Money and Financial Markets - riassunti completi libro e slides, Appunti di Economia Monetaria

Scarica Money and Financial Markets - riassunti completi libro e slides e più Appunti in PDF di Economia Monetaria solo su Docsity! MONEY AND FINANCIAL MARKETS – Traficante 8 CFU Six parts of the financial system: The financial system has 6 parts, each of which plays a fundamental role in our economy. 1) Money  used to pay for our purchases and to store our wealth. Money once consisted of gold and silver coins, replaced then by paper currency. Nowadays these are being eclipsed by electronic funds transfers. 2) Financial instruments  to transfer resources from savers to investors and to transfer risk to those who are best equipped to bear it. 3) Financial markets  allows us to buy and sell financial instruments quickly and cheaply. 4) Financial insitutions  provide all the services of the financial system, including access to the financial markets and collecting information about borrowers to ensure they are credit worthy. Banks, securities firms, and insurance companies are examples of financial institutions. 5) Regulatory agencies  they are responsible for making sure that the elements of the financial system (instruments, markets, and institutions) operate in a safe and reliable manner. 6) Central banks  their aim is to monitor financial institutions and the availability of money, in order to promote low inflation, high growth and stabylize the economy. Typically central banks communicate the level of interest rate: to reduce inflaction it is needed to increase interest rate; otherwise, if the rate of inflation is not a problem and it doesn’t affect the economy, they could reduce interest rate. 5 Core Principles of Money and Banking : 1) Time has value  Time affects the value of financial transactions. As most loan contracts allow the borrower to spread out the payments over time, the total repayment is higher than the loan amount. This because the borrower has to pay the interest to compensate the lender for the time during which he used the funds. Interest payments are fundamental to a market economy. 2) Risk requires compensation  In a world of uncertainty, individuals will accept risk only if they are properly rewarded: the higher the risk, the bigger the payment. 3) Information is the basis for decisions  Without the right amount of information, we couldn’t take any decisions. The more important the decision we have to take, the more information we need to gather: collecting information is the foundation of the financial system. 4) Markets determine prices and allocate resources  Markets are the core of the whole economic system. Their goal is to channel resources and minimize the cost of gathering information and making transactions. In general, the better developed the financial markets, the faster the country will grow. 5) Stability improves welfare  A stable economic system, in addition to growing faster, reduces risks and imporves everyone’s welfare. Central banks play a central role in this regard, as one of their main roles is to stabilize the economy. CHAPTER 2: MONEY AND THE PAYMENTS SYSTEM Money is an asset that’s generally accepted as payment for goods, services and also as repayment of debt. The main characteristics of money are 3: 1. Means of payment (mezzo di pagamento), which is the most important one: people insist on payment in money as it’s easier and finalizes payments so there’s no further claim on buyers and sellers. The increase in the numbers of buyers and sellers requires something like “money” to make transactions smoother. 2. Unit of account (unità di conto), as it is used to quote prices and record debts. Prices provide the information needed to ensure that resources are allocated to their best uses. 3. Store of value (riserva di valore): A means of payment has to be durable and capable of transferring purchasing power from one day to the next. There are also other forms of wealth are considered as a store of value, like stoks, bonds, houses… Although these assets sometimes are better than money, we all go on holding money due to its liquidity. Liquidity is a measure of the ease with which an asset can be turned into a means of payment. The more costly it is to convert an asset into money, the less liquid it is. Currencies are the most liquid asset. The payment system is a web of arrangements that allows the exchange of goods, services and assets. The efficience of an economy depends directly on the payment system. There're 3 possible methods of payment: - Commodity and Fiat Monies  have an intrinsic value. To be successful a commodity money must be durable, usable by most people, easily transportable, divisible into smaller units. - Checks  A check is an instruction that is given to the banks to take funds from your own account and transfer them to another account. - Electronic Payments (credit and debit cards, electronic funds transfers…) Measuring money Changes in the quantity of money are related to 3 main economic variables: - Interest rates - Economic growth - Inflation  the pace at which prices in general are increasing over time: it’s the process of prices rising, and it is calculated by the inflation rate: percent variation of prices from two different periods of time. With high inflation, you need more money to buy the same goods, that’s why inflation is a tax. One of the main cause of inflation is the presence of too much money in the system. The value of the means of payment depends on how much of it is circulating. Different