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Chapter Fifteen

Chapter Fifteen. Money, the Banking System, and Foreign Exchange. Introduction Money Banking Crises Foreign Exchange Bringing It All Together How a Flexible Exchange Rate Regime Works How a Fixed Rate Regime Works. Chapter Fifteen Outline. Introduction.

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Chapter Fifteen

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  1. Chapter Fifteen Money, the Banking System, and Foreign Exchange

  2. Introduction Money Banking Crises Foreign Exchange Bringing It All Together How a Flexible Exchange Rate Regime Works How a Fixed Rate Regime Works Chapter Fifteen Outline

  3. Introduction • This chapter will examine the markets for money and foreign exchange and • The effect of openness on the money market. • Perhaps the most important key to understanding policy options in the world macroeconomy. • Most obvious effect involves the introduction of a foreign exchange market.

  4. What Is Money? • Money is an asset that its owner can use directly as a means of payment. • Currency held by the public and deposits on which checks can be written constitute a country’s money stock. • Nonmoney assets, such as stocks, bonds, real estate, certificates of deposit, and diamonds, also represent purchasing power to their owners, but they typically cannot be used directly as a means of payment.

  5. What Is Money? • In order to use the purchasing power of a nonmoney asset to buy a new car, the transaction would require two steps: • The individual must find someone to buy the asset (exchanging the asset for money); and • The individual uses the money to buy the car. • A nonmoney asset exchanged directly for an automobile would be an example of a barter exchange.

  6. What Is Money? • Nominal money stock (M): a country's money stock measured in current dollars. • “Stock” denotes the quantity of dollars existing at a point in time. • Real money stock: at any time equals the nominal money stock divided by a price index – the GDP deflator, P: Real money stock = Nominal money stock/Price index = M/P

  7. Demand for Money • The demand for money reflects the quantity of currency and checkable deposits the public wants to hold to make purchases. • Real money balances: nominal money balances divided by the price level. • Differential between the interest paid on NOW accounts and the interest paid on bonds still represents an opportunity cost of holding money.

  8. Demand for Money • Figure 15.1 depicts the relationship among the quantity of real money balances, the interest rate, and income. • The negative slope of each demand curve represents the negative relationship between the interest rate and the quantity demanded of real money balances. • Changes in income shift the demand curve for real money balances.

  9. Figure 15.1: The Demand for Real Money Balances i (Q > Q ) 1 0 L(Q , i) 1 L(Q , i) 0 0 Quantity of Real Money Balances

  10. Where Does Money Come From? • The central bank creates the basis for a country’s money stock by buying nonmoney assets (such as government bonds or foreign exchange) from the public, using checks written by the central bank and drawn on itself. • Central-Bank Balance Sheet • Balance sheet records the assets owned by an organization as well as its liabilities, or what the organization owes to others. • Difference between an organization’s total assets and its total liabilities equals its net worth.

  11. Where Does Money Come From? • Commercial Bank Balance Sheet • Commercial banks hold at least three types of assets: • The banks’ reserves (not to be confused with their foreign reserves). • Under the fractional reserve banking system adopted by most economies, banks can lend funds from their deposits – required to hold only a fraction of their deposits on hand to cover withdrawals by customers. • Loans • Other assets • Includes office buildings, real estate, government bonds, etc.

  12. Where Does Money Come From? • Changing the money stock by buying or selling government bonds. • Policies by which the central bank does this are called open market operations. • A central bank purchase of bonds increases the money stock. • Example of deposit expansion: Joe borrows $900 from bank to buy stereo. Bank credits Joe’s account with $900. Joe buys the stereo and the $900 moves into the stereo dealer’s bank account. That bank must hold only a fraction of the $900 in reserves and can lend out the rest. • At end of this process, the money stock will have grown by a multiple (called the money multiplier).

  13. Where Does Money Come From? • Changing the money stock by buying or selling foreign exchange. • Th central bank can obtain exactly the same effects on the money stock in the FX market as using government bonds. • Central bank can buy the excess foreign-currency-denominated assets from the public – it purchases them with its special check. • The same deposit expansion process occurs. • Current money stock (M) equals the money multiplier (mm) times the government bonds (GB) and FX reserves (FXR) held by the central bank.

  14. Money Market Equilibrium • Equilibrium in the money market requires that the real money stock equal the quantity of real money balances demanded by the public. • Figure 15.2 illustrates this: • The equilibrium interest rate is the opportunity cost of holding money at which individuals willingly hold the existing stock of real money balances. Increases in income raise demand for money and increase the interest rate (panel [a]). • Increases in the money stock produce a decline in the interest rate, inducing individuals to hold the new higher level of real money balances (panel [b]).

