Aggregate demand

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/Aggregate_demand 

 

In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amount of goods and services that will be purchased at all possible price levels. Consumer spending, investment, corporate and government expenditure, and net exports make up the aggregate demand.

The aggregate demand curve is plotted with real output on the horizontal axis and the price level on the vertical axis. While it is theorized to be downward sloping, the Sonnenschein–Mantel–Debreu results show that the slope of the curve cannot be mathematically derived from assumptions about individual rational behavior. Instead, the downward sloping aggregate demand curve is derived with the help of three macroeconomic assumptions about the functioning of markets: Pigou's wealth effect, Keynes' interest rate effect and the Mundell–Fleming exchange-rate effect. The Pigou effect states that a higher price level implies lower real wealth and therefore lower consumption spending, giving a lower quantity of goods demanded in the aggregate. The Keynes effect states that a higher price level implies a lower real money supply and therefore higher interest rates resulting from financial market equilibrium, in turn resulting in lower investment spending on new physical capital and hence a lower quantity of goods being demanded in the aggregate.

The Mundell–Fleming exchange-rate effect is an extension of the IS–LM model. Whereas the traditional IS-LM Model deals with a closed economy, Mundell–Fleming describes a small open economy. The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS–LM model, which focuses only on the relationship between the interest rate and output).

The aggregate demand curve illustrates the relationship between two factors: the quantity of output that is demanded and the aggregate price level. Aggregate demand is expressed contingent upon a fixed level of the nominal money supply. There are many factors that can shift the AD curve. Rightward shifts result from increases in the money supply, in government expenditure, or in autonomous components of investment or consumption spending, or from decreases in taxes.

According to the aggregate demand-aggregate supply model, when aggregate demand increases, there is movement up along the aggregate supply curve, giving a higher level of prices.

History

Main article: The General Theory of Employment, Interest and Money

John Maynard Keynes in The General Theory of Employment, Interest and Money argued during the Great Depression that the loss of output by the private sector as a result of a systemic shock (the Wall Street Crash of 1929) ought to be filled by government spending. First, he argued that with a lower ‘effective aggregate demand’, or the total amount of spending in the economy (lowered in the Crash), the private sector could subsist on a permanently reduced level of activity and involuntary unemployment, unless there were active intervention. Business lost access to capital, so it had dismissed workers. This meant workers had less to spend as consumers, consumers bought less from business, which because of additionally reduced demand, had found the need to dismiss workers. The downward spiral could only be halted and rectified by external action. Second, people with higher incomes have a lower average propensity to consume their incomes. People with lower incomes are inclined to spend their earnings immediately to buy housing, food, transport and so forth, while people with much higher incomes cannot consume everything. They save instead, which means that the velocity of money, meaning the circulation of income through different hands in the economy, is decreased. This lowered the rate of growth. Spending should therefore target public works programmes on a large enough scale to speed up growth to its previous levels.

Components

An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources:

${\displaystyle AD=C+I+G+(X-M)}$

where

• ${\displaystyle C}$ is consumption (may also be known as consumer spending), which is given by ${\displaystyle C_0+c(Y-T)}$ where ${\displaystyle Y}$ is consumers' income and ${\displaystyle T}$ the taxes paid by consumers,
• ${\displaystyle I}$ is investment,
• ${\displaystyle G}$ is government spending,
• ${\displaystyle NX=X-M}$ is net exports, where
  • ${\displaystyle X}$ is total exports, and
  • ${\displaystyle M}$ total imports, given by ${\displaystyle M_0+m(Y-T)}$.