definitions of money are based upon degree of liquidity. There are 2 different money aggregates: - M1 component: it’s the narrowest definition of money, given by currency in public’s hands + demand deposits - M2 component: it’s the broader definition of money, it includes assets not used as means of payment, such as time deposits, savings deposits. CHAPTER 3: Financial Instruments, Financial Markets, and Financial Institutions Economists distinguish 2 different types of finance: direct finance (in which a borrower sells a security directly to a lender), and indirect finance (in which an institution like a bank stands between the lender and the borrower). Financial instruments A financial instrument is the written legal obligation of one party to transfer something of value, usualy money, to another party at the some future date, under specified conditions. Stocks, loans, and insurance are all examples of financial instruments. Taking them as a group, we can see that they have three main functions. Financial instruments can act as a means of payment, and they can 1. Depository institutions  like commercial banks, savings banks, and credit unions. They take deposits and make loans. 2. Insurance companies  accept premiums, which they invest, in return for promising compensation to policy holders under certain events. 3. Pension funds  invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers. 4. Security firms  include brokers, investment banks, underwriters, mutual fund companies private equity firms, and venture capital firms. 5. Finance companies  raise funds directly in the financial markets in order to make loans to individuals and firms. 6. Government-sponsored enterprises  are federal credit agencies that provide loans directly for farmers. CHAPTER 4 (integra con formule ed esercizi sul quaderno) Future Value and Compound Interest Future value is the value on some future date of an investment made today. Future value in one year is given by the present value of the investment today multiplied by 1+ the interest rate. We can see right away that the higher the interest rate or the amount invested, the higher the future value. But this example is too simple. Most financial instruments don’t make single payments in exactly 1 year, so we need to figure out what happens when the time to repayment varies. Using one-year interest rates to compute the value of an investment that will be repaid more than one year from now requires applying the concept of compound interest, which is interest on the interest. So to compute future value, all we need to do is calculate 1+ the interest rate (measured as a decimal) raised to the nth power and multiply it by the present value. Present Value Present value is the value today (in the present) of a payment that is promised to be made in the future. It is obtained reversing the future value formula: future value of the payment divided by 1+ the interest rate (measured as a decimal) raised to the nth power. From this simple expression, we can deduce three important properties of present value. Present value is higher: 1. The higher the future value of the payment (FV). 2. The shorter the time until the payment (n) 3. The lower the interest rate (i) While future value tells us what today’s investment will be worth in the future, present value tells us what promised future payments are worth today. This means that the properties of present value mirror those of future value. In the same way that future value rises as the interest rate rises, present value falls as the interest rate rises. This means that higher interest rates are associated with lower present values, no matter what the size or timing of the payment. Conversely, lower interest rates are associated with higher present values. In the same way, at any fixed interest rate, an increase in the time until a payment is made reduces its present value. Internal rate of return  is the interest rate that equates the present value of an investment with its cost. BONDS (OBBLIGAZIONI) One of the most common uses of the concept of present value is in the valuation of bonds. A bond is a promise to make a series of payments on specific future dates. Bonds create obligations, they’re legal conctracts that requires the borrower to make payments to the lender, and specify what happens if the borrower fails to do so. The most common type of bond is a coupon bond. In this case the bond issuer is required to make annual payments, called coupon payments. The annual amount of those payments (expressed as a percentage of the amount borrowed) is called the coupon rate. The bond also specifies when the issuer is going to repay the initial amount of money and when the payments will stop, called the maturity date or term to maturity. The final payment, a repayment of the initial loan, is called the principal, face value, or par value of the bond. Lower interest rates mean higher bond prices, while higher interest rates mean lower bond prices. As bonds promise fixed payments on future dates, the higher the interest rate, the lower their present value. It follows that the value of a bond varies inversely with the interest rate used to calculate the present value of the promised payment. Real and nominal interests rate  The nominal interest rate (i) is the interest rate expressed in current-dollar terms.  