Monetary Economics in Globalised Financial Markets

Preface

Contents

1 Money and Credit Supply

1.1 Money Definition, Functions, Kinds and Origin

1.1.1 Definition and Functions

1.1.2 Kinds of Money

1.1.3 Origin of Money

1.2 From the Gold to the Paper Money Standard

1.2.1 The Gold Standard

1.2.2 Gold Standard and the Price Level

1.2.3 Trade, Gold Movements, Prices and Income

1.2.4 Pros and Cons of the Gold Standard

1.2.5 The End of the Gold Standard

1.3 Money and Credit Creation

1.3.1 Base Money Supply

1.3.2 Central Bank Balance Sheet

1.3.3 The US Federal Reserve

1.3.3.1 Asset Side of the Balance Sheet

1.3.3.2 Liability Side of the Balance Sheet

1.3.3.3 Calculating the Monetary Base

1.3.4 The Eurosystem

1.3.4.1 Asset Side of the Balance Sheet

1.3.4.2 Liability Side of the Balance Sheet

1.3.4.3 Illustration

1.3.5 Credit and Money Creation

1.3.6 Multiple Credit and Money Creation

1.3.7 The Tinbergen Approach to the Money Multiplier

1.3.8 Open Market Operations

1.3.8.1 Open Market Operations in the US

1.3.8.2 Open Market Operations in the Euro Area

1.3.8.3 Example: The ECB's Variable and Fixed Tender Procedure

1.3.9 A Closer Look at the Demand for Base Money

1.3.9.1 Re (i): Minimum Reserves

1.3.9.2 Re (ii): Cash Drain

1.3.9.3 Re (iii): Working Balances

1.3.10 Supply of and Demand for Base Money

1.3.11 Impact of Short- on Long-Term Rates

1.3.12 Exogenous Versus Endogenous Money Supply

1.3.12.1 The Statistical Issue

1.3.12.2 The Theoretical Issue

1.4 Money Aggregates

1.4.1 International Definitions of Money Aggregates

1.4.1.1 United States

1.4.1.2 Euro Area

1.4.1.3 Japan

1.4.1.4 Switzerland

1.5 Digression : Divisia Monetary Aggregates

1.4.1 Weak Separability of Utility Functions

1.4.1 Constructing a Divisia Monetary Aggregate

1.5 Impact of Portfolio Shifts on Money

1.5.1 Autonomous Bank Refinancing

1.5.2 Bank Refinancing Via Selling Assets

1.5.3 Disintermediation

1.5.4 Inversion of the Yield Curve

1.6 A Look at Global Liquidity

1.6.1 Calculating a Global Liquidity Aggregate

1.6.2 The Effects of Cross-Border Selling of National Currency on National Monetary Aggregates

1.7 Digression : Key Facts About Major Central Banks

1.6.2 The US Federal Reserve System

1.6.2.0 Objectives

1.6.2.0 Federal Reserve Open Market Committee

1.6.2.0 Meetings and Proceedings of the FOMC

1.6.2 European Central Bank

1.6.2.0 Objectives

1.6.2.0 ECB, ESCB and Eurosystem

1.6.2.0 Decision Making Bodies

1.6.2.0 Meetings and Communication

1.6.2 Bank of Japan

1.6.2.0 Objectives

1.6.2.0 Decision Making Bodies

1.6.2.0 Meetings and Communication

1.6.2 Bank of England

1.6.2.0 Objectives

1.6.2.0 Committees

1.6.2.0 Meetings and Communication

2 Money and Credit Demand

2.1 Classical Demand for Money Theory

2.1.1 The Cambridge Approach

2.1.2 The Role of Wealth in the Transaction Approach

2.2 Keynesian Money Demand Theory

2.2.1 Explaining the Trend of Income Velocity of Money

2.2.2 Some Empirically Testable Money Demand Hypotheses

2.3 Portfolio Oriented Money Demand Theory

2.3.1 Monetarist Money Demand

2.3.2 Post-Keynesian Money Demand Theory

2.3.2.1 Inventory Model Approach to Transaction Balances

2.3.2.2 Tobin's Demand for Speculative Balances

2.3.2.3 Re (i): Change in Expected Return

2.3.2.4 Re (ii): Change in Risk

