Thursday, 9 June 2011

Economics: Money Market

Money market
Different people may have different combinations of assets (portfolio) like money, flats, shares, etc. We analysis the relationship between the nominal interest rates and the real output of goods and services in the market by this model.
People keep their assets based on three criteria:
1)       Nominal interest rate (n) = Nominal return/Amount of money invested on the asset * 100%, where nominal return is given by net income receipts (income derived from the assets, like rent) + change in asset price (like change in stock prices).
2)       Risk is the uncertainty between expected and actual nominal interest rate. If the actual nominal interest rate is much lower than the expected one, it has a high risk.
3)       Liquidity is the ease of converting assets into money (means of transaction) so as to change their portfolios.
Therefore people have the demand on money since (1) zero risk, absolutely certain on the nominal interest rate which is 0%. (2) Highest liquidity since no conversion is needed. However there’s cost of holding money which is the highest nominal interest rate. This explains why they don’t prefer to hold money other than the necessary money demand.
Money demand is the sum of money that at a point of time the economy desire to hold. There’re two types of money demand:
1)       Transactions demand for money (Mt): the economy desire to hold money as a medium of exchange due to the non-synchronization between money receipts and expenditures. e.g., you don’t spend all of your money once you receive income, so you have to keep some for further spending. Money is the most liquid assets so it has demand for transaction.
Factors affecting Mt:
-          Real GDP Volume of transactions Mt
-          Price level nominal value of transactions Mt
-          Saving Volume of transaction Mt
-          Time interval between two successive income receipts Volume of transaction Mt
-          Advancement of payment technology(e.g. octopus card) Cashless transaction Mt
2)       Asset demand for money (Ma): the economy desire to hold money to store wealth for (1) when negative nominal return is expected in various assets; (2) Minimizing risk during liquefying assets, and (3) Transaction cost as a barrier for people not to put all money in their assets but money.
Factors affecting Ma:
-          n Cost of holding money Ma
-          Risk of holding income-earning assets desire to hold them Ma
-          Transaction cost Net return from assets n Ma
-          Wealth amount of various assets Ma

From the above analysis, we know that Mt is independent of n while Ma is negatively related to n. Graphically we can show their relationship by n-quantity of money graph.

MD = Mt + Ma so it’s also downward slopping. A change in n shifts the point along the curve while a shift of determinants shifts the whole MD curve.

Now we consider MS at the same time. It’s independent of n, decided by the central bank only, so it’s also a straight line. The equilibrium occurs in the intersection point between MD and MS. It decides the equilibrium n and quantity of money.
When n is lower than ne, MD>MS, there’s excess demand on money, then people sell their income-earning assets to fulfill the excess demand, then the price of income-earning assets falls, n and MD and eventually reach the equilibrium.
When n is higher than ne, MD<MS, there’s excess supply on money, then people buy more income-earning assets, the price rises, n, MD and reach ne.
Shifting of MD: MD↑→excess demandpeople sell assetsn. Note that the quantity of money doesn’t change.

Shifting of MS: MS↑→excess supplypeople buy assetsn. Note that n and the quantity of money changed at the same time.
When they shift together, the change of n and quantity of money depends on the magnitude of shifting.
Monetary policy is policies that achieve economic goals by adjusting MS or n.
Four tools in monetary policy
1)       Open market operations: Government buy bondsmoney in circulation↑→MS, oppositely if government sell government bonds, MS decreases.
2)       Discount rate(lending rate between private banks and central banks) lending rate of banks to public less borrowing banking multiplier MS
3)       Required reserve ratio(rrr) Max. money created money contraction MS
4)       Printing money MS, note that it’s not available in HK, common in US due to the adverse effect on confident of the currency. We ignore the exchange rate here since we are talking about their nominal value of MS only.
Recall that n cost of consumption C, I AD GDP in SR, we can change the real GDP by monetary policy in SR and price level in both SR and LR.
1)       Expansionary monetary policy raises the real GDP in short run.
2)       Contractionary monetary policy reduces the real GDP in short run.
The whole flow is given by: MS/↓→n/↑→C,I/↓→AD/↓→P,Y/.
In the case of inflationary/deflationary output gap, adjustment of AD by MS is permanent because the long run equilibrium can be reached.
If the economy is already at LR equilibrium, MS/↓→AD/↓→P,Y/in short runP/ repeatedly and Y back to Yf in long run.
Situation in HK
-          HKMA carries out the above policies.
-          There’s no r.r.r. in HK but liquidity ratio have similar effect as the r.r.r..
-          In HK HKMA seldom carries out the exchange of bonds. Instead they buy or sell Exchange Fund Bills and Notes (debt issued by HKMA).
-          Discount rate can varies in HK for different period, from overnight to 1 year.
Quantity Theory of Money (QTM)
Consider money as the medium of exchange:
Total expenditure on final products = Total value of final products exchanged
Then we will have MV = PY = nominal GDP where
-          M is the quantity of money (nominal MS)
-          V is the velocity of circulation of money, i.e., the average number of times that money has to change hands as to complete transactions of final products in 1 year.
-          P is the relative price level.
-          Y is the real GDP, so PY = nominal GDP.
Classical theory of exchange
-          V is related to technological/institutional factors like payment or financial system which seldom change, so we assume it as constant.
-          Y is fixed at Yf in long run, but it varies in short run.
In SR: we have MV=PY where V is constant, a raise in MS gives proportional rise in nominal GDP, but we don’t know the rate of rise for P and Y respectively.
In LR: we have MV=PY where V,Y is constant, then a raise in MS gives proportional rise in price level only. This is called the classical theory of exchange.
This can be applied in explaining the relationship between MS and price level as well.
For example, a rise in MS:
1)       by MS: MS↑→n↓→AD↑→Pin LR
2)       by QTM: a rise in MS gives proportional rise in P, so P rises in LR.

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