Monetary Economics & Financial Markets
Monetary Economics & Financial Markets
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Common stock, its purpose and how it affects business investment decisions.
→ A common stock represents a share of ownership in a company.
→ It is a security, and is a claim on the earnings and assets of the corporation.
→ Selling stock is way to raise funds for financing the companies activities.
→ It affects business decisions as higher stocks prices in the stock market mean that the company
will be able to raise more finance through selling stock at higher prices.
List two ways in which the quantity of money may affect the economy
1) Through the aggregate price level
2) Through interest rates.
Difference between nominal and real GDP and their uses
→ Nominal GDP is when the total value of final goods and services is calculated using current prices.
→ Real GDP is calculated with constant prices, given at a base year.
→ Nominal GDP can be misleading as an increase could be due to a rise in the price level or an
actual increase in final good and services.
→ An increase in Real GDP can only be from an increase in final goods and services and not and
increase in prices.
→ Direct finance: borrowers borrow funds directly from financial markets by selling securities
→ Indirect finance: a financial intermediary borrows funds from lender-savers and then uses these
funds to make loans to borrower-spenders.
→ Financial markets are critical for producing an efficient allocation of capital which contributes to
higher production and efficiency for the economy as a whole.
→ Structure of financial markets
1) Debt and Equity Markets
→ Short-term less than a year. 1-10 years are intermediate. > 10 is long-term
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→ Firms or individuals can obtain funds through issuing debt instruments (bonds/mortgage) or
issue equities (stock)
→ A disadvantage of equities is the holder is a residual claimant, the firm must pay debt holders
first before its equity holders.
→ A advantage to holding equities is the direct benefit of increased firm profits versus the fixed
amounts of debt, because of ownership rights of equities.
→ Brokers are agents of investors who match buyers with sellers, dealers link buyers and sellers by
buying and selling at stated prices.
2) Primary and Secondary Markets
→ Primary market for initial issues of securities (Investment banks).
→ Secondary markets (JSE) make securities more liquid, also set benchmark prices for the
primary market.
3) Exchange and OTC markets
→ Secondary markets.
→ Exchanges, central location where buyers and sellers of securities conduct trades
→ OTC dealers at different locations sell securities to anyone willing to pay their prices. Similarly
competitive to exchanges due to technology.
4) Money and Capital Markets
→ Money market: short-term securities
→ Capital markets: 1 year or greater.1
Financial market instruments
→ Money market short-term debt instruments.
1) US Treasury Bills. Short-term, no interest payments, set payment at maturity, sold at a discount.
Most liquid and safest. Mainly held by banks.
2) Negotiable Bank Certificates of Deposit: a certificate of deposit (CD) is a debt instrument sold
by a bank to depositors that pays annual interest of a given amount and at maturity pays back
the original price. Negotiable CD’s are traded in secondary markets. Big source of funds for
banks.
3) Commercial Paper is a short-term debt instrument issued by large banks and well-know
corporations.
4) Repurchase agreements are effectively short-term loans less than 2 weeks for which Treasury
bills serve as collateral. Big source of funds for banks. Issued mainly by corporations.
5) Federal Funds, overnight loans between banks using their deposits at the Federal reserve.
→ Capital Market for longer term debt.(Riskier than money market)
1) Stocks. Largest security in capital market, Held by households and institutions.
2) Mortgages are loans to households or firms to purchase housing, land or real structures that
serve as collateral. Largest debt market in US.
→ Mortgage back security is a bond like instrument backed by a bundle of individual mortgages
whose interest and principle payments are collectively paid to the holder-of the security.
3) Corporate Bonds. Issued by corporations with strong credit ratings. Convertible bonds can be
changed into stock anytime up till maturity. Principle buyers are life insurance, pension funds
households and other large holders. Not as liquid as government securities. Larger than new
stock issues.
4) US Government Securities. Most liquid security.
5) US Government Agency Securities
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6) State and Local Government Bonds (Municipal bonds). Issued by state and local governments
for big projects, exempt for income tax. Banks largest holders.
7) Consumer and Bank Commercial Loans.
Indirect finance and 4 financial intermediary functions
→ The basic function of financial markets is to channel funds from savers who have excess funds to
spenders who have a shortage of funds.
→ Direct finance is when borrowers borrow funds directly from lenders by selling them securities
→ The process of indirect finance using financial intermediaries is call financial intermediation.
→ More important source of funds for corporations than securities markets.
→ Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn
use those funds to acquire assets by purchasing securities or making loans.
→ Indirect finance involves an intermediary that stands between lenders and borrows and helps
transfer funds from one to the other.
Transaction Costs / Liquidity services
→ Time and money spent in carrying out financial transactions.
→ Intermediaries can reduce transaction because they benefit from economies of scale due to
expertise and size.
→ Intermediaries provide liquidity services that make it easier for customers to conduct transactions.
e.g Checking accounts to pay bills.
Risk sharing
→ They sell less risky investment and then use the funds to purchase more risky investments.
→ They earn profit on the difference between the returns on risky assets they bought and the
payments made on assets they sold. Also called asset transformation.
→ They help individuals to diversify and thereby lower the amount of risk through low costs and
assets pooling.
Asymmetric information
→ One party does not know enough about the other party to make accurate decisions.
→ Intermediaries are better equipped and can alleviate asymmetric information problems.
→ Two forms
1) Adverse selection
→ Occurs before the transaction
→ Potential borrowers who are the mostly like to produce an undesirable outcome are the ones
who most actively seek out a loan and are thus most likely to be selected.
→ Results in fewer loans to all as lenders hesitate to lend at all.
2) Moral hazard
→ Occurs after the transaction.
→ The risk that the borrower will engage in activities undesirable to the lender hence increase in
chance of default.
→ Reduces loans for all due hesitation to lend.
→ If there were no asymmetric information there could still be a moral hazard problem because
the lender knows there might be a default and reducing such risk is too costly, therefore still a
moral hazard.
