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EPPE 6124 Monetary Economics

- Foundations of Monetary Economics -


Main References:
Handa (chapt 1), Walsh (chapt 1), Mishkin (chapt 1)
Norlin Khalid
School of Economics, Faculty of Economics and Management,
Universiti Kebangsaan Malaysia
February 20, 2014
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Why Study Monetary Economics?
Empirical evidence suggest that money plays an important role in
generating business cycles Recessions (unemployment) and
expansions - to study the relationship between money and
business cycle, money and output as well as money and ination.
monetary policy acts as a stabilization policy and not a growth
policy.
study the conduct of an optimal monetary policy
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Money Growth (M2 annual rate) & Business Cycle in
U.S (1950-2011)
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Aggregate Price Level & Money Supply in U.S
(1950-2011)
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Average Ination Rate Vs. Average Rate of Money
Growth for Selected Countries (2000-2010)
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Stylized Facts - Long Run Correlations
The correlation between long run infation and money
growth is almost one across countries
McCandles & Weber (1995) - data 30-year from 110 countries
using several denitions of money - coe of corr varies between
0.92 and 0.96
A change in the growth rate of money induces an equal change in
the rate of price ination
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Stylized Facts - Long Run Correlations
There is no clear long run correlation between ination
and the growth of real output or between money growth
and the growth of real output.
Some nd positive correlations between money growth and
output, ex: McCandless & Weber (1995) for OECD
Some nd no LR correlation between money growth and output
growth, ex: Geweke (1986)
Some nd negative correlation between ination and output, ex:
Barro (1995, 1996)
Results hinge on which countries are used and therefore, long run
eects on output are less robust
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Stylized Facts - Long Run Correlations
The relationship between interest rates, ination and money.
Ination and nominal interest rates in the long run?
Fisher equation: i
t
= r
t
+E
t

t+1
In steady-state, i
ss
= r
ss
+
ss
If real returns are independent of ination, then higher long-run
ination should raise long-run interest rates (roughly conrmed by
empirical analyses, see Mishkin (1992), Moneet & Weber (2001))
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
Why do we Study Monetary Economics
Stylized Facts: Money and Economic Aggregates
Monetary Economics?
Anything that central bankers should be interested in - studies
the formulation of monetary policy, usually by the central bank
or the monetary authority, supply of money and interest rates -
what is actually done and what would be optimal.
It investigates the relationship between real economic variables at
the aggregate level and nominal variables - has considerable
overlap with macroeconomics.
It focuses on the monetary and other nancial markets, the
determination of the interest rate, the extent to which these
inuence the behavior of the economic units and the implications
of that inuence in the macroeconomic context.
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
What is money and what does it do?
Money Market
The concept of Money
Denition of money is a bit tricky - Money is anything that
generally accepted...although with no intrinsic value.
In economics money is dened as an asset (a store of value) which
functions as a generally accepted medium of exchange, i.e., it can
in principle be used directly to buy any good.
Generally accepted mediums of exchange are also called means of
payment. So money is characterized by being a fully liquid asset -
Thus, an assets liquidity is the ease with which the asset can be
converted into money or be used directly for making payments.
M1 -dened as currency in circulation + demand deposits held by
the non-bank public in commercial banks. Thus M1 embraces all
in practice fully liquid assets in the hands of the non-bank public.
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
What is money and what does it do?
Money Market
Historical Remark
1
Commodity Money
such as seashells, rice, cocoa and metals are used as money
comodities that were easily divisible, handy to carry, immutable
and involved low costs of storage and transportation
2
Paper Money
has became a more ecient way to trade - coins and notes in
circulation with little or no intrinsic value
regulation by a central authority
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
What is money and what does it do?
Money Market
Functions of Money
Money is dened in terms of the functions that it performs.
The traditional specication of these functions is:
1
Medium of exchange/payments.
2
Store of value.
3
Standard of deferred payments.
4
Unit of account.
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
What is money and what does it do?
Money Market
Money Supply
The money supply is the total amount of money available in an
economy at a particular point in time (a stock).
Monetary aggregates:
1
M
0
i.e, monetary base -sometimes called high powered money.
2
M
1
i.e, dened as currency in circulation plus demand deposits
held by the non-bank public in commercial banks.
3
M
2
= M
1
plus savings deposits with unrestricted access and small-
denomination time deposits. These claims may not be instantly
liquid.
4
M
3
= M
2
plus large-denomination time-deposits
Notice that, denition of money have not become standardized,
so that their denitions remain country specic.
As we move down the list, the liquidity of the added assets
decrease, while their interest yield increases.
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
What is money and what does it do?
Money Market
Money Demand
In macroeconomics the demand for money is considered as part
of a portfolio allocation problem about how economic agents
allocate their nancial wealth among the dierent existing assets,
including money.
The portfolio decision involves a balance of considerations of
expected rate of return after tax, risk, and liquidity.
The incorporation of a micro-founded money demand in
macromodels is often based on one or another kind of short-cut:
1
The cash-in-advance constraint
2
The shopping-costs approach
3
The money-in-the-utility function approach.
4
The money-in-the-production-function approach.
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -
Monetary Economics
The Concept of Money
What is money and what does it do?
Money Market
Money Market
Money market is meant an abstract market place (not a
physical location) where at any particular moment the aggregate
demand for money meets the aggregate supply of money.
Aggregate demand for real money balances can be approximated
by the function L(Y, i ), where L
Y
> 0 and L
i
< 0
Let the monetary aggregate in focus be M1 and let P be the
general price level in the economy (say the GDP deator)
Then money market equilibrium is:
M = PL(Y, i )
that is, the available amount of money equals nominal money
demand.
Norlin Khalid EPPE 6124 Monetary Economics - Foundations of Monetary Economics -