as they have only limited
possibilities for hedging against it. Stable prices help to
maintain social cohesion and stability

vii. Sudden revaluations of financial assets undermine

the soundness of the banking sector’s balance
sheets and decrease thr wealth of households. If
monetary policy succeeds in maintaining price stability
and avoiding inflationary as well as deflationary shocks
to the real value of nominal assets

Summary: Benefits of price stability
Monetary policy aimed at price stability provides an

important contribution to financial stability
A central bank that maintains price stability makes a

substantial contribution to the achievement of broader
economic goals, such as higher standards of living, high
levels of economic activity, better employment prospects
and fostering social stability
Empirical studies reveal a negative relationship between

inflation and growth

Transmission of Monetary Policy
The process through which monetary policy decisions affect

the real economy is known as the transmission
mechanism of monetary policy
The transmission of monetary impulses to the real economy

involves a number of different mechanisms and actions by
economic agents
As a result, monetary policy action usually takes time to

affect price developments and/or the real economy. The size
and strength of the different effects can vary according to
the state of the economy

Shocks outside of the control of the ECB
Economic developments and thereby price developments

are continuously influenced by shocks from a wide variety of
sources:
• Changes in oil or other commodity prices
• Developments in the world economy or in fiscal policies
may influence aggregate demand
• Changes in financial asset prices and exchange rates
Monetary policy should take into account all developments

that are inconsistent with or threatening price stability

Transmission channels
Transmission channels are the individual links through which

monetary policy impulses are transferred to the real economy
The (long) chain of cause and effect linking monetary policy

decisions with the price level and the real economy starts with a
change in the official interest rates set by the central bank
The central bank typically provides funds to MFIs. The banking

system demands money issued by the central bank (known as
base money) to meet public demand for currency and to meet the
requirements with regard to holding minimum reserves

ECB’s Main Refinancing Operations
The ECB’s primary instrument are its weekly main refinancing operations
Announcement of a minimum lending bid. With respect to demand for money,

the ECB chooses the interest rate, currently being 0.05%, before deciding on
the actual supply of base money

Interest Rate Channel
The central bank controls the interest rates and thereby

affects the funding cost of liquidity for banks, banks need to
pass on these costs when lending to their customers
(interest rate channel)
Through such a process, the central bank steers the money

market interest rates. Changes in money market rates in
turn affect other interest rates e.g. the interest rates set by
banks on short-term loans and deposits

Interest Rate Channel
Monetary policy can also guide the expectations of

economic agents with regard to future inflation and thus
influence price developments. In addition, expectations
towards future official interest rate changes affect
longer-term market interest rates since these reflect
expectations of the future evolution of short-term interest
rates

Interest Rate Channel: Euler equation
Ct = β(1 + rt )Et Ct+1 (5)
Changes in interest rates affect the saving, spending and

investment decisions of households, higher interest
rates
• tend to make it less attractive for households financing
their consumption needs by loans
• make it more attractive for households to save current
income rather than spending it, since they can expect
higher returns on their savings

Interest Rate Channel: Euler equation, cont.
As a consequence of changes in consumption and investment, the

level of domestic demand for goods and services relative to
domestic supply will change. When demand exceeds supply, all
other things being equal, upward pressure on prices is likely to
result. Moreover, changes in aggregate demand may translate
into tighter or looser conditions in labour and intermediate
product markets, and these in turn can affect price and
wage-setting in the respective market
Because of their impact on financing conditions in the economy

and on expectations, monetary policy decisions can affect other
financial variables such as asset prices (e.g. stock market prices)
and exchange rates. Changes in the exchange rate can affect
inflation directly, insofar as imported goods are part of the
consumption basket

Credit Channel
Changes in interest rates affect the supply of credit (credit

channel)
Following an increase in interest rates, the risk that some

borrowers cannot safely pay back their loans may increase
to such a level that the bank will refuse a loan to these
borrowers
As a consequence, such borrowers are forced to postpone

their consumption or investment plans

Exchange Rate Channel
Changes in the exchange rate will affect inflation in three

ways:
• Firstly, exchange rate movements may directly affect
the domestic price of imported goods. If the exchange
rate appreciates, the price of imported goods will tend
to fall, thus helping to reduce inflation directly, insofar
as imported products are directly used in consumption
• Secondly, if imported goods are used as inputs into
the production process, lower prices for inputs might,
over time, lead to lower prices of final goods

Exchange Rate Channel
• Thirdly, exchange rate developments may also have an effect

via their impact on the competitiveness of domestically
produced goods on international markets.
If an appreciation in the exchange rate makes domestically
produced goods less competitive in terms of their price on
world markets, this tends to constrain external demand and
thus reduce overall demand pressure in the economy. All
other things being equal, an appreciation of the exchange
rate tends to reduce inflationary pressures
Exchange rate effects are in general less important for large

economies than for small open economies. Financial asset prices,
like the exchange rate, depend on many other factors in addition
to monetary policy