The real interest rate (r) is the rate adjusted by inflation. Borrowers look at the inflation-adjusted cost of borrowing, while lenders focus on the inflation-adjusted return. No one cares only about the number of dollars. People also care about what those dollars can buy. In other words, everyone cares about real interest rates. This is why economists think of the nominal interest rate as having two parts, the real interest rate and expected inflation. Fisher equation: The nominal interest rate (i) must be based on expected inflation equals the real interest rate (r), + expected inflation, p The higher the expected inflation, the higher the nominal interest rate. CHAPTER 5: Understanding risk Risk is a measure of uncertainty about the future payoff to an investment, assessed over some time horizon and relative to a specified benchmark. This definition has several important elements: - risk is a measure that can be quantified . In comparing two potential investments, we want to know which one is riskier and by how much. The riskier the investment, the less desirable and the lower the price. Uncertainties that are not quantifiable cannot be priced. - risk arises from uncertainty about the future . We know that the future will follow one and only one of many possible courses, but we don’t know which one. - risk has to do with the future payoff of an investment , which is unknown. - the definition of risk refers to an investment or a group of investments. - risk must be assessed over some time horizon , as every investment has a time horizon. In general, risk over shorter periods is lower. - risk must be measured relative to a benchmark rather than in isolation. How to measure risk In determining expected inflation or expected return, we need to understand expected value. To do that we should rely to the probability theory. Probability is a measure of the likelihood that an event will occur, and it is always expressed as a number between 0 – 1. The closer the probability is to zero, the less likely it is that an event will occur. If the probability is exactly 0, we are sure that the event will not happen. The closer the probability is to 1, the more likely it is that an event will occur. If the probability is exactly 1, the event will definitely occur. The expected value of an investment is the most likely outcome: after listing all of the possible outcomes and the probabilities that they will occur, we compute the expected value as the sum of their probabilities times their payoffs. But most people don’t discuss investment payoffs in terms of dollars; instead, they talk about the percentage return. Expressing the return as a percentage allows investors to compute the gain or loss on the investment regardless of the size of the initial investment. Reasoning in terms of risk, it seems intuitive that the wider the range of outcomes, the greater the risk. There’s a particular type of asset that has no risk at all, it’s called risk free asset: is an investment whose future value is known with certainty and whose return is the risk free rate of return. Variance and Standard Deviation The variance is defined as the average of the squared deviations of the possible outcomes from their expected value, weighted by their probabilities. The standard deviation is the positive square root of the variance. The standard deviation is more useful than the variance because it is measured in the same unit as the payoffs: dollars; while variance is measured in dollars squared. Given a choice between 2 investments with equal expected payoffs, most will choose the one with the lower standard deviation. In fact, the greater the standard deviation, the higher the risk. Standard deviation is the most common measure of financial risk. But in some circumstances we are less concerned with the spread of possible outcomes than with the value of the worst outcome. The value at Risk (VaR) is the worst possible loss over a specific horizon at a given probability. For example, as regard a mortgage, the worst case scenario means you cannot afford your mortgage and will lose your house. VaR answers this really important question: how much will I lose if the worst possible scenario occurs? Risk Aversion, the Risk Premium, and the Risk-Return Tradeoff Most people don’t like risk and they will pay to avoid it because most of us are risk averse. A risk averse investor will always prefer an investment with a certain return to one with the same expected return but any amount of unertainty. Therefore, the riskier an investment, the higher the risk premium. The compensation investors required to hold the risky asset. A risky investment, then, must have an expected return that is higher than the return on a risk-free asset. In economic terms, it must offer a risk premium . In general, the riskier an investment, the higher the risk premium (the higher the compensation investors require for holding it). Sources of Risk: Idiosyncratic and Systematic Risk All risks can be classified into 2 groups: - Those affecting a small number of people but nobody else: idiosyncratic or unique risk - Those affecting everyone: systematic or economy-wide risks. Idiosyncratic risks can be classified into 2 types: 1. A risk is bas for one sector of the economy but good for another (ex: a rise in oil prices is bad for car industry but good for the energy industry); 2. Unique risks specific to one person or company and no one else. - They start bidding up the price - Excess demand puts upward pressure on the price until supply equals demand. Factors that shft bond supply: 1. Changes in Government Borrowing  The government’s need to issue bonds affects the supply of bonds: actually any increase in the government’s borrowing needs increases the quantity of bonds outstanding, shifting the bond supply curve to the right. The result is an increase in quantity of the bonds supplied at every price. 