Slides MF

Money and Financial Markets
PD Dr. M. Pasche
Friedrich Schiller University Jena
Creative Commons by 3.0 license 2015 (except for included graphics from other sources)
Work in progress! Bug Report to: markus@pasche.name
S.1
Outline:
1. Financial Markets
1.1 Overview over Financial Markets
1.2 Interest Rate Theory
2. Theory of Financial Structure

2.1
2.2
2.3
2.4
2.5
Financial Intermediates
Management of Return, Risk and Liquidity
Adverse Selection Problems
Moral Hazard Problems
Efficient Market Hypothesis and its Limits
3. The Money Supply Process

3.1
3.2
3.3
3.4
Function and Measurement of Money

Creation of Central Bank Money
Deposit Creation and the Multiplier
Endogenous Money Supply
S.2
4. Theory of Money Demand

4.1 Keynesian Theory of Liquidity Preference
4.2 Portfolio Theory of Money Demand
5. Central Banking and Transmission of Policy

5.1
5.2
5.3
5.4
Goals of Monetary Policy

Transmission Channels
Targets, Strategies, and Rules
The Taylor Rule on Macro Models
S.3
Basic Literature:
Mishkin, Frederic S. (2012), The Economics of Money,

Banking, and Financial Markets, 10th ed., Boston et al:
Pearson International Edition.
Bailey, Roy E. (2005), The Economics of Financial Markets,

Cambridge: Cambridge University Press.
Bofinger, Peter (2001), Monetary Policy: Goals, Institutions,

Strategies, and Instruments. Oxford: Oxford University Press.
References to more specific literature can be found in the slide

collection.
S.4
Preliminary time schedule (summer 2015):

17.4.
24.4.
1.5.
8.5.
15.5.
22.5.
29.5.
5.6.
12.6.
19.6.
26.6.
3.7.
10.7.
17.7.
ch. 1
ch. 1
(Labor Day)
ch.2
ch.2
ch.2
ch.2
ch.2,3
ch.3
ch.3
ch.4
ch.5
ch.5
ch.5
S.5
1.
1.1
Financial Markets
Overview over Financial Markets
Outline:
1.1.1 Asset Market Classifications
1.1.2 Bond Markets
1.1.3 Loan Markets
1.1.4 Equity Markets
1.1.5 Further Markets
Basic literature:
Mishkin (2012), chapter 2 and parts of chapter 5
S.6
1.
Financial Markets

(Financial) Asset: Money Financial Assets All Assets

Examples: Currency, checkable deposits, bonds, stock shares,
claims from loan contracts,...
Different assets have different properties:
1. Expected returns (interest rates, dividends, difference in buying
and selling price) an increase in expected returns makes an asset
c.p. more attractive demand will increase
2. Risk (returns may have a variance, possible covariance with other
assets) an increase of risk makes an asset c.p. less attractive
demand will decrease
3. Liquidity (how fast can the asset be sold or used for transactions)
the more liquid the asset is c.p., the more attractive it is demand
will increase
S.7
1.
Financial Markets

Asset markets: In contrast to goods markets (producer,

consumer) it is possible that an individual or an institution is on
the supply and the demand side.
Economic theory is interested into the questions (e.g.):
How do different types of agents (e.g. banks, non-banks)

structure their balance sheet = how do they behave on the
demand and supply side on the asset markets?
How can the price movements in aggregated markets be

explained?
S.8
1.
Financial Markets

a) Debt and Equity Markets

Debt:
Contractual agreement, where the borrower pays the holder of

the asset a fixed amount (interest rate) per period until a
specified expiration date (maturity date). The borrowed
amount is returned until (or at) the maturity date.
The maturity of a debt is the time until the expiration date

(short-term < 1 year, long-term > 10 years)
Examples: Consumer loans/credits, mortgages, bonds
Depending on the contract, the borrower can sell the asset,

especially bonds.
S.9
1.
Financial Markets

Equity:
The buyer of an equity has a claim to share the net income

and the assets of the sellers business. The net income is an
uncertain residual and is often payed as dividends. The
instrument has usually no expiration date, hence the funds are
not returned to the holder of the equity.
Example: Stock shares
The holder of an equity can sell the asset e.g. on the stock
exchange market.
S.10
1.
Financial Markets

Advantages and disadvantages:

Debt: Regular payments are more or less certain (unless the debitor
stays solvent).
Equity: Residual payments are uncertain. Residual means that the
firm has to pay the debitors (and taxes) first.
Debt: In case of insolvency the creditor has a prior claim on the
remaining assets.
Equity: Secondary claim on remaining assets in case of insolvency.
S.11
1.
Financial Markets

Advantages and disadvantages: (cont.)

Debt: Holder do not profit from increasing profitability and
increasing firm value since their payments are fixed.
Equity: The holder profits directly by higher dividends and increased
value of their shares.
Debt: Holder has not the right to vote about management issues
and about the distribution of the net income of the firm.
Equity: Holder has these rights.
S.12
1.
Financial Markets

b) Primary, Secondary and Derivative Markets

Primary Market:
New issues of assets are sold to initial buyers.

Examples: firm sells new stock shares or new bonds to an
investment bank; a bank and a firm sign a loan contract; central
bank issues currencies by open market operations.
Secondary Markets:
Once an asset has been issued it can be traded at the current price.
The transactions are often performed by brokers instead of the asset
holders themselves.
Example: stock exchange, foreign exchange.
Derivative Markets:
Not the assets themselves are traded but other claims related to the
underlying assets, e.g. the right to buy a certain asset to a certain
price within a certain period.
Example: options, futures.
S.13
1.
Financial Markets

Secondary markets make assets more liquid: contract can be

sold to a current price. Increasing liquidity makes the assets
more desirable.
On secondary markets the price is determined by the flow of

information as well as by expectations of many agents. In
efficient markets price movements reflect the risk-return
performance of an asset due to new information. The
(expected) price on secondary markets may also affect the
price on the primary market.
S.14
1.
Financial Markets

c) Exchanges and OTC Markets ( secondary markets):

Exchange:
Organized, centralized, regulated trading of assets, high

transparency of bids, asks and price setting, very competitive,
almost arbitrage-free.
Over the counter (OTC):
Decentralized market where the seller sells the assets over

the counter to a buyer. Since OTC dealers are connected by
computer networks, there is also high price transparency and
competitivenes, but much less regulation.
S.15
1.
Financial Markets

d) Money and Capital Markets:

Money Maket:
Short-term contracts (maturity < 1 year) with high liquidity
Capital Markets:
Long-term contracts (maturity > 1 year, assets without

expiration date like stock shares)
Note, that this definition of a money market differs from the

term as used in macroeconomics where money is defined in a
specific manner.
Sometimes money market = market for central bank reserves
(e.g. interbank market).
S.16
1.
Financial Markets

1.1.2 Bond Markets
Bonds are issued by firms (corporate bonds) or by government

(governmental, treasury, municipal bonds).
Two types of bonds:
Coupon-bond: owner of the bond receives a fixed payment

per year (coupon rate) until the maturity date. At the
maturity date the specified final amount (face vaule, pair
value) is payed. Special case: perpetuity bond without an
expiration date.
Discount bond (zero-coupon bond): There is no coupon

interest rate. The bond is sold to a price below the face value.
At the maturity date the owner receives the face value.
S.17
1.
Financial Markets

1.1.2 Bond Markets
Interest rate i when holding the bond until maturity:

n
P0 =
X
C
F
+
n
(1 + i)
(1 + i)t
t=0
with P0 = bonds price in t = 0, F = face value, C = coupon rate,

n = maturity date.
Expected return r when holding the bond for one period (before
maturity, without discounting):
r=
C + Pt+1 Pt
Pt
where Pt+1 is the expected bonds price in t + 1.
S.18
1.
Financial Markets

1.1.2 Bond Markets
In both formulas there is an inverse relationship between

interest rate/return and the bonds price!
If the interest rate is lower than expected return it would be

profitable for all bonds holders to hold the bond only for one
period and to sell it in t + 1. Therefore, it can be expected
that Pt+1 will fall, which results in a decreasing r .
In the opposite case, the holders would decide to hold the
bond for a longer time (until maturity). The prices in t + 1
will therefore rise until i and r will be equal.
S.19
1.
Financial Markets

1.1.2 Bond Markets
Slope of demand and supply curves:
The demand for bonds is negatively related to the bonds

price but positively related to the interest rate i.
If the interest rate is low and vice versa the bonds price is
high it is more attractive for governments, firms or institutions
to issue bonds to finance their activities. The supply curve
can be assumed to be downward sloped in i. Alternatively, in
the short run the bonds supply can be assumed to be
exogenously fixed.
S.20
1.
Financial Markets

1.1.2 Bond Markets
price
interest
rate
BS
BD
BD
BS
B
S.21
1.
Financial Markets

1.1.3 Loan Markets
Types of loans:
Simple loan: borrowed amount L is paid back plus interest
payment IP at the maturity date n. The interest rate i then solves:
L=
L + IP
(1 + i)n
Fixed-payment loan: borrowed amount is paid back including

interest in fixed payments FP (amortisation plus interest) per
period until maturity date. The interest rate i then solves
L=
n
X
t=1
FP
(1 + i)t
S.22
1.
Financial Markets

1.1.3 Loan Markets
Solvency: ability of the borrower to pay back the loan plus

interest.
Risk: probability distribution for the cases that the borrower is

able to pay back percent of {loan plus interest}; typical
measure for risk: variance.
Example: full return (probability p) versus total loss
(probability 1 p)
Expected return: r = pi + (1 p)(1)
Variance of return: r2 = p(i r )2 + (1 p)(1 r )2
(If p = 1 then r = i and r2 = 0)
S.23
1.
Financial Markets

1.1.3 Loan Markets
Borrower has to provide collaterals. The lender can claim the

collateral in case of insolvency.
In case of mortgages the borrower is not allowed (or it is not

possible) to sell the collateral. The lender has the right to
claim the collateral unless the loan is fully returned.
There is asymmetric information about p before the

contract (adverse selection problem), and after the contract
when the loan is used to finance an uncertain project (moral
hazard problem). See section 2.3 2.4.
S.24
1.
Financial Markets

Stock shares as the most common type of equities.

An owner of a stock share has
What is the firm value?
Net present value of expected cash flow?

Value of the physical and non-physical assets?
Different models on pricing stock shares

Problems:
claims on the net residual profits

occasionally paid dividends.
claims on the firm value.
Expectations depend sensitively on news flow.

Expectations may be driven by less rational determinants
(moods, herding effects etc.)
Expectations are a source of speculation, speculation may drive
the prices, price movements confirm speculation ( bubbles).
High volatility of stock prices, high risk.
S.25
1.
Financial Markets

A case for bubbles? (Dow Jones Index)
S.26
1.
Financial Markets

Options:
Option contracts are derivatives.

The holder of an option has the right (not the obligation) to
buy or to sell an underlying asset (e.g. stock shares, bonds,
foreign exchange, oil, crop,...) to a predetermined price until a
defined expiration date.
Buy = call option
Sell = put option
The option itself can be traded. The institution which issues
the option has the obligation to buy/sell the underlying asset
if the holder of an option wishes to exert his right.
The pricing of options is complicated and is not addressed in
this lecture. The volatility of option prices is high. If the right
is not exercised until the expiration date (this can be
rational!) there is a 100% loss for the buyer of the option.
S.27
1.
Financial Markets

Futures:
Future contracts are derivates similar to options.

The main difference is that buyer and seller are obliged to
execute the transaction (and option holder has only the right
to do that).
The date of transaction is determined in the contract.
Why options and futures?