2.3.2.5 Re (iii): Increase in Taxes

2.4 Digression: Income Velocities of US Monetary Aggregates

2.4 Money-in-the-Utility Function and Cash-In-Advance Models of Money Demand

2.4.1 Money-in-the-Utility Function of Money Demand

2.4.2 Cash-in-Advance Models of Money Demand

2.5 Estimating Money Demand Functions for the US and the Euro Area

2.5.1 Money Demand in the US

2.5.2 Euro Area Money Demand 1980-Q1 to 2001-Q4

2.5.3 Euro Area Money Demand 1980-Q1 to 2006-Q1

2.6 Credit Demand

3 Interest Rate Theories

3.1 Introductory Remarks

3.2 The Austrian Theory of the Interest Rate

3.3 The Neo-Classical Theory of the Interest Rate

3.3.1 The Intertemporal Budget Constraint

3.3.2 The Intertemporal Production Frontier (IPPF)

3.3.3 Determining the Market Interest Rate

3.3.4 Sum of the Parts: the Neo-Classical Interest Rate

3.4 Knut Wicksells Theory of the Interest Rate

3.4.1 Wicksell's Loanable Funds Theory

3.4.2 The Concept of the Real Neutral Interest Rate

3.4.2.1 Time Preferences

3.4.2.2 Productivity and Population Growth

3.4.2.3 Fiscal Policy and Risk Premia

3.4.2.4 Institutional Structure of Financial Markets

3.4.3 Estimating the Natural Real Interest Rate

3.4.3.1 Long-Term Averages of Actual Real Interest Rates

3.4.3.2 Real Yields of Inflation Index Bonds

3.4.3.3 Time Series Models

3.4.3.4 Structural Models

3.5 The Keynesian Liquidity Preference Theory

3.6 Nominal Versus Real Interest Rates

3.7 Credit Spreads

4 Financial Market Asset Pricing

4.1 Prices, Returns and Distributions

4.1.1 Prices and Returns

4.1.1.1 Holding Period Returns

4.1.1.2 Compounding Returns

4.1.1.3 Continuous Compounding

4.1.2 Joint, Marginal, Conditional and Unconditional Distributions

4.1.2.1 Joint Probability Density Function (PDF)

4.1.2.2 Marginal PDF

4.1.2.3 Conditional and Unconditional PDF

4.1.2.4 Statistical Independence

4.1.2.5 Continuous Joint PDF

4.1.2.6 Random Variables and the Normal PDF

4.1.2.7 From the Unconditional to the Log-Normal Distribution

4.1.2.8 The Lognormal Distribution

4.2 Stylised Facts for International Asset Price Linkages

4.2.1 Latest Developments

4.2.2 Descriptive Statistics and Some Tests

4.2.2.1 Empirical Findings for International Asset Returns

4.2.3 Measuring International Asset Return Linkages

4.2.3.1 Re (i): Causality

4.2.3.2 Re (ii): Co-Movement of Various Asset Prices

4.2.3.3 Re (iii): Convergence of Asset Prices and Valuations

4.2.3.4 Some Empirical Estimation

4.3 Digression: Price Earnings Ratios and Future Stock Market Performance

4.2.3 Long-Run Relation Between International Bond Yields

4.3 Rational Expectations and the Efficient Market Hypothesis

4.3.1 Formalising the EMH

4.3.2 Orthogonality Property

4.3.3 Random Walk

4.3.4 No Abnormal Returns

4.3.5 Market Relevant Information

4.4 Bond Valuation Basic Valuation Concepts

4.4.1 Prices, Yields and the RVF

4.4.1.1 Terminal Value of Investment

4.4.1.2 Discounted Present Value (DPV)

4.4.1.3 Time Value of Money

4.4.1.4 Pure Discount Bonds and Spot Yields

4.4.1.5 Coupon Paying Bonds

4.4.1.6 Spot Rates

4.4.1.7 Approximating Spot Rates from Coupon Paying Bonds

4.4.1.8 Forward Rates

4.4.1.9 Holding Period Yield (HPY) and the Rational Valuation Formula (RVF)

4.4.1.10 Duration

4.4.1.11 Nominal Versus Real Values

4.4.2 Theories of the Term Structure of Interest Rates