2. Change in General Business Conditions  As the amount of debt in the economy rises, the quantity of bonds outstanding with a given risk goes up. As business conditions improve, the bond supply curve shifts to the right, forcing bond prices down and interest rates up. 3. Changes in Expected Inflation  When expected inflation rises, the cost of borrowing falls, shifting the bond supply curve to the right. Higher expected inflation increases the bond supply, reducing bond prices and raising interest rates. Factors that shift bond demand: 1. Wealth: The more rapidly the economy grows, the wealthier individuals become. As their wealth increases, they will investment more in stocks, bonds... Thus, increases in wealth shift the demand for bonds to the right, raising bond prices and lowering yields. 2. Expected inflaction: A decline in expected inflation means that the payments promised by the bond’s issuer have a higher value than borrowers originally thought, so the bond will become more attractive. This fall in expected inflation shifts the bond demand curve to the right, raising bond prices and lowering interest rates. 3. Expected return and expected interst rate: If the expected return on bonds rises relative to the return on alternative investments, the quantity of bonds demanded at every price will rise, shifting the bond demand curve to the right. Similarly when interest rates are expected to change in the future, bond prices adjust immediately: whenever interest rates are expected to fall, then bond prices are expected to rise, creating an expectation of a capital gain that shifts the bond demand curve to the right. This makes bonds more attractive. 4. Risk relative to alternatives: Investors require compensation for risk, which means that when a bond becomes more or less risky, the demand for the bond changes. The less risky the bond, the higher the price investors are willing to pay for it. From this we can conclude that if a bond becomes less risky relative to alternative investments, the demand for the bond shifts to the right. At the contrary, increases in risk will reduce investor demand for bonds at every price, shifting the demand curve to the left, decreasing the equilibrium price and the quantity of bonds. 5. Liquidity realtive to alteratives: Liquidity matters for investors: the less liquid a bond is, the lower the demand for it, and the lower the price. So when a bond becomes more liquid relative to alternatives, the demand curve shifts to the right. Why bonds are risky? The return an investor receives for holdng a bond is far from being riskless. Bondholders usually face 3 major risks: - Default risk  is the chance that the bond’s issuer may fail to make the promised payment. The higher the default risk, the higher the probability that the bondholders will not receive the promised payments. Risk reduces the expected value of a given promise, lowering the price an investor is willing to pay and raising the yield. The higher the default risk, the higher the yield. - Inflation risk  Bondholders can’t be sure of what the real value of the payments will be, in fact inflation may be higher than expected, reducing the real return on holding the bond. The greater the inflation risk, the larger the compensation for it. - Interest-rate risk  it arises from the fact that investors don’t know the holding period return of a bond; in fact interest rates may rise between the time a bond is purchased and the time it is sold, reducing the bond’s price. In general, the longer the term of the bond, the larger the price change for a given change in the interest rate. For investors with holding periods shorter than the maturity of the bond, the potential for a change in interest rates creates risk. The more likely the interest rates are to change during the bondholder’s investment horizon, the larger the risk of holding a bond. CHAPTER 7 (integra con le formule sul quaderno) The Risk and Term Structure of Interest Rates Default is one of the most important risks a bondholder faces. Independent companies, such as rating agencies, exist specifically to evaluate the creditworthiness of potential borrowers. Their function is to monitor the status of individual bond issuers and assess the likelihood a lender/bondholder will be repaid by the borrower/bond issuer. Companies with good credit, low levels of debt and high profitability earn high bond ratings. A high rating suggests that a bond issuer will have little problem meeting a bond’s payment obligations. Firms or governments with an exceptionally strong financial position carry the highest ratings and are able to issue the highest rated bonds: Aaa. The top categories are considered investment-grade bonds, meaning they have a very low risk of default. The distinction between investment-grade and noninvestment-grade bonds is really important. Actually many institutional investors, like commercial banks, are not allowed to invest in bonds that are rated below the investment-grade, since these bonds are issued by companies or countries that may have difficulty meeting their bond payments. Then, we have highly speculative bonds, which consist of debts that are in serious risk of default. All bonds with ratings below investment grade are often referred to as junk bonds, or high-yield bonds. The Impact of Ratings on Yields Bond