Derivative contracts are like bets when expectations of
buyers and sellers are divergent.
Instrument to incorporate more information into the price
system.
Leverage effect: potential for high profits from speculative
derivative contracts.
Derivatives can be used to hedge risks of the underlying asset.
S.28
1.
Financial Markets

Foreign Exchange Markets:
Foreign exchange/currency are also assets.
Transactions on foreign exchange markets can be caused by

underlying transactions on goods or capital markets (e.g.
change sale earnings into domestic currency, demand for
foreign exchange in order to pay back a loan).
Transactions can also be caused by the expectation that the

demanded foreign exchange will appreciate (speculation).
There are spot markets and future markets for foreign

exchange. The latter can e.g. be used for hedging the risks of
an underlying transaction on the goods market.
S.29
1.
1.2
Financial Markets
Interest Rate Theory
Outline:
1.2.1 Behavior of Interest Rates
1.2.2 Risk Structure of Interest Rates
1.2.3 Term Structure of Interest Rates
Literatur:
Mishkin (2012), chapter 4, 5, parts of chapter 6
S.30
1.
Financial Markets

Equilibrium interest rates for bonds changes with demand and

supply on the bonds market:
Demand shifts by Net Financial Wealth (+), expected

inflation (-), changes in expected returns (+), risk (-), liquidity
(+) of bonds (or vice versa in case of alternative assets).
Supply shifts by changed profitability of investment

opportunities (+), expected inflation (+), governmental
activities (deficit spending) (+).
S.31
1.
Financial Markets

The role of expected inflation
Real interest rate = nominal interest rate - (expected)

inflation rate (Fisher equation):
i real = i p
Debt contracts specify fixed payments per time interval. The

real value of the payments decreases with inflation. This is
bad for the creditor/lender but good for the debitor/borrower
(distribution effect of inflation).
Holding debt assets becomes less attractive, portfolios are

restructured in favor of alternative assets. This leads to an
increase of the nominal interest rates so that real interest
rates are not affected by monetary variables (Fisher effect).
S.32
1.
Financial Markets

B2D
interest
rate
B1D
expected inflation
raises
B2S
B1S
B
Source: Mishkin (2010)
S.33
1.
Financial Markets

Source: Mishkin (2010)
S.34
1.
Financial Markets

Risk: (details in Bailey (2005), chapter 4)
Realized returns are uncertain, they are dispersed around an

(estimated) mean.
Agents can assumed to be risk averse = utility function is
concave in returns: u (r ) > 0, u (r ) < 0.
Risk premium:
Given a return of a risk-free asset A. Which risk premium RP on
the return will be neccessary so that the utility of the uncertain
asset B equals the utility of the risk-free asset A?
A =
A ,
B =
B + ,
E [u(A )] = E [u(B )]
E [] = 0, V [] > 0
A + RP =
B
S.35
1.
Financial Markets

u(r )
E [u(
A )] = E [u(B )]
RP
S.36
1.
Financial Markets

The risk premium increases with the risk V [].
In case of fixed-payment debt instruments, risk is determined

by risk of default of the debitor.
Debt assets with higher risk have a higher nominal interest

rate ( spread of interest rates).
The interest rates of more risky bonds are higher than of low
risk bonds e.g. corporate bonds are more risky than US
government bonds, bonds of AAA-rated firms are less risky
than of BBB-rated firms etc..
S.37
1.
Financial Markets

increasing risk of corporate bonds

interest
rate
B1D
B2D
B1D
interest
rate
B2D
spread
BS
treasury bonds
BS
corporate bonds
S.38
1.
Financial Markets

source: Mishkin (2010)
S.39
1.
Financial Markets

source: German Council of Economic Experts
S.40
1.
Financial Markets

Interest rate differentials can furthemore be explained by
different liquidity of bonds or loan contracts: The more

illiquid an asset is, the higher the interest rate must be in
order to compensate this disadvantage.
different income taxes on interest payments: The more the

interest payments are taxed, the higher the nominal interest
rate will be.
S.41
1.
Financial Markets

Yield Curve:
Describes the term structure of interest rates for bonds of a given
type (with identical risk and liquidity characteristics) or for a
bundle of bonds.
Upward sloping yield curve (normal yield curve): long-term

interest rate above short-term interest rates
Downward sloping yield curve (inverted yield curve): vice

versa
Flat yield curve: same interest rate in short and long run
(Inverted) U-shaped yield curve etc.
S.42
1.
Financial Markets

interest
rate
normal yield curve
flat yield curve
inverted yield curve
residual maturity in years

(Daily and historical yield curves can be interactively calculated on the ECBs
home page. Estimation on the basis of a bundle of specific bonds, for details
see homepage.)
S.43
1.
Financial Markets

Stylised empirical facts:

1. Interest rates of bonds with different maturities move jointly.
2. If the short term rate is low it is likely that yield curve is
upwards sloped; vice versa if the short-term rate is high.
3. The upwards sloped yield curve is the typical case.
S.44
1.
Financial Markets

Expectations Theory
Assume that short-term rate is low. Agents expect increasing

economic activity (productivity, profitability, but also inflation
increase). Therefore the demand for funds to finance
additional investments will increase. The expected interest
rate level will rise (= falling bonds prices). If you buy a
long-term bond today, the expected higher short-term interest
rates in the future have to be reflected in the current
long-term interest rate.
Explains the first two stylised facts but not the third one.
S.45
1.
Financial Markets

Example: Amount L is invested for two periods.

Question: Buying one long-term contract or two subsequent
short-term contracts?
Rlong = L (1 + i0,2 )2
Rshort = L (1 + i0,1 )(1 + i1,1 )
where ij,k is the interest rate at time j for a k-period contract.
In an arbitrage-free market we have Rlong = Rshort which implies
q
i0,2 = (1 + i0,1 )(1 + i1,1 ) 1
where i1,1 is the expected interest rate. The current long-term
interest rate is the geometric mean of the current and the expected
short-term interest rate in the future.
S.46
1.
Financial Markets

If expectations are not systematically false, there should be a

correlation between the slope of yield curves and the business
cycle: before a cyclical downturn the yield curve will become flat or
inverted. Before an economic recovery the slope of the yield curve
will rise.
Empirical Literature:
Bernhard, H., Gerlach, S. (1998), Does the Term Structure Predict
Recessions? The International Evidence. International Journal of
Finance and Economics Vol. 3(3), 195-215.
S.47
1.
Financial Markets

Segmented Markets Theory:
Long- and short-term bonds are no close substitutes.
Investors have different preferences for different maturities.
Bonds are traded in different (segmented) markets.
It seems to be plausible that investors prefer short-term

maturities which would explain the stylised fact 3 but not fact
1 and 2.
S.48
1.
Financial Markets

Liquidity Theory:
Bonds of different maturities are (imperfect) substitutes

expected returns correlate like in expectations theory.
Investors prefer short-term maturities so that short-term

markets are more liquid. Buying a less liquid bond requires a
liquidity premium.
Since this incorporates the expectations theory, all three

stylised facts are explained.
S.49
2.
2.1
Theory of Financial Structure

Financial Intermediates
Outline:
2.1.1 Economic Functions of Financial Intermediates (FI)
Asset Transformation
Reducing Transaction Costs
Risk Sharing
Dealing with Asymmetric Information
2.1.2 Types of Financial Intermediates

Literature:
Mishkin (2006), chapter 2
S.50
2.
2.1 Financial Intermediates

2.1.1 Economic Functions of Financial Intermediates
Indirect Finance
Financial Intermediates:
1.
2.
3.
4.
Provider:
1.
2.
3.
4.
Households
Firms
Government
Foreign
Banks
Mutual Funds
Pension Fonds
etc.
Receiver:
Market
Direct Finance
1.
2.
3.
4.
Households
Firms
Government
Foreign
S.51
2.

a) Asset Transformation:
(Note that liabilities of the intermediate = asset of the houshold or firm)
Lot size transformation:

e.g. many small deposits, few large credits
Maturity transformation:
short run liabilities, long-run assets
Risk transformation:
e.g. less risky liabilities, more risky credits (see below)
Liquidity transformation:
high liquid liabilities, less liquid assets
S.52
2.

b) Reducing Transction Costs:
FI have economies of scale:

getting information about demanded and provided funds,
assessing risks, bargaining, designing and enforcing contracts,
buying/selling stock shares these tasks can be accomplished
by FI with much lower transaction costs due to specialized
information processing abilities, large transaction volumes,
specific human capital (expertise).
FI have economies of scope:

FI provide additional services like risk diversification,
optimizing portfolios, and consulting. Sometimes these
services need the same infrastructure and the same human
capital. Hence it may reduce cost when one FI provides these
services.
S.53
2.

c) Evaluating, Pooling and Allocating Risk:
Risk: e.g. investment projects may fail, borrowers may become

insolvent.
Evaluating risks calculating risk premia.
Reducing the risk by pooling and diversification.
Transforming the risk structure of financial assets.

Examples:
Depositors hold safe asset and receive low interest rates.

Bank provide risky loans with high interest rates (including risk
premia).
Securitization of risky loans and selling them changes asset
structure and re-allocates the risk.
S.54
2.

d) Dealing with Asymmetric Information (see 2.3 2.4)
Adverse Selection:
Moral Hazard:
Hidden characteristics of a potential borrower before

contracting.
Borrower knows his risk better than the lender.
If lender offers a contract which is optimal for a borrower with
average risks, this may be unattractive for those with good
risks. This may result in a market failure.
Hidden action of a borrower after contracting.
Borrower takes the money to engage in a prject that is
undesireable for the lender. This reduces the probability for a
successfully returned credit.
FI may mitigate this problem e.g. by screening, collaterals,

optimal design of contracts. Again, they have the resources to
do that with low transaction costs.
S.55
2.

Depository institutions (banks):

Accept deposits from individuals and institutions as liabilities,
providing loans and mortgages as assets.
Example: Commercial banks, thifts.
Contractual savings institutions:
Accept premiums and contributions from government, firms
and individuals as liabilities, investment in bonds, stocks and
government securities.
Example: life insurance, retirement funds
Investment intermediates:
Selling commerical stocks, bonds or shares as liabilities,
providing business loans and investment in stocks and bonds
as assets.
Example: Finance companies, private equity funds
S.56
2.

Type of FI
Depository Institutions
Commercial Bank
Saving/loan associations
and mutual saving banks
Contractual saving Institutions
Life Insurance Companies
Fire/Caaualty Insur. Comp.
Pension funds
Gov. retirement funds
Investment Intermediates
Finance Companies
Mutual Funds
Money market mutual funds
Primary Liabilities
Primary Assets
Deposits
Loans, mortgages,
bonds
Mortgages,
consumer loans
Deposits
premiums
premiums
employer/employee
contributions
employer/employee
contributions
Bonds, mortgages
bonds, stocks
bonds, stocks
commercial papers,
stocks, bonds
issued shares
issued shares
loans
Value
12,272
1,518
4,798
1,337
5,193
bonds, stocks
2,730
bonds, stocks
money market instr.
(US Data 2008 , Bill. Dollar; source: Mishkin (2010), Tables 3 and 4, data from Federal Reserve)
1,910
6,538
3,376
S.57
2.

Non-bank Financial Intermediaries (NBFI) are sometimes called

shadow banks
Risk originators:
Risk bearers:
Depository institutions (commercial bank 6 NBFI)

Broker dealer (investment banks)
Finance companies
Managed funds (insurance companies, retirement funds etc.)
Institutional investors (mutual funds, money market funds,
hedge funds)
Special Purpose Vehicles (intermediary institution for the

securitization process)
Poschmann, J. (2012), The Shadow Banking System Survey and Typological

Framework. Global Financial Markets Working Papers No.27, Jena/Halle.
S.58
2.

