Introductory Material (Handa, Chapter 1)

1. Introductory Material(Handa, Chapter 1) Monetary Theory and Policy Graduate Seminar ECON 6411 Fall 2008

2. What is money? • Refers to assets that have come to take on certain roles (or serve certain functions) in an economy. The specific assets change over time and are different across societies. These functions are: • Medium of exchange/payments; • Store of value (temporary abode of purchasing power) • Standard of deferred payments; • Unit of account. • M1, M2, etc.

3. Monetary Base • Monetary Base (MB): Currency held by the public and by banks, plus reserves held by commercial banks on deposit at the Federal Reserve Banks (FRBs). • High-powered money is the MB plus money issue by other monetary authorities (e.g., the Treasury).

4. What is Monetary Economics? • Monetary economics is the economics of the money stock and of its repercussions on the economy. • In a monetary economy, virtually all market transactions involve money. • Monetary economics has both microeconomic and macroeconomic aspects.

5. Microeconomics • Handa argues that the money market—money supply and demand, and their equilibrium—is microeconomic. • The money market is a simplified summary of a complex market interaction known as the financial sector. • A complete study of monetary economics must include a study of the financial institutions and their behavior.

6. Money as Macroeconomics ys w0 P • In the classical/neoclassical model, money was the only variable that was truly macroeconomic. Thus macroeconomics was monetary economics. • In later models, money was shown to influence output and employment, interest rates, exports and imports, exchange rates, and the balance of payments. yd w/p y Y=F(N,K) Nd Ns N

7. Money as Macro (2) • Long-run effects of money include effects on growth. • Real analysis vs. monetary analysis. • Models take many forms: • Classical/Marshallian • Classical/Walrasian • Keynesian • Neokeynesian (disequilibrium) • Nonwalrasian (e.g., temporary equilibrium models) • Overlapping Generations Models

8. Money Supply and Demand r r Ms Ms Md Md M M Market supply of money, e.g., free banking. Exogenously determined Ms, e.g., by central bank.

9. Financial Intermediaries • These organizations stand between ultimate borrowers and ultimate lenders to facilitate their interaction. • Banks, mutual funds, pension funds, insurance companies, etc. • Intermediaries often repackage assets through was is called the asset-transmutation process. • For example, banks may take “short money” as deposits and create “long money” for loans. • Note that such assets have offsetting liabilities, so that the creation of financial assets by intermediaries does not create net wealth.

10. Inside vs. Outside Money • Gurley and Shaw (1960) ask: When can money be considered an asset in portfolios? • Inside Money: Money created by intermediaries in which there are offsetting liabilities in the private sector. • Outside Money: Money introduced from outside the private sector, which has no offsetting liabilities in the private sector. • According to Gurley and Shaw, outside money is the only money which is part of the private sector’s net wealth.

11. Barro’s Ricardian Equivalence • Barro’s article asks specifically “Are Government Bonds Net Wealth?” • In other words, are gov’t bonds held by the private sector net assets to the private sector? • If the issuance of a bond creates a tax liability to the private sector, then gov’t bonds are not net wealth.

12. Net Wealth • What about an increase in the money supply? • What if money supply increases are viewed as monetizations of debt? • Gurley and Shaw seem to be arguing that all money, while an asset to its owner, is a debt for someone else. • Pesek and Saving view all money as an asset. They argue that the inside-outside distinction is irrelevant. • The creation of high-powered money by the gov’t is always considered an asset.

13. Some definitions • Neutrality: Money is neutral if, following a change in the money supply, a new equilibrium is reach in which all real variables return to the same values as before the change. Money is non-neutral otherwise. • Superneutrality: Money is superneutral if a change in the growth rate of the money supply does not result in a change in the capital/labor ratio that exists on the equilibrium growth path (i.e., the real sector is unchanged). • Dichotomous Money: A macromodel is said to dichotomize if a subset of equations can determine the values of all the real sector variables, with the level of the money supply playing no role in determining the value of any real variable.

14. General Equilibrium Assumptions (1) All Agents Optimize (and on the same thing) (2) Perfect Information. (All agents seek and find full and free information.) (3) No Start-up or Setup Costs (Free Entry & Exit) (4) All Factors are Homogeneous (5) All Factors are Continuously Variable & Substitutable (6) Markets Adjust Instantly (7) Taxes are Neutral Critical to Pareto Optimality (8) Complete Markets (9) All Markets are competitive (10) No Externalities (11) Constant Returns to Scale Critical To Uniqueness (12) Convex Preferences (13) Convex Production Isoquants  dim. marginal rates of transformation and substitution