ratings reflect default risk: the lower the rating, the higher the risk of default. Since investors require compensation for assuming risk, the lower a bond’s rating, the lower its price and the higher its yield. So, lower-rated bonds will have higher yields. The easiest way to understand the impact of ratings on bond yields is to compare them to a benchmark, that’s why they are usually referred to as benchmark bonds, and the yields on other bonds are measured in terms of the spread over Treasuries. We can think of any bond yield as the sum of two parts: the yield on the benchmark U.S. Treasury bond + a default-risk premium (also called risk spread). Bond Yield = U.S. Treasury yield + Default risk premium Default risk is not the only factor that affects the return on a bond. The second important factor is taxes. Bondholders must pay income tax on the interest income they receive from owning privately issued bonds. These are called taxable bonds. Bondholders care about the return they actually receive, after tax authorities have taken their cut, which means that investors base their decisions on the after-tax yield. Term Structure of interest rates A bond’s tax status and rating aren’t the only factors that affect its yield. In fact, bonds with the same default rate and tax status but different maturity dates have different yields. This because long-term bonds are like a composite of a series of short-term bonds, so their yield depends on what people expect to happen in the future. The relationship among bonds with the same risk characteristics but different maturities is called the term structure of interest rates. Comparing them we can note that: - Interest rates of different maturities tend to move together . - Yields on short-term bonds are more volatile than yields on long-term bonds . Long-term rates are averages of short-term - Long-term yields tend to be higher than short-term yields . Default risk and tax differences cannot explain these relationships. There are 2 explanations: the Expectations Hypothesis and the Liquidity Premium Theory.  The Expectation Hypothesis of interest rates: This theory focuses on the risk-free interest rate, which can be computed assuming there’s no uncertainty about the future. If this uncertainty is absent, then an investor will be indifferent between holding a single two-year bond or 2 different one-year bond. Certainty means that bonds of different maturities are perfect substitutes for each other. The expectations hypothesis implies that the current two-year interest rate should equal the average between current one-year rate and the one-year interest rate 1 year in the future. According to the expectations hypothesis: (vedi grafici) - When interest rates are expected to rise in the future, long-term interest rates will be higher than short-term interest rates, with the consequence that yield curve will slope up. - If interest rates are expected to fall, the yield curve will slope down. - When interest rates are expected to remain unchanged, the yield curve will be flat. The expectation hypothesis of the term structure of interest rates explain just the first 2 of the 3 observations we started with: 1) The expectations hypothesis tells us that long-term bond yields are all averages of expected future short-term yields, this means that interest rates of different maturities will move together. 2) The expectations hypothesis implies that yields on short-term bonds will be more volatile than yields on long-term bonds. In fact, long-term rates are averages of short-term rates, so changing one short-term rate has little effect on the long term rate. 3) The expectations hypothesis cannot explain why long-term yields are normally higher than short- term yields, because it implies that the yield curve slopes upward only when interest rates are expected to rise. By ignoring risk and assuming that investors view short and long-term bonds as perfect substitutes, we have explained why yields at different maturities move together and why short-term interest rates are more volatile than long-term rates. While to understand why the yield curve normally slopes upward, we need to extend the expectations hypothesis to include risk. Actually risk is the key to understand the upward slope of the yield curve. This observation bring us to the Liquidity Premium Theory of interest rates.  The Liquidity Premium Theory of interest rates: Long-term interest rates are typically higher than short-term interest rates because long-term bonds are riskier than short-term bonds. Bondholders face both inflation and interest-rate risk. The longer the term of the bond, the greater both types of risk. Computing the real return from the nominal return requires a forecast of expected future inflation. For instance, for a three-month bond, an investor needs to be concerned just on infl ation over the next three months. For a 10-year bond, conversely, computation of the real return requires a forecast of inflation over the next decade. In summary, uncertainty about inflation creates uncertainty about a bond’s real return, making the bond a risky investment. The further we look into the future, the greater the uncertainty about inflation. We are more uncertain about the level - to maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production - to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. CHAPTER 17 (integra con le formule sul quaderno) The Central Bank Balance Sheet and the Money Supply Process The central bank engages in various financial