Purchasing Power Parity
PPP exists when a basket of goods costs the same amount in one country as it does in another.
A long run requirement for international monetary equilibrium because...
If something is cheaper in another country, why wouldn't you either just buy it from them or buy it from them and sell it here for more money and profit?
3 Types of Exchange Rates
Fixed: Rigid exchange rate.
Floating: Fluctuates freely in response to changes in supply and demand for the two nations currencies.
managed floating: Both monetary authorities stand prepared to intervene is the exchange rate moves past certain bounds.
Difference between fixed and floating rate...
under a fixed rate, the exchange rate cannot adjust to preserve PPP... so it preserved by changes in the amount of int reserve currency available to each country.
Under a floating rate system it adjusts on its own and has no bearing on the quantity of money or level of prices of its trading partners.
International Reserve currency
If both are using fiat money one country will serve as the int reserve currency.
Free floating fiat monies
prevalent in the 1970's
Exchange rates are free to adjust and the price levels and money stock are independent of one another.
So the same money will buy the same bundle in both places
A Fixed Fiat Regime
When two fiat money economies link their currencies by setting a fixed exchange rate.
Ex) 1 rupee equals .25
In this situation, prices in their country must stay at 4 times our price level for PPP to hold.
Protecting/Defending a fixed rate
if there is a drop in demand of rupees then their gov can reduce the supply of rupees or they can use US dollars and buy rupees to incresse the demand of rupees relative to dollars.
Failures of the fixed rate
if it falls beneath a 100% backing then it tends to undermine peoples confidence in the rupee
Fed's Instruments of monetary control
1. OMO (most important today)
2. discount rate (supposed to use this one tho)
3. Statutory reserve requirements (changed only in rare situations)
What monetary policy should be aimed at:
minimizing the harmful effects of monetary disequilibrium (in the short run)
cause in the long run the price level would adjust itself
A monetary rule consists of some explicit instruction a central bank is supposed to follow including...
some observable target variable or statistic,
a path that the variable is supposed to follow (like a rate at which a variable is supposed to grow)
an example might be that the job of the central bank might be to keep the CPI at zero... meaning keep the general price level constant.
Only nominal values can be the basis for a feasible monetary policy rule....
because REAL variables have natural values to which their actual values will tend to conform no matter how the money stock is managed.
Radical Reform Alternative: The Gold Standard
Limiting inflation by bringing back the gold standard
Time line for Gold Standard
1879-1933: Gold coin standard
1933-1945: Gold bullion standard
1946-1971: Balton-Woods system
1971-present: Fiat money
Advantages of the gold standard
de-politicization: when supply demands on impersonal market forces and not on the will of bureaucrats and politicians.
Alleged defects of a gold standard
will reward gold mining nations
is difficult to implement
is incompatible with centralized management of money
"Social Savings" From Fiat Money
Friedman and Keynes
They both feel like under fiat money, its better because we save money by not mining and those same resources can go toward relevant goods.
The reality is that fiat money inflates alot and causes problems, but gold limits inflation and is a source of social savings.
Money which represents the prose of life, and which is hardly spoken of in the parlors without an apology, is in its effects and laws as beautiful as roses.
Money vs Wealth
Money is cash. Something you use to buy things. Wealth can be held in all forms. Property...etc.
Paper and coin forms of money
Public understanding is the key to economic stability
apparently. If people know what to expect or what is happening they can respond accordingly
a generally accepted medium of exchange
M1. M2. M3.
Checkable deposits (money in checking account)
Non Bank Currency holdings (cash)
-Savings + Deposits
-Small time deposits (<100,000)
-balance in personal money market mutual funds
-money market deposit accounts
-overnoight eurodollar deposits
-overnight repurchase agreements
M2 + large denomination time deposits
-term repurchase agreements
-Institutional money market fund balances
The Monetary Base (B)
Bank reserves plus the money in the hands of the public
Base Money vs Credit Money
Base money is legal tender (commodity and fiat money. Cash)
Credit money refers to redeemable claims to base money (bank deposits, checks, bank notes).
Money serves two main purposes
A medium of account (way to measure value)
A medium of exchange (an efficient means for trading goods and services)
In order for bartering to work there has to a double coincidence of wants. One that you want what they have, and two that they want what you have to offer in exchange.