Why do NBFI exist?
Specialisation on transactions where no deposits are involved.
Financial intermediation combination with different private

goods (e.g. insurance).
Regulatory arbitrage: Banks are highly regulated, but

shadow banks are much less regulated they can do risky
investments to less costs. But: no access to short-run central
bank liquidity and safety nets like deposit insurance.
This can utilized also by banks e.g. by securitization and

selling the claims from loans to NBFI.
S.59
2.
2.2

Portfolio Selection and the Management of Return, Risk and Liquidity
Outline:
2.2.1 General Principles of Bank Management
2.2.2 Theory of Portfolio Selection
2.2.3 The Value at Risk Approach
Literature:
Bailey (2005), chapter 5
S.60
2.
2.2 Portfolio Selection and the Management of Return, Risk and Liquidity
The Banks Balance Sheet

Assets
Reserves (required, excess)
Cash
Securities/Bonds
firm bonds
governmental bonds
(Checkable) Overnight
deposits
Nontransaction desposits
Loans
Liabilities
industrial
consumer
real estate
inter-bank
other
Other assets
(e.g. physical assets)
Borrowings
Time deposits
Redeemable deposits
(saving accounts)
Inter-bank loans
Central bank loans
Other
Bank Capital / Net Worth
S.61
2.
a) Liquidity Management
Inflows are stochastic (e.g. risk of non-repayment of

debt/interest rates), outflows are stochastic (e.g. sudden
deposit withdrawals) need for liquid assets like cash or
reserves.
If there are not enough liquid assets, the bank needs expensive
overnight loans, or has to sell other assets (fire sales), or it
becomes illiquid.
Problem: If customers receive a signal of possible liquidity
problems, they wish to draw their deposits. This enforces the
liquidity problem and may induce bankruptcy (bank run
equilibrium, see Diamond/Dybvig model).
Given a probability distribution of inflows and outflows on the
liability side, the asset side should consist of enough liquid
assets to meet the obligations to the depositors and creditors.
S.62
2.
Excourse: Interbank market
Most transactions are deposit transfers from bank A to bank B.

Bank A is then in need for liquid reserves while bank B has excess
liquidity.
Interbank market for clearing the demand and supply of liquid

reserves by short-run interbank loans (often called money market).
The money market interest rate is the primary operative goal of the
central bank policy.
What happens if banks do not supply excess liquidity on the

interbank market, e.g. because of distrust to other banks or fear of
liquidity distress? increased central bank loans; central bank aims
to avoid liquidity problems in the banking sector.
Financial crisis 2008/2009 (and also later): drastically increased

central bank loans but also drastically increased excess reserve
holding at the central bank.
S.63
2.
b) Asset Management
Management of risk and return of the assets. Investing into a

mix of risky and riskless assets with the highest expected
utility (portfolio approach). But: portfolio approach requires
assumption of risk aversion which is empirically questionable.
Restrictions to asset management:
Liquidity considerations: The need for sufficient liquiditiy is a

restriction for asset management.
Capital regulation (Basel II/III): value of rsiky assets is risk
weighted, capital requirements for these risk weighted assets.
This prevents from holding too many too risky assets.
Incentive for securitization
S.64
2.
Excourse: Securitization
Illiquid assets like loans are pooled to a specific portfolio.

This portfolio is transferred to an entity called Special
Pupose Vehicle (SPV).
The SPV securitizes this portfolio and issues rated Asset
Backed Securities e.g. to funds, and receives liquid assets in
exchange which are transferred back to the bank.
From the banks perspective, and illiquid asset is therefore
transformed into a liquid asset. The risk of the underlying
securities is transferred to the fund (and fund share holders).
Although the amount of issued risky loans is the same as
before, the bank has a better loans/capital ratio.
Different types of securitization and ABS (not to be discussed
here).
S.65
2.
c) Liability management
Deposits are not given and not the only source of funds.
Decision how to aquire which types of liabilities.
Differences of liabilities:
Hows fast could an additional liability be aquired?

Probability of outflows
Differences in maturity
Costs = interest rates (e.g. for time deposits, for inter-bank or
central bank loans)
Development of new financial instruments (e.g. certificates of

deposits (CD) which are similar to bonds)
S.66
2.
d) Bank Capital Management
Most assets have risks: Credits may fail, bonds prices may fall.
Hence, the value of the asset side is under risk of being
depreciated.
With a certain probability the losses of the asset side may

exceed the bank capital: the bank becomes insolvent.
Trade-off: More risky investments enlarge c.p. the return on

equity capital, but also the risk of insolvency!
This is regulated by Basel II / III (see above)
S.67
2.
Outline of Portfolio Theory

(Bailey (2005), chapter 5)
We address the case of two risky and one risk-free asset.

Risky means, that the returns are stochastic.
Notation:
i
12
ii
ai
r0
expected return of risky asset i = 1, 2

covariance between the returns of asset 1 and 2
variance of returns of asset i = 1, 2
P
proportion of portfolio invested in asset i, i ai = 1
return of the risk-free asset
S.68
2.
a) The portfolio P of risky assets

We have
P =
P2
XX
ai i
(1)
ai aj ij2
(2)
In case of two risky assets the proportion a1 (obviously a2 = 1 a1 )

determines the expected return and the variance of the portfolio.
S.69
2.
b) Efficiency Frontier
In case of more than two risky assets the convex set of

proportions a1 , ...an define a convex set of
(P , P2 )-combinations.
Most of these combinations are inefficient, since there exist

many portfolios with the same P but different P2 .
In the first step, the efficiency frontier has to be derived by

minimizing P2 (overP
ai = 1, ...n) under the constraints of
given P =
P and i ai = 1
In case of two risky assets, this step is not necessary since ai

determines a unique (P , P2 )-combination.
S.70
2.
The shape of the efficiency frontier EF depends on the covariance

2
(1 2 = 12
/(1 2 ) is the correlation coefficient).
P
with 12 = 1
F
Asset 1
with 12 (1, 1)
with 12 = 1
Asset 2
S.71
2.
c) Optimal portfolio without a risk-free asset
From the set of efficient portfolios choose the optimal

portfolio wich maximizes the utility function.
Mean-Variance-Approach:
X
max E [u(rP )] = P P2
with
ai = 1
ai
with > 0 as the degree of risk aversion.

Note: This is a special type of utility function. From a theoretical
point of view it is not necessary that the preferences can be
represented by a utility function of this type.
In a (P , P )-diagram the indifference curves are upwards

sloped. The tangential point (R) of the indiffrenece curve with
the efficient portfolio frontier is the solution of the
optimization problem.
S.72
2.
indifference curves
P
Asset 1
R
optimal portfolio without
a risk-free asset
Asset 2
S.73
2.
d) Optimal portfolio with one risk-free asset
The riskless asset has a return r0 and zero variance.
The risky portfolio Z is a mix of two risky assets with
Z = Z 1 + (1 Z )2
(3)
2
Z2 = 2Z 12 + (1 Z )2 22 + 2Z (1 Z )12
q
Z = 2Z 12 + (1 Z )2 22 + 2Z (1 Z )12
(4)
(5)
where Z has to be determined in an optimal way. The

resulting portfolio Z must lie on the efficiency frontier.
S.74
2.
If portfolio Z is mixed with the riskless asset (share P ). The

resulting portfolio P has the properties:
P = P r0 + (1 P )Z
P2
P )2 Z2
= (1
q
P = (1 P )2 Z2 = (1 P )Z
(6)
(7)
(8)
Thus, the risk and return of P is a linear combination of Z

and the riskless asset.
S.75
2.
In a (, )-diagram we can therefore write

(see also the figure):
P = r0 + bP

Z r 0
P
= r0 +
Z
r0
(9)
(10)
Asset 1
(Z = 1)
r0
(Z = 0)
Asset 2
S.76
2.
How to determine the risky portfolio Z ?
Note, that an optimal portfolio P will be a tangential pont of

the indifference curve with the linear function (9).
Every point on a steeper linear function (9) dominates the

points on a flatter linear function since we obtain a higher
return with the same standard deviation.
Therefore, we maximize the slope b = (Z r0 )/Z with

respect to Z under the condition that Z , Z are defined
according to (3) and (5). This guarantees that Z lies on the
efficiency frontier.
Obviously, Z must be a tangential point on the efficiency

frontier!
S.77
2.
max b =
Z
Z =
Z r 0
Z
s.t. (3), (5)
(1 r0 )2 (2 + r0 )12
(1 r0 )2 + (2 r0 )1 + 2r0 12 (1 + 2 )12
Now the optimal risky portfolio Z is determined. The linear

equation (9) with Z (and henceforth b ) is called Capital
Allocation Line (CAL).
Now, the optimal mix between Z and the riskless asset is
determined as usual as the tangential point of the indifference
curve with the CAL. The solution depends on the degree of
risk aversion. But it is remarkable, that irrespective to the
individual risk aversion, all rational investors will choose the
same risky portfolio Z (Tobin separation).
S.78
2.
capital allocation line

Asset 1
Z
r0
Asset 2
S.79
2.
capital allocation line

Asset 1
Z
P
optimal portfolio with

two risky assets and
one risk-free asset
r0
Asset 2
S.80
2.
Limitations:
Risky assets have to be backed by capital.
The bank needs a certain liquidity of their assets. Liquidity is

not addressed in the portfolio approach (see below).
Banks have to hold specific securities in order to have access

to Central Bank credits.
These things are constraints to the Portfolio Approach.
Empirically seen, there is not much risk aversion.
S.81
2.
Now we turn back to solvency and liquidity management

considerations.
Once, the optimal portfolio is determined, the value of the

assets is uncertain: Bad loans have to be depreciated, the
bonds prices may fall the value of the assets is a stochastic
variable.
For a given period (e.g. 1 month) it is possible to construct a

probability distribution F for the losses of value (where
negative losses are gains).
Assume that the bank management (or the regulation

authority) wishes that in the given period the bank stays
solvent with a probability of 1 %. Then the upper -fractil
of the distribution F denotes the (tolerated) losses the VaR
benchmark which can be expected with probability of %.
S.82
2.
% tolerated loss
(1 )%
0
VaR
loss
S.83
2.
In order to stay solvent the bank has to keep bank capital

which covers (at least) the VaR benchmark, for example
BC VaR1% . Staying solvent means that the obligations to
the depositors can be fulfilled.
If VaR is determined, then r denotes the percentage of the

asset volume A which will be lost with probability :
VaR = r A
BC
r
A
Example: If = 0.01 and r0.01 = 0.15 then 15% of the asset

volume are lost with probability of 1%. If BC r0.01 A then
losses which exceed bank capital (insolvency) have a
probability less than 1%.
S.84
2.
Applying VaR to Liquidity Management:
Consider a liquid asset (e.g. excess reserves), while the

deposits D are stochastic. The banks liquidity management
should ensure that the bank stays liquid when depositors wish
to draw their deposits.
The VaR approach can also be applied to this task: Let G be

the pobability distribution of daily deposit net outflows (where
negative outflows are net inflows). Then is the probability
that the outflows exceeds the liquid excess reserves and the
bank gets into liquidity troubles.
Similar to the BC /A = r ratio in case of solvency we have a

ratio r of excess reserves and deposits to ensure liquidity with
a probability of percent.
S.85
2.
It has to be noted that the VaR approach to liquidity is an

additional constraint for the portfolio management: The
share of the most liquid asset (here e.g.: excess reserves) is
determined by the degree of risk aversion of the bank but is
also restricted by the VaR approach.
Summing up: The bank makes simultanous decisions about

the volume and the structure of the asset and the liability side.
S.86
2.
2.3

Adverse Selection Problems
Outline:
2.3.1 Introduction
2.3.2 How Adverse Selection Influences Financial Structure
2.3.3 Solutions: Screening, Signalling, Regulation, Collaterals
2.3.4 What Stylized Facts are Explained by Adverse Selection?
Literature:
Wolfstetter, E. (1999), Topics in Microeconomics, chapter 9
S.87
2.
2.3 Adverse Selection Problems

2.3.1 Introduction
Information Asymmetries:
Principal: offers contract, lack of information

Agent: signs contract, private information
Before contracting: hidden characteristics adverse selection
buying shares or bonds of a firm characteristics are not

known to the buyer
providing a loan to a borrower with unknown ability to pay
back the loan (credit risk)
Principals decision is based on expectations about agents

characteristics
expectations are built on information
limited possibilities to reveal the unknown characteristics
Pooling vs. Separating equilibria
S.88
2.

After contracting: hidden action moral hazard
Agent uses the funds for financing projects which are more
risky than announced to the principal, or he reduces the
managerial effort because this might enhance his benefits.
Principal cannot observe this, but he can expect that there is

an incentive for moral hazard.
Optimal design of the contract in order to mitigate or avoid

MH.
S.89
2.