  15. Figure 15.2: Money Market Equilibrium (M /P) (M /P) (M /P) i i 1 0 0 (M > M ) (Q > Q ) 1 0 1 0 i 1 i i 0 0 i i 2 2 L(Q , i) 1 L(Q , i) L(Q , i) 0 0 Quantity of Real 0 0 Quantity of Real Money Balances Money Balances (a) Money Market Equilibrium (b) Increase in Money Stock

  16. The LM Curve • LM Curve: the upward-sloping curve in Figure 15.3 (b) shows the combinations of income and interest at which the money market is in equilibrium. • Rise in income increases the demand for money. For quantity demanded to be reequated with the fixed stock of money, a rise in interest rate is necessary. • Similarly, a rise in interest rate lowers the quantity demanded of money.

  17. The LM Curve • LM Curve and Fig. 15.3 (cont.) • With the stock of money fixed, income must rise to increase the demand for money. • Therefore, the interest rate and income combinations are positively related. The curve summarizing this positive relationship between I and Q is the LM curve, because at each point on it the quantity demanded of money (L) equals the money stock (M/P). • To the right of the LM curve, the quantity demanded of money exceeds the money stock – to the left of it, the quantity demanded of money is less than the money stock.

  18. Figure 15.3a: The LM Curve Represents Equilibrium in the Money Market i (M /P) (a) Money Market Equilibrium 0 (M /P) > L(Q , i ) 0 0 1 i 1 II (Q > Q ) 1 0 i 0 I (M /P) < L(Q , i ) 0 1 0 L(Q , i) 1 L(Q , i) 0 0 (M /P) Quantity of Real 0 Money Balances

  19. Figure 15.3b: The LM Curve Represents Equilibrium in the Money Market i LM(M /P) 0 (M /P) > L(Q, i) 0 (b) LM Curve (Q , i ) 0 1 i (Q , i ) 1 1 1 (Q , i ) 0 0 i (Q , i ) 0 1 0 (M /P) < L(Q, i) 0 0 Q Q Q 0 1

  20. The LM Curve • Since we assume the price level is fixed, only a change in the nominal money stock, M, can cause a change in the real money stock. • As illustrated in Figure 15.4, increases in the nominal money stock shift the LM curve to the right. • Any given level of income now requires a lower interest rate for money market equilibrium.

  21. Figure 15.4a: Effects of an Increase in the Real Money Stock on the LM Curve i (M /P) (M /P) (a) Money Market Equilibrium 0 1 (M > M ) II 1 0 i 1 IV i 3 I i 0 III i 2 L(Q , i) 1 L(Q , i) 0 0 (M /P) (M /P) Quantity of Real 0 1 Money Balances

  22. Figure 15.4b: Effects of an Increase in the Real Money Stock on the LM Curve i LM(M /P) 0 LM(M /P) 1 II i 1 i 3 IV i I 0 i III 2 0 Q Q Q 0 1 (b) LM Curve

  23. Banking Crises • How important are banking problems? • IMF reports that 130 countries experienced “significant banking sector problems” between 1980 and 1996 (shown in Figure 15.5). • Banking crises can impose large costs on an economy (shown in Figure 15.6). • The U.S. had costs of $180 billion in 1984-91 to correct the savings & loan crisis.

  24. Figure 15.5: Countries Experiencing Banking Sector Problems, 1980-1996 Banking Crisis Significant Banking Problems No Significant Banking Problems/Insufficient Information

  25. Figure 15.6: Direct Cost to Government of Banking Crisis (Percent of GDP) Argentina 1980 – 82 Chile 1981 – 83 Uruguay 1981 – 84 Israel 1977 – 83 C ô te d'Ivoire 1988 – 91 Venezuela 1994 – 95 Senegal 1988 – 91 Benin 1988 – 90 Spain 1977 – 85 Mexico 1995 Mauritania 1984 – 93 Bulgaria 1995 – 96 Tanzania 1987 – 93 Hungary 1991 – 93 Direct Cost of Banking Crisis (Percent of GDP) Finland 1991 – 93 Brazil 1994 – 95 Sweden 1991 Ghana 1982 – 89 Sri Lanka 1989 – 93 Colombia 1982 – 87 Malaysia 1985 – 88 Norway 1987 – 89 United States 1984 – 91 0 10 20 30 40 50 60

  26. Banking Crises • What does it mean for a bank to be “unsound”? • Bank can be unsound in one of two ways: • Illiquidity occurs when a bank’s assets are sufficient to cover its liabilities, but there is a time-horizon mismatch. • Liabilities are due now, but revenue from the assets are not available until later. • Insolvency: occurs when the value of a bank’s assets is insufficient to cover the value of its liabilities. • Net worth is negative. • Bank must then be “recapitalized,” bailed out by the government or taxpayers.