Some superior group or being will adopt a medium of exchange.
Some lesser group will adopt their medium of exchange because of its usefulness, attractiveness, or the need of the larger groups goods.
This continues to happen until all outsiders must adopt the medium of exchange that is most widely used if they want to be able to trade with the other groups
And that medium has taken over. Voila. Snowball effect.
Bad money(less valuable) drives good money(more valuable) out of circulation meaning:
-When two coins of equal LEGAL value (both are said to be equal to a dollar), and UNEQUAL actual value (copper vs gold) are being used in commerce, will use the less valuable coin to buy things and hoard the more valuable coin and sell it off or something.
-This is only valid when the government is forcing people not to discriminate between equally legally valued money.
Centralized Decision VS Spontaneous Evolution (of money)
Centralized decision meaning that people got together and decided to make something money
Spontaneous decision meaning everybody just started using the same thing as money magically.
Short comings over a 100% coin standard
I have no idea... right now
Undervalued at the mint
When the money is worth more across seas than it is at the mint or bank or whatever, then it gets exchanged for the other type of money on the world market.
if gold is worth 20 dollars in the US,
and gold is worth 40 dollars in the UK,
People will just go to the UK and trade their gold coins for dollars.
This only works if the transaction costs are two high for a merchant to administer a dual pricing system. Other wise its irrelevant.
They're job was simply to hold your money and keep it safe. No mass.
Modern Banks (Intermediary)
Keep part of money in reserves in case someone wants to withdraw money, uses the rest of the money to give out loans.
ACCORDING TO ADAM SMITH
blah blah idk
Multilateral bank clearing
when you take all of what each bank owes switch in the most efficient way... through a clearinghouse
Several possibilities depending on the order of transactions... not really efficient.
Difference between banks then and banks now
We now have
What is a central bank?
Lender of last resort
controller of the money supply
Price-Specie Flow mechanism
The flow of gold away from countries with relatively high prices to countries with relatively low prices.
It becomes a problem when bank notes are redeemable for gold... and there's not that much gold available.
General option would be to suspend gold payments until further notice.
Last bank to officially abandon the convertibility of bank notes into gold
was the central bank in 1971
a critic of central banking... believed in free banking
First Federal Bank (Bank of the United States)
1791-1811 >> struck down by jefferson administration
2 ten year federal charters
Second Federal Bank
Established in 1816
Lasted 20 years
Jacksonians killed it in 1832
Was NOT common.
After 1837 Banking was free-er but
there were laws about branching and there were bond deposit requirements placed on banks.
Cause of Wildcat banking and Bank Failures
Was a byproduct of government regulation.
Restrictions on Bank Branching
Limited note-holders access to banks and made most banks operate as small, undiversified businesses.
Bond deposit Requirements
Gave consumers false confidence in the banks notes by implying that they were fully backed by safe assets. They were often junk bonds that bankers could buy at discounts.
Dishonest bankers would profit from this
Honest bankers suffered from these requirements because the bonds often depreciated over time and left the bank insolvent.
Would free banking have worked?
It worked in scotland and canada!
The Suffolk System
The closest thing the US has ever had to free banking.
Established in 1818
From 1818-1824: Aggressively purchased discounted country notes and returned them to their issuers trying to drive them out of business.
1825: Acted as a redemption agent for country banks as long as the banks kept permanent non interest earning deposits at the suffolk bank.
1825-1858: New England becomes the only region with uniform currency, country notes no longer circulate at a discount
Greenbacks came along during civil war
Were the basis for a fiat money standard until 1879
National Bank Acts
Based on earlier "free banking laws"
Time in US banking without regulation
1836-1863 there was no chartering or regulation of US banks.
Except there was regulation.
Federal Reserve Act
Created a system of 12 district Federal Reserve Banks
Governing body in washington
Originally consisted of 7 appointed members known as federal reserve board.
Membership into the system was required for National banks and voluntary for state banks.
Unanticipated gold inflows
fractional reserve requirement allowed the Fed to issue liabilities equal to a multiple of the amount of the gold inflows.