Markets for Lemons
Akerlof, G.A. (1970), The Market for Lemons: Qualitative

Uncertainty and the Market Mechanism. Quarterly Journal of
Economics Vol. 84, 499-500.
Wolfstetter, E. (1999), Topics in Microeconomics. (Chapter

9.2.1)
Nobel Prize 2001 to George A. Akerlof, A. Michael Spence, Joseph

E. Stiglitz for their analyses of markets with asymmetric
information.
Foundation of market imperfections or market failures due to
information asymmetries.
S.90
2.

The original version: Market for used cars
Cars have a different quality q (from very good q = b to

bad q = 0, bad cars = lemons)
The seller is privately informed about the quality q [0, b].
The seller will accept any price p q.
The buyer is willing to pay any price p q with > 1.
For any given q there exists a price [q, q] where buyer and
seller mutually benefit from the deal.
But: The buyer is not able to observe q

building expectations E [q].
S.91
2.

Assume that the quality q is uniformly distributed on [0, b]. This is

known by the buyer. For any used car the expected quality is hence
E [q] = b/2. Therefore
p(E [q])
b
2
Two cases:
Case 1: 2. Then the buyer is willing to pay p b and all

cars will be sold.
Case 2: 1 < < 2. Then the market breaks down!
S.92
2.

Market breakdown:
For < 2 the buyer will never pay p = b.
No high quality cars (q = b) will be sold. They can be removed

from the interval (e.g. q [0, b ]).
This can be anticipated by the buyer. The expected average quality

decreases (e.g. E [q] = (b )/2).
The willingness to pay also decreases.
The remaining best quality cars leave the market.
and so forth... (race to the bottom)
S.93
2.

Or in another way:
Assume an arbitrary merket price p > 0. Obviously there are

only sellers i the market with qi [0, p]. The average quaility
is hence E [q] = p2 .
This is known by the buyers. The are willing to pay maximum

p(E [q]) = /2 p.
For < 2 this is lower than the market price and no deal
comes about.
S.94
2.

Financial Markets:
Firm needs funds to finance a risky project. Assume that the

firm demands for a loan L.
The firm is willing to pay an interest rate iL which does not
exceed the expected return of the project r .
The bank will provide the loan L when the interest rate covers
at least the interest rate for a secure asset iS plus the risk
premium RP.
Assume that the loan is either returned successfully with
probability 1 p or it fails completely with probability p. The
minimum risk premium is therefore:
L(1 + iS ) = L(1 + iL )(1 p) + 0 p

p
RP = iL iS =
(1 + iS )
1p
(11)
(12)
S.95
2.

Problem: p is private information of the firm!

Offering a loan contract with an interest rate iL (incl. risk
premium) based on the expected probability E [p] taken from
a prior distribution of risks.
Typically the expected return and the risk of investment
projects are positively correlated. Firms with profitable low
risk projects with
r < iS +
E [p]
(1 + iS )
(1 E [p])
will not have in incentive to sign a loan contract!

The remaining projects are hence more risky which leads to
an increase of E [p] a similar mechanism as in the market
for lemons example applies.
S.96
2.

Credit Rationing:
Adverse Selection Effect: With an increasing interest rate more and
more good (= low risk) projects leave the market and the expected
risk increases:
dE [p(iL )]
>0
E [p] = E [p(iL )],
diL
Profit maximizing bank: (L given)
max = (1 E [p(iL )])(1 + iL )L
iL
dE [p(iL )]
d
=
(1 + iL )L + (1 E [p(iL )])L = 0
diL
diL
iL
(1 E [p(iL )])
dE [p(iL )]
diL
dE [p(iL )]
diL
(13)
(14)
(15)
S.97
2.

What are the consequences?
The profits do not monotonously increase with market interest

rate iL .
If loans demand increases, there is not neccessarily a

Walrasian adjustment of the equilibrium interest rate!
The demand side of the loans market will be rationed.
Existence of rationing equilibria.
The notional plans of the firms cannot be fulfilled

spillover to other markets
e.g. markets for bonds or equities to finance the project

e.g. markets for investment goods
S.98
2.

LS
rationing
LD
iL
iL
S.99
2.

Literature:
Stiglitz, J., Weiss, A. (1981), Credit Rationing in Markets

with Imperfect Information. American Economic Review 71,
393-410.
Greenwald, B., Stiglitz, J., Weiss, A. (1984), Information
Imperfections in the Capital Market and Macroeconomic
Fluctuations. American Economic Review 74, 194-199.
Note:
The problem of rationing may be (partially) overcome e.g. by

collaterals.
The problem may also occur in bonds and stock markets: the
price which the buyer is willing to pay reflects his uncertainty
about the risk type of the firm!
S.100
2.

There are different ways how to solve or to alleviate the problem:
Providing better information = decreasing information

asymmetry
Screening: The less informed agent has an incentive
to collect information by himself

to buy additional information supplied by other agents
to provide different contracts with self-selection effects
Signalling: The privately informed agent has an incentive to

provide a trustworthy (costly) signal about his characteristics.
Governmental Regulation
Collateral and Net Worth

The information asymmetry is not neccessarily resolved but
has minor consequences since in case of a failed project the
return of the loan is backed.
S.101
2.

Screening by collecting information
High information costs, especially for lenders with low

expertise.
Bank as a financial intermediate with expertise and specialized
human capital reduces such information costs:
Multiple lender of funds bank deposits

Bank is pooling the risks and guarantees the depositor an
interest rate
Screening costs of multiple non-specialized lenders are reduced
and transferred to the bank
The bank as the intermediate lender faces a lower information
asymmetry
The existence of a professional banking system is a

prerequisite for a working credit market.
S.102
2.

Screening by buying information provided by others
Rating agencies (e.g. Standard & Poors, Moody): (large)

borrowers are rated according to a standardized scale (see
Mishkin (2006), chapter 6, p.123)
In Germany: SCHUFA (Schutzgemeinschaft f
ur allgemeine
Kreditsicherung)
Problems:
Free-rider problem since information is a non-rival good.

Once, when information is made public, there is no incentive
anymore to pay for it.
How trustworthy is that information? RA typically payed by
the better informed party. Less informed party is not able to
asses the reliability of the information Moral Hazard
problem.
S.103
2.

Screening and self-selection (separating equilibrium):
High/low risk investors with probabilities of default pH > pL where

pj is private information.
Bank offers two types of contracts: (iL , CL > 0) and (iH , CH = 0).
For a high risk investor it is more likely that he will have to pay the
collateral. Both investors compare the expected costs:
(1 pj )iL + pj CL (1 pj )iH
iH iL
pj
1 pj
CL
Since the l.h.s. is larger for the risky investor, there exists
combinations of (iL , iH , CL ) where the inequality sign is different for
both investor types.
Investors will choose different contracts and therefore reveal their

type (separating equilibrium)!
S.104
2.

Governmental Regulation:
If investors need financial funds, e.g. by demanding credits or
selling bonds or stocks, they can be forced by law to provide some
information to reduce the information asymmetry. E.g.
adhere standard accounting principles
providing information about the balance sheet and other

(financial) indicators like sales, earnings, assets
in case of stock markets: publish relevant informations

regularly; annual meeting of shareholders etc.
S.105
2.

Signalling:
A firm with a low risk project has an incentive to provide a

signal so that the lender is informed about the low risk.
If signalling should make sense...
(a) the signal must be costly
(b) there must exist signals that are too expensive for a high risk
firm but not too expensive for low risk firms
discrimination is possible.
Otherwise high risk firms have an incentive to imitate the

signal so that signalling provides no information (pooling
equilibrium).
S.106
2.

Signalling means building reputation. Reputation signals (e.g.):
Loans have been successfully returned in the past.
Projects are financed also with equity capital.
Firm provides voluntarily more sensitive information than

required by law.
Firm has valuable assets ( similar to collaterals).
This may be a problem for new and small firms.
S.107
2.

Collaterals:
In case of failure of the investment project the investor has

other assets which can be sold to meet the debt obligations.
Borrower must prove that he has such collaterals before

signing the credit contract.
Credit contract includes the obligation that the collateral

must not sold until the credit is returned successfully.
Cedit contract includes that lender automatically becomes the

owner of an asset in case of a credit failure.
In some contracts, the lender has property rights on the asset

which is financed by the credit. These property rights are
returned to the borrower in case of a successfully returned
credit mortgages (e.g. in case of housing)
S.108
2.

Collaterals C lower the risk premium:
L(1 + iS ) = L(1 + iL )(1 p) + pC

p C
p
(1 + iS )
RP = iL iS =
1p
1p L
(16)
(17)
with C = arg max{0, (1 + iS )L}. In case of C = L(1 + iS ) there is

no credit risk for the lender anymore.
Problems:
Providing collaterals and liquidation is costly (e.g. opportunity

costs).
The access to collaterals is limited (e.g. start-up companies).
The value of collaterals may be uncertain (see the housing crisis in

the U.S. dramatic decrease of house prices = decrease of the
value of collaterals)
S.109
2.

Literature on Collaterals:
Bester, H. (1985), Rationing in Credit Market with Imperfect

Information. American Economic Review 75, 850-855.
Besanko, D., Thakor, A. V. (1987), Collateral and Rationing:

Sorting Equilibria in Monopolistic and Competitive Credit
Markets. International Economic Review 28, 671-689.
S.110
2.

1. Credit and loans are an importnat source of financing business
One could think that there is an incentive for a firm to finance

their business primarly by selling equities (e.g. stocks), since
the stock owner only have claims on the residual profit.
Due to information asymmetries about risky business projects

the owner of financial funds prefer to buy assets with a lower
risk like bonds, or to buy risk-free assets like time deposits
which are used by the financial intermediates to provide
credits.
Financial intermediates have lower costs to achieve

information about the risky business.
S.111
2.

(Source: Mishkin (2006), p.171)
S.112
2.

2. Indirect Financing via Intermediates (like banks) is much more

important than Direct Financing
The same argument applies
3. The financial system is one of the most regulated sectors in the

economy.
Regulation is needed to alleviate the problems of information

asymmetries.
S.113
2.

4. Large well-established firms have a more easy access to financial

funds than small or new firms.
Large firms have more expertise as well as more economies of

scale to provide detailed information.
Only large firms are rated by rating agencies.
Well-established firms have built up reputation.
Large firms can provide much more collaterals.
5. Collaterals are a prevalent ingredient of loan contracts for firms

and households.
Collaterals lead to a drastic decrease of risk premiums what

alleviates the adverse selection effect.
Combining different interest rates and collateral requirements
may lead to self-selection (separating eqilibrium).
S.114
2.

Excourse: Microfinance in Developing Countries
Many small businesses with small amounts of required loans.
Typically no collaterals!
Consequently, extremely high interest rates for private lending or no

access to capital.
Idea:
Bundling several borrowers to a group (group lending). Every

group member is liable for all repayments screening and
monitoring task is partially shifted to the borrowers.
Self-selection of reliable lenders, incentive to monitor the efforts

in creating profitable business.
Repayment scheme which incentivices monitoring. Short-run

opportunistic behavior will reduce likelihood of loan prolongation or
future loans.
However: Could lead to severe social pressure within a group.
S.115
2.
2.4

Moral Hazard Problems
Outline:
2.4.1 Introduction into Principal-Agent-Problems
2.4.2 How Moral Hazard Affects the Choice Between Debt and
Equity
2.4.3 Solving Moral Hazard Problems
2.4.4 What Stylized Facts are Explained by Moral Hazard?
Literature:
Wolfstetter, E. (1999), Topics in Microeconomics. Cambridge University
Press, chapter 11
S.116
2.
2.4 Moral Hazard Problems

General Structure:
Principal offers a contract to the agent.
The payoff depends on the unobservable behavior of the agent

as well as on stochastic variables.
Examples
Employer-employee relationship: The outcome for the employer

depends on the unobservable effort of the employee.
Borrower-lender relationship: The risk of debt failure depends
on the project choice of the borrower (high risk or low risk)
The agent has an incentive to exploit the unobservability of

his choice in order to maximize his own utility instead of
making decisions in accordance to the preferences of the
principal (= moral hazard). This can be anticipated by the
pricinpal.
S.117
2.

(uP1 , uA1 )
high effort
A
low effort
random
variable
(opportunism)
P
equity contract
accept
(uP2 , uA2 )
reject
(
uP , uA )
S.118
2.