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→ Intermediaries are better equipped to screen out bad risk (reduce adverse selection) and monitor
borrowers (reduce moral hazard)
Economies of scope
→ Lowering the cost of information production for each service by applying one information resource
to many different services.
→ Credit risk evaluation on corporation for loan and then sale of the corporation’s bonds to the
public.
→ Creates conflict of interest (moral hazard problem) due to offering multiple services, and by
information being concealed or misleading.
Type of financial intermediates
Investment banks
→ Don’t take deposits.
→ Advises corporations on type of security to issue and then purchase the security at a
predetermined price and resells on the market (underwriting).
→ Act as deal makers and earn fees on mergers and acquisitions.
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→ Credit in both these two forms serves as a medium of exchange, but these forms of credit do not
lead to an increase in cash or deposits, and the money stock is not affected.
→ Not included because of difficulties in measuring these forms of credit.
→ The provision of trade credit, for example, may lead to indirect increases in money supply.
Measuring money in SA
→ Defined as currency plus deposits held by domestic, private nonbank sector at commercial banks.
→ In South Africa currency is all the paper money and coins in circulation less cash held in bank
vaults. → 𝑀 = 𝐶 + 𝐷
→ Deposits are all domestic private non-bank deposits in banks and excludes:
1) Government deposits at commercial banks
2) Foreign bank deposits at commercial banks
3) Cash held by banks themselves (vault cash), Excluded because they are not available for
spending by the private sector and cannot function as a medium exchange.
→ Economic transactions in principle do not affect the money stock.
→ The amount of currency in circulation is known since only the central bank issues currency.
→ Because deposits are always held at banks, banks know the exact amount of deposits held by the
non-bank (private) sector.
→ Monetary authorities: SARB and the CPD (Corporation for public deposits)
→ Commercial banks. Only registered banks and mutual banks, the Landbank and the Postbank are
classified as other depository institutions.
Monetary aggregates
→ Stock variables measured at month end.
1) M1A
→ Consists of cash (coins and banknotes) + cheque and transmission deposits
→ Cheque and transmission deposits are no interest deposits mainly used to make payments.
→ If interest rate rises on medium to long-term deposits there will be a transfer into medium to
long-term deposits.
→ In SA constituents small portion of M3
2) M1 Narrow definition.
→ M1A + other demand deposits by private sector.
→ Other demand deposits are monetary deposits other than transaction or chequeable
deposits.
→ Other demand deposits are deposits that are convertible into cash on demand, and normally
carry a payment facility.
→ High interest rates on other assets, means opportunity cost of keeping funds in monetary
demand deposits is high, and funds are shifted to interest-bearing deposits.
→ In SA constituents large portion of M3
3) M2
→ a broader definition of money
→ M1 + plus deposits
→ Includes short-term (1 to 31 days) and medium-term deposits (32-180 days) such as savings
deposits, savings bank certificates, ”share” investments, negotiable certificates and
promissory notes.
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→ Cannot be converted into cash on demand, but only after some time, does not carry a
payment facility.
→ Near money, because terms are short and they are closely related and substitutes for
demand monetary deposits in M1,
→ They are liquid.
→ In SA constituents large portion of M3
4) M3
→ The most comprehensive measure of money
→ M2 + long-term deposits.
→ Includes all monetary and non-monetary deposit liabilities of the monetary banking sector.
→ Long terms deposits are relatively liquid.
→ Because it involves considerable effort and cost to move funds between the components of
M3 and financial assets that do not form part of M3, the M3 monetary aggregate is much
more stable than its components, and is a much better indicator of domestic spending.
What causes money stock to increase
1) Bank loans to private nonbank sector (Most important)
2) Transactions in financial assets between the banking sector (central and commercial banks)
and the private nonbank sector
3) Government transactions with the private nonbank sector
4) Foreign exchange transactions
Implications of the government printing money
→ Two types:
1) Printing banknotes and coins to finance expenditure.
→ Only SARB has the right to print money.
→ SARB prints money and sells it to banks (replaces old notes and for private sector cash
requirements Vault Cash). The SARB profits (Income less costs) are then transferred to
government bank accounts. No increase in money supply (Government deposit excluded).
→ Government then spends money and private sector deposits increase, therefore money
supply increases.
→ Normally not a problem (cash component small proportion of total money stock) unless
government is corrupt and abuses the processes creating excess money.
2) Government forces the central bank to buy excessive issues of government securities
→ Monetisation of government debt.
→ Central banks are not independent enough
→ MV+PY and therefore an increase in money stock causes an increase price level.
→ Hyperinflation occurs when, over the medium to long term, a vicious cycle of (money creation →
inflation → money creation) occurs..
→ In Zimbabwe it destroyed both the financial sector and the economy, caused untold hardship and
misery to the population, with the poor, being unable to protect themselves against the ravages of
high inflation, suffering most.
Part 2
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→ A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds
whose terms to maturity are longer than the holding period.
→ The more distant a bond’s maturity, the lower the rate of return that occurs as a result of the
increase in the in the interest rate.
→ The more distant a bond’s maturity, the greater the size of the percentage price change associated
with an interest rate change.
→ Paper loss if bond is not sold.
Interest rate risk
→ Prices and returns for long-term bonds are more volatile than those for shorter-term bonds due
the sensitivity of longer term bonds to interest rate changes.
→ Due in lager fact to the term to maturity being more than the holding period.
→ Bonds with a maturity that is as short as the holding periods have no interest rate risk.
→ Reinvestment risk: when the holding period is longer than the term to maturity of a bond, due to
uncertain future interest rates when reinvestment men occurs.
The distinction between real and nominal interest rates
→ Real interest rate: nominal rate less expected inflation. 𝑟 = 𝑖 − 𝜋𝑒
→ Real interest rate reflects the real cost of borrowing.
→ ex ante real interest rate is before the fact and ex post real interest rate is after the fact.
→ When the real interest rate is low there are greater incentives to borrow and fewer incentives to
lend.