transactions. It supplies currency, provides deposit accounts to the government and commercial banks, makes loans, and buys and sells securities and foreign currency. All these activities cause changes in the central bank’s balance sheet. The structure of the balance sheet shows us how the institution operates. The central bank’s balance sheet is divided in 2 components: assets and liabilities. Between the assets we find: - securities  are the primary assets of most central banks. The quantity of securities Fed holds is controlled through purchases and sales known as open market operations. - foreign exchange reserves  are the central bank’s and government’s balances of foreign currency. These are held in the form of bonds issued by foreign governments. These reserves are used in foreign exchange interventions, when officials attempt to change the market values of various currencies. - loans  There are several kinds of loans, and their importance varies depending on how the central bank operates. Discount loans are the loans the Fed makes when commercial banks need short-term cash. Turning to the liabilities side of central bank’s balance sheet, we can find: - Currency  Nearly all central banks have a monopoly on the issuance of the currency used in everyday transactions. Currency circulating in the hands of the nonbank public is the principal liability of most central banks - The government's deposit account  Governments need a bank account like the rest of us. The central bank provides the government with an account into which the government deposits funds (mostly tax revenue) and from which the government makes payments. By shifting funds between its accounts at commercial banks and the Fed, the Treasury usually keeps its account balance constant. - Commercial bank accounts (reserves)  Commercial bank reserves are the sum of two parts: deposits at the central bank plus the cash in the bank’s own vault. The bank can withdraw its deposits at the central bank and, in addition, a commercial bank can transfer a portion of its deposit account balance to another bank. Of all central bank liabilities, bank reserves are the most important in determining the quantity of money and credit in the economy, and for this reason, they play a central role in monetary policy operations. Increases normally lead to a rise in deposits and to growth in the availability of money and credit; decreases do the opposite. There are two types of reserves: those that banks are required to hold (called required reserves), and those they hold voluntarily (called excess reserves). Together, currency in the hands of the public and reserves in the banking system form the monetary base, also called high-powered money, which is the base on which all other forms of money stand. The central bank can control its size. Changing the Size and Composition of Balance Sheet The central bank controls the size of its balance sheet. Thus, policymakers can enlarge or reduce their assets and liabilities at will. There are 4 main types of transactions made by the central bank, each one of which have an impact on both the central bank’s balance sheet and the banking system’s balance sheet: 1) Open Market Operation: are those in which the central bank buys or sells a security. 2) Foreign Exchange Intervention: those in which the central bank buys or sells foreign currency. 3) Extention of a discount loan to a commercial bank by the central bank. 4) Decision by an individual to withdraw cash from their bank. Open market operations, foreign exchange interventions, and discount loans all affect the size of the central bank’s balance sheet and change the size of the monetary base. Cash withdrawals by the public shift components of the monetary base, changing the composition of the central bank’s balance sheet but leaving its size unaffected. To figure out the impact of each of these 4 transactions on the central bank’s balance sheet, we need to remember one simple rule: when the value of an asset on the balance sheet increases, either the value of another asset decreases so that the net change is zero or the value of a liability rises by the same amount. What’s true for assets is also true for liabilities. An increase in a liability is balanced either by a decrease in another liability or by an increase in an asset. [Central Bank’s balance sheet: Summary]  tab 17.2 The Deposit Expansion Multiplier Central bank liabilities form the base on which the supplies of money and credit are built; that is why they are called the monetary base. The central bank controls the monetary base, causing it to expand or to contract. However, our interest is focused on the broader measures of money, M1 and M2, which are mostly liabilities of private banks. M1 is currency plus demand deposits and M2 adds time deposits to M1. These are the money we think of as available for transactions. To understand the relationship between the central bank’s liabilities and these broader measure of money, we need to know a process called multiple deposit creation. In a system of banks, only the Fed can create and destroy the monetary base, but the nonbank public determines how much of it ends up as reserves in the banking system and how much is in currency. All the banks can do is move the reserves they have around among themselves. We’ll start by making few assumptions: 1) Banks hold no excess reserves; 2) the reserve requirement is 10% of checking account deposits; 3) when the level of checking account deposits and loans changes, the quantity of