When the commercial bank gives the fed an 100 dollar 30 day IOU and then the Fed gives them back 99 dollars cash. (example)
Pretty much encourages member bank rediscounting ... not something a bank that is only a lender of last resort does.
Boom aided by low rate of discount Fed
1919-1920 bank loans and investments increase over 25%
Gold began flowing back into europe around 1920
partially because the war was over and partially because high US prices caused a price-specie flow effect.
Gold stock fell 336 mil or 12% from April 1919- April 1920 (easy money policy)
Market int rates rose 7 and 8 percent
Summer of 1920 crash
Commodity and Stock prices collapsed
Sharp but short collapse.
The US recovered quickly
Open Market Operations
Banks didnt wanna borrow from the Fed despite their extremely low rates
Use of OMO marked the Fed's change from a lender of emergency money to a manager of the money stock
Caused 1920's boom
Glass - Steagall Act
separated investment from commercial banking
limiting or prohibiting the payment of interests on bank deposits.
Goverment insurance of bank deposits
Three Things Congress did after the depression ... during the new deal
Glass-Steagall Act, Regulation Q, FDIC
According to Kevin Dowd...
Free banking was tried successfully in both the England and the US but was suppressed for political reasons.
According to the US constitution...
States cannot declare anything other than gold and silver to be legal tender
The difference between early and modern central banks and ordinary commercial banks is...
That one has special note issuing powers and privileges
The advantage of gold based fractional reserves is that...
it channels scarce savings into more productive uses
Evidence from private mints suggest that when people have a free choice in coinage...
good coins tend to drive bad coins out of circulation.
Because given the choice to refuse certain coins, people will only accept the valuable coin for their goods so people will only carry and spend the GOOD money.
In a system where people are not free to choose their coinage then the opposite occurs
Bank Failures in "Free banking" systems in the antebellum south were due to
the depreciation of the junk bonds that the banks were required to back their money with... during the supposedly free banking times
According to Thorton?? in "Why does Velocity Matter?" Why the flack do we have to know everything in those long boring ass articles? JEEZ
a re-domination of the currency. Corresponding with a scaling down of prices.
Because nothing is changing!! They are just changing the numbers around. This is what happens when they print more money to "attempt" to save people from high prices.
Said that fiat money was an outgrowth of redeemable credit monies
Difference between fiat money and Gold standard is
that the gold standard a built in limit to inflation. Can't inflate past the boundaries of a limited amount of money... since its backed
We can print cash like crazy if we want. Make inflation go ham.
When a bank has a monopoly on note issuing in a gold standard banking system...
their notes will be treated by other banks as a reserve asset.
What a government's revenue from money creation was originally known as.
A firm that basically holds money, gives out loans, etc. A Department store of finance.
Too much money
Too little Money
Causes depression and financial crisis
The importance of monetary control
England's Panic of 1825
Excessive monetary expansion in england that triggered the price-specie-flow mechanism
Determinants of the quantity of money
1. Quantity of base money
2.division of base money between the public and banks
3.Banking system reserve ratio
The Money Stock (M)
=(1/r) R + (1/c) D
Demand Deposits (D)
Money in bank accounts. Checking accounts more specifically I think. Money that can be demanded?
Monetary Base (B)
Includes all bank reserves (R) and currency holdings of the public.
B = R + Cp
=1/r (B+Cp) + 1/c (M-Cp)
=1/r B - 1/r ((1/c)D)
Reserve Ratio (r)
The desired or equilibrium ratio of reserves to deposits.
r = (R/D)
The Currency Ratio (c)
The publics desired ratio of currency to deposits.
c = (Cp/D)
When is the money stock (M) changed?
M goes up when B goes up, because the public's currency holdings go up and the money stock is defined as the sum of the public's currency holdings and demand deposits.
The Reserve Ratio... also effects M
An increase in the reserve ratio (holding the monetary base constant) calls for a decrease in bank deposits and currency holdings.
The Rule of Excess Reserves
Excess reserves = Actual reserves - required reserves
Money deposited by customers
Bank created demand deposits (like borrowing from another bank).
Multiple deposit expansion
Defines how much money will be created by a deposit.
Change in Deposits = original deposit amount * (1/reserve ratio)
Multiple Deposit Contraction
This is what happens when a bank borrows from another bank. Same process in a negative way.