4.4.2.1 Theories of the Term Structure of Interest Rates Using the HPY

4.5 Digression: The Information Content of the US Term Spread for Future Economic Activity

4.4.2 Explaining the Term Structure of Interest Rates Using Spot Yields

4.4.2.1 The PEH and Spot Yields

4.4.2.1 PEH: Tests Using Different Maturities

4.4.3 The Term Structure Spread and Future Short-Term Rate Changes

4.5 Stock Valuation

4.5.1 Discounted Cash Flow Under EMH-RE

4.5.1.1 Stock Valuation

4.5.1.2 RVF for Stocks with Constant Expected Returns

4.5.1.3 Gordon's Constant Dividend Growth Model

4.5.1.4 Gordon's Dividend Growth Model with Variations in Dividend Growth

4.5.1.5 Excess Volatility of Stock Prices (''Variance Bounds'')

4.5.2 Dividend Yields, Expected Returns and the Campbell-Shiller Model

4.5.2.1 Dividends Yields and Expected Returns

4.5.2.2 The Campbell-Shiller Model

4.5.2.3 An Empirical Application of the Campbell-Shiller Model

4.5.2.4 Some Words of Caution: Data Persistence and the Quality of Long-Horizon Forecasts

4.6 Capital Asset Pricing Model (CAPM)

4.6.1 Portfolio Selection Theory

4.6.2 Model of the Capital Market Line (CML)

4.6.3 Two-Fund Separation Theorem

4.6.4 The Capital Asset Pricing Model

4.6.5 Estimating the Beta-Factor

4.7 Liquidity Provision A Theoretical Framework

4.7.1 The Financial System as a Private Provider of Liquidity

4.7.2 Financial Fragility and Cash-in-the-Market Pricing

4.7.3 Contagion

4.7.4 Asymmetric Information

5 Causes, Costs and Benefits of Sound Money

5.1 The Objective of Price Stability

5.1.1 The Index Regime -- Measuring Price Stability

5.1.2 Headline Versus Core Indices

5.1.3 Predictive Power of Core Inflation

5.1.4 Role of Core Inflation in Monetary Policy

5.1.5 International Definitions of Price Stability

5.1.6 Inflation Versus Price Level Objective

5.1.7 Price Level Stability and Positive Supply-Side Shocks

5.1.7.1 Re (i): Supply Shock Without Policy Intervention

5.1.7.2 Re (ii): Supply Shock with Policy Intervention

5.1.7.3 Conclusion

5.1.8 Inflation Versus Price Level Targeting in a Simple Phillips Curve Model

5.1.8.1 Some Simulations

5.1.8.2 Conclusion

5.1.9 A Brief Look at Inflation History

5.2 Causes of Inflation

5.2.1 Monetary Inflation Theory

5.2.1.1 The Equation of Exchange

5.2.1.2 Money Growth and Inflation

5.2.1.3 The Information Content of Money in a Low Inflation Environment

5.2.1.4 The Concept of ''Core Money'' and ''Core Inflation''

5.2.1.5 Cagan's Model of Prices, Money and Hyperinflation

5.2.2 Non-Monetary Inflation Theory

5.2.2.1 One-Off Price Level Effect Versus Inflation

5.2.2.2 Do ''Models Without Money'' Explain Inflation as a Non-Monetary Phenomenon?

5.2.3 Fiscal Theory of the Price Level

5.2.3.1 Weak Form Fiscal Theory of the Price Level

5.2.3.2 Strong Form Fiscal Theory of the Price Level

5.2.3.3 How Much Price Stability Is Desirable?

5.2.3.4 Does the FTPL Provide Useful Input into the Design of Socially Efficient Policies?

5.2.3.5 What Insights Does the FTPL Provide in the End? A Critical Assessment

5.3 Costs and Benefits of Inflation

5.3.1 Costs of Inflation

5.3.1.1 Costs of Non-Anticipated Inflation

5.3.1.2 Costs of Anticipated Inflation

5.3.1.3 Inflation -- A Collective Societal Evil

5.3.2 Benefits of Inflation -- The Phillips Curve

5.3.2.1 The Traditional Phillips Curve