  27. Banking Crises • What are some of the main recipes for banking-system problems? • A run on an individual bank • Economy-wide bank runs • Bad loans • Declines in value of non-loan assets • Examples: corporate stock, bonds, or real estate. • Figure 15.7 reports banks’ local real estate holdings in 1997 for economies most affected by financial crisis. • Figure 15.8 reports declines of Asian stock indices between mid-1997 and mid-1998.

  28. Figure 15.7: Estimates of Asian Banks’ Loans to Property Sector (% of Total Loans, End of 1997) Philippines South Korea Indonesia Malaysia Thailand Singapore Hong Kong 0 10 20 30 40 50 60 70 80 90 100 Percent

  29. Figure 15.8: Asian Stock Prices, June 30, 1997to May 8, 1998 (Percent Change) Singapore 6/30/97 – 12/31/97 1/1/98 – 5/8/98 6/30/97 – 5/8/98 Taiwan South Korea Hong Kong Philippines Indonesia Malaysia Thailand 2 50 2 40 2 30 2 20 2 10 0 10 20

  30. Banking Crises • What are some of the main recipes for banking-system problems (cont.)? • Corruption and political favors • When corruption affects a banking system, the economy’s most productive firms may have trouble getting loans, which go instead to the politically well connected. • Figure 15.9 presents data on corruption in various countries. • Foreign-exchange problems • Figure 15.10 indicates the currency movements of several Asian economies during their recent financial crisis.

  31. Figure 15.9: Corruption Index, 2001 10 Finland LEAST CORRUPT 9 Singapore 8 Hong Kong United States Chile Japan 7 Corruption Index, 2001 6 Taiwan Malaysia 5 South Korea 4 Brazil Argentina China 3 Thailand Philippines India Russia 2 Indonesia Nigeria 1 MOST CORRUPT 0

  32. Figure 15.10: Asian Currencies Against the Dollar,June 30, 1997 to May 8, 1998 (% Change) Singapore Taiwan South Korea Hong Kong 6/30/97 – 12/31/97 1/1/98 – 5/8/98 6/30/97 – 5/6/98 Philippines Indonesia Malaysia Thailand 2 80 2 70 2 60 2 50 2 40 2 30 2 20 2 10 0 10 20 30

  33. Banking Crises • Why do banks matter so much? • Answer lies in recognizing the many central roles that banks play in an economy: • Banks allocate capital – they channel savers’ funds to firms to finance investment projects. • Banks play key role in economy’s monetary policy – interact with both central bank and public . • Strong banks allow country’s policy makers to carry out the macroeconomic policies needed by rest of economy. • Banks play major role in financial intermediation (channeling saving to investors). • Figure 15.11 reports 1994 figures for several countries.

  34. Figure 15.11: Banks’ Share in Total Financial Intermediation, 1994 Argentina Brazil Hong Kong Venezuela Indonesia Mexico Colombia Taiwan India Japan Germany Thailand Singapore Malaysia Chile South Korea United States 0 10 20 30 40 50 60 70 80 90 100 Percent

  35. Foreign Exchange • Equilibrium in the foreign exchange market…again. • Let CAB denote the current-account balance and KAB denote the capital-account balance… • When the sum of the current-account and capital-account balances equals zero, the overall balance of payments is in equilibrium. • The foreign exchange market is also in equilibrium, since the quantity demanded of foreign-currency-denominated assets equals the quantity available: CAB + KAB = 0 for BOP equilibrium Also: CAB = -KAB for BOP equilibrium

  36. Foreign Exchange • Figure 15.12 represents graphically this requirement for equilibrium in the balance of payments or the foreign exchange market by a negatively sloped 45-degree line. • Below and to the left of the line, there is a deficit. • Above and to the right of the line, the BOP is in surplus.

  37. Figure 15.12: Balance of Payments Equilibrium Requires that the CAB & KAB Sum to Zero BOP = 0 + ) * (Q , Q, R CAB 1 BOP > 0 2 (Surplus) 6 45o + ( KAB ) * e f i , i, e ,e 3 BOP < 0 5 (Deficit) 4 CAB = – KAB

  38. Foreign Exchange • For the remainder of this chapter, we assume that foreign income, relative prices of domestic and foreign goods and services, foreign interest rates, the spot exchange rate, the forward rate, and the expected future spot exchange rate are fixed. • Will examine relationship between domestic income and interest rate that must hold for equilibrium in the foreign exchange market.