→ Real returns which indicate the amount of extra goods and services that can be purchased.
→ Real interest rates are a more accurate indicator of the tightness of credit market conditions.
Indexed bonds
→ Interest and principal payments are adjusted for changes in the prices level.
→ Provide a direct measure of a real interest rate.
→ They are useful because to monetary policy makers because subtracting their interest rates from a
nominal rate on a non-indexed bond, they give insight into expected inflation.
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Changes in the interest rate due to expected inflation, the Fisher Effect
→ When expected inflation rises, interest rates will rise, also called the Fisher Effect.
→ Ambiguous change in quantity, but certain increase in interest rate.
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Supply and demand in the market for money: The liquidity preference framework
𝐵𝑆 + 𝑀 𝑆 = 𝐵𝑑 + 𝑀 𝑠 or 𝐵𝑆 − 𝐵𝑑 = 𝑀 𝑑 − 𝑀 𝑠
→ Simpler analysis is of effects from changes in income, price level and supply of money.
→ Simplifying assumptions:
1) Assumes there are only two kinds of assets, money and bonds which equals total wealth, and
therefore implicitly ignores any effects on interest rates from changes in expected returns on
real assets such as cars.
3) Assumes money has a zero rate of return as it earns no interest. Supply curve is vertical which
is not the case in South Africa.
→ Demand curve: As the interest rate rises the expected return of money relative to bonds falls and
the demand for bonds increases. The quantity of money demand and interest rate are negatively
related because of the rising opportunity costs of holding money when interest rates are
increasing.
→ Supply curve: Central bank supplies a fixed quantity.
→ Equilibrium: 𝑀 𝑠 = 𝑀 𝑑 at the intersection of the supply and demand curves.
→ When the price level increases more money will be demanded to restore purchasing power.
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2) Liquidity
→ the higher the bond’s liquidity the more appealing it is and therefore there would be a
rightward shift in the demand for bonds curve.
→ US Treasury bonds are the most liquid of all bonds.
→ Same graph as default risk case.
3) Income tax considerations.
→ Bonds that are exempt from tax have higher expected returns and hence there is an
increased demand for them.
→ Bonds with tax free interest payments have lower interest rates.
→ Municipal bonds are not default free and not as liquid as treasury bonds.
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Expectations theory
→ The interest rate on a long term-term bond will equal an average of the short-term interest rates
that people expect to occur over the life of the long-term bond.
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→ The key assumption is that buyers of bonds do not prefer bonds of one maturity over another, so
they will not hold any quantity of a bond if its expected return is less that that of another bond with
a different maturity
→ Implies Bonds with different maturities are perfect substitutes therefore same expected return.
→ When the yield curve is upward sloping short term interest rates are expected to rise. Or the
average of expected future short-term rates is higher than the current short-term rate.
→ When the yield curve is inverted the average of future short-term interest rates is expected to be
lower than the current short-term rate, implying that short-term interest rates are expected to fall.
→ If the yield curve is flat short-term interest rates are not expected to change on average in the
future.
→ Explaining empirical facts:
1) A rise in short term rates will raise people’s expectation of future short-term rates and given
that long-term rates are an average of short-terms rate they to will rise and hence move
together. 2) When short term rates are low people will expect them to rise in the future and
hence the average of future short-term rates rate is will be higher relative to the current
short-term rates hence long-terms rates will bi higher and the yield curve has an upwards slope.
Conversely for the high short-term rates and the inverted yield curve.
3) It cannot explain this fact as it predicts a typical curve would be flat because a rise or fall in
interest rates is equally likely.
Segmented market theory
→ Sees markets for different-maturity bonds as completely separate and segmented no substitution
and no effect on each other expected returns.
→ Bond are not substitutes at all due to the fact that investors have a strong preference for bonds of
one maturity but not for another and are only concerned with the expected returns of their
preference. This is due to the preference for a certain holding period. (holding period = term to
maturity = no interest rate risk).
→ The interest rate for each bond with a different maturity is then determined by supply and demand
for that bond.
→ Explaining empirical facts:
1) Unable to explain fact due to the fact that different maturity bonds are segmented and have no
influence on each others interest rates.
2) Unable to explain because it is not clear how demand and supply for short-term bonds versus
long-terms bonds change with the level of short term interest rates.
3) Demand for short-term bonds is higher due to the lower risk hence higher prices and lower
interest rates and long term bonds have lower prices and higher interest rates. This explain the
normal upward slope.
Liquidity premium theory and preferred habitat theory
→ Most widely accepted because explain facts the best and the other two theories lay ground work
for this one, and shines a light on how economist modify theories to empirical evidence.
→ The liquidity premium theory states the the interest rate on a long-term bond will equal an average
of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity
premium (term premium) that responds to supply and demand.
→ Key assumption is that bonds of different maturities are substitutes with their expected
returns influencing one another, they are not perfect substitutes.
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→ Investor tend to prefer short term bonds as they have lower interest-rat risk.
→ Investor must be offered a positive liquidity premium to induce them to hold longer-term
bonds.
→ Preferred habitat theory assumes investors have preference for bonds of one maturity over
another and will only buy non-preferred bonds with higher expected returns.
→ Most investor prefer the shorter-term habitat and therefore longer term bonds will have higher
prices.
→ Explaining empirical facts:
1) A rise in short-term interest rates mean short-term rates will be higher on average and therefore
so will long-term rates and so they move together.
2) If short-term rates are high people expected them to come down, therefore average of future
short term rates will be expected to be much more lower, therefore lower long-term rates
(despite the liquidity premium) are lower and there is an inverted yield curve.
3) Because the liquidity premium rises with a bond maturity because of the strong preference for
short-term bonds.
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→ The short-term bond yield is heavily affected by monetary policy and the repo rate.
→ The long-term bond yield is heavily affected by inflation, foreign exchange markets and the
general economic outlook.
Part 3
Chapter 8: An Economic analysis of financial structure
How financial intermediaries reduce transaction costs.