(uP1 , uA1 )
low risk project
A
risky project
random
variable
(opportunism)
P
debt contract
(low risk premium)
accept
(uP2 , uA2 )
reject
(
uP , uA )
S.119
2.

The principal is (at the best case) able to observe the

outcome of the agents deicion, not the decision itself =
hidden action (except for monitoring).
In some cases it is possible to conclude from the outcome to

the underlying actions of the agent (revelation), in other cases
this is not possible (non-revelation).
Therefore, the contractual payments can depend on the

outcome but not on the behavior of the agent.
S.120
2.

low effort or low risk

high effort or high risk
reveal
not reveal
reveal
low effort or low risk

high effort or high risk
not reveal
S.121
2.

Two types of Moral Hazard problems:
Agent = manager: In case of equity contracts the agent tends

to reduce his effort, since the equity holder benefits from the
returns due to his efforts. In case of a debt contract, the
lender receives fixed payments, and the agent has an incentive
for high efforts since he benefits from the increasing expected
return.
Agent = investor: In case of debt contracts the agent tends to

invest into too risky projects than negotiated with the
lender. The reason is that in case of negative returns of the
project the debt fails = the lender also carries the risk. The
risk of the agent, however, is limited.
How to construct a financial contract which incentivices the

agent to decide according to the principals preferences?
S.122
2.

2.4.2 How Moral Hazard Affects the Choice Between Debt and Equity
Contracting in the presence of Moral Hazard:
The financial contract regulates how the (stochastic) return

and how the risk is allocated to the principal and the agent
(risk-return-scheme).
Each type of a risk-return-scheme incentivices a certain

behavior of the agent.
The principal anticipates the incentive structure of the agent.

He proceeds in two steps:
1. What is the optimal risk-return-scheme which incentives the
agent to choose a certain project or a certain effort level?
2. Which risk-return-scheme maximizes the utility of the
principal?
S.123
2.

Two extreme cases:
Fixed payments (= low risk) for the agent,

residual return (= high risk) for the principal
Examples: fixed wages in case of employer-employeerelationships; shareholder and fixed payed manager of a firm
Residual returns for the agent,

fixed payments for the principal
Example: premium wages for employee and fixed return for
the employer; fixed interest payments for the bank, residual
return for the investor
S.124
2.

A note on guarantees (suretyship):
Guarantees from third parties (like government) reduces the

risk of the lender in case of a credit failure.
The lender has a bias towards financing too risky projects.
Similar to Moral Hazard effects in case of insurances.
Example: bank crisis in 2008 if large banks could expect

that in case of insolvency there will be a governmental bailout
they might be less cautious in buying risky assets.
S.125
2.

Equity Markets:
a) Monitoring:
Providing information about the decisions of the investor and

their consequences for earnings and profits. Thus, the actions
are less hidden.
This is costly!
Legal constraints.
If there are many principals, a free-riding problem arises.
S.126
2.

b) Governmental Regulation:
Same argument as in case of adverse selection (see above).
c) Co-determination of management decisions
This is only possible in case of financial intermediation: Financial
funds are given to a FI (e.g. an investment corporation) that buys
equities of a firm but also participate in the management.
S.127
2.

d) Manager contracts
If managers are payed according to the impact of their decisions on
the firm value (e.g. by stock options), it could be expected that
they have similar preferences than other holders of equity shares.
e) Mixing with debt contracts
Similar effect: The lender receives fixed payments, the agent
receives the residual profit. He will show more effort and choose
projects according to his risk preferences.
S.128
2.

Especially in loan markets:

a) Net Worth
Sum of assets minus liabilities = Net Worth. A failure of the
project (negative returns) reduces the agents own net worth.
Hence agent has incentive to choose projects with proper risk
insetad of exploiting the moral hazard effect and shifting the risk of
loss to the lender.
b) Collaterals
Most debt contracts contain covenants to keep some valuable
collaterals. In case of debt failure the lender can claim these
collaterals. This works similar to the net worth effect (see above).
S.129
2.

c) Provision of information / Monitoring

The debt contract contains covenants that the borrower must
provide (regularly) information about his activities. There may be
contractual penalties in case of verified false information.
d) Financial intermediation
Restrictions in contracts must be monitored and enforced.
Intermediates can do this more effectively and with lower
transaction cost than an individual lender.
S.130
2.

Summary:
Moral Hazard (MH) arises in both, equity and debt contracts.
MH may result in (a) too low effort of the agent, (b) choosing
too risky projects.
Financial contracts should be designed in an incentive

compatible way, i.e. that agents utility maximizing decisions
are compatible with the preferences of the principal. This is
not always perfectly possible.
Financial intermediates have better possibilities to alleviate

the MH problem.
S.131
2.

2.4.4 What Stylized Facts are Explained by Moral Hazard?
1. Credit and loans are an importnat source of financing business

2. Indirect Financing via Intermediates (like banks) is much more
important than Direct Financing
3. The financial system is one of the most regulated sectors in the
economy.
5. Collaterals are a prevalent ingredient of loan contracts for firms
and households.
6. Debt contracts are typically complicated and contain many
restrictions on the behavior of the borrower.
S.132
2.
2.5
We leave the theory of financial intermediation and turn to

secondary markets where financial assets are valued by market
participants.
Mishkin, Frederic S. (2012), The Economics of Money,

Banking, and Financial Markets, 10th ed., Boston et al:
(chapter 7)
Malkiel, B.G. (2003), The Efficient Market Hypothesis and Its

Critics. Journal of Economic Perspectives 17(1), 59-82
S.133
2.
2.5
Study of behavior of stock prices by L. Bachelier (1900):

random character of stock prices.
E. Fama (1960ies):
Started as a technical analyst: trying to find patterns in
past data which enables investor to predict stock prices
But: Random Walk successive price changes are
independent
interpreted RW as an indicator that all relevant information is
processed efficiently!
S.134
2.
2.5
Idea:
If we could predict in t from available information that price

pt+1 will exceed pt then it would be rational for all
participants to buy in t (speculation). Thus, pt will
instantanously increase until the level pt+1 so that pt is the
best predictor for pt+1 .
Thus speculation is seen as an acrtivity making markets

informationally efficient.
S.135
2.
2.5
An efficient market is defined as a market where there are a large

number of rational profit-maximizers actively competing, with each
trying to prdict future market values of individual securities, and
where important current information is almost freely available to
all participants [...] on average, competition will cause the full
effects of new information on intrinsic value to be reflected
instantanously in actual prices. (Fama 1965)
S.136
2.
2.5
Informational no-arbitrage: a further analysis is useless
Not possible to beat the market (generate excess returns)
Consistent with the Rational Expectations Hypothesis
S.137
2.
2.5
Lot of empirical work in late 1980ies. Resume in Fama (1970,

Journal of Finance), elaborated EMH in three forms:
Weak efficiency: prices fully reflect all information from past

data (technical analysis cannot have any advantages); no
systematic market inefficiencies which could be exploited.
Prices should follow Random Walk testable hypothesis
Mixed evidence: main problem is the momentum effect

(persistence of temporary trends); episodes of euphoria and
glooms.
Example: Pesaran, M.H. (2010), Predictability of Asset

Returns and the Efficient Market Hypothesis. CESifo Working
Paper No. 3116.
S.138
2.
2.5
Semi-strong efficiency: prices fully reflect all information

from past data and all current information which is publicily
available.
New informations which are relevant for fundamental value of

the asset is incorporated in the prices immediately.
Returns from an asset: general market moves versus individual

(residual) component. Which infiormations drive the residual
component? E.g.: announced stock splits, quarterly earnings
reports, issuing new stock shares, other relevant information
Mainly empirical support of semi-strong efficiency.
S.139
2.
2.5
Strong efficiency: same as semi-strong but also incorporating

private information of market participants.
However: in most legislations this is forbidden (insider trade).
Not much evidence for strong efficiency.
S.140
2.
2.5
Implications of EMH:
Only surprising news are moving the market (very quickly).

Published information which has been anticipated already,
does not move the prices.
Dont trust hot tips (either forbidden insider trades, or

useless)
S.141
2.
2.5
Critique:
Micro-perspective:
Bounded rationality, various cognitive biases which prevent
even sophisticated people to make statistically correct
predictions (e.g. over-confidence, distorted risk-perception
Herding behavior, irrational exuberance.
Behavioral Finance (e.g. Robert Shiller)
Macro-perspective:
Bublles and crashes; global financial crisis
(Note: Eugene Fama and Robert Shiller as well as Lars Peter Hansen won 2013
the Nobel Prize in Economics....)
S.142
2.
2.5
However:
Fama argues that bubbles do not exist: a theory which

defines and explains bubbles should be able to predict them.
As long as there is no such a theory there is no reason to
believe in bubbles. They are seen as an ex post attribution
of an observed rapid price decline.
Detection of a bubble requires that we know something

about the fundamental value. According to EMH, all
relevant information about this is already included in the price.
Thus a sudden crash could be explained by the occurence of
new (even small) information triggering the expectations.
Problem of self-reference of (rational) expectations:

expectations about future fundamental firm value
fundamental firm value: net present value of future expected
cash flow.
S.143
2.
2.5
Joint Hypothesis Problem:
To test efficiency, the modeler has to consider all relevant

information which is necessary to compute the best
prediction.
If test does not reject EMH, we cannot reject that market

participants are doing the same as the modeler (EMH is not
rejected 6= proven as true).
If test rejects EMH, than this shows that the underlying model
is not completely specified (e.g. the modeler did not use all
the information which the market participants have used).
Therefore, EMH is not testable
S.144
3.
The Money Supply Process
3.1
Function and Measurement of Money
Outline:
3.1.1 Functions
3.1.2 Monetary Aggregates
3.1.3 Other Definitions of Money
Literature:
Bofinger (2001), chapter 1
S.145
3.
3.1 Function and Measurement of Money

3.1.1 Functions
Money is what money does. Money is defined by its
function. (J. Hicks 1976)

Functions:
Medium of Exchange
Unit of Account
Store of Value
S.146
3.

3.1.1 Functions
Medium of Exchange:
Without money each good can possibly exchanged with each

other good (bartering). Hence we have for n goods n(n 1)/2
exchange relations = relative prices.
Finding a transaction partner with symmertic exchange wishes

(A: books whiskey, B: whiskey books) is extremly
expensive transaction costs. Since there are numerous
possibilities to exchange goods over several edges (e.g.
books butter cutting hair whiskey) there are extreme
high information costs to find the best exchange relation.
Money as a generally accepted medium of exchange leads to a

dramatic decrease in transaction costs (only n money prices).
S.147
3.

3.1.1 Functions
Unit of Account:
Money as a numeraire: Money prices makes comparisons very

easy (what is cheap, what is expensive?), hence money
reduces information costs.
Money as a precondition for accounting systems: A general

unit enables accounting systems like balance sheets to measure
the financial wealth or current accounting systems to measure
the inflow and outflow of money and eranings per period.
S.148
3.

3.1.1 Functions
Store of Value:
Receiving money (instead of goods or services) enables the

money holder to buy goods and servies to an arbitrary time.
His purchaising power is conserved.
If the disposition of the agent changes over time, the stored

money can be used for varying expenditures concept of
liquidity, money as the asset with the highest degree of
liquidity.
The possibilities for intertemporal decisions (like savings in t0

for additional production and consumption in t1 ) increase
dramatically with such a store of value.
Problem: Inflation! Money may be substituted by real assets.

This function of money is fulfilled by another asset.
S.149
3.

3.1.1 Functions
The functions define money in an abstract manner.
There are different forms of apparance of money (financial

assets) like currency, deposits, time deposits, checks etc.
It is reasonable to define collections of financial assets which

are called monetary aggregates.
S.150
3.

M1 =
M2 =
M1
M3 =
M2
+
+
+
+
+
+
currency in circulation
overnight deposits
deposits with an agreed maturity of up to two years
deposits redeemable at notice of up to three months.
repurchase agreements
money market fund shares
debt securities with a maturity of up to two years
S.151
3.