  39. Foreign Exchange • Figure 15.13 illustrates the effects of domestic income and interest on the market for foreign exchange. • Starting from a point of BOP equilibrium (point I) in panel (a), an increase in domestic income moves the CAB toward a deficit, resulting in a BOP deficit at an unchanged interest rate (point II). • To cause increased capital inflows with which to offset the decreased current-account surplus, the interest rate must rise (point III). • At point III, the BOP is again in equilibrium, but with a smaller current-account surplus and capital-account deficit than at point I.

  40. Figure 15.13a: Effects of Domestic Income and Interest on the Market for Foreign Exchange _ ( ) CAB Q BOP = 0 Surplus CAB(Q ) 0 I III CAB(Q ) 1 II Deficit + 45o KAB(i) KAB(i ) KAB(i ) 0 1 BOP = 0 (a) Balance-of-Payments Equilibrium

  41. Foreign Exchange • The BOP Curve • The upward-sloping line of Figure 15.13 panel (b). • Reflects all combinations of income and interest rates that correspond to BOP (and FX) equilibrium. • Because increases in income move the CAB toward a deficit while increases in interest rates move the KAB toward a surplus, the BOP line is upward sloping. • Points I and III in panel (b) refer to those combinations of income and interest resulting in equilibrium points I and III in panel (a).

  42. Figure 15.13b: Effects of Domestic Income and Interest on the Market for Foreign Exchange i (b) BOP Curve BOP > 0 BOP III i 1 I i II 0 BOP < 0 0 Q Q Q 0 1

  43. The BOP Curve (cont.) • Increases in the foreign interest rate, expected depreciations of the domestic currency, or increases in the forward rate encourage capital outflows, moving the KAB toward a deficit. • An offsetting move toward a surplus in the current account requires a fall in domestic income to reduce imports. • Because a lower level of domestic income is required at each interest rate, the BOP curve shifts to the left. • Figure 15.14 summarizes these results.

  44. Figure 15.14: Changes in Foreign Income, Relatives Prices . . . Shift the BOP Curve i * Decrease in Q BOP' Increase in R * Increase in i e f Increase in e or e BOP BOP" * Increase in Q Decrease in R Decrease in i * e f Decrease in e or e 0 Q

  45. The BOP Curve (cont.) • Two special cases: capital mobility and the BOP curve. • Figure 15.15 shows how the degree of capital mobility determines the slope of the BOP curve. • Perfectly mobile capital means no transactions occur in the nonofficial capital account in response to changes in i or i*. • The BOP includes only the CAB, which equals zero at a single level of income, Qca, in panel (a). • Perfectly mobile capital means that small changes in the interest rate generate large global capital flows, implying a horizontal BOP curve as in panel (b).

  46. Figure 15.15: The Degree of Capital Mobility Determines the Slope of the BOP Curve i i BOP (BOP > 0) A B (BOP < 0 ) (BOP > 0 ) BOP (BOP < 0) 0 Q 0 Q Q ca (a) Perfectly Immobile Capital (b) Perfectly Mobile Capital

  47. Bringing It All Together • Figure 15.16 brings together the IS, LM, and BOP curves that represent equilibrium in the markets for goods and services, money, and foreign exchange, respectively. • A general equilibrium requires that the three curves share a common point of intersection. • At such a point, the markets for goods and services, money, and FX are all in equilibrium simultaneously at the given combination of Q, i, and e.

  48. Figure 15.16: Combining the IS, LM, and BOP Curves i LM BOP IS 0 Q

  49. How a Flexible Exchange Rate Regime Works See Figure 15.17 • Under a perfectly flexible exchange rate regime, the exchange rate continually adjusts to keep the BOP in equilibrium and, equivalently, to keep the quantity demanded of FX equal to the quantity supplied. • Figure 15.17 indicates how this happens: the BOP surplus at point I causes the domestic currency to appreciate, shifting the BOP and IS curves to the left. • Point II represents equilibrium with income equal to Q1, the interest rate at i1, and the domestic-currency price of foreign currency at e1.

  50. Figure 15.17: Automatic Adjustment from Position of BOP Surplus under a Flexible Exchange Rate i LM BOP (e ) 1 I BOP (e ) i 0 0 II i 1 (e < e ) 1 0 IS (e ) '(e IS ) 0 1 0 Q Q Q 1 0

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