Amount of money held by the public in relation to base money?
M = mB (m = money muliplier)
Base Money Multiplier (m)
m = (1+c)/(r+c)
Why is the money multiplier greater than 1?
Why impose statutory reserve requirements? Official Reason
to allow the authorities to control money stock and enhance liquidity of banking system
Why impose statutory reserve requirements? Unofficial Reason
to extract revenue from the banks and their customers. Interest lost due to higher reserve requirements equals income for the U.S. Treasury...
Why banks hold prudential reserves?
So that they don't start each day off with zero reserves!!
Optimal Prudential Reserves minimizes the sum of two costs...
1. The opportunity cost (OC) of reserve holding, equal to the quantity of reserves held times the interest rate on loans.
2. the expected penalty costs (PC) of reserve shortages, equal to the probability of claims exceeding reserves times some fixed penalty representing the loss of reputation or costs of emergency borrowing
Total cost of reserve holding is equal to
the sum of opportunity costs and penalty costs (in short).
optimal prudential reserve ratio r = R/D where D is taken as given. (see pg 105 of notes)
inflation refers to
any persistant upward movement in the price level
"One shot" changes in the price level:
can be due to changes in V or y as well as changes in M.
Inflation is almost always a consequence of...
excessive growth in the quantity of nominal money. (nominal: expressed in terms of a specific amount)
The crude quantity theory of Inflation
Holds that changes in the money stock lead to proportionate changes in the price level, with causation always running from money to prices.
Comparison with the Equation of Exchange
Critical assessment of the crude quantity theory
The case of hyperinflation
Despite the crude theory's empirical failure...
the general idea that inflation "is always and everywhere a monetary phenomenon" remains valid.
Most well known episode of hyperinflation:
Took place in Germany after WWI. From the outbreak of war til the currency reform that took place on Nov. 15th, 1923 (which ended hyperinflation overnight), the German Reichsbank 92.8 quintillion marks. and increased prices by 245 bil times prewar prices.
Most extreme instance of inflation:
In Hungary around 1945
Three stages of hyperinflation
1) Output stimulus stage: Change in money stock is greater than change in prices
2) Quantity-Theory Stage: change of money stock equals change in prices (growth rate of output returns to normal... Growth rate of velocity rises so the 2 are approximately equal).
3) Flight to real goods stage: Change (increase) in money stock is less than change (increase) in prices (Fear of continuing inflation causes further rise in velocity).
Higher nominal int rate >
higher velocity >
higher inflation >
higher inflationary expectation >
Costs of inflation
1. Loses to money holders: As prices rise, purchasing power of any given stock of M declines proportionally.
2. Loses to other creditors: Anyone holding fixed nominal int rate debt instruments lose money because real rate of int earned will be less than nominal rate by amount of inflation. iR = iN - pi (where pi is rate for inflation... money loaned at 10% yields zero return)
Costs on inflation (cont.)
3. Losses of businessmen and workers: Failure of selling prices to keep up with rising costs.
4. Losses to tax payers: (Bracket Creep) People are making more dollars, but not real earnings... end up paying higher taxes but still having to afford higher prices.
Net Costs of Inflation
1. Losses to money holders =
Gain to money issuers
2. Losses to creditors =
Gains to debtors
3. Losses to taxpayers =
Gains to government
Inflation is costly in the overall sense due to:
Distorted price and profit signals
Diversion of entrepreneurial effort (in to coping with inflation instead of development and improving production possibilities)
Dealing With Inflation
True Remedy: Monetary Restraint
Must stop the excessive growth of the money stock.
Ludwig Von Mises underscores this essential component of anti-inflationary policy
Slowing down money growth may be insufficient. You need to stop velocity as well. People need to BELIEVE you'll stop printing money.
How Germany did it:
New monetary institutions> strict regulations governing future money issues> ... Private banks ... new rentenmarks linked to gold ... no monetization of government debt
How New Zealand Did it:
Central Bankers job security linked to his success in fighting inflation
Anti inflationary policy is only successful if...
People expect inflation to end and adjust accordingly. If people expect inflation to continue and anti-inflationary policy is pursued, it could result in a serious depression. Happened in the early 1980's
Britian's return to Pre-war gold standard in 1925 (Explanation)
... To combate inflation I think... Not sure exactly.
