Presentation Transcript

1. Money and BankingChapters 20-23

   Marc Prud’Homme University of Ottawa Last update: 14/09/12
2. Money Supply and Money Demand: The Big Questions How is inflation linked to money growth? Why do the Bank of Canada and the ECB treat money growth differently? Why do central bankers focus on interest rates
3. Inflation and money growth
4. Deposit Expansion and the Money Multiplier The monetary base is formed by central bank liabilities on which the supplies of money and credit are built M1 and M2 become a focus for central bankers; they are multiples of this monetary base Multiple deposit creation is the process in which central bank reserves become bank deposits
5. Deposit Expansion and the Money Multiplier Deposit creation by a single bank
6. Deposit Expansion and the Money Multiplier Only the Bank of Canada (the central bank) can create and destroy the monetary base. The nonbank public determines how much of it ends up as reserves in the banking system and how much is in currency The banks move the reserves they have around among themselves. Deposit expansion multiplier is the increase in commercial bank deposits following a one-dollar open market purchase of securities
7. Deposit Expansion and the Money Multiplier
8. Deposit Expansion and the Money Multiplier A change in reserves stimulates a significant change in the level of loans and chequable deposits in the banking system The fact that individuals change their cash holdings and thereby change the level of reserves in the banking system complicates the analysis Cash withdrawals reduce the impact of a given change in reserves on the total deposits in the system
9. Demand for money and velocity Velocity of money (V): The number of times each dollar is used (per unit of time). Quantity of Money (M) x Velocity (V) = Nominal GDP Nominal GDP = Price level (P) x Real Output (Y) MV = PY Implies
10. Demand for money and velocity Controlling inflation means controlling the growth of the monetary aggregates.
11. The Demand for Money: Transactions Demand The quantity of money people hold for transactions purposes depends on their nominal income the cost of holding money and the availability of substitutes As the nominal interest rate rises people reduce their checking account balances shift funds into and out of higher-yield investments more frequently
12. The Demand for Money: Transactions Demand The higher the nominal interest rate,the higher the opportunity cost of holding money, the less money individuals will hold for a given level of transactions.
13. The Demand for Money: Portfolio Demand As a store of value, money provides diversification when held with a wide variety of other assets, including stocks and bonds. Portfolio demand depends on Wealth the expected return relative to the alternatives expectations that interest rates will change in the future Risk Liquidity
14. Money Supply and Money Demand Central banks have a choice: they can set the interest rate or they can set the monetary base – not both
15. Monetary Policy and Financial Crisis How did the “Great Moderation” evolve into a global economic crisis? What were some of the key indicators which pointed to trouble ahead? What role did financial innovation and risk play? How did the financial regulators and central banks respond?
16. The great moderation Based on the past twenty years it appeared that policy makers had figured out how to keep the economy on a path of stable growth In Canada we saw steady growth in output, and falling inflation from a 5% level 1991 to less than 2% by 2000 While there were periods of turbulence in the global financial markets economic crises were contained to Latin America and Asia Monetary policy makers in Canada and other countries took credit for much of this stability – however some argue that monetary policy may have created the underlying conditions for the financial and economic crisis of 2008
17. Accommodative Monetary Policy Monetary policy , especially driven by the US after 9/11 and the collapse of the Tech bubble, have put downward pressure on interest rates Federal Reserve policies arguably supported the housing bubble – a key factor in the crisis Critics charge that former Fed. Chairman Greenspan should have aggressively raised rates as asset prices rose and consumers took on too much risk
18. Mispricing of Risk A decrease in credit spreads – the difference between the interest rates on government securities and corporate bonds – was also a contributing factor Causes of this could relate to: underestimation of asset risk falling risk premiums lack of information regarding risk of complex financial instruments
19. Financial innovation New financial products developed were complex and not clearly understood by many investors or regulators Mortgage Backed Securities (MBS) became highly risky as they increasingly were derived from risky subprime mortgages The complexity of these derivatives and others – including credit default swaps, lead to a mispricing of the risk associated with these instruments
20. The Evolution of the Financial Crisis The US is seen as the epicentre of the recent financial crisis Falling US house prices – especially on sub-prime mortgages caused the beginning of a domino effect Mortgage defaults and uncertainty over the true value of derivatives based on these mortgages caused a cascading level of redemptions and ultimately panic
21. The Financial Crisis in the Rest of the World While Canada’s banking system held up better than most during the crisis many had exposure to the US housing market All Cdn banks took significant loan provisions and saw their capital eroded The global impact of the crisis was significant Many countries had exposure directly to the US housing market or directly to US financial institutions Iceland was particularly hard hit as they were highly leveraged – three of their largest banks went bankrupt
22. Monetary policy responses The collapse of asset prices – such as share and real estate prices - was a result of the crisis As the availability of credit dried up businesses were not able to fund production Eventually this lead to a significant decline in consumer confidence, wealth, and spending. A financial crisis turned into an economic crisis In Canada and the United States, the monetary authorities responded with what are known as “unconventional” policies They expanded their balance sheets, and targeted longer-term interest rates These policies carried great risk as they had not been tried before – with the impact being uncertain
23. Monetary policy responses Interest rate reductions – the Fed lowered the target federal funds rate numerous times, eventually down to essentially zero Changes in the Fed Balance Sheet – (1) increasing the amount of reserves available to the banks, and (2) increasing the amount of deposits in the Treasury account Changes in the Bank of Canada Balance Sheet – unlike in the US there was no significant increase in banking system reserves. The entire expansion of the balance sheet was been funded by government deposits.
24. Bank of Canada balance sheet
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