Expectations Channel
The expectations channel works by influencing the private

sector’s longer-term expectations. It has gained particular
relevance for the conduct of monetary policy over the
past decades. Its effectiveness crucially depends on the
credibility of central bank communication
For instance, if a central bank enjoys a high degree of

credibility in pursuing its objective, monetary policy can
exert direct influence on price developments by guiding
economic agents’ expectations with regard to future
inflation and thereby influencing their wage and
price-setting behavior

Barro und Gordon (1983): Credibility of monetary

policy
• Surprise inflation stimulates real economic activity and

reduces real government debt
• This results in excess inflation, compared to an
equilibrium in which monetary policy can credibly
commit to an self-proclaimed inflation target

Barro und Gordon (1983): Credibility of monetary

policy
Solution:
• An independent central bank does not implement
surprise inflation in repeated interaction
• Monetary policy sets the inflation rate according to a
specified target level in a repeated game and builds up
reputation
The resulting credibility allows the monetary policy

maker to achieve a self-proclaimed inflation target

Expectations Channel, cont.
If economic agents believe in the central bank’s ability and

commitment to maintain price stability, inflation
expectations will remain firmly anchored to price stability
This, in turn, will influence wage and price-setting in the

economy given that, in an environment of price stability,
wage and price-setters will not have to adjust their prices
upwards for fear of higher inflation in the future. In this
respect, credibility facilitates the task of monetary policy

Transmission Channels: Overview
The transmission is characterized by long, variable and

uncertain time lags and is influenced by exogenous shocks

Empirical knowledge of the transmission process
One of the main findings of the Monetary Transmission

Network is that monetary policy affects the economy mainly
through the interest rate channel
A number of widely accepted and well-established facts

have been confirmed to be valid for the euro area:
• Firstly, long and uncertain lags exist in the transmission
of monetary impulses to the domestic price level

Empirical knowledge of the transmission process,

cont.
• Secondly, in normal times, monetary policy works

mainly through the interest rate channel: A tightening
of monetary policy leads to a transitory decrease in
output, which is estimated to reach its maximum
between one and two years after the interest rate
increase occured. Prices tend to decline more gradually,
and respond more sluggishly to the tightening of
monetary policy than output

Empirical knowledge of the transmission process,

cont.
• Thirdly, beyond these aggregate effects, interest rate

changes also affect economic activity via their impact on
firms’ cash flows and the supply of bank loans, hence
confirming the relevance of the credit channel for
monetary policy

Monetary Transmission Mechanism: Euro Area
(i) ECB announces a target short-term interest rate that

depends upon its objectives and the state of the
economy
(ii) The ECB undertakes open market operations to meet its
interest-rate target. For the Euro Area, the main
refinancing operations are the most important
instrument
(iii) Interest-rate target and announced strategy anchor
market expectations with regard to the inflation rate
and future financial conditions, thereby determining the
term structure of interest rates, asset prices and
exchange rates

Monetary Transmission Mechanism: Euro Area,

cont.
(iv) Changes in interest rates, credit conditions, asset prices

and exchange rates affect real economic variables, in
particular, consumption, investment and net exports
(v) Changes in investment, consumption and net exports
affect inflation rate and aggregate demand

Summary of the Monetary Transmission

Mechanism
The ECB adjusts the interest rate routinely in weekly

refinancing operations. For the graphical analysis we
assume:
• no taxes
• no risks
Thus, the ECB sets r and therefore affects i according to the

Fisher equation
i = r + πe (6)
for given expectations of households. The above relation

illustrates the importance of central bank credibility

Example: Recession
We assume that aggregate demand decreases Y ↓, e.g. a negative

demand shock - households are uncertain about the future
The ECB decides to stimulate the economy by decreasing the

interest rate r, private investment increases

r ↓: Summary
The above consideration utilized the oversimplified approach of

the Keynesian cross. In the AS-AD diagram, a decrease in the
interest rate r ↓ affects C(i) (Euler equation), I(i) (investment
demand) and X(e) (exchange rate channel)

The ECB decides to stimulate Demand: r ↓

The ECB decides to stimulate Demand: r ↓, cont.
The ECB decides to r ↓, thus

i ↓= r ↓ +πe (7)
where the effect on i depends on the credibility of the ECB
As a result, we expect I(i) ↑, C(i) ↑ and e ↓ (depreciates) which

implies X(e) ↑ and therefore an overall increase in aggregate
demand Y ↑
As a result, Q ↑, P ↑ and thus πe ↑ offsets the policy in the

long run - money is neutral

Neutrality of money
Real income or the level of employment in the economy

are, in the long run, essentially determined by real
(supplyside) factors:
Technology, population growth, the preferences of economic

agents and all aspects of the institutional framework of the
economy (Production Possibility Frontier)