5.3.2.2 The Modified Phillips Curve

5.3.2.3 Expectation Based Phillips Curve

5.3.2.4 The Hysteresis-Based Phillips Curve

5.3.2.5 Why Is the Use of Full-Fledged Hysteresis Models So Attractive for Monetary Policy Consulting?

5.3.3 A Path-Dependent Long-Run Phillips Curve -- The Case of Hysteresis

5.3.3.1 Introduction

5.3.3.2 The Micro Model Under Certainty

5.3.3.3 Macro Level: An Aggregation Approach

5.3.3.4 The Micro Model Under One-Off Uncertainty and the Possibility of Waiting

5.3.3.5 Aggregation to the Macro Level Under Uncertainty

5.3.3.6 Conclusions and Implications for Monetary Policy

5.3.3.7 Monetary Policy and Investment Decisions -- A Stylized Treatment of the Uncertainty Trap

5.3.4 Monetary Policy and the Phillips Curve

5.3.4.1 Monetary Policy Under a Keynesian Phillips-Curve

5.3.4.2 Monetary Policy Under a Monetarist Phillips-Curve

5.3.4.3 Monetary Policy Under a Neo-Classical Phillips-Curve

5.3.4.4 Re (iv): Neo-Keynesian Phillips-Curve

5.3.4.5 Re (v): Monetary Policy Under a Hysteretic Long-Run Phillips Curve

5.3.4.6 Summary

5.3.4.7 Monetary Policy, the Phillips Curve and Partisan Political Business Cycles

5.4 Optimal Inflation

5.5 Deflation

5.5.1 Demand and Supply Shocks and Deflation

5.5.1.1 Keynesian Investment Trap

5.5.1.2 Keynesian Liquidity Trap

5.5.1.3 The Case Against (Persistent) Deflation

5.5.2 Debt-Deflation Theories

5.5.2.1 Fisher's Debt-Deflation Theory

5.5.2.2 Mises' Deflation Theory

5.5.2.3 Minsky's Debt Deflation Theory

5.5.2.4 Bernanke's Debt Deflation Theory

5.6 Asset Price Inflation

5.6.1 From ''Bubbles'' to Asset Price Inflation

5.6.2 Keeping Track of Asset Price Inflation

5.6.2.1 The Role Asset Prices Play in the Transmission Mechanism

5.6.2.2 The Role of Financial Asset Prices for the Stability of the Financial System

5.6.2.3 The Use of Assets Prices as Information and Indicator Variables

5.6.2.4 The Discussion About Including Asset Prices in the Monetary Policy Objective

5.6.2.5 Discussion

6 Theory of Monetary Policy

6.1 Uncertainty in Monetary Policy Making

6.1.1 Model Uncertainty

6.1.2 Data Uncertainty

6.2 The Debate About Rules Versus Discretion

6.2.1 Arguments in Favour of Monetary Policy Discretion

6.2.2 Arguments in Favour of Rules

6.3 The Time Inconsistency Problem

6.3.1 Time Inconsistency in a Two-Period Model

6.3.2 Time Inconsistency in a Multi-Period Model

6.3.3 Alternative Solutions to Inflation Bias

6.3.3.1 The Concept of a Conservative Central Banker

6.3.3.2 Optimal Contracts for Central Banker

6.3.3.3 Implementing Economic Reforms

6.3.4 Conflicting Views on the Relation Between the Degree of Monetary Policy Autonomy and Structural Reforms

6.3.5 A Benchmark Model

6.3.6 Results from the Benchmark Model I: Credible Commitment to a Strict Monetary Policy Rule

6.3.7 Autonomy Results from the Benchmark Model II: Discretion and Time Inconsistency of Optimal Monetary Policy

6.3.8 Welfare Comparisons of Different Monetary Policy Regimes

6.3.9 Putting the Model into Perspective: Conditions for More Reforms Under a Discretionary Regime

6.3.10 Conditions Favoring More Reforms Under a Rule-Based Regime

6.3.11 Extension to the Open Economy Case

6.4 Institutions for Safeguarding Price Stability

6.4.1 The Way Towards Central Bank Independence