→ Financial intermediaries stand between lender-savers and borrow-spenders.
→ They enable funds to be transferred from people with non-productive opportunities to people with
productive opportunities.
→ In financial markets the costs of transacting is high.
1) Economies of scale
→ They bundle investors funds together to reduce the cost per individual investor.
→ The costs of a small transaction are similar to the costs of a large transaction.
→ Example a Mutual fund financial intermediary which sells shares to individuals and then
invests the proceeds in bonds and stocks. The charge fees for administrating accounts.
→ They increase diversification of risk, buy purchasing a range of securities, as small investors
would be compelled to keep all their eggs in the same basket, to keep costs down.
→ Economies of scale are important in lowering costs for communication and computerisation
in financial transaction.
2) Expertise
→ Expertises in things such as computer technology, providing help desks and information.
→ They provided liquidity services (easier transactions or being able to pay bills).
Lemons problem and adverse selection
→ Buyers cannot asses the quality of used cars, therefore the price buyers will pay must reflect the
average quality, between a low lemon and a high peach.
→ The owners knows the quality of the used car
1) If its low (lemon) they will be happy to accept the average price which is higher than a lemon.
2) If its high(peach) then the owner knows the car is undervalued at the average price and may not
sell.
→ The result is fewer good cars and the average quality ill be low, hence few sales and a poorly
functioning market.
→ In the absence of asymmetric information where buyers know as much about the quality of the
used car as the sellers then buyers will be willing to pay full value for good used cars.
→ Because byers are getting a fair price they will sell, and the market will have many transactions.
→ Similar arguments for stock and bond markets.
→ Tools to solve adverse selection problem
1) Private production and sale of information
→ Provide the people supply funds with more details about the individuals or firms seeking
finance.
→ Private companies collect and produce information that distinguishes good from bad.
→ Creates the free-rider problem, where people who don’t pay for the information take
advantage of the information other people have paid for.
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→ If A paid for info to invest in undervalued securities, and B and many others copy A, then the
price will go up and the security will no longer be undervalued and hence A will not buy info
in the future.
→ The weakened ability of private firms to profit from selling information will lead to less
information in the marker and an increase in adverse selection.
2) Government regulation to increase information
→ Government would be reluctant to release negative information as it would be politicly
unfavourable.
→ Governments regulate securities markets to encourage firms to reveal honest and accurate
information about themselves, and requiring audits.
→ Does not always work e.g. Enron. Statistics do not reveal the entire picture and bad
companies tend to paint the information in a good light.
3) Financial intermediation
→ They become experts in the production of information about firms and sorting the good credit
risks from the bad ones.
→ The higher profits from the information serves to incentivise information production.
→ They avoid the free-rider problem by making private non-traded loans and not public
purchases.
→ Banks have an increased role in developing economies because they reduced adverse
selection
→ As information becomes easier to acquire the role of banks will decline.
→ Easier for bigger firms to get funds in the direct route as more information about them is
available.
4) Collateral and net worth
→ Reduces the lenders loss in the result of default and therefore reduces adverse selection
→ Lenders are more willing to make loans because of the reduce risk.
→ Borrowers are more willing to supply collateral to get the loans
→ High net worth (difference between assets and liabilities) can serve as collateral
Moral hazard and equity contracts
Principal-agent problem (Moral hazed in equity contracts)
→ Separation of ownership and control involves moral hazard, as managers (agents) may act in their
own interests rather than in the interests of the stock-holders (principles) because the managers
have less incentive to maximise profits than shareholders do.
→ Examples are pursuing personal interests like diverting funds, or acquisitions of firms that increase
personal power but do not increase profitability.
→ Would not arise if owners had complete information about the mangers and could prevent
wasteful or fraudulent expenditure.
→ Would also not arise if there was no separation of ownership and control.
→ Tools to solve moral hazard problem in equity contracts
1) Production of information: Monitoring (Costly state verification)
→ Principles can monitor agents actions, conduct regular audits
→ Can be expensive in terms of time and money and makes equity contracts less desirable.
→ Subject to free-rider problem where if you know other stockholders are monitoring the agents
then you can take a free ride on their activities, if everyone does this the moral hazard
increases.
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Great Depression
1) Stock market crash
→ Stock market in a boom
→ Fed was tightening monetary policy.
→ Stock market crashed
→ Stocks temporarily recovered part of their losses.
2) Bank panics
→ Severe drought lead to large losses on farm mortgages.
→ Substantial withdrawals from banks lead to bank panic.
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→ Individuals and firms with the riskiest investment projects are those who are willing to pay the
highest interest rates. If increased demand for credit drives up interest rates sufficiently, good
credit risks are less likely to want to borrow while bad credit risks are still willing to borrow.
→ When there is weak bank regulation and supervision, then financial institutions will take on
excessive risk because market discipline is weakened by the existence of a government safety net.
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Basic banking
→ General profits are from asset transformation. (Selling one type buying another)
→ Borrows short and lends long.
→ T-account. Simplified balance sheet with lines in the form of a T, and lists changes that occur in
balance sheet items starting from some initial position.
→ When a bank receives additional deposits it gains an equal amount of reserves and vice versa.
→ 5 C’s
1) Character
2) Capacity (ability to pay)
3) Collateral
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How a capital crunch caused a credit crunch during the Global Financial Crisis
→ Shortfalls of capital (losses on mortgage back securities) therefore sale of assets.
→ Difficult to raise new capital so tightened lending standards and reduced lending.
Managing credit risk
Screening and monitoring
1) Screening: Collecting information about prospective borrowers and making judgement calls.
Statistics and personal information.
2) Specialisation in lending. Concentrating lending on firms in specific industries, banks become
more knowledgable about specific industries and better able to predict default risk.
3) Monitoring and enforcement of restrict covenants. Provisions in loan contract restricting risky
activities, must be monitored for compliance.