Neutrality of money, cont.
In the long run, the central bank cannot influence economic

growth by changing the money supply. After all adjustments
in the economy have worked through, a change in the
quantity of money in the economy (all other things being
equal) will be reflected in a change in the general level of
prices and will not induce permanent changes in real
variables such as real output or employment
A change in the quantity of money in circulation ultimately

represents a change in the unit of account (and thereby the
general price level) which leaves all other variables
unchanged

Inflation is Ultimately a Monetary Phenomenon
”inflation is always and everywhere a monetary phenomenon”
Milton Friedman
Prolonged periods of high inflation are typically associated

with high monetary growth. While other factors (such as
variations in aggregate demand, technological changes or
commodity price shocks) can influence price developments
over shorter horizons, over time their effects can be offset
by some degree of adjustment of the money stock. In this
sense, the longer term trends of prices or inflation can
be controlled by the central bank

Inflation is Ultimately a Monetary Phenomenon,

cont.
The close association between the growth of money and

inflation in the economy and the long-run neutrality of
monetary policy have been confirmed by a very large
number of economic studies, covering various time frames
and countries
Both, empirical and theoretical research has confirmed

that the costs of inflation and deflation are substantial

Inflation is Ultimately a Monetary Phenomenon,

cont.
In a regime of price stability, however, these costs are small

and more difficult to discern empirically. Consequently, it is
widely acknowledged today that price stability contributes
to increasing economic welfare and has an impact on the
growth potential of an economy


Set 6 - Monetary Policy and The Financial System

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Set 6 - Monetary Policy and The Financial System

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Introduction Financial System Money Eurosystem Price Stability Transmission Mechanism Monetary Policy

Dr. Christoph Bierbrauer

Cologne Business School

Winter Term 2016/2017

The ﬁnancial system enables the transfer and eﬃcient

Moreover, by enabling money transfers between buyers

We survey strategies and instruments that enable monetary

The overwhelming objective of monetary policy in Europe

Monetary transmission mechanism; interaction between

The major part of the ﬁnancial system is composed of for-proﬁt

Financial System: Markets

The ﬁnancial system encompasses institutions that carry

These participate in various ﬁnancial markets, e.g.:

Financial Markets, cont.

Transactions take place in ﬁnancial markets. These

Financial intermediaries represent institutions that

Functions of the Financial System: Flow of Funds

Financial assets are monetary claims by one party against

• Nominal assets; the payment is ﬁxed in euro terms

Fiancial Assets: Asset to GDP Ratio 2000

Fiancial Assets: Asset to GDP Ratio 2007

10/ 90 Economics 2: Macroeconomics

Fiancial Assets: Asset to GDP Ratio 2010

11/ 90 Economics 2: Macroeconomics

Fiancial Assets: Asset to GDP Ratio 2013

12/ 90 Economics 2: Macroeconomics

Major Functions of the Financial System

Transfer of resources across time, sectors and regions: Allows

Management of risks: E.g. insurance companies spread risks by

Pooling and subdivision of funds: Small amounts of money

Clearinghouse function: Facilitation of transactions between

13/ 90 Economics 2: Macroeconomics

Financial Instruments or Assets

Saving accounts: Deposits at banks or credit institutions,

Credit market instruments: Euro-denominated obligations

14/ 90 Economics 2: Macroeconomics

Financial Instruments or Assets, cont.

Common stocks: Equity, ownership rights to companies in

Money market funds and mutual funds: Funds that hold

Financial derivatives; Forms of ﬁnancial instruments

The most important asset owned by most people: Their

15/ 90 Economics 2: Macroeconomics

Wealth and Assets: Private Households in Germany

Wealth: In 2010, German citizens holding a net wealth of

More than 60% of the overall net wealth of Germans is

16/ 90 Economics 2: Macroeconomics

Wealth and Assets: Family Homes

Approximately 90% of the wealthy are house owners, on

17/ 90 Economics 2: Macroeconomics

Main Financial Assets in the Euro Area 2009

18/ 90 Economics 2: Macroeconomics

Risk and Return

Based on the considerations in Set 3, we know that assets

Risk-aversion: The disutility from losing a particular

19/ 90 Economics 2: Macroeconomics

Risk and Return on Major Investments, 1926-2005

20/ 90 Economics 2: Macroeconomics

Bubbles and Crashes

In general, private investors can be divided in two

Fundamental analysis tries to identify the intrinsic value of

Market psychologists attempt to read the believes of

21/ 90 Economics 2: Macroeconomics

Eﬃcient Market Theory