6.4.2 Dimensions of Central Bank Independence

6.4.3 Measuring Independence

6.4.4 Empirical Evidence

6.5 The Relation Between Fiscal and Monetary Policy

6.5.1 The Government's Single-Period Budget Constraint

6.5.2 Seigniorage and the Budget Constraint

6.5.3 Inflation and the Single-Period Budget Constraint

6.5.4 The Limits to Seignorage Deficit Financing

6.5.5 The Intertemporal Budget Constraint

6.5.6 The Government Debt Dynamics

6.5.7 Extension of the Analysis

6.5.8 Consolidation Efforts

6.5.9 When Does It Become a ''Ponzi Game''?

6.6 Digression : The Allocation of Power in the Enlarged ECB Governing Council

6.5.9 Introduction

6.5.9 Minimum Representation: The ECB's Reform Proposal

6.5.9 How to Apply the Power Index Concept

6.5.9 Results

6.5.9.0 Relative Voting Share and Power in the Reformed ECB Council

6.5.9.0 Comparison with the Status Quo: One Person, One Vote

6.5.9.0 An Assessment of Principle of Representativeness

6.5.9 Conclusions and Potential for Further Research

7 Transmission Mechanisms

7.1 The Effects of Changes in Money Supply

7.1.1 Interest Rate Channel

7.1.2 Asset Price Channel

7.1.2.1 The Role of the Stock in the Transmission Process

7.1.2.2 Real Estate Prices

7.1.3 Credit Channel

7.1.3.1 Bank Lending Channel

7.1.3.2 Firm Balance Sheet Channel

7.1.4 Credit Rationing

7.2 Digression : The Financial Crisis of 2007/2008 Overview and Policy Lessons

7.1.4 Symptoms and Chronicle of the Credit Crisis

7.1.4 Real Effects of the Subprime Mortgage Crisis: Is It a Demand or a Finance Shock?

7.1.4 Monetary Policy Before and During the Subprime Crisis

7.1.4 Does Liquidity Provision Help at All?

7.1.4 Did Monetary Policy Trigger the Credit Crisis?

7.1.4 How to Avoid Planting the Seeds of the Next Crisis?

7.1.4 What Kind of Research Program Should Be Drawn from the Financial Crisis?

7.1.4.0 Role of Liquidity in the Credit Crisis-- Cash-in-the Market Pricing

7.1.4.0 The Effects on Interbank Markets and Collateralized Markets

7.1.4.0 Fear of Contagion

7.1.5 Exchange Rate Channel

7.1.5.1 Exchange Rate Effects on Net Exports

7.1.5.2 Exchange Rate Effects on Balance Sheets

7.2 Theory of Crisis: The Austrian Theory of the Business Cycle

7.3 The Vector-Autoregressive (VAR) Model A Benchmark for Analysing Transmission Mechanisms

7.3.1 Overview on VAR Models

7.3.2 Technicalities of the VAR Model

7.3.3 Imposing Restrictions

7.3.4 Impulse Response Functions

7.3.5 A Simple VAR Model for the US

7.4 Digression : Global Liquidity and the Dynamic Pattern of Price Adjustment: A VAR Analysis for OECD Countries

7.3.5 Motivation

7.3.5 The Global Perspective of Monetary Transmission

7.3.5 The Price Adjustment Process

7.3.5 Empirical Analysis

7.3.5.0 Data Description and Aggregation Issues

7.3.5.0 The VAR Methodology Again

7.3.5 Empirical Findings

7.3.5.0 The Baseline Model

7.3.5.0 Augmenting the VAR with Gold and Stocks

7.3.5 Robustness Checks

7.3.5 Conclusions

7.3.5 How Has the Euro Changed the Monetary Transmission?

7.4 Monetary Policy and the Zero Bound to Nominal Interest Rates

7.4.1 Alternative Channels for Monetary Policy

7.4.1.1 Increasing the Quantity of Money

7.4.1.2 Increasing Inflation (Expectations)

7.4.1.3 Lessons to Be Learned from the Zero Bound Nominal Interest Rate Discussion

8 Monetary Policy Strategies