These four major parts, which can be stated in either 'nominal' or 'real' terms, are:

• personal consumption expenditures (${\displaystyle C}$) or "consumption", demand by households and unattached individuals; its determination is described by the consumption function. A basic conception is that it is the total consumption expenditures of the domestic economy. The consumption function is ${\displaystyle C=C_0+c\times (Y-T)}$, where
  • ${\displaystyle C_0}$ is autonomous consumption, ${\displaystyle c}$ the marginal propensity to consume, and ${\displaystyle (Y-T)}$ the disposable income.
• gross private domestic investment (${\displaystyle I}$), such as spending by business firms on factory construction. This is conceived as all private sector spending aimed at the production of some future consumable.
  • In Keynesian economics, not all of gross private domestic investment counts as part of aggregate demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned inventory accumulation or "general over-production"). The Keynesian model forecasts a decrease in national output and income when there is unplanned investment. (Inventory accumulation would correspond to an excess supply of products; in the National Income and Product Accounts, it is treated as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (${\displaystyle I_p}$) is counted as part of aggregate demand. (So, ${\displaystyle I}$ does not include the 'investment' in running up or depleting inventory levels.)
  • Investment is affected by the output and the interest rate (${\displaystyle i}$). Consequently, we can write it as, ${\displaystyle I(Y,i)}$, a function I which takes total income and interest rate as parameters. Investment has positive relationship with the output and negative relationship with the interest rate. Thus, an increase in the interest rate will cause aggregate demand to decline. Interest costs are part of the cost of borrowing and as they rise, both firms and households will cut back on spending. This shifts the aggregate demand curve to the left. This lowers equilibrium GDP below potential GDP.
• gross government investment and consumption expenditures (${\displaystyle G}$), also determined as ${\displaystyle G-T}$, the difference of government expenditures and taxes. An increase in government expenditures or decrease in taxes, therefore leads to an increase in GDP as government expenditures are a component of aggregate demand.
• net exports (${\displaystyle NX}$ and sometimes (${\displaystyle X-M}$)), net demand by the rest of the world for the country's output. This contributes to the current account.

In sum, for a single country at a given time, aggregate demand (${\displaystyle D}$ or ${\displaystyle AD}$) is given by ${\displaystyle C+I_p+G+(X-M)}$.

These macroeconomic variables are constructed from varying types of microeconomic variables from the price of each, so these variables are denominated in (real or nominal) currency terms.

Aggregate demand curves

Understanding of the aggregate demand curve depends on whether it is examined based on changes in demand as income changes, or as price change.

Keynesian cross

Main article: Keynesian cross

Aggregate demand-aggregate supply model

Main article: AD–AS model

Sometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve that looks like that in a typical Marshallian supply and demand diagram.

Aggregate supply/demand graph

Thus, we could refer to an "aggregate quantity demanded" (${\displaystyle Y^d=C+I_p+G+NX}$ in real or inflation-corrected terms) at any given aggregate average price level (such as the GDP deflator), ${\displaystyle P}$.

In these diagrams, typically the ${\displaystyle Y^d}$ rises as the average price level (${\displaystyle P}$) falls, as with the ${\displaystyle AD}$ line in the diagram. The main theoretical reason for this is that if the nominal money supply (M^s) is constant, a falling ${\displaystyle P}$ implies that the real money supply (${\displaystyle \frac{M^s}{P}}$)rises, encouraging lower interest rates and higher spending. This is often called the "Keynes effect".

Carefully using ideas from the theory of supply and demand, aggregate supply can help determine the extent to which increases in aggregate demand lead to increases in real output or instead to increases in prices (inflation). In the diagram, an increase in any of the components of ${\displaystyle AD}$ (at any given ${\displaystyle P}$) shifts the ${\displaystyle AD}$ curve to the right. This increases both the level of real production (${\displaystyle Y}$) and the average price level (${\displaystyle P}$).

But different levels of economic activity imply different mixtures of output and price increases. As shown, with very low levels of real gross domestic product and thus large amounts of unemployed resources, most economists of the Keynesian school suggest that most of the change would be in the form of output and employment increases. As the economy gets close to potential output (${\displaystyle Y^{\ast }}$), we would see more and more price increases rather than output increases as ${\displaystyle AD}$ increases.

Beyond ${\displaystyle Y^{\ast }}$, this gets more intense, so that price increases dominate. Worse, output levels greater than ${\displaystyle Y^{\ast }}$ cannot be sustained for long. The ${\displaystyle AS}$ is a short-term relationship here. If the economy persists in operating above potential, the ${\displaystyle AS}$ curve will shift to the left, making the increases in real output transitory.