currency held by the nonbank public does not; Now we can derive a formula for the deposit expansion multiplier, which is the increase in commercial bank deposits following a one-dollar open market purchase. [formula e spiegazione] The monetary base and the Money Supply The simple deposit expansion multiplier is too simple. In fact by deriving it, we ignored a few details: - We assumed banks lend out all their excess reserves, but banks do hold some of their excess reserves. - We ignored the fact that the nonbank public holds cash. And both of these affect the relationship among reserves, the monetary base, and the money supply. The Money multiplier To better understand the relationship between deposits and reserves, we can derive the money multiplier, which shows how the quantity of money s related to the monetary base. If we label the quantity of money M and the monetary base MB, the money multiplier m is defined as: M = m × MB To derive the money multiplier, we start with a few simple relationships: - money equals currency (C) plus checkable deposits (D); - the monetary base (MB) equals currency plus reserves in the banking system (R); - reserves equal required reserves (RR) plus excess reserves (ER). Writing these relationships as simple equations, we have:  M = C + D  Money = Currency + Checkable deposits  MB = C + R  Monetary base = Currency + Reserves  R = RR + ER  Reserves = Required reserves + Excess reserves We know that banks holdings of required reserves depends on the required reserve ratio. The amount of excess reserve a bank holds depends on the cost and benefits of holding them. [Vedi formule e procedimenti analitici sul quaderno………………] The equation we ‘ve just obtained tells us that the quantity of money in the economy depends on four variables: - monetary base , which is controlled by Federal Reserve  if the monetary base increases, the quantity of money increases as well. - reserve requirement  an increase in either the reserve requirement or banks’ excess reserve holding reduces money. - the bank’s desire to hold excess reserves  when an individual withdraws cash, he increases the currency in the public and decreases reserves. - the nonbank public’s demand for currency Discount Lending, the Lender of Last Resort, and Crisis Management: By controlling the quantity of loans it makes, a central bank can control: - The size of reserves - The size of the monetary base - Interest rates Today, lending by the Federal Rserve Banks to commercial banks, called discount lending, is usually a small aside from crisis periods. Discount lending is the Fed’s primary tool for: - Ensuring short-term financial stability - Eliminating bank panics - Preventing the sudden collapse of institutions that are in financial difficulties The central bank, then, is the lender of last resort, making loans to banks when no one else will or can. This means that it can provide liquidity to financial markets when nobody else is available to do that. In addition to providing a mechanism for stabilizing the fi nancial system, the discount lending procedures also help the Fed meet its interest-rate stability objective. To see how this all works, we need to look at the details of how lending functions. The Federal Reserve makes 3 types of loans, called primary credit, secondary credit, and seasonal credit. The Fed controls the interest rate on these loans, not the quantity of credit granted. The banks decide how much to borrow. Let’s look at each one: 1) Primary credit  is extended on a very short-term basis, usually overnight, to institutions that the Fed’s bank supervisors deem to be solid. The interest rate on primary credit is set at a spread above the IOER rate. This is called the primary discount rate. 2) Secondary credit  is available to institutions that are not suffi ciently sound to qualify for primary credit. Because secondary credit is provided to banks that are in trouble, the secondary discount rate is set above the primary discount rate . There are 2 reasons why a bank seek secondary credit: - the standard one: a temporary shortfall in reserves - the fact that hey cannot borrow from anyone else. By borrowing in the secondary credit market, a bank shows that it is in trouble.In fact, secondary credit is for banks that are experiencing longer-term problems. Before making the loan, the Fed it has to make sure that there is a good chance the bank will be able to survive. That’s why secondary credit is rare. 3) Seasonal credit  is used primarly by small agricultural banks in the Midwest to help managing the cyclical nature of farmers’ loans and deposits. Reserve Requirements Reserve requirements are the fourth tool in the monetary policymaker’s toolbox. The Federal Reserve Board has the authority to set the reserve requirements, which are the minimum level of reserves banks must hold, either as vault cash or on deposit at the Fed. Any changes in the reserve requirement affect both the money multiplier and the quantity of money and credit circulating in the economy. So, by adjusting the reserve requirement, the central bank can influence economic activity. EUROPEAN CENTRAL BANK’S CONVENTIONAL POLICY TOOLBOX: Like the Fed’s, the ECB’s monetary policy toolbox contains: 1) An overnight interbank rate (= to the federal funds rate). 2) A rate at which the central banks lends to commercial banks (= to the discount rate). 3) A reserve deposit rate (= to the IOER). 