Monetary aggregates in 02/2014 (Bill. Euro)

(source: ECB):
currency in circulation
overnight deposits
deposits mat. < 2 years
red. deposits < 3 months
repos
money market fund shares
debt sec. < 2 years
919
4574
1663
2117
130
427
87
M1= 5493
M2= 9273
M3= 9918
S.152
3.

(Source: ECB)
S.153
3.

(Source: ECB)
S.154
3.

S.155
3.

Definition by the transmission mechanism
There are different transmission theories on how monetary

shocks affects the real sphere or the inflation rate.
Take a transmission theory: monetary aggregate M then

includes all financial assets which are consistent with the
transmission theory.
Advantage: If the transmission theory is true, the aggregate

M is a good intermediate goal for monetary policy.
Problem: If M is defined in this way then the underlying

transmission theory can not be falsified. It is a tautology.
S.156
3.

Econometric definition
There are diffreent theories of money demand. In the long run

it can be assumed that the money market is in equilibrium,
i.e. money equals money demand.
Take a theory of money demand. Money includes then all

financial assets which are demanded by the agents (example:
Keynes theory Ld (Y , i)). Statistical regression then decides
whether a type of financial asset is significant to explain
money demand.
Advantage: The definition of money is based on an economic

theory rather than being arbitrary or a matter of convention.
Problem: If M is defined in this way, the underlying money

demand theory can not be falsified.
S.157
3.
3.2

Creation of Central Bank Money (Money Base)
Outline:
3.2.1 Balance Sheets of the Financial Sector
3.2.2 Basic Operations of the Central Bank
3.2.3 Overview: Policy Instruments
Literature:
Bofinger (2001), chapter 3.1-3.3
Mishkin (2010), chapter 15, parts of chapter 16
ECB (2004), The Monetary Policy of the ECB (downloadable)
McLeay, M., Radia, A., Ryland, T. (2014), Money creation in the modern
economy. Bank of England, Quarterly Bulletin 2014 Q1
S.158
3.
3.2 Creation of Central Bank Money (Money Base)

central banks balance sheet (simplified)

Assets
Liabilities
Foreign reserves F
Currency (C )
Loans to commercial
banks (Lc )
Deposits of commercial
banks (reserves) (R)
Securities (S cb , B)
(e.g. bonds)
Other Liabilities
Net Worth
Monetary Base M0 = C + R
S.159
3.

commercial banks balance sheet (simplified)

Assets
Liabilities
Reserves (R)
Loans:
= required reserves
central bank loans (Lc )
+ excess reserves
inter-bank loans
Loans (L):
inter-bank loans
commercial loans
reals estate
Deposits of non-banks (D):

overnight deposits
time deposits
saving deposits
Bonds/Securities (B):
Cash items
Other assets
Other debt instruments
Bank Capital/Net Worth (BC )
S.160
3.

Central bank can create money M0:
non-borrowed reserves: purchasing securities like bonds on the

security market: S cb or B > 0
borrowed reserves: providing a loan to a commercial bank:
Lc > 0
Since there is a inter-bank market for (borrowed) reserves, the

main central bank loans are also called open market
operations.
Furthermore, banks could borrow reserves overnight
standing facilities.
S.161
3.

Case 1: Central bank buys a security from a commercial bank

central bank
Assets
Liabilities
B = 100 R = 100
commercial bank
Assets
Liabilities
B = 100
R = 100
With the additional reserves the commercial bank is able to

provide additional loans to the non-bank sector or to buy
other assets.
This is a restructuring of the banks portfolio. The bank will

do this only if it is profitable.
S.162
3.

Similar accounting records (e.g.):
Central bank buys securities from a commercial bank and pays

with currency: S cb = C .
Central bank buys foreign reserves from a non-bank and pays

with currency: F = C .
etc. (see Mishkin (2010) for examples)
Reserves may be changed into currency and vice versa

(no effect on M0):
R = C
S.163
3.

Case 2: Central bank loan to a commercial bank

central bank
Assets
Liabilities
Lc = 100 R = 100
commercial bank
Assets
Liabilities
R = 100 Lc = 100
Again, with the additional reserves the commercial bank is

able to provide additional loans to the non-bank sector or to
buy other assets.
This extends the commercial banks balance sheet and shifts

the debt/equity ratio of the liability side.
S.164
3.

Some characteristics of the central bank loans:
The commercial bank has to pay interest rates. These interest

rates are the primary policy instrument.
The loan contract has typically a maturity of one week or

three months (open market operations), or it is an
overnight loan (standing facilities). In times of financial
distress there are also long-term contracts.
The banks must provide securities = function of a collateral.
When the loan is returned at the maturity date, the monetary

base M0 decreases reverse accounting record.
S.165
3.

Overview over ECB policy instruments:

1. Reserve requirements: The bank must hold a part of their
deposits as reserves. There is a need to borrow liquidity from the
central bank.
2. Open Market Operations: The central bank provides liquidity to
the banks while the banks provide specified securities; tender
procedures.
Main operations: interest rates weekly adjusted; maturity 1
week
Long term-operations: interest rates monthly adjusted;
maturity three months.
Structural and fine-tuning operations: also definitve purchases
and sales of securities are possible.
3. Standing Facilities:
Short-run (overnight) loans
Overnight deposits
S.166
3.

Reserve requirements:
Liabilities with positive reserve ratio:
Deposits (including overnight deposits, deposits with an agreed

maturity up to two years and deposits redeemable at a period
of notice of up to two years)
Debt securities issued with a maturity of up to two years
Liabilities with zero reserve ratio
Deposits (including deposits with an agreed maturity of over

two years and deposits redeemable at a period of notice of
over two years)
Debt securities issued with a maturity of over two years
Repurchase agreements
S.167
3.

(source: ECB (2004))
S.168
3.

Market for (borrowed) reserves:
Supply of liquid excess reserves e.g. in case of inflowing

deposits.
Demand for liquid reserves e.g. in case of outflowing deposits

or expansion of loans.
Collateralized and non-collateralized borrowing.
Interbank (money) market interest rate: e.g. EONIA (Euro

Overnight Index Average)
Since interbank loans and central bank loans are close

substitutes, the central bank has a strong impact on the
money market rate, and it determines the circulating reserves.
Fixed reserve supply and aggregated net demand for

reserves.
S.169
3.

Stylized market for (borrowed) reserves:

(i cb = discount rate, i M = market interest rate)
interest
rate
i cb
supply (cb)
iM
demand
reserves
S.170
3.

Effects of monetary policy on borrowed reserves and interest rates:

interest
rate
Changing the
discount rate
interest
rate
reserves
Outright purchases
of securities
reserves
S.171
3.

How to respond to a increasing demand for reserves?

interest
rate
full accomodation
(goal: stable i)
interest
rate
reserves
no accomodation
(goal: stable M0)
reserves
CB cannot fully control both, interest rate and M0. Most CB use
interest rate as operational target, thus they accomodate demand for M0.
S.172
3.

(source: Deutsche Bundesbank)
S.173
3.
3.3

Multiple Deposit Creation and the Multiplier
Outline:
3.3.1 The Money Multiplier
3.3.2 Determinants of the Multiplier
3.3.3 Objections against Static Multiplier Analysis
Literature:
Bofinger (2001), chapter 3.4
S.174
3.
3.3 Multiple Deposit Creation and the Multiplier

Monetary aggregat M1 defined as

M1 = C + D
(18)
with C as currency and D as deposits.
The monetary base, controlled by the central bank, ist

defined as
M0 = C + R
(19)
where R are the reserves with
R = RR + ER = r D + ER
(20)
where RR are the required reserves and r is the required

reserve ratio. ER are the excess reserves.
S.175
3.

Behavior of the non-bank public:

People have certain transaction customs. They wish to hold
currency and deposits in a certain ratio (= assumption)
c=
C
D
C = cD
(21)
Behavior of commercial banks:

Due to liquidity considerations they hold excess reserves as a
high liquidity risk-free asset (as a reaction to expected deposit
outflows). The ratio of excess reserves and deposits are
assumed to be
e=
ER
D
ER = eD
(22)
S.176
3.

Inserting (21 ) and (22) into (18) and (19) we have:

M0 = cD + rD + eD = (c + r + e)D
(23)
M1 = cD + D = (1 + c)D
(24)
Solving (23) to D and inserting into (24) we have the money

multiplier
1+c
M0
r +c +e
M1
1+c
=
m
M0
r +c +e
M1 =
(25)
From (23), the deposit multiplier is

D
1
=
M0
c +r +e
(26)
S.177
3.

Required reserve rate r : fixed by the central bank; negative

correlation with the money supply.
Currency/deposit ratio c: depends on the behavior of

non-banks; negative correlation with the money supply (the
change of the denominator is relatively large compared to the
change of the numerator).
Excess reserves/deposit ratio e: depends on bank behavior ;

negative correlation with the money supply.
What drives c and e?
S.178
3.

Excess Reserves are an asset with low return, no risk, and high
liquidity. Bank holds excess reserves e.g. to meet deposit
outflows or, generally, to avoid illiquidity.
If the interest rate (for bonds and/or loans) increases, the

opportunity costs of holding excess reserves increas. Hence,
the excess reserves are negatively correlated with i.
Excess reserves can be borrowed to other banks (inter-bank

market). This depends primarly on trust, and also on the
difference between money market rate and central banks
deposit rate.
Normally, excess reserves do not play a major role, the effcts

on the multiplier are small.
Exception: Financial crisis 2008/2009 sharp increase of E !
S.179
3.

(Source: Mishkin (2006), p.381)
S.180
3.

(Source: ECB)
S.181
3.

For the determination of c we have no theory about payment

customs.
Further determinants of M1 = m M0:
The money base M0 changes according to
the central banks activities on the security market

(purtchasing/selling securities S cb )
the demand for central bank loans Lc
The major policy instrument is Lc . Central bank can reduce

deposit rate but cannot force banks to demand Lc . They can
also not completely refuse to provide Lc in case of strong
liquidity needs market interest rate would increase, losing
control over the interest rate.
S.182
3.

The static multiplier approach M1 = m M0 suggests that the

central bank is able to determine money supply. However, there are
some objections:
The approach suggests that the multiplier process is initiated by the

central bank, not by the demand for loans (deposits). However,
credit demand initiates the demand for M0 which is then
accomodated by the CB.
It is assumed that additional reserves are transformed into

additional credits. But credit supply and demand behavior is not
founded by microeconomic reasoning. Thus, you cannot push M
by an increase of M0.
The determinants c, e are assumed to be fixed in the multiplier

process. But the behavior of banks and non-banks may change
because the multiplier process takes place since it affects e.g.
interest rates and liquidity positions. Furthermore, if a monetary
impulse has real effects (e.g. Y increases) then this has a feedback
on credit demand.
S.183
3.

S.184
3.
3.4

Outline:
3.4.1 Bofingers price theoretic model
3.4.2 The Bernanke/Blinder approach
3.4.3 Outline of an integrated model
Literature:
Bofinger (2001), chapter 3.4
Bernanke, B., Blinder, A.S. (1988), Credit, Money, And Aggregate
Demand. American Economic Review, Papers And Proceedings Vol.78,
435-439.
Palley, T.I. (2002), Endogenous Money: What It Is And Why It Matters.
Metroeconomica Vol. 53, 152-180.
S.185
3.
3.4 Endogenous Money Supply

Simplified version of the Bofinger model Basic Ideas:

The multiplier approach provides no microeconomic foundation
neither of the banks credit supply nor of the credit demand. This
foundation should be (partially) provided.
The loan interest rate (price) coordinates supply and

demand of credits.
In order to provide credits the bank needs reserves.
The equilibrium interest rate on the credit market determines

the banks demand on the market for (borrowed) reserves.
The central bank can accomodate the reserve demand or it

can change the discount rate for borrowed reserves. Hence the
discount rate affects the credit supply function.
S.186
3.

Simplified banks balance sheet: rD + L = D + Lc

Simplified central banks balance sheet: Lc = rD
In the simplified version there is no currency, therefore
M1 = D and M0 = R = rD and therefore m = 1/r .
The multiplier relation is then D = mLc .
The loan supply is derived from a profit maximizing calculus:

max = iL ic Lc L2
L
(27)
where the term L2 describes the increasing risk of debt failures.