Wage and Price controls: consequences are widespread shortages and distorted relative prices.
Money's influence upon the rate of interest... Classical View
Interest is a non-monetary phenomenon. Linked to consumer impatience to consume and to the productivity of capital... Therefore changes in the quantity of money not capable of influencing rate of interest
Money's influence upon the rate of interest... Keynesian View
Interest is a purely monetary phenomenon. Interest is equivalent to the price of money... which is therefore determined by the demand and supply of money. The greater the supply relative to demand, the lower the rate will be and vice versa.
Money's influence upon the rate of interest... NeoClassical View (Wicksellian view)
In the long-run the real interest rate (rate adjusted for inflation), depends on non monetary factors only. ... In the short run during times of disequlibrium (when the rate hasnt quite adjusted to changes in the price level yet), changes in money supply and demand can change the rate of interest and cause it to defer from its natural rate.
The WICKSELL or LIQUIDITY effect
The lower interest rate posted due to an increase in savings can be a way of letting people know "Hey! We have some extra bank loans available" and also a way of signifying an increase in the availability of real resources to be purchased.
If a bank expands its lending anyway...
It'll also lower int rates, but only in the short run. Eventually that new money will lead to higher prices tho.
The Fisher Effect 1890's
Positive inflationary expectations can be the basis for a monetary influence upon interest rates. Works thru changes in the inflation rate instead changes in the price level.
Phillip's Curve Controversy
1950s-1960s ... Showed a negative relation between inflation and unemployment. The higher the inflation rate, the lower the unemployment rate.
According to F. A. Hayek...
inflationary policies can lead to high unemployment... by overcompensating expectations (inflationary) and increasing natural rate of unemployment.
"Workers care not about the face value of the coins they recieve, they care only about how much money they can buy with them."
"Excess money growth can TEMPORARILY reduce interest rates."
John Maynard Keynes
"The interest rate is nothing more than the price of money "
"Excess money growth ultimately raises nominal interest rates"
"Inflation is always and everywhere a monetary phenomenon."
The Crude Quantity of money theory assumes...
that the growth rate of real output is the same as the growth rate of money's velocity.
Using Price and Wage controls tends to...
lead to a persistant and growing shortage of all goods and services.
Debiting verses Crediting
...A Debit adds. So if I debit your account, I am giving you more. Adding to it.
When Selgin asks a question about money and reserves and what to do...
If you have some amount of money and you decide to keep some reserves... what do you do to achieve this? You add the excess reserves to the amount you plan on lending out. You debit the borrowers account...
Bank Reserves Consist of...
Deposit credits from the Fed.
Federal Reserve Notes in the ATM
Fed Reserve notes in the banks vault
They do not consist of money spent... only money available. So currently invested money is NOT part of the reserves.
UGH! OK. To measure a persons currency ratio...
Take their CURRENTLY held money and DIVIDE that amount by what he has in the bank. So money in hand/money in bank.
cash in hand over cash in bank
a currency ratio of one means you have the same in the bank as in hand.
To measure money stock...
You add the money in the bank plus the money in your hand.
If some one has a one to one currency ratio then they have half in the bank and half out the bank
An increase in penalty costs...
will make banks increase their prudential reserves (personally chosen reserves)
The factor most responsible for a growth in money stock in the US is...
The growth of BASE money.
A bank acting independently of other banks can afford to lend...
its excess reserves
Banks borrow temporarily from the...
Federal funds market
Things that cause an increase in the banking system reserves
Reduced public demand for money
Fed reserve bond purchases
Reduced Fed rate
NOT in an increase in the amount of banks. Has nothing to do with it. DUH! smh.
The natural rate of unemployment...
According to monetarists... Booms are less common than busts because...
Prices are more flexible upward than downward
The Austrian school believes that the great depression could have been avoided if...
there had been less rapid monetary expansion during the 20's
Monetary expansion (according to Austrians)
causes a temporary decline in interests rates.... causing investors to favor more capital intensive projects (cause they can get money for cheap! YAY! CHEAP MO-NAY!)
The long run aggregate supply schedule is a vertical line that indicates...
the natural rate of unemployment