Long-term customer relationships
→ Analysis of past activity
→ Lower costs of monitoring
→ Easier to obtain loans for borrowers.
→ Helps with unanticipated moral hazard contingencies.
Loan commitments
→ Commitment to a commercial customer to provided loans up to a given amount for a specified
future period of time at market interest rates.
→ Advantage for firms as a source of credit when needed.
→ Promotes long-term relationships.
Collateral and compensating balances
→ Compensating balances: A required minimum cash balance in checking account as collateral.
Also Allows bank to monitor account for activity.
Credit rationing
→ Refusing loans of any amount. Reduces adverse selection as higher inters rates only attract riskier
borrowers.
→ Restricting size of loan to less than amount wanted. Reduces moral hazard. More borrowers
repay their loans if they are small.
Managing interest rate risk
→ Rate-sensitive assets/liabilities are short-term.
→ If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank
profits and a decline in interest rates will raise bank profits.
Gap and duration analysis
→ Gap analysis = rate-sensitive assets - rate-sensitive liabilities X change in interest rate.
→ Duration analysis examines the sensitivity of the market value of bank’s total assets and liabilities
to changes in interest rates.
Application: strategies for managing interest rate risk
→ Shortening or lengthening duration of banks assets to increase/decrease sensitivity to interest rate
changes
→ Can be costly.
Off-balance-sheet activities
Loan sales (Secondary loans)
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Part 4
Chapter 14: Central banks: a global perspective
Central Bank Independence:
FOR:
→ Political pressures would impart an inflationary bias due to their short-term focus on winning the
next election; this could lead to a political business cycle, with expansionary policy just before an
election and contraction policy after.
→ It could also be used to fund budget deficits and increase inflation.
→ Politicians also lack the ability to control monetary policy, and the agency problem is far worse for
politicians as they have fewer incentives to act in the public interest.
→ Independent central banks can pursue politically unpopular policies.
→ Empirical evidence suggest Independence is best for targeting inflation but central banks should
be accountable to parliament.
AGAINST:
→ Undemocratic to be controlled by a few elites, with a lack of accountability.
→ There needs to be a coordinated effort between fiscal and monetary policy to reduce cross
purposes.
→ Central banks may pursue narrow self interests and can be bureaucratic.
→ Does not always use its freedom well, and can fail to act when required.
→ Can be used as a whipping boy to take heat of politicians.
Can monetary policy help to alleviate SA unemployment problem?
→ No, Monetary policy is an ineffective tool to achieve this goal, reason why
1) South Africa’s high level of unemployment is mainly a structural problem
→ Most unemployed are unskilled workers and businesses demand skilled workers
→ Structural problems of a long term nature are best solved by long term structural solutions.
→ Such as a good school system, development of worker skills and entrepreneurship.
2) The economies of countries that have a lower inflation rate generally perform better.
→ Lowering interest rates increases inflation and lowers long term economic growth.
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→ In the long term, there is no trade-off between price stability and growth
3) Lower interest rates increase disposable income of households and increases borrowing,
increasing aggregate demand and consumption. However
→ little impact on unemployment if consumption is on imports
→ in SA production is not very sensitive to interest rates
→ even if lower interest rates increase production, it will not necessarily affect employment
→ More likely that output and employment will react to medium and long term interest rates and not
to changes in the short term repo rate.
4) Everybody can gain by low inflation as the unemployed and poor are impacted the most.
5) Lower interest rates might lead to a depreciation of the value of the Rand, increasing the price
of imports and raising inflation.
6) The real interest rate may be low.
→ The best contribution the SARB’s monetary policy can make is to maintain price stability and
contain cyclical variation in production employment levels. This creates favourable conditions for
sustainable growth in income and employment.
The South African Reserve Bank (SARB)
6 Main Functions
1) Sole right to issue cash or currency
→ Controls SA Mint Company which issues coins and owns SA Bank Note Company which
prints banknotes.
→ New currency is printed to serve the needs of the public.
→ The relatively small net income from printing currency accrues to government
→ Because the printing of new currency generates revenue for the government, it calls for care
and restraint, otherwise hyperinflation will occur.
2) Clearing and the settlement of interbank obligations
→ Cheques and electronic payments are cleared centrally by the SARB (through the Automated
Clearing Bureau)
→ Settlement is the final discharge of an obligation of one bank in favour of another (A at bank
AA writes cheque to pay B at bank BB), by means of the accounts the banks hold with the
SARB.
→ The SARB also oversees the safety and soundness of the payment system through the
introduction of settlement risk reduction measures.
3) Banker for and supervisor of other banks and lender of last resort
→ Provides accommodation to banks on a daily basis when they experience liquidity shortages
→ Holds the statutory cash reserves
→ To maintain sound and effective banking practices in the interest of depositors and the
economy.
4) Formulation and implementation of monetary and exchange rate policy
→ Politically sensitive
→ Refinancing or accommodation system where banks are forced into a liquidity shortage and
must borrow from SARB at the set repo rate, this then influence the level of all interest rates
and hence all participants in the economy.
→
5) Banker for government
→ Administering the auctions of government bonds and treasury bills
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→ If banks choose to hold on to all or some of their excess reserves, the full expansion of deposit
creation does not occur, i.e. does not account for excess-reserves ratio 𝑒 = 𝐸𝑅𝐷
→ Depositors decisions on how much currency to hold and bankers decisions on the amount of
excesses reserves should be taken in to account.
→ Static model that ignores the steps over time of the deposit creation process.
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Money multiplier
→ 𝑅 = 𝑅𝑅 + 𝐸𝑅 (equilibrium) (ER = excess reserves) (1)
→ 𝑅𝑅 = 𝑟𝑟 × 𝐷 (D = checkable deposits) (2)
→ Substitute 2 into 1, 𝑅 = (𝑟𝑟 × 𝐷) + 𝐸𝑅 (𝑟𝑟 < 1)
→ 𝑀 𝐵 = 𝑅 + 𝐶 = (𝑟𝑟 × 𝐷) + 𝐸𝑅 + 𝐶
→ Given currency ratio 𝑐 = 𝐷𝐶 and excess reserve ratio 𝑒 = 𝐸𝑅 , then after rearranging ratios
𝐷
𝑀 𝐵 = (𝑟𝑟 × 𝐷) + (𝑒 × 𝐷) + (𝐶 × 𝐷) = (𝑟𝑟 + 𝑒 + 𝑐) × 𝐷
1
→ Rearranging gives 𝐷 = × 𝑀 𝐵 (3)
𝑟𝑟 + 𝑒 + 𝑐
→ Using M1 definition of money 𝑀 = 𝐷 + 𝐶 and using 𝐶 = 𝑐 × 𝐷 gives
𝑀 = 𝐷 + (𝑐 × 𝐷) = (1 + 𝑐) × 𝐷 (4)
1+𝑐
→ Substitute 4 into 3 gives 𝑀 = × 𝑀𝐵
𝑟𝑟 + 𝑒 + 𝑐
1+𝑐
→ therefore money multiplier 𝑚 = × 𝑀 𝐵 (𝑚 > 1 if 𝑟𝑟 < 1)
𝑟𝑟 + 𝑒 + 𝑐
Money supply response to changes in the factors
→ 𝑀 = 𝑚 × (𝑀 𝐵𝑛 + 𝐵)
→ level of currency does rise when the monetary base and checkable deposits increase because
𝑐>0
Monetary policy in SA
→ SARB does not pay interest on bank reserves and government deposits.
→ Government transfers from SARB to banks/nonbank accounts increases reserves.
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→ (D → R or M → MB) implies that changes in r, c and e ratios does not cause a change in the
impact of R on D.
→ If banks are assured cash reserves, there is no reason for excess cash reserves. Excess cash
reserves are lent to other banks.
→ Banks only need to keep the required cash reserves as an average over a month period.
Removes the need to hold large excess reserves on a daily basis.
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→ Secondary credit (Banks in financial trouble) higher rate than discount rate
→ Seasonal credit for vacation and agricultural areas. (average of discount and CD rates)
3) Lender of last resort
→ Provide reserves to banks when no one else will to prevent bank failure.
→ Moral hazard problem with banks willing to take on more risk than they would normally
especially with banks to big to fail.
4) Reserve requirements
→ Increases in reserves requirements decrease the money multiplier, increases demand for
reserves and raises the federal funds rate.
→ Rarely used.
5) Interest on Reserves
→ Sets a floor and encourages banks to lend in the federal funds market and monitor each other.
→ Usually set below federal funds rate.
Relative Advantages of the Different Tools.
→ Open market operations are the most important because
1) Complete control over volume unlike discount operations where Fed cannot control the volume.
2) They are flexible and precise. Can be used for small or large operations.
3) They are easily reserved. To many purchases and be undo with immediate sales.
4) They can be implemented quickly and involve no administration delays. Changes to reserve
requirements take time and are costly to implement.
→ Other operations are better when:
→ Massive open markets operations would be needed to remove excess reserves and is better
to raise the federal funds rate by raising interest on reserves.
→ Discount policy is better used for lender of last resort.
A framework for monetary policy in South Africa
→ South African interbank market is to small to function effectively, lack of competition.
→ SARB conducts OMOs to ensures banks do NOT obtain all the reserves they need to meet their
reserve requirements and banks are forced to obtain unconditional accommodation loans. Reveal
more about behaviour of SARB than banks.
→ Vertical (AB) shows that the supply of nonborrowed reserves 𝑀 𝐵𝑛 is independent of the cash
funds rate.
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→ SARB ensures that the banks always have a liquidity shortage which forces them to borrow
reserves from the SARB.
→ Because repo rate is fixed, model only determines the total amount of borrowed reserves (and
hence total reserves) and not the interest rate.
How monetary policy is applied in South Africa
Open-market operations
→ SARB is constantly active in the money market to drain excess liquidity in order to force a liquidity
shortage
→ The SARB carefully estimates the banks’ overall liquidity requirements and then offers securities
on auction at varying interest rates. Banks estimate their liquidity shortage and tender for the
amounts and interest rates, which are then allocated in ascending order of interest rates bid.
→ To drain liquidity from the market, the SARB also sells longer-term reverse repo from its monetary
policy portfolio
→ SARB also uses foreign exchange swap transactions to temporarily drain rand liquidity from the
market.
→ Transfers to and from tax and loan accounts of the government held with private banks to
accounts at SARB.
Accommodation Policy
→ The purpose of accommodation policy is to provides liquidity (borrowed cash reserves) to banks
through repo agreements. Much larger in SA than USA(discount loans).
→ A change in the repo rate amounts to a change in monetary policy because the repo rate affects
interest rates in general.
→ At refinancing repo auctions that occur weekly, banks sell their securities to the SARB for a period
of one week, in return for cash reserves. Banks pay then repay the original amount provided a
week ago plus interest at the repo rate.
→ Ownership of the securities remains with banks, who also retain the right to interest income.
→ Shortages are provided for by a supplementary repo auction or a standing facility repo.
→ Surplus liquidity is absorbed by means of a supplementary reverse repo auction or a standing
facility reverse repo.
→ Also provides a lender of last resort role at higher rates.
Reserve requirements
→ Required to hold 2,5% of their total liabilities to the public as required reserves.
→ Required reserves held at the SARB are in addition to vault cash.
→ SARB does not change required reserves often because they need gazette a change which is
slow, it is crude because small changes in the reserve requirement lead to relatively large changes
in required reserves, and a fluctuating reserve requirement increases uncertainty for banks. It
amounts to a tax on the banking system.
Explain whether the formula M=m.MB applies to South Africa.
→ If we assume that c, r and e are constant over time then the formula M= m x MB explains how MB
and M are related. Of course, c, r and e are, in practice, not constant over time which causes the
relationship between MB and M to be less than perfect (meaning a constant ratio over time).
→ The formula appears to imply that MB is controlled by the central bank and that changes in MB
causes changes in M (MB → M). In SA, the MB is not controlled by the central bank as indicated in
the answer to activity (5). The central bank only controls the supply of nonborrowed reserves while
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the banks are accommodated by the central bank with as much supply of borrowed reserves
(𝐵𝑅 = 𝑅 − 𝑀 𝐵𝑛 ) as needed to meet their total reserve requirement (𝑅 = 𝑅𝑅 + 𝐸𝑅 = 𝑟 × 𝐷 + 𝐸𝑅).
Because BR automatically adjusts to other variables, and reserves are not controlled (fixed) by the
central bank, the causality does not run from MB → M but rather from M � M.B. Thus reverse
causality applies.
Part 6
Chapter 20: Quantity theory, inflation and the demand for money
Quantity theory of money
→ Theory of the demand for money and suggests interest rates have no effect on the demand for
money.
Velocity of money and equation of exchange
→ Velocity of money, the average number of times per year that a dollar is spent buying the total
amount of goods and services produced.
→ 𝑉 = 𝑃𝑀 ×𝑌 where 𝑃 × 𝑌 is total spending
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Determinants of velocity
→ Assumed to be constant
→ Institutional and technological features would only affect velocity slowly over time.
→ Credits card mean less money and therefore a higher velocity.
Demand for money
→ 𝑀 𝑑 = 𝑘 × 𝑃 𝑌 where 𝑘 = 𝑉1
→ Suggest demand is a then purely a function of income and interest rates have no effect on the
demand for money.
Quantity theory of money
→ 𝑃 × 𝑌 = 𝑀 × 𝑉̄
→ Implies change in the quantity of money leads to a proportional change in price level.
Quantity theory and inflation
→ inflation rate 𝜋 = %Δ𝑀 − %Δ𝑌
→ Quantity theory of money indicates that the inflation rate equals the growth of the money supply
minus the growth rate of aggregate output.
→ The quantity theory of money is a good theory of inflation in the long run but not in the short run.
→ Classical theory assumes wages and prices are completely flexible.
Government budget constraint
→ 𝐷𝐸𝐹 = 𝐺 − 𝑇 = Δ𝑀 𝐵 + Δ𝐵 where Δ𝐵 government bonds held by public.
→ If the government budget deficit is financed by an increase in bond holdings by the public, there is
no effect on the monetary base or money supply.
→ If the deficit is not financed by increased bond holdings by the public, the monetary base and
money supply increase.
→ The budget deficit will increase the monetary base if financed with high powered money.
→ Financing a persistent deficit by money creation will lead to a sustained inflation.
Liquidity preference theory
Motives for the demand for money
1) Transactions Motive. Medium of exchange, demand for money declining due to new
technology. Proportional to income.
2) Precautionary Motive. Cushion against unexpected wants. Proportional to income.
3) Speculative Motive. Store of wealth. Proportional to opportunity cost of holding which the
interest earned on bonds.
→ liquidity preference function. 𝑀𝑃 = 𝐿(𝑖, 𝑌 ) where 𝑀𝑃 is real money balances.
𝑑 𝑑
−+
→ Velocity is therefore 𝑉 = 𝑃𝑀𝑌 = 𝐿(𝑖,𝑌
𝑌
)
and it fluctuates.
→ Liquidity trap, where conventional monetary policy has no direct effect on aggregate spending,
because a change in the money supply has no effect on interest rates, occurs when nominal
interest rates are 0 and the demand for money7 is flat.
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3) Legislative lag
4) Implementation lag
5) Effectiveness lag
Inflation: Always and everywhere a monetary phenomenon
→ Monetary authorities can target any inflation rate in the long run with autonomous monetary
adjustments
→ Potential output and therefore the quantity of aggregate output produced in the long run is
independent of Monterey policy.
→ This is correct in the sense that a high rate of money growth is a necessary condition for sustained
inflation.
→ Inflation, in the sense of a sustained increase in the general price level, must necessarily be
supported by a continuous increase in money growth. If the money growth is limited or blocked,
then the inflation process cannot continue.
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→ Demand-pull inflation, result from policy makers pursing policies that increase aggregate
demand.
→ Policy makers underestimate the natural rate of unemployment and set a target that is to low.
→ Typically when unemployment is below the natural rate.
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period.
→ PPI is a measure of prices of manufactured goods at the factory door and values imports at the
price importers pay. The aim of the PPI is to measure the cost of production.
→ The CPI measures the cost of consumption.
→ Core inflation, is CPI net highly volatile short term prices, or prices sets by government (fresh fruit
and vegetables, bond rate, VAT rate) and measures the more sustained inflationary tendencies in
the economy.
→ SA use CPI to set inflationary targets.
→ When a market price increases, suppliers raise their claims on real wealth at the expense of
Demanders (first-generation effect).
→ If Demanders subsequently react to these losses, not by simply accepting them or by
compensating for them through increasing their real wealth creation (produce and sell more), but
by playing the same trick on other Demanders when acting as supplier themselves, price
increases feed on themselves and total income claims keep on running ahead of total real wealth
creation at existing prices (second-, third-, umpteenth-generation effect). In order to achieve ex
post equality between total income claims and real wealth creation, the nominal value of the latter
is then inflated.
→ While inflationary impulses can be a matter of either cost-push or demand-pull, inflationary spirals
are a matter of cost-push only
Social conflict and inflation proneness
→ Inflation is thus essentially a symptom of conflict over income distribution, which is not settled by
relative price/wage movements.
→ Three factors:
1) Regular significant increases in the price of goods or services which are an important input into
the production process or of the cost of living
2) Is affected by the competitiveness of both its goods and labour markets. (powerful interest
groups)
3) If the money stock is highly elastic. When there is less money and the demand for goods is
scarcer, firms are encouraged to absorb more cost increases and accept lower profit margins.