At low levels of ${\displaystyle Y}$, the world is more complicated. First, most modern industrial economies experience few if any fall in prices. So the ${\displaystyle AS}$ curve is unlikely to shift down or to the right. Second, when they do suffer price cuts (as in Japan), it can lead to disastrous deflation.

Debt

A post-Keynesian theory of aggregate demand emphasizes the role of debt, which it considers a fundamental component of aggregate demand; the contribution of change in debt to aggregate demand is referred to by some as the credit impulse. Aggregate demand is spending, be it on consumption, investment, or other categories. Spending is related to income via:

Income – Spending = Net Savings

Rearranging this yields:

Spending = Income – Net Savings = Income + Net Increase in Debt

In words: What you spend is what you earn, plus what you borrow. If you spend $110 and earned $100, then you must have net borrowed $10. Conversely, if you spend $90 and earn $100, then you have net savings of $10, or have reduced debt by $10, for a net change in debt of –$10.

If debt grows or shrinks slowly as a percentage of GDP, its impact on aggregate demand is small. Conversely, if debt is significant, then changes in the dynamics of debt growth can have significant impact on aggregate demand. Change in debt is tied to the level of debt: if the overall debt level is 10% of GDP and 1% of loans are not repaid, this impacts GDP by 1% of 10% = 0.1% of GDP, which is statistical noise. Conversely, if the debt level is 300% of GDP and 1% of loans are not repaid, this impacts GDP by 1% of 300% = 3% of GDP, which is significant: a change of this magnitude will generally cause a recession.

Similarly, changes in the repayment rate (debtors paying down their debts) impact aggregate demand in proportion to the level of debt. Thus, as the level of debt in an economy grows, the economy becomes more sensitive to debt dynamics, and credit bubbles are of macroeconomic concern. Since write-offs and savings rates both spike in recessions, both of which result in shrinkage of credit, the resulting drop in aggregate demand can worsen and perpetuate the recession in a vicious cycle.

This perspective originates in, and is intimately tied to, the debt-deflation theory of Irving Fisher, and the notion of a credit bubble (credit being the flip side of debt), and has been elaborated in the Post-Keynesian school. If the overall level of debt is rising each year, then aggregate demand exceeds Income by that amount. However, if the level of debt stops rising and instead starts falling (if "the bubble bursts"), then aggregate demand falls short of income, by the amount of net savings (largely in the form of debt repayment or debt writing off, such as in bankruptcy). This causes a sudden and sustained drop in aggregate demand, and this shock is argued to be the proximate cause of a class of economic crises, properly financial crises. Indeed, a fall in the level of debt is not necessary – even a slowing in the rate of debt growth causes a drop in aggregate demand (relative to the higher borrowing year). These crises then end when credit starts growing again, either because most or all debts have been repaid or written off, or for other reasons as below.

From the perspective of debt, the Keynesian prescription of government deficit spending in the face of an economic crisis consists of the government net dis-saving (increasing its debt) to compensate for the shortfall in private debt: it replaces private debt with public debt. Other alternatives include seeking to restart the growth of private debt ("reflate the bubble"), or slow or stop its fall; and debt relief, which by lowering or eliminating debt stops credit from contracting (as it cannot fall below zero) and allows debt to either stabilize or grow – this has the further effect of redistributing wealth from creditors (who write off debts) to debtors (whose debts are relieved).

Criticisms

Austrian theorist Henry Hazlitt argued that aggregate demand is "a meaningless concept" in economic analysis. Friedrich Hayek, another Austrian, wrote that Keynes' study of the aggregate relations in an economy is "fallacious", arguing that recessions are caused by micro-economic factors.

 

Money market

From Wikipedia, the free encyclopedia
https://en.wikipedia.org/wiki/Money_market 

The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.

As short-term securities became a commodity, the money market became a component of the financial market for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in money markets is done over the counter and is wholesale.

There are several money market instruments in most Western countries, including treasury bills, commercial paper, banker's acceptances, deposits, certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-lived mortgage- and asset-backed securities. The instruments bear differing maturities, currencies, credit risks, and structures. A market can be described as a money market if it is composed of highly liquid, short-term assets. Money market funds typically invest in government securities, certificates of deposit, commercial paper of companies, and other highly liquid, low-risk securities. The four most relevant types of money are commodity money, fiat money, fiduciary money (cheques, banknotes), and commercial bank money. Commodity money relies on intrinsically valuable commodities that act as a medium of exchange. Fiat money, on the other hand, gets its value from a government order.

Money markets, which provide liquidity for the global financial system including for capital markets, are part of the broader system of financial markets.

Participants

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods, typically up to twelve months. Money market trades in short-term financial instruments commonly called "paper". This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of interbank lending—banks borrowing and lending to each other using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e., priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

Finance companies typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP), which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Some large corporations with strong credit rating issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the U.S. Treasury issues Treasury bills to fund the U.S. public debt:

• Trading companies often purchase bankers' acceptances to tender for payment to overseas suppliers.
• Retail and institutional money market funds
• Banks
• Central banks
• Cash management programs
• Merchant banks

Functions

Money markets serve five functions—to finance trade, finance industry, invest profitably, enhance commercial banks' self-sufficiency, and lubricate central bank policies.

Financing trade

The money market plays a crucial role in financing domestic and international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade.

Financing industry

The money market contributes to the growth of industries in two ways:

• They help industries secure short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc.
• Industries generally need long-term loans, which are provided in the capital market. However, the capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market.

Profitable investments

The money market enables commercial banks to use their excess reserves in profitable investments. The main objective of commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of its depositors. In the money market, the excess reserves of commercial banks are invested in near money assets (e.g., short-term bills of exchange), which are easily converted into cash. Thus, commercial banks earn profits without sacrificing liquidity.

Self-sufficiency of commercial banks

Developed money markets help commercial banks to become self-sufficient. In an emergency, when commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. They can instead meet their requirements by recalling their old short-run loans from the money market.

Help to central bank

Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smooths the functioning and increases the efficiency of the central bank.

Money markets help central banks in two ways:

• Short-run interest rates serve as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy,
• Sensitive and integrated money markets help the central bank secure quick and widespread influence on the sub-markets, thus facilitating effective policy implementation

Instruments

• Certificate of deposit – Time deposit, commonly offered to consumers by banks, thrift institutions, and credit unions.
• Repurchase agreements – Short-term loans—normally for less than one week and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
• Money market mutual funds - short term investment debt, operated by professional institutions. Money market mutual funds are an investment fund where a number of investors invest their money in mutual fund institutions, and they diversify the funds in various investments.
• Commercial paper – Short term instruments promissory notes issued by company at discount to face value and redeemed at face value
• Eurodollar deposit – Deposits made in U.S. dollars at a bank or bank branch located outside the United States.
• Federal agency short-term securities – In the U.S., short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association. Money markets is heavily used function.
• Federal funds – In the U.S., interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
• Municipal notes – In the U.S., short-term notes issued by municipalities in anticipation of tax receipts or other revenues
• Treasury bills – Short-term debt obligations of a national government that are issued to mature in three to twelve months
• Money funds – Pooled short-maturity, high-quality investments that buy money market securities on behalf of retail or institutional investors
• Foreign exchange swaps – Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future
• Short-lived mortgage- and asset-backed securities

Discount and accrual instruments

There are two types of instruments in the fixed income market that pay interest at maturity, instead of as coupons—discount instruments and accrual instruments. Discount instruments, like repurchase agreements, are issued at a discount of face value, and their maturity value is the face value. Accrual instruments are issued at face value and mature at face value plus interest.

Demand for money

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/Demand_for_money 

Macroeconomics

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value (even a temporary one) by interest-bearing assets. However, M1 is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money for near-future expenditure and the interest advantage of temporarily holding other assets. The demand for M1 is a result of this trade-off regarding the form in which a person's funds to be spent should be held. In macroeconomics motivations for holding one's wealth in the form of M1 can roughly be divided into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear a non-trivial interest rate is based on the asset demand. These can be further subdivided into more microeconomically founded motivations for holding money.

Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor.

Conditions under which the LM curve is flat, so that increases in the money supply have no stimulatory effect (a liquidity trap), play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate.

A typical money-demand function may be written as

${\displaystyle M^d=P\times L(R,Y)}$

where ${\displaystyle M^d}$ is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real income, and L(.) is real money demand. An alternate name for ${\displaystyle L(R,Y)}$ is the liquidity preference function.

Motives for holding money

Transaction motive

Main article: Transactions demand

The transactions motive for the demand for M1 (directly spendable money balances) results from the need for liquidity for day-to-day transactions in the near future. This need arises when income is received only occasionally (say once per month) in discrete amounts but expenditures occur continuously.

Quantity theory

The most basic "classical" transaction motive can be illustrated with reference to the Quantity Theory of Money. According to the equation of exchange MV = PY, where M is the stock of money, V is its velocity (how many times a unit of money turns over during a period of time), P is the price level and Y is real income. Consequently, PY is nominal income or in other words the number of transactions carried out in an economy during a period of time. Rearranging the above identity and giving it a behavioral interpretation as a demand for money we have

${\displaystyle M^d=P\frac{Y}{V}}$

or in terms of demand for real balances

${\displaystyle \frac{M^d}{P}=\frac{Y}{V}}$

Hence in this simple formulation demand for money is a function of prices and income, as long as its velocity is constant.

Inventory models

The amount of money demanded for transactions however is also likely to depend on the nominal interest rate. This arises due to the lack of synchronization in time between when purchases are desired and when factor payments (such as wages) are made. In other words, while workers may get paid only once a month they generally will wish to make purchases, and hence need money, over the course of the entire month.

The most well-known example of an economic model that is based on such considerations is the Baumol-Tobin model. In this model an individual receives her income periodically, for example, only once per month, but wishes to make purchases continuously. The person could carry her entire income with her at all times and use it to make purchases. However, in this case she would be giving up the (nominal) interest rate that she can get by holding her income in the bank. The optimal strategy involves holding a portion of one's income in the bank and portion as liquid money. The money portion is continuously run down as the individual makes purchases and then she makes periodic (costly) trips to the bank to replenish the holdings of money. Under some simplifying assumptions the demand for money resulting from the Baumol-Tobin model is given by

${\displaystyle \frac{M^d}{P}=\sqrt{\frac{tY}{2R}}}$

where t is the cost of a trip to the bank, R is the nominal interest rate and P and Y are as before.

The key difference between this formulation and the one based on a simple version of Quantity Theory is that now the demand for real balances depends on both income (positively) or the desired level of transactions, and on the nominal interest rate (negatively).

Microfoundations for money demand

While the Baumol–Tobin model provides a microeconomic explanation for the form of the money demand function, it is generally too stylized to be included in modern macroeconomic models, particularly dynamic stochastic general equilibrium models. As a result, most models of this type resort to simpler indirect methods which capture the spirit of the transactions motive. The two most commonly used methods are the cash-in-advance model (sometimes called the Clower constraint model) and the money-in-the-utility-function (MIU) model (as known as the Sidrauski model).

In the cash-in-advance model agents are restricted to carrying out a volume of transactions equal to or less than their money holdings. In the MIU model, money directly enters agents' utility functions, capturing the 'liquidity services' provided by money.

Precautionary demand

Main article: Precautionary demand

The precautionary demand for M1 is the holding of transaction funds for use if unexpected needs for immediate expenditure arise.

Asset motive

The asset motive for the demand for broader monetary measures, M2 and M3, states that people demand money as a way to hold wealth. While it is still assumed that money in the sense of M1 is held in order to carry out transactions, this approach focuses on the potential return on various assets (including money broadly defined) as an additional motivation.

Speculative motive

Main article: Speculative demand for money

John Maynard Keynes, in laying out speculative reasons for holding money, stressed the choice between money and bonds. If agents expect the future nominal interest rate (the return on bonds) to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. If the future interest rate falls, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate (in addition to the standard transaction motives which depend on income).

The fact that the current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand. If these expectations are formed, as in Keynes' view, by "animal spirits" they are likely to change erratically and cause money demand to be quite unstable.

Portfolio motive

The portfolio motive also focuses on demand for money over and above that required for carrying out transactions. The basic framework is due to James Tobin, who considered a situation where agents can hold their wealth in a form of a low risk/low return asset (here, money) or high risk/high return asset (bonds or equity). Agents will choose a mix of these two types of assets (their portfolio) based on the risk-expected return trade-off. For a given expected rate of return, more risk averse individuals will choose a greater share for money in their portfolio. Similarly, given a person's degree of risk aversion, a higher expected return (nominal interest rate plus expected capital gains on bonds) will cause agents to shift away from safe money and into risky assets. Like in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what matters additionally in the Tobin model is the subjective rate of risk aversion, as well as the objective degree of risk of other assets, as, say, measured by the standard deviation of capital gains and losses resulting from holding bonds and/or equity.

Empirical estimations of money demand functions

Is money demand stable?

Friedman and Schwartz in their 1963 work A Monetary History of the United States argued that the demand for real balances was a function of income and the interest rate. For the time period they were studying this appeared to be true. However, shortly after the publication of the book, due to changes in financial markets and financial regulation money demand became more unstable. Various researchers showed that money demand became much more unstable after 1975. Ericsson, Hendry and Prestwich (1998) consider a model of money demand based on the various motives outlined above and test it with empirical data. The basic model turns out to work well for the period 1878 to 1975 and there doesn't appear to be much volatility in money demand, in a result analogous to that of Friedman and Schwartz. This is true even despite the fact that the two world wars during this time period could have led to changes in the velocity of money. However, when the same basic model is used on data spanning 1976 to 1993, it performs poorly. In particular, money demand appears not to be sensitive to interest rates and there appears to be much more exogenous volatility. The authors attribute the difference to technological innovations in the financial markets, financial deregulation, and the related issue of the changing menu of assets considered in the definition of money. Other researchers confirmed this finding with recent data and over a longer period. Money demand appears to be time varying which also depends on household's real balance effects.

Laurence M. Ball suggests that the use of adapted aggregates, such as near monies, can produce a more stable demand function. He shows that using the return on near monies produced smaller deviations than previous models.

Importance of money demand volatility for monetary policy

If the demand for money is stable then a monetary policy which consists of a monetary rule which targets the growth rate of some monetary aggregate (such as M1 or M2) can help to stabilize the economy or at least remove monetary policy as a source of macroeconomic volatility. Additionally, if the demand for money does not change unpredictably then money supply targeting is a reliable way of attaining a constant inflation rate. This can be most easily seen with the quantity theory of money equation given above. When that equation is converted into growth rates we have:

${\displaystyle g_m+g_v=\pi +g_y}$

which says that the growth rate of money supply plus the growth rate of its velocity equals the inflation rate plus the growth rate of real output. If money demand is stable then velocity is constant and ${\displaystyle g_v=0}$. Additionally, in the long run real output grows at a constant rate equal to the sum of the rates of growth of population, technological know-how, and technology in place, and as such is exogenous. In this case the above equation can be solved for the inflation rate:

${\displaystyle \pi =-g_y+g_m}$

Here, given the long-run output growth rate, the only determinant of the inflation rate is the growth rate of the money supply. In this case inflation in the long run is a purely monetary phenomenon; a monetary policy which targets the money supply can stabilize the economy and ensure a non-variable inflation rate.

This analysis however breaks down if the demand for money is not stable — for example, if velocity in the above equation is not constant. In that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rates and result in economic fluctuations. An alternative policy of targeting interest rates rather than the money supply can improve upon this outcome as the money supply is adjusted to shocks in money demand, keeping interest rates (and hence, economic activity) relatively constant.

The above discussion implies that the volatility of money demand matters for how monetary policy should be conducted. If most of the aggregate demand shocks which affect the economy come from the expenditure side, the IS curve, then a policy of targeting the money supply will be stabilizing, relative to a policy of targeting interest rates. However, if most of the aggregate demand shocks come from changes in money demand, which influences the LM curve, then a policy of targeting the money supply will be destabilizing.

Money creation

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/Money_creation 

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, money creation is controlled by the central banks. Money issued by central banks is termed base money. Central banks can increase the quantity of base money directly, by engaging in open market operations. However, the majority of the money supply is created by the commercial banking system in the form of bank deposits. Bank loans issued by commercial banks that practice fractional reserve banking expands the quantity of broad money to more than the original amount of base money issued by the central bank.

Central banks monitor the amount of money in the economy by measuring monetary aggregates (termed broad money), consisting of cash and bank deposits. Money creation occurs when the quantity of monetary aggregates increase. Governmental authorities, including central banks and other bank regulators, can use policies such as reserve requirements and capital adequacy ratios to influence the amount of broad money created by commercial banks.

Money supply

Main article: Money supply

The term "money supply" commonly denotes the total, safe, financial assets that households and businesses can use to make payments or to hold as short-term investment. The money supply is measured using the so-called "monetary aggregates", defined in accordance to their respective level of liquidity. In the United States, for example:

• M0: The total of all physical currency including coinage. Using the United States dollar as an example, M0 = Federal Reserve notes + US notes + coins. It is not relevant whether the currency is held inside or outside of the private banking system as reserves.
• M1: The total amount of M0 (cash/coin) outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits
• M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).

The money supply is understood to increase through activities by government authorities, by the central bank of the nation, and by commercial banks.

Money creation by the central bank

Central banks

Main article: Central banks

The authority through which monetary policy is conducted is the central bank of the nation. The mandate of a central bank typically includes either one of the three following objectives or a combination of them, in varying order of preference, according to the country or the region: Price stability, i.e. inflation-targeting; the facilitation of maximum employment in the economy; the assurance of moderate, long term, interest rates.

The central bank is the banker of the government and provides to the government a range of services at the operational level, such as managing the Treasury's single account, and also acting as its fiscal agent (e.g. by running auctions), its settlement agent, and its bond registrar. A central bank cannot become insolvent in its own currency. However, a central bank can become insolvent in liabilities on foreign currency.

Central banks operate in practically every nation in the world, with few exceptions. There are some groups of countries, for which, through agreement, a single entity acts as their central bank, such as the organization of states of Central Africa,  which all have a common central bank, the Bank of Central African States; or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the European Central Bank. Central banking institutions are generally independent of the government executive.

The central bank's activities directly affect interest rates, through controlling the base rate, and indirectly affect stock prices, the economy's wealth, and the national currency's exchange rate. Monetarists and some Austrians argue that the central bank should control the money supply, through its monetary operations. Critics of the mainstream view maintain that central-bank operations can affect but not control the money supply.

Open-market operations

Open-market operations (OMOs) concern the purchase and sale of securities in the open market by a central bank. OMOs essentially swap one type of financial assets for another; when the central bank buys bonds held by the banks or the private sector, bank reserves increase while bonds held by the banks or the public decrease. Temporary operations are typically used to address reserve needs that are deemed to be transitory in nature, while permanent operations accommodate the longer-term factors driving the expansion of the central bank's balance sheet; such a primary factor is typically the trend of the money-supply growth in the economy. Among the temporary, open-market operations are repurchase agreements (repos) or reverse repos, while permanent ones involve outright purchases or sales of securities. Each open-market operation by the central bank affects its balance sheet.

Monetary policy

Main article: Monetary policy

Monetary policy is the process by which the monetary authority of a country, typically the central bank (or the currency board), manages the level of short-term interest rates and influences the availability and the cost of credit in the economy, as well as overall economic activity.

Central banks conduct monetary policy usually through open market operations. The purchase of debt, and the resulting increase in bank reserves, is called "monetary easing". An extraordinary process of monetary easing is denoted as "quantitative easing", whose intent is to stimulate the economy by increasing liquidity and promoting bank lending.