When required reserves R = rD are subtracted from the balance
sheet and applying D = mLc , we have the multiplier:
L = Lc + (1 r )mLc = mLc
(28)
S.187
3.

Solving (28) to Lc = 1/m L and inserting into the profit function

the maximizing calculus (27) leads to credit supply function
L = L(i, ic , ) =
1
(i ic /m)
2
(29)
which depends positively on i and negatively on ic and .

On the other market side we have a decreasing credit demand
function LD (i, y ) with LD /i < 0 and LD /y > 0.
The equilibrium L(i , ic , ) = LD (i , y ) determines the
equilibrium interest rate i = i (ic , , y ).
S.188
3.

Now we turn to the demand for reserves:

Taking the optimal loan supply (29) and substituting L into (28)
we obtain the optimal reserve demand:
Lc (i, ic , ) =
1
(i ic /m)
2m
(30)
which is a linear decreasing function of ic . It is parametrized by the

equilibrium interest rate on the credit market.
S.189
3.

The Bofinger model:

i
credit market
L(i, ic , )
interest rate
relation
LD (i, y )
L
ic
demand for
borrowed reserves
L = mLc
(multiplier)
Lc
S.190
3.

Interpretation:
Upper right: The credit market with upward sloping credit

supply function (29) and a linear cerdit demand function.
Lower right: The multiplier relation translates the desired

level of loans L into the level of required reserves which are
neccessary to create deposits to finance these loans.
Lower left: The demand for borrowed reserves Lc (eq. (30)).
Upper left: The market equilibrium interest rate i is an

implicit function of the discount rate ic . In case of linear
functions also this relationship is linear.
S.191
3.

Case 1: Central bank increases the discount rate ic

i
L(i, ic2 , )
L(i, ic1 , )
LD (i, y )
ic
ic2
ic1
Lc
S.192
3.

Case 2: The demand for loans increases, central bank does not adapt ic
i
L(i, ic , )
LD (i, y2 )
LD (i, y1 )
L
ic
Lc
S.193
3.

For an extensive analysis (e.g. the case of fluctuating credit

demand) see Bofinger (2001), chapter 3.4 and appendix
The model has implications for the macroeconomic IS-LM analysis:
Demand shocks on the credit market may lead to a reaction

of the central bank. Depending on their primary goals
(stabilizing the interest rate vs. stabilizing the money base)
different types of LM curves occur.
If the central bank does not respond to the demand shock, an

increasing y leads to an increasing credit demand and thus to
a monetary expansion. In the traditional IS-LM analysis this is
not the case Money creation is (partially) demand driven.
S.194
3.

Increasing income Y1 Y2 leads to a right-shift of money demand

(credit demand) and hence to a shift of the demand for borrowed
reserves.
Case 1 Money volume targeting: Central bank will keep

the money volume on the same level. It has to increase the
discount rate. This leads to a left-shift of the credit supply
curve. The LM curve will be steep.
Case 2 Discount rate targeting: Central bank will keep
the discount rate on the same level. Hence it will provide more
central bank loans and the money volume increases. The LM
curve will be more flat (positively sloped).
Case 3 Loans rate targeting: Central bank will keep the
interest rate on the loans market on the same level. It will
fully accomodate the additional money demand by decreasing
the discount rate. The LM curve will be horizontal.
S.195
3.

L(i, ic )
i
L(i, ic )
LM (case 1)
LD (i, Y2 )
LD (i, Y
ic
ic
ic
1)
Y1
L
money volume targeting
Y2
Lc
S.196
3.

i
L(i, ic )
LM (case
LD (i, Y2 )
discount rate targeting
LD (i, Y1 )
ic
ic
Y1
Y2
Lc
S.197
3.

i
L(i, ic )
L(i, ic )
LM (case 3)
LD (i, Y2 )
interest rate targeting
LD (i, Y1 )
ic
ic ic
Y1
Y2
Lc
S.198
3.

LM (case 1)
LM (case 2)
Y1
Y2
S.199
3.

Dont confuse these LM curves with the LM curve of the

standard Keynesian IS-LM model. The latter assume a fixed
M, determined by the central bank. This is only a very special
case in the Bofinger framework.
For most LM curves in this framework there is no fixed (but

an endogenously determined) money supply.
S.200
3.

Assume that the commercial banks balance sheet is

rD
+ E} +L + B = D
| {z
R
E + L + B = (1 r )D
where B are bonds. The is no currency C and no central bank

loans Lc . The central bank determines the money base R by
purchasing or selling bonds.
The acitivity of the bank is to choose an appropriate portfolio
structure of the asset side.
S.201
3.

The asset side contains two risky assets L and B, and a risk-free
asset E . The structure of the portfolio is given by:
E (i) = E (i)(1 r )D
L(i, ) = L (i, )(1 r )D
B b (i, ) = (1 E (i) L (i, ))(1 r )D
{z
}
|
B (i,)
where i is the interest rate of the bonds, ane is the interest rate
of loans.
The portfolio share L [0, 1] depends positively on , negatively
on i, and vice versa for B , E depends negatively on i.
S.202
3.

The reserves of the commercial bank are

R = rD + E = rD + E (i)(1 r )D = (r + E (i)(1 r ))D (31)
Hence the money multiplier is
1
D
= m(i) =
R
r + E (i)(1 r )
The multiplier depends on the banks portfolio considerations and
is endogenously determined by the bonds interest rate i. Note,
that i is determined on the bonds market and that the central
bank is an agent on the bonds market.
S.203
3.

The equilibrium on the credit market is determined by

Ld (i, , y ) = L = L (, i)(1 r )D
It is assumed that non-banks also hold a portfolio of bonds and
money so that the loan demand is determined by i (+) and (-).
Money supply is given by the multiplier D = m(i)R while the
money demand follows the standard assumptions D d (i, y )
(positive dependency on y and negative dependency on i).
Money market equilibrium is given by (LM curve)

D d (i, y ) = m(i)R
S.204
3.

Comparison:
Bofinger model:
only borrowed reserves = discount rate policy
banks have only loans as an asset, no portfolio approach
Fixed multiplier, but an endogenously determined money base
Bernanke/Blinder model:
only non-borrowed reserves = open market operations on the

security market
banks use a portfolio approch to determine their portfolio which

contains loans, bonds, and excess reserves
Exogenously determined money base, but an endogenously

determined money multiplier
S.205
3.

Remind the stylized balance sheet of a bank:

Assets
Reserves (required, excess)
Liabilities
Deposits
Cash
Inter-bank loans
Securities/Bonds
Central bank loans
Loans to non-banks
Other debt instruments
Inter-bank loans
Bank Capital / Net Worth
S.206
3.

Bank decides about
structure of the asset side

structure of the liability side
size of the balance sheet
Decisions depend on expected returns, risks, and liquidity of

assets, as well as the interest rates to be paid for deposits,
interbank and central bank loans (costs).
Decisions are made under constraints such like Basel II/III.
S.207
3.

Deposits are created by new loans.

Hence, the loans supply and demand determines the loans
interest rate and the loan (deposit) volume.
The central bank influences (not: determines) this process by
the conditions for borrowing reserves, amount of
non-borrowed reserves, the required reserve rate: The
elasticity how loan supply depends on these monetary policy
variables, depends also on other endogenous variables.
The central bank has to respond to changes e.g. on the loans
market and to changed reserve demand. Central banks role in
a phase of financial distress.
Increased role of non-bank financial intermediates (shadow
banks) might change the transmission of monetary policy
and even the ability of the central bank to affect the liquidity.
S.208
3.
3.4

Some Implications:
Monetary policy has some impact on the money supply but

does not control it. Monetary expansion is primarly
determined by the money demand of the private sector (and
the government).
If money is created according to the money demand, it is

questionable to construct a money market equilibrium
(supply = demand) like the LM curve.
Inflation by monetary expansion is therefore not only a matter

of a wrong central bank policy but a consequence of
massive credit expansion e.g. by governmental debt. Success
of monetary policy depends also e.g. on fiscal discipline.
S.209
4.
4.1
Theory of Money Demand

Keynesian Theory of Liquidity Preference
Outline:
4.1.1 Transaction Motive
4.1.2 Money as an asset
4.1.3 Precautionary Motive
4.1.4 Evidence
Literature:
S.210
4.

Money is used for transaction purposes:

X
Mv =
pi ti
i
with M = money (stock variable), v = velocity, pi , ti as the

prices and the quantities determining transaction i in the
period (flow variable).
Since there is no statistical data about all transactions, we use

the price index P and the real income Y as a proxy:
Mv = PY
M
v =Y
P
Mr v = Y
(32)
The velocity v is a matter e.g. of payment customs. Eq. (32)

is called the quantity theory of money.
S.211
4.

Income velocity of M3 in Euro area:
(Source: Brand, C., Gerdsmeier, D., Roffia, B. (2002), Estimating the Trend of M3 Income Velocity Underlying the
Reference Value for Monetary Growth. ECB Occasional Papers No. 3)
S.212
4.

If money is primarly needed for transactions, the demand for

money is (so called Cambridge form)
Md =
1
PY = kPY
v
or in real terms
Md
LT (Y ) = kY
P
(33)
This is the only motive in classical (pre-Keynes) economics.
While the quantity theory (32) is a pure definition (and hence

always true), the Cambridge form (33) is interpreted as a
behavioral hypothesis.
S.213
4.

Keynes assumes that agents could choose to hold either

money or bonds as a financial asset.
Money: No return, no risk

Bonds. Positive return, positive risk
Assume that bonds have no maturity date and are held for
only one period (no discounting).
Agents are assumed to be risk-neutral = they decide only

according to expected return.
S.214
4.

Bt
e
Bt1
C
price of the bond in t

expected price in t + 1
regular coupon rate payments
The effective interest rate is defined by

C
C
Bt =
it =
Bt
it
Holding the bond for one period is profitable if
e
= C + Bt+1
Bt > 0
C
C
C+ e >0
it+1
it
1
1
1+ e >0
it+1 it
it >
e
it+1
= ic
e
1 + it+1
S.215
4.

For it > i c there are positive returns from holding the bond,
and negative returns in case of it < i c .
e
Depending on individual expectations it+1
the agent will hold
financial wealth either in bonds or in money.
Similar calculations can be made for the case that money (e.g.
deposits) have a positive interest rate.
e
Different individuals have different expectations it+1
and
c
hence different i . If market interest rate falls, more and more
individual critical interest rates are undercut, and more and
more individuals sell bonds and hold money instead.
S.216
4.

individual demand
aggregated demand
ic
LS
LS
S.217
4.

The money demand from the asset motive

(or as Keynes said: speculation) is:
Ls = Ls (i),
dLS
<0
di
Note:
The money asset LS is limited by the financial wealth: LS in

case of money is the unique asset type for all individuals.
If you consider other alternatives than bonds (e.g. time

deposits), there is a dependency on multiple interest rates.
Instead of interest rate it may be plausible to use real interest

rates since LT , LS are real values.
S.218
4.

Bringing both motives together, we have the money demand

L = L(Y , i),
with
L
L
> 0,
<0
Y
i
Defining the velocity by

v=
Y
Y
=
r
M
L(Y , i)
Keynes liquidity preference theory can be interpreted as the

Cambridge approach with an endogenous velocity:
L=
1
Y = k(Y , i)Y
v (Y , i)
S.219
4.

4.1.3 Precautionary Motive
Money is hold to make unexpected transactions = to avoid

illiquidity in case of neccessary unexpected transactions.
Money holder faces opportunity costs i.
Also from this motive we have a dependency from

Y (+) and i (-):
LP = LP (Y , i)
Original Keynesian idea: liquidity preference (hording) as a

response to fundamental uncertainty because liquidity can be
transformed in everything if the economy evolves in an
unperceived way, and if people lack knowledge to form reliable
expecattions about that.
S.220
4.

4.1.4 Evidence
Empirical Evidence:
Since the money demand reflects plans which are not
observable, it is assumed (!) that the money market is always
sufficiently close to the equilibrium, i.e. that real money
circulation is a good proxy for the money demand.
For M r = L(Y , i) we assume a log-linear form like
ln Mtr = 0 + 1 ln Yt + 2 it + t
where 0 , 1 , 2 are coefficients to be estimated, and t is a

serially uncorrelated stochastic variable.
Derivation with respect to time t shows that
dM r Y
d ln M r /dt
1 =
d ln Y /dt
dY M r
is the income elasticity of money demand, while 2 is the
semi-interest rate elasticity of money demand.
S.221
4.

4.1.4 Evidence
Questions:
Which monetary aggregat? (M1, M2, M3)
Which income? usually real GDP
Which interest rate? usually bond interest rates;

short term, long term interest rates?
Regression analysis; cointegration
S.222
4.

4.1.4 Evidence
Some results (details in Bofinger (2001)):
Positive income elasticity (some studies: near 1)
Negative interest rate elasticity (but mostly small)
In Europe more or less stable parameters, in USA not stable

(eventually due to financial innovations)
Large monetary aggregates do not depend on short term

interest rates.
S.223
4.
4.2

Portfolio Theory of Money Demand
Outline:
4.2.1 Money and Bonds in a Portfolio Equilibrium
4.2.2 Effect of Interest Rate Changes
Literature:
Bofinger, Peter (2001), Monetary Policy: Goals, Institutions, Strategies,
and Instruments. Oxford: Oxford University Press.
Thompson, N. (1993), Portfolio Theory and the Demand for Money.
Hampshire.
S.224
4.

Keynes Speculation Motive:
Risk Neutrality
e
only it+1
(expected mean) is relevant
(0, 1)-decision between money and bonds
Mixture of money and bonds in a population with

heterogenous expectations.
Portfolio Approach:
Risk Aversion
e
the distribution of it+1
is relevant
each individual mixes money and bonds
S.225
4.

Let i be the expected return from holding a bond, and B2 is

the variance of these returns.
The Financial Wealth of an individual is composed of money
and bonds: FW = M + B. Let l = M/FW be the fraction of
money in the portfolio, while 1 l = B/FW is the fraction of
bonds.
Expected return and standard deviation of a portfolio unit is
then
(l) = l 0 + (1 l) i
(34)
(l) = (1 l)B
(35)
Solving (35) to 1 l and inserting into (34) gives the linear

restriction
=i
(36)
B
S.226
4.

We have a utility function u(, ) with the standard

properties for a risk-averse agent. The indifference curve in
the (, )-space are increasing and convex (see figure).
Maximizing utility with respect to l conditional to the linear

constraint (36) gives the tangential solution
u/
i
=
u/
B
(see figure)
Thus, for a given (i, B ) the optimal portfolio structure is

determined.
S.227
4.

=i
(1 l)
l
1
(1 l) =
S.228
4.

What happens if the interest rate increases from i0 to i1 ?
= i1
= i0
income effect
substitution effect
(1 l)
l0 l1
1
(1 l) =
S.229
4.

The result depends on the income and the substitution effect!

dl
Typical result: di
< 0 dM
di < 0
i
S.230
4.

Substitution effect:
An increasing it makes bonds more attractive relative to money:

Portfolio will be restructured in favor of bonds. This effect is
unambigous (l decreases, see figure).
Income effect:
An increasing it shifts the expected profits with given standard

deviations upwards, or shifts the risks downwards with given profits.
According to the preferences, this leads to an adaption of the
portfolio where the direction is ambigous: l might decrease or
increase. If it increases, it might outweight the substitution effect or
not.
In the figure we assumed that the income effect increases l but does
not outweight the substitution effect.
S.231
4.

The total effect is henceforth:

M(i) = l(i)FW ,
dl
dM
= FW
di
di
Note, that money demand depends on Financial Wealth!
Adding a transaction motive gives:

M(Y , i) = l(Y , i)FW
l
>0
Y
S.232
5.
5.1
Central Banking and Transmission of Policy

Outline:
5.1.1 Social Welfare and Inflation
5.1.2 Social Costs of Inflation
5.1.3 Operationalization of the Inflation Goal
Literature:
Mishkin (2006), chapter 18, 26
S.233
5.
5.1

Goals versus Targets:
Ultimate goals like social welfare or low inflation could

not directly affected by monetary policy tools.
It is assumed (based on macroeconomic theory on

transmission channels) that intermediate targets have an
influence on the goals Example: Monetary aggregates M1,
M2, M3, loans volume, interest rates, inflation expectations.
Also the intermediate targets could not be accomplished

directly. It is assumed that they depend on operating targets
or instrument targets. These targets are close to the policy
tools. Example: reserves, monetary base M0, interest rate for
borrowed reserves.
Policy tools operating targets intermediate targets goals
S.234
5.
5.1 Goals of Monetary Policy

Ultimate goal social welfare
E.g. high employment, economic growth, price stability
Conflicts among the goals, e.g. price stability and low

unemployment (short run Phillips curve)
In many models maximizing welfare means minimizing a loss

function (= maximizing loss), e.g. like
P
target )2 u 2 ,
L = (P
>0
with u as the unemployment rate, or

P
target )2 (Y Y pot )2
L = (P
with Y pot as the potential output.
S.235
5.

Reasons why most central banks are primarly focussed

on the inflation goal (price stability):
Rational Expectations and Commitment problems
Policy Assignment
Long-term orientation of the policy
S.236
5.

Rational Expectations and Commitment problems:

Barro, R.J., Gordon, D.B. (1983), Rules, Discretion, and Reputation in a
Model of Monetary Policy. Journal of Monetary Economics 12, 101-122.
Assume a central bank which announces the goal of zero inflation.

It is always possible that the central bank is able to realize the goal.
If the public is believing this zero inflation goal, they incorporate

these expectations in their dispositions, e.g. wage contracts.
By doing so it is no longer optimal for the central bank to achieve

zero inflation. Their policy is hence time-inconsistent. It will exploit
the low inflation expectations by choosing a positive inflation rate
and positive real effects on output and employment.
Rational agents will anticipate this time-inconsistency and not

believe the zero inflation goal.
The only time-consistent optimal inflation rate is positive.
Rule-binding to zero inflation better than discretion.
S.237
5.

Policy Assignment:
Tinbergen rule (Jan Tinbergen, 1903-1994): In a framework

of conflicting goals you need as many (linearly independend)
instruments as you have goals. These instruments are
assigned to the goals.
Monetary Policy assigned to the inflation goal, since money

is assumed to be neutral in the long run.
Fiscal Policy assigned to the output goal.
(However, requirements of the Tinbergen model are rarely met.)
S.238
5.

Long-term orientation:
Many macroeconomists agree (with except for e.g.

Post-Keynesian macroeconomists) that in the long run
inflation is a monetary phenomenon, and monetary policy is
not able to affect real decisions. Real economic processes
depend in the long run only on relative prices rather than on
the price level.
Achieving a low inflation level is assumed to be good for

allocation efficiency and growth.
S.239
5.

From the ECBs statute (chapter II, article 2):

To maintain price stability is the primary objective of
the Eurosystem and of the single monetary policy for
which it is responsible. This is laid down in the Treaty
establishing the European Community, Article 105 (1).
Without prejudice to the objective of price stability,
the Eurosystem will also support the general economic
policies in the Community with a view to contributing to
the achievement of the objectives of the Community.
These include a high level of employment and
sustainable and non-inflationary growth.
S.240
5.

Transaction costs for price changes (menu costs)
Confusion about absolute and relative price changes distorts

the allocation (loss of efficiency), i.e. there is no perfect
anticipation which part of a single price change is due to
inflation.
Biases in fixed-payment-contracts: disadvantage for the
receiver, since the real value of the payment is reduced.
fixed wages
retirement pensions
debt contracts (!)
Bias in the distribution of financial wealth, and

Distortion of intertemporal allocation
Solution: Indexed contracts (in most cases not allowed since this
would accelerate inflation)
S.241
5.

Inflation and taxation
Cold Progression (nominal increase in income leads to

increasing tax rates)
Inflation tax: Inflation reduces real net interest rates
Fisher equation: i = r + p
(nominal interest rate = real interest rate + inflation rate)
After taxation with tax rate t:
rN = (r + p)(1 t) p
rN > 0
r>
t p
1t
Inflation reduces the incentive to invest.

0
S.242
5.

Money loses its function as a store of value: Inflation raises

the opportunity costs of holding money.
Sub-optimal level of holding money. Other assets serve as a

substitue for storing purchasing power, e.g.
foreign currency ( depreciation of domestic currency),
real estate or gold ( with accompanying price effects)
This distorts the portfolio structure.
Some negative aspects occur only in case of unanticipated
inflation. However, the higher the inflation rate, the higher is the
volatility.
S.243
5.

Positive effects of inflation?
Some negative effects are alleviated when the inflation rate is

stabilized because the effects of inflation could be anticipated
and taken into consideration (e.g. in contracts).
Since nominal wages have downward rigidity, inflation helps

to make real wages to become more flexible.
Allowing for small positive inflation rates means that

monetary policy can be used for short-run real effects.
S.244
5.

Price index:
Two common concepts:

Laspeyres-Index PL and Paasche-Index PP
Pn
Pn
t t
pit qi0
i=1 pi qi
i=1
P
,
P
=
P L = Pn
P
n
0 0
0 t
i=1 pi qi
i=1 pi qi
where pij is the price of good i in period j (with j = 0 as the

base period) and qij as the quantity share in the basket.
The shares qij may be adjusted according to the consumer

behavior of typical houshold.
Different price indices e.g. for consumer prices. In Europe:
HCPI (Harmonized Consumer Price Index) according to the
Laspeyers concept, and the GDP-deflator according to the
Paasche concept.
S.245
5.

Inflation target of the ECB:

... narrow below 2% of an increase of the HCPI.
Why not zero inflation?
The HCPI (as all Laspeyres indices) overestimates inflation.
Allowing for small positive inflation rates allows for using

monetary policy in the short run for other goals.
could not exactly be achieved (stochastic effects)
Since P
and deflation causes more welfare losses than inflation a small
positive rate minimizes the expected losses.
S.246
5.

expected loss
loss
p
p
S.247
5.

Biases in the inflation index:
Quality bias (example: computer)
New goods bias (example: consumer electronics)
Relative price changes lead to substitution effects which are

not incorporated in the fixed qi0 .
There is not a single price for a good but a price dispersion;

while pij reflects an average price, consumer tend to choose
low price offers.
S.248
5.

Excursus: On the economically correct measure of inflation

Alchian, A.A., Klein, B., (1973), On a correct measure of inflation.
Journal of Money, Credit and Banking 5(1), 173-191.
All known indices are based on a standardized basket of goods (e.g.

HCPI index for a representative household) or the basket of goods
which have been produced in a period (GDP deflator).
The logic of saving/investing is that you can produce consumption

goods in the future. The expectation of future prices are hence the
basis for saving/investment decisions.
The net present value of accumulated savings (capital stock) = the

price of the asset stock reflects the value of future consumption.
To measure not only the loss of real wealth of present

(consumption) goods but also of future goods a price index should
primarly be based on asset prices.
These issues are actually discussed in monetary policy.
S.249
5.
5.2

Transmission Mechanisms (Channels)
Outline:
5.2.1 Basic Problems: Limited Knowledge, Lags
5.2.2 Quantity Theory as a Black-Box Approach
5.2.3 Interest Rate Channels
5.2.4 Credit Channels
5.2.5 Expectation Channels
Literature:
S.250
5.
5.2 Transmission Mechanisms (Channels)

There exist different causal relationships between policy

instruments, intermediate targets and final goals.
Some of them are complementary, some may have

countervailing effects.
The magnitude of effects depend on the value of exogenous

and endogenous variables.
The effects occur with time lags (timing of monetary policy,

role of forecasts).
The causal relationships are controversially discussed in theory

(e.g. Are prices sticky? Do reserves determine lending or does
lending determine reserves? Are investments limited by credit
rationing?).
S.251
5.

Monetary Policy Art or Science? (O. Blanchard 2006)

Der Transmissionsprozess der Geldpolitik ist trotz intensiver
theoