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The Monetary Model (Assets as “Perfect Substitutes”) Three supporting ideas: Walras’ Law Law of One Price Markets Functi

The Monetary Model (Assets as “Perfect Substitutes”) Three supporting ideas: Walras’ Law Law of One Price Markets Function to Maintain Equilibrium (in particular: goods, assets and money markets) Basic (simple) Idea of the Monetary Model

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The Monetary Model (Assets as “Perfect Substitutes”) Three supporting ideas: Walras’ Law Law of One Price Markets Functi

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  1. The Monetary Model (Assets as “Perfect Substitutes”) Three supporting ideas: Walras’ Law Law of One Price Markets Function to Maintain Equilibrium (in particular: goods, assets and money markets)

  2. Basic (simple) Idea of the Monetary Model 1. The BOP measures autonomous nominal money flows in and out of the country, i.e. to and from the domestic money supply. 2. If markets (= people) are “happy” with the amount of nominal money in circulation the domestic money market is in equilibrium. No one will attempt to accumulate or reduce nominal money holdings. So: If the BOP is not in equilibrium, people are not “happy” with the amount of money in circulation, i.e.the money market is not in equilibrium.

  3. BALANCE OF PAYMENTS - + PRIVATE ASSETS CA F Start by recalling the model of the BOP, and assume a fixed exchange rate regime and fixed prices. D PRIVATE SECTOR M - + KA FOREIGN HOME OMO FOREX - + ORA OFFICIAL ASSETS FR - OFFICIAL SECTOR + OSB D M

  4. BALANCE OF PAYMENTS PRIVATE ASSETS Consider the following initial (private sector) equilibrium and the asset distribution as shown. 3 3 3 9 F - + CA + KA D PRIVATE SECTOR M FOREIGN HOME OMO FOREX - + ORA OFFICIAL ASSETS 3 3 4 10 FR - OFFICIAL SECTOR + OSB D M

  5. BALANCE OF PAYMENTS PRIVATE ASSETS 3 2 4 9 F - + CA + KA D Now assume that the central bank wants to stimulate the economy by raising the real money supply. With fixed prices, this can be accomplished by raising the nominal money supply by 1… it buys domestic assets from the private sector using Open Market Operations PRIVATE SECTOR M FOREIGN HOME OMO FOREX - + ORA OFFICIAL ASSETS 3 4 3 10 FR - OFFICIAL SECTOR + OSB D M

  6. BALANCE OF PAYMENTS GOODS PRIVATE ASSETS ASSETS F - + CA + KA D PRIVATE SECTOR M 1 But if the private sector doesn't want the extra nominal money, what can it do? Answer: Get rid of it by buying goods and/or assets from the foreign sector! FOREIGN HOME OMO FOREX - + ORA OFFICIAL ASSETS FR - OFFICIAL SECTOR + OSB D M

  7. BALANCE OF PAYMENTS GOODS PRIVATE ASSETS ASSETS F - + CA + KA D PRIVATE SECTOR M 1 NOTE: The deficit of 1 shown above is some combination of CA and KA nominal money outflow! It could be, for example: CA = -1 & KA = 0 or: CA = 0 & KA = -1 or: CA = +10 & KA = - 11 or : CA = -0.5 & KA = -0.5 or any other combination as long as it implies a deficit of 1 ! But if the private sector doesn't want the extra money, what can it do? Answer: Get rid of it by buying goods and/or assets from the foreign sector! FOREIGN HOME OMO FOREX - + ORA OFFICIAL ASSETS FR - OFFICIAL SECTOR + OSB D M

  8. BALANCE OF PAYMENTS GOODS PRIVATE ASSETS But then the fixed exchange rate regime comes into play… The Central Bank must intervene and BUY THE EXCESS SUPPLY OF HOME MONEY ON THE FOREX… The result? The nominal money which the Central Bank attempted to inject into the economy returns to the Central Bank, where it came from! ASSETS F - + CA + KA D PRIVATE SECTOR M FOREIGN HOME OMO FOREX - + ORA 1 OFFICIAL ASSETS FR - OFFICIAL SECTOR + OSB D 1 M ASSETS

  9. BALANCE OF PAYMENTS BEFORE AFTER GOODS PRIVATE ASSETS 3 3 3 9 3.5 2 3 8.5 ASSETS F - + CA + KA D PRIVATE SECTOR M 1 The new “equilibrium”: The Private Sector: 1. The nominal money supply is at the (unchanged) desired level (3). 2. Some combination of more foreign goods and more foreign assets is now in the possession of the private sector. Note that “more foreign goods” means that the country has moved towards higher foreign debt! FOREIGN HOME OMO FOREX - + ORA 1 OFFICIAL ASSETS 2 4 4 10 3 3 4 10 FR - OFFICIAL SECTOR + OSB D 1 M ASSETS

  10. BALANCE OF PAYMENTS BEFORE AFTER GOODS PRIVATE ASSETS 3 3 3 9 3.5 2 3 8.5 ASSETS F - + The new “equilibrium”: The Official Sector: 1. The attempt to raise the nominal money supply has failed. 2. The Central Bank has lost 1 foreign reserves (it now only has 2 left) 3. The Central Bank has more domestic assets (4). CA + KA D PRIVATE SECTOR M 1 FOREIGN HOME OMO FOREX - + ORA 1 OFFICIAL ASSETS 2 4 4 10 3 3 4 10 FR - OFFICIAL SECTOR + OSB D 1 M ASSETS

  11. BALANCE OF PAYMENTS BEFORE AFTER GOODS IMPORTANT: Note that the fall in the Central Bank’s holdings of foreign reserves make it more difficult to defend the home currency on the FOREX.. andeverybody knows this! That means…. TROUBLE !!!! PRIVATE ASSETS 3 3 3 9 3.5 2 3 8.5 ASSETS F - + The new “equilibrium”: The Official Sector: 1. The attempt to raise the money supply has failed. 2. The Central Bank has lost 1 foreign reserves (it now only has 2 left) 3. The Central Bank has more domestic assets (4). CA + KA D PRIVATE SECTOR M 1 FOREIGN HOME OMO FOREX - + ORA 1 OFFICIAL ASSETS 2 4 4 10 3 3 4 10 FR - OFFICIAL SECTOR + OSB D 1 M ASSETS

  12. Therefore, according to the Monetary Model, if the policy makers (usually the central bank) maintain money market equilibrium, the BOP will always be in equilibrium, too. In principle, the money market/BOP disequilibrium is self-correcting… In the previous example, as the money flows out, the excess supply of nominal money disappears, and in the end equilibrium is again achieved… but be careful… it’s a DIFFERENT EQUILIBRIUM! Note that central banks can try and prevent this “self-correction” by sterilization. Another reason why sterilization is a dubious policy objective!

  13. Finally… what would have happened if instead of a fixed exchange rate, there had been a flexible exchange rate? The behavior of the private sector would have been identical… so, an excess supply of home money would have appeared on the FOREX. But with flexible exchange rates, there would have been no Central Bank intervention; instead, the home currency would have depreciated ! Would this also have led to a new equilibrium? And if so, how?

  14. The answer: Yes, but via a different adjustment mechanism. With flexible exchange rates and a depreciating currency, the ultimate result would be a higher price level. This higher price level will influence nominal money demand… it will rise! So, when the depreciating currency has succeeded in raising the home price level by enough to make the private sector willing to hold the higher nominal money supply (in the example, 4 instead of 3), equilibrium will again have been restored... But it will be a different equilibrium!

  15. The answer: Yes, but via a different adjustment mechanism. With flexible exchange rates and a depreciating currency, the ultimate result would be a higher price level. This higher price level will influence nominal money demand… it will rise! So, when the depreciating currency has succeeded in raising the home price level by enough to make the private sector willing to hold the higher money supply (in the example, 4 instead of 3), equilibrium will again have been restored... But it will be a different equilibrium! IMPORTANT: The demand for nominal money is derived from REAL money demand, i.e.: Real Money Demand = M/P = f ( Y, r ) where M is nominal money, P is the price level, Y is national income and r is the interest rate. So, if Y and r do not change, the ratio M/P cannot change either… in other words, if price P goes up, people want more M, too! + -

  16. The answer: Yes, but via a different adjustment mechanism. With flexible exchange rates and a depreciating currency, the ultimate result would be a higher price level. This higher price level will influence money demand… it will rise! So, when the depreciating currency has succeeded in raising the home price level by enough to make the private sector willing to hold the higher money supply (in the example, 4 instead of 3), equilibrium will again have been restored... But it will be a different equilibrium! IMPORTANT: Note that the “higher price level” means INFLATION.. andthis is a problem since macroeconomic stability is endangered by inflation. That means…. TROUBLE !!!!

  17. Summarizing: In the new equilibrium with flexible exchange rates: 1. There is more (nominal) money, M (4 instead of 3). 2. There is a higher price level, P . But... Together, these two changes imply an unchanged REAL money supply, M/P ! Furthermore, in the time interval which is required to depreciate the currency, CA + KA outflows will take place, with the same potential consequences for private sector assets and the country’s international debt position.

  18. Copyright (c) 1999 R. Gigengack http://www.eco.rug.nl/medewerk/gigengack a.r.m.gigengack@eco.rug.nl Summarizing: According to the Monetary Model, disequilibrium on the home money market, possibly (likely?) caused by Central Bank policy, is responsible for BOP deficits… Nothing else! This disequilibrium is, in principle, “self-correcting” (like the Hume “Specie-flow” adjustment mechanism), regardless of whether there is a fixed or flexible exchange rate (although the adjustment channels differ). The “new equilibrium” is characterized by failure of the Central Bank to achieve its objective… the (real) money supply is UNCHANGED. Therefore the typical monetarist policy advice to central bankers: “Do Nothing ! Your objectives won’t be realized, and you risk inflation and/or increased international debt.”

  19. Copyright (c) 1999 R. Gigengack http://www.eco.rug.nl/medewerk/gigengack a.r.m.gigengack@eco.rug.nl This ends the slide show.

  20. This slide show has been designed to accompany courses in International Economics at the University of Groningen. Other slide shows and animations of useful graphs for economic analysis, especially international economics, can be viewed elsewhere on: HTTP://WWW.ECO.RUG.NL/~GIGENGACK This slide show was created by: R. Gigengack ã 1999-2006 E-mail: A.R.M.Gigengack@RUG.NL

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