8.1 Strategy Requirements

8.1.1 On the Monetary Policy Strategy

8.1.2 Intermediate Variable

8.1.3 A Model for Intermediate Targeting

8.1.3.1 Optimal Interest Rate Policy

8.1.3.2 Optimal Money Supply

8.1.3.3 Responding to the Actual Stock of Money

8.1.3.4 The Emergence of Several Shocks Under Intermediate Targeting

8.1.3.5 Interest Rate Rule Under Intermediate Targeting

8.2 Monetary Targeting (MT)

8.2.1 Money Growth Targets

8.2.2 The Income Velocity of Money

8.2.3 Inflation Indicators -- Measures of Excess Liquidity

8.2.4 The Price Gap

8.2.4.1 A Constant Money Growth Rate and the Role of Money Growth Seen in the Past

8.2.4.2 The Price Gap and Money Demand

8.2.5 The Real Money Gap

8.2.6 The Nominal Money Gap

8.2.7 The Monetary Overhang

8.2.8 Comparisons of the Measures of Excess Liquidity

8.2.9 The Difference Between the Nominal Money Gap and the Monetary Overhang

8.2.10 The Difference Between the Nominal Money Gap and the Real Money Gap

8.3 Inflation Targeting (IT)

8.3.1 The Role of the Inflation Forecast Under IT

8.3.1.1 Inflation Forecast Assuming Unchanged Official Interest Rates

8.3.1.2 Inflation Forecasts Using Market Expectations of Interest Rates

8.3.2 A Critical Review of the Inflation Forecasting Exercises

8.3.2.1 Do Inflation Projections Qualify as an Intermediate Target of Monetary Policy?

8.3.2.2 Inflation Expectations and Central Bank Credibility

8.3.2.3 Optimism Bias

8.3.2.4 The Circularity Problem

8.3.2.5 The Potential for Confusion

8.4 Nominal Income Targeting (NIT)

8.4.1 Positive Demand Side Shock

8.4.2 Negative Demand Side Shock

8.4.3 Positive Supply Side Shock

8.4.4 Negative Supply Side Shock

8.4.5 A Critical Review of NIT

8.4.6 Comparing NIT with MT

8.5 The Taylor Rule

8.5.1 A Taylor Rule for the Swedish Riksbank

8.5.2 The Measurement Problems of the Taylor Rule

8.5.3 Does the Taylor Rule Qualify as a Policy Strategy?

8.5.4 Comparing the Taylor Rule with MT

8.6 The McCallum Rule

8.6.1 Calculating the McCallum Rule

8.6.2 Illustrations of the Basic McCallum Equation

8.6.3 Extensions of the McCallum Rule

8.6.4 Final Remarks

8.7 Interest Rate Targeting

8.7.1 Monetary Policy and the Neutral Real Interest Rate

8.7.2 Poole's Analysis of Interest Rate Targeting Versus Monetary Targeting

8.7.2.1 Positive Demand Shock Under Interest Rate Targeting

8.7.2.2 Money Demand Shock Under Monetary Targeting

8.7.3 Poole's Analysis in the Context of Stochastic Shocks

8.7.3.1 Basic Model

8.7.3.2 Control Errors for Broad Money

8.7.3.3 Base Money Adjustments

8.7.3.4 The Role of Variances for Optimal Policy

8.8 The Monetary Conditions Index (MCI)

8.9 Digression : How the ECB and the US Fed Set Interest Rates

8.8.0 Central Bank Reaction Function: The ''Taylor Rule''

8.8.0 Theory of the Taylor Rule

8.8.0 Empirical Evidence of the Taylor Rule

8.8.0 Simulations

8.8.0 Concluding Remarks

8.9 Digression II : Does the ECB Follow the Fed?

8.8.0 Motivation

8.8.0 ECB and Fed Interest Rate Setting -- First Prima Facie Evidence

8.8.0 Empirical Analysis

8.8.0.4 Preliminaries

8.8.0.4 Granger Causality?

8.8.0 Does the Relationship Change Over Time?

8.8.0.4 The Role of the 11th of September 2001: Evidence Based on GC Tests

8.8.0.4 Breaks Around the Turn-of-Year 2000/01? Evidence Based on GC Tests

8.8.0 Policy Conclusions

Index