Econ 111 – Monetary Economics

1. Econ 111 – Monetary Economics Summer Session I Tue-Thu, 5:00PM – 7:50PM Center Hall 216 Dr. Hisham Foad

2. Why Take this Class? • To understand how the financial markets like the bond and stock markets work • To articulate why these markets react so strongly to actions taken by the central bank • To evaluate the effectiveness of monetary policy in dealing with economic shocks and inflation • To analyze the effects of policy on interest rates and how different interest rates affect different actors in the economy. • To explain the role of money in the economy and the process by which banks create money • To understand how moral hazard and adverse selection in financial markets led to the current credit crisis • To evaluate how domestic policy affects exchange rates and capital flows abroad.

3. The Economy Market for Factors Income Factor Payments Labor, Land, and Capital Purchased Labor, Land, and Capital for Sale Households Firms Goods and Services Purchased Goods and Services for Sale Market for Goods and Services Consumption Firm Revenue

4. The Economy Market for Factors Income Factor Payments Private Savings Interest Financial Markets Loans Public Savings Interest Households Firms Transfers Transfers Government Taxes Taxes Government Spending Market for Goods and Services Consumption Firm Revenue

5. Features of Financial Markets • A financial market is any market that matches borrowers and lenders • A borrower is anyone who is trading future income in exchange for current consumption • A lender is anyone trading current consumption for future income. • Generally, lenders must be compensated for giving up current consumption. • This compensation is represented by the interest rate paid on a loan • There are many different interest rates in the economy • Differences due to the length of loans, the risk involved in a loan, and the tax treatment of interest payments • Generally, however, all interest rates tend to move in the same direction.

6. Three Different Interest Rates

7. Stocks vs. Bonds • Two broad categories of financial markets are the stock and bond markets • A stock is an equity security that represents a share of ownership in a corporation. Ownership of a stock entitles you to a fraction of that corporations earnings and assets. • A bond is a debt security in which a loan is paid back to the lender with specified payments over a specified period of time. • Both bonds and stocks may be traded in secondary markets (e.g. the NYSE or the LSE for stocks; various computerized exchanges for bonds), although the entity first issuing the stocks or bonds does not receive any additional financing from these trades. • In general, stock returns are more volatile than bond returns. • Stocks are effectively loans with no maturity dates. • Equity holders are residual claimants – corporations must pay off all debt holders first in the face of bankruptcy

8. DJIA, 1950-2005

9. Monthly Interest Rates vs. Monthly Stock Returns Monthly Interest Rate on the 10 year T-bill S&P 500 Monthly Return

10. Why Save? Why Borrow? • What motivates someone to save? • Generally, we would prefer consumption today over consumption next year • However, we would also like to maintain a stable level of consumption over our lifetimes • We do this by saving when income is high then borrowing when income is low. • Saving can insulate consumption from income fluctuations • What motivates someone to borrow? • Since savers will demand positive interest on loans, borrowing money today implies that you will have more to pay back in the future. • When will you be willing to do this? When the return on your borrowing exceeds the amount you have to pay back. • Ex: You want to borrow $100,000 to open a restaurant that you think will generate $110,000 in profits next year. • Would you be willing to borrow at a 5% interest rate? • Would you be willing to borrow at a 12% interest rate?

11. The Importance of Financial Intermediaries • In reality, borrowers and lenders cannot costlessly find one another • Borrowers would like to shop around for the best interest rate and may have a hard time directly finding a lender with enough liquidity for their needs • Lenders have to expend resources assessing the risk of borrowers • Financial intermediaries like banks and mutual funds reduce search costs by acting as central clearinghouses where borrowers and lenders indirectly interact • They can overcome the large fixed costs of risk assessments by dealing in a large volume of loans • By making many different loans, they are better diversified against risk • However, banks are subject to agency problems in which the managers of the bank may act to better their own interests at the expense of the banks creditors and debtors.

12. Some Quotes on Money • "It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” • Henry Ford • “The process by which banks create money is so simple that the mind is repelled.” • “Money differs from an automobile or mistress in being equally important to those who have it and those who do not.” • John Kenneth Galbraith • “It’s a kind of spiritual snobbery that makes people think they can be happy without money.” • Albert Camus

13. The Monetary System • Money is defined as the set of assets in an economy that can be readily used to purchase goods and services • Money must serve three functions • Medium of Exchange • Unit of Account • Store of Value • Without money, economic exchange would be conducted through straight barter • Requires a Double Coincidence of Wants, which would greatly limit trade.

14. Effectively the Same Thing!

15. The Evolution of the Monetary System • Commodity Money Commodity Money takes the form of or is backed by a commodity that has intrinsic value. Examples include gold/silver coins, paper currency backed by gold, or even cigarettes in prisons. • Fiat Money Fiat money has no intrinsic value and is made viable solely by government decree. It is not backed by any commodity and only the collective belief in the government’s stability keeps the monetary system in operation. • Checks Checks are used to conduct payments within the banking system. Often payments cancel each other out, reducing the need for physical transfer of money across locations. • Electronic Payments Since the checks themselves still need to be physically sent and received, e-payments developed as a means to instantly instruct banks to make payments. • E-Money Debit cards, gift cards, pre-paid cards, PayPal.

16. The Central Bank • Under a fiat money system, one institution controls the supply of money in the economy, known as the Central Bank • In the U.S., the central bank is called the Federal Reserve System. • They are the sole issuers of paper currency and regulate the private banking system. • Through several policy tools, the Fed can greatly influence the supply of money circulating throughout the economy • Through these actions, the Fed may also influence such economic variables as the inflation rate, interest rates, rates of savings, stock market aggregates, exchange rates, and even unemployment.

17. More than $2,000 in currency per person in the US! What’s in Money?

18. Money and Exchange Rates • With an increasingly globalized economy, we need to consider the effects of domestic policy abroad and the effects of international policy at home • Why has the dollar been declining in value against the euro? • Why has the declining value of the dollar contributed to higher oil prices? • Why has the weak dollar helped mitigate the drop in US housing values but hurt European automakers?