4) An increase in the rand price of imported goods (for an unchanged volume) raises foreign
claims on the local social product. South Africans have no choice but to give up some of their
real income. This necessary and unavoidable real income sacrifice could be extremely painful.
→ 3 ways to bear the pain.
1) Non-inflationary scenario,
→ local producers and retailers keep their rand prices unchanged and accept lower profit
margins.
2) Fully inflationary scenario (Inflationary spiral)
→ Local businesses carry their import cost increases forward into higher prices in full, to
maintain real profit margins
→ Consumers carry their living cost increases forward into higher wage demands to protect
their real wage rates.
3) Partially inflationary scenario
→ Business, labour and government each absorb some of the pain by carrying forward only part
of their cost increases in higher prices/wages, accepting some decrease in profit margins
and real wages.
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Combating inflation
→ Inflation cannot come down unless real income sacrifices are made
1) Price controls
→ Fixing prices by law.
→ Empirical evidence shows that it does not work
→ Creates black markets, reduces supply, stifles competition.
→ Only temporarily reduces inflation.
2) A voluntary social contract between business, labour and government
→ Business, labour and government work out a compromise on allowable price/wage/tax
increases
→ Problem in SA because of mutual distrust between business, labour and government.
3) Tight monetary policy: increasing the scarcity of demand
→ One adopted by most central banks
→ Tight monetary policy by way of high interest rates.
→ A greater scarcity of demand increases competition between businesses, and encourages
firms to accept lower profit margins, and strengthens their resolve to withstand wage
demands by labour.
→ Might not immediately lead to lower credit demand. (lag) Still an immediate reduction in
disposable income thought.
→ An increase in the interest rate not only works on the demand side by lowering demand for
goods, but also on the supply side by increasing costs (interest payments) which can have an
inflationary effect.
→ Success of tight monetary policy in combating inflation requires the cooperation of business
and labour, which the central bank does not always enjoy
→ Productivity increases can neutralise the inflationary effect of increased income demands.
4) The role of the foreign sector
→ An increase in the value of the currency is a painless and effective way of reducing inflation,
apart from the fact that it reduces the rand income of local exporters.
5) The self-reinforcing nature of lower inflation: the role of inflationary expectations
→ influence the public’s inflationary expectations
→ Widely publicising an inflation target and emphasising the government’s resolve to reach that
target is an exercise in persuasion.
→ People factor their inflationary expectations into their current income demands
→ Can create a downward inflationary spiral.
→ However in the current climate of rising inflation and pessimistic forecasts, the central bank’s
ability to influence people’s inflation expectations is severely tested.
The costs of inflation
→ Inflation damages real productivity when it turns economic agents away from productive activity
and productive investment, which can happen for three reasons.
1) Contributes towards a general climate of instability and pessimism
2) Inflation means that changes in nominal prices no longer reflect changes in relative prices
3) Causes people to divert their effort and capital away from productive enterprise towards
non-productive investment such collection stamps.
→ Adverse effects on income distribution:
1) Those who lack the bargaining power to increase their nominal incomes
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→ If nominal rates are zero, a commitment to future expansionary monetary policy raises inflation
exceptions, thereby lower the real interest rate.
Other asset price channels
Exchange rate effects on net exports
𝑟 ↓ ⇒ 𝐸 ↓ ⇒ 𝑁 𝑋 ↑ ⇒ 𝑌 𝑎𝑑 ↑ where 𝐸 ↓ is a depreciation of currency due to lower demand.
Tobin’s q theory
→ Explains how monetary policy can affect the economy through its effect on the valuation of
equities.
→ 𝑞 is the market value of firms divided by the replacement cost of capital.
→ If 𝑞 is high the market price of firms is high relative to the replacement cost of capital and new
plant and equipment capital is cheap relative to the market value of firms, companies can issue
stock and get a high price. Investment spending increases.
𝑟 ↓ ⇒ 𝑃𝑠 ↑ ⇒ 𝑞 ↑ ⇒ 𝐼 ↑ ⇒ 𝑌 𝑎𝑑 ↑ where 𝑃𝑠 is stock prices.
Wealth effects
→ Consumption is spending by consumers on non-durable goods and services.
→ Consumers smooth out their consumption over time.
→ Therefore the lifetime resources (financial wealth, mainly stocks) of consumers determines
consumption spending and not just today income.
→ Can be applied to house prices
𝑟 ↓ ⇒ 𝑃𝑠 ↑ ⇒ wealth ↑ ⇒ consumption ↑ ⇒ 𝑌 𝑎𝑑 ↑
Credit view
→ As a result of financial frictions from asymmetric information.
Bank lending channel
→ Banks play a special role in solving asymmetric information problems.
→ Expansionary monetary policy increases bank reserves and bank deposits raising the quantity of
bank loans available.
→ Many borrowers are dependant on banks for loans to finance activities and this increases in loans
causes investment spending to rise.
→ Implies monetary policy will have more of an impact on small firms than larger firms who can get
funds through direct finance.
→ Declining in importance
Bank reserves ↑ ⇒ bank deposits ↑ ⇒ bank loans ↑ ⇒ 𝐼 ↑ ⇒ 𝑌 𝑎𝑑 ↑
Balance sheet channel
→ A decline in net worth increase the the adverse selection problem, and leads to decreased lending
to finance investment.
→ A lower net worth in increases the moral hazard problem because owners have lower equity stake
and engage in riskier investments.
→ Easing of monetary policy leads to increased net worth and increase aggregate output.
𝑟 ↓ ⇒ 𝑃𝑠 ↑ ⇒ firm’s net worth ↑ ⇒ adverse selection ↓ ⇒ moral hazard ↓ ⇒ lending ↑ ⇒ 𝐼 ↑ ⇒ 𝑌 𝑎𝑑 ↑
Cash flow channel
→ A rise in cash flow from lower nominal interest rates increases liquidity and therefore increases
lending.
→ Also lower adverse selection by reducing credit-rationing.
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