Physical currency

The central bank, or other competent, state authorities (such as the treasury), are typically empowered to create new, physical currency, i.e. paper notes and coins, in order to meet the needs of commercial banks for cash withdrawals, and to replace worn and/or destroyed currency. The process does not increase the money supply, as such; the term "printing [new] money" is considered a misnomer.

In modern economies, relatively little of the supply of broad money is in physical currency.

Role of commercial banks

Main article: Money multiplier

When commercial banks lend money, they expand the amount of bank deposits. The banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in a process called the multiplier effect.

Banks are limited in the total amount they can lend by their capital adequacy ratios, and their required reserve ratios. The required-reserves ratio obliges banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank. The theory holds that, in a system of fractional-reserve banking, where banks ordinarily keep only a fraction of their deposits in reserves, an initial bank loan creates more money than it initially lent out.

The maximum ratio of loans to deposits is the required-reserve ratio RRR, which is determined by the central bank, as

${\displaystyle \mathit{R}\mathit{R}\mathit{R}=\frac{R}{D}}$

where R are reserves and D are deposits.

Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.

Credit theory of money

Main article: Credit theory of money

The fractional reserve theory where the money supply is limited by the money multiplier has come under increased criticism since the financial crisis of 2007–2008. It has been observed that the bank reserves are not a limiting factor because the central banks supply more reserves than necessary and because banks have been able to build up additional reserves when they were needed. Many economists and bankers now believe that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.

A study of banking software demonstrates that the bank does nothing else than adding an amount to the two accounts when they issue a loan. The observation that there appears to be no limit to the amount of credit money that banks can bring into circulation in this way has given rise to the often-heard expression that "Banks are creating money out of thin air". The exact mechanism behind the creation of commercial bank money has been a controversial issue. In 2014, a study titled "Can banks individually create money out of nothing? — The theories and the empirical evidence" empirically tested the manner in which this type of money is created by monitoring a cooperating bank's internal records:

This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

The credit theory of money, initiated by Joseph Schumpeter, asserts the central role of banks as creators and allocators of the money supply, and distinguishes between "productive credit creation" (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and "unproductive credit creation" (resulting in inflation of either the consumer- or asset-price variety).

The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesian and Post-Keynesian analysis as well as central banks. The major argument offered by dissident analysis is that any bank balance-sheet expansion (e.g. through a new loan) that leaves the bank short of the required reserves may affect the return it can expect on the loan, because of the extra cost the bank will undertake to return within the ratios limits – but this does not and "will never impede the bank's capacity to give the loan in the first place". Banks first lend and then cover their reserve ratios: The decision whether or not to lend is generally independent of their reserves with the central bank or their deposits from customers; banks are not lending out deposits or reserves, anyway. Banks lend on the basis of lending criteria, such as the status of the customer's business, the loan's prospects, and/or the overall economic situation.

Monetary financing

Main article: Debt monetization

Policy

"Monetary financing", also "debt monetization", occurs when the country's central bank purchases government debt. It is considered by mainstream analysis to cause inflation, and often hyperinflation. IMF's former chief economist Olivier Blanchard states that

governments do not create money; the central bank does. But with the central bank's cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.

The description of the process differs in heterodox analysis. Modern chartalists state:

the central bank does not have the option to monetize any of the outstanding government debt or newly issued government debt...[A]s long as the central bank has a mandate to maintain a short-term interest rate target, the size of its purchases and sales of government debt are not discretionary. The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetization. The central bank is unable to monetize the government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves.

Restrictions

Monetary financing used to be standard monetary policy in many countries, such as Canada or France, while in others it was and still is prohibited. In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments. In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month, and owns, as of Oct 2018, approximately 440 trillion JP¥ (approx. $4trillion) or over 40% of all outstanding government bonds. In the United States, the 1913 Federal Reserve Act allowed federal banks to purchase short-term securities directly from the Treasury, in order to facilitate its cash-management operations. The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion". After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981.