4) A reserve requirement  The ECB’s Target Interest Rate and Open Market Operations Now the ECB provides reserves to the European banking system primarily through collateralized loans, in what are called refinancing operations. In normal times, the main refinancing operation is a weekly auction (asta) of repurchase agreements (repo), in which the ECB, through the National Central Banks, provides reserves to banks in exchange for securities, and then reverses the transaction up to few weeks later. When reserves are scarce, the ECB’s main policy instrument is the minimum bid rate, set by the Governing Council as the minimum interest rate accepted at these refinancing auctions. This is the European equivalent of the Fed’s target federal funds rate, so it can be called as target refinancing rate. Linking Tools to Objectives: Making Choices Monetary policymakers use the various tools they have to meet the objectives society gives them. Their main goals are: - Low and stable inflation - High and stable growth - A stable financial growth - Stable interest and exchange rates Over the years, a consensus has developed among monetary policy experts, that: 1. the reserve requirement is not useful as an operational instrument 2. Central bank lending is necessary to ensure financial stability 3. Short-term interest rates are the conventional tool to use to stabilize short-term fluctuations in prices and output. We define a monetary policy tool as “good” if it has 3 features: 1) It has to be easily observable by everyone: a policy tool wouldn’t be very useful if you can’t observe it or predict its impact on the objectives. 2) It has to be controllable and quickly changed: controllability is important in both the short term and the long term. An instrument that can be adjusted quickly is clearly more useful than one that takes time to adjust. 3) It has to be tighty linked to the policymakers’ objctives: the more predictable the impact of an instrument, the easier it will be for policymakers to meet their objectives. INFLATION TARGETING The inflation targeting regime is a monetary policy whose final objective is a low and stable inflation. It is a monetary policy strategy that involves public announcement of a numerical inflation target and underscores the central bank’s commitment to price stability. When the target is credible, inflation rate will be low. If we imagine that the next year the expected inflation will rise, people will try to anicipate their expenditure, and this implies that the aggregate demand goes up; so, as a consequence, it triggers an increase in prices in the current period (in the present). Long-term expectations of low inflation act to anchor low long-term interest rates and promote economic growth. When we talk about inflation targeting, we can consider 2 arrangements - Hierarchicale mandate  in which price stability goes first and everything else comes second. - Dual mandate  in which the goal of price stability and maximum employment are equal. Increases policymakers accountability and helps estabilish their credibility. It helps overcome the time- consistency problem. The result is not just a lower and a more stable inflation, but usually a higher economic growth. THE TAYLOR RULE The Tylor Rule, that takes its name from the Professor John Taylor, tracks the actual behaviour of the target federal funds rate and relates it to the real interest rate, inflation and output. Formula: Target fed funds rate = Natural rate of interest + Current inflation + ½ (Inflation gap) + ½ (Output gap) The natural rate of interest rate is the real short-term interest rate that prevails when the economy is using resources normally. Taylor originally used 2%, which is close to the real average. The inflation gap is given by the current inflation minus an inflation target (both measured as percentages). When inflation exceeds the target level, the inflation gap is positive. The output gap is the percentage deviation of the current output (real GDP) from potential output. When current output is above potential output, the output gap is positive. From this formula, Taylor found out that when inflation rise above its target level , the response is to raise interest rates. Conversely, when output falls below the target level , the response is to lower interest rates. Finally, if inflation is currently on target and there is no output gap , the target federal funds rate should be set at the natural rate of interest plus target inflation. The Taylor rule has some interesting properties: - The increase in current inflation feeds one for one into the target federal funds rate - The increase in the inflation cap is halved. A 1% point increase in the inflation rate raises the target federal funds rate 1½ percentage points. The Taylor rule tells us that for each percentage point increase in inflation, the real interest rate, equal to the nominal interest rate minus expected inflation, goes up half a percentage point. The halves in the equation depend on both how sensitive the economy is to interest-rate changes, and on the preferences of central bankers. The more bankers care about inflation: - The bigger the multiplier for the inflation gap - the lower the multiplier for the output gap. When financial conditions are much stronger or much weaker than usual, in order to stabilize the economy, policymakers may set an interest rate target that differs substantially from the Taylor rule. In 2008 for example, the Fed cut rates below the Taylor rule to prevent the interest rate sinking below zero. In this environment, even a zero-rate target probably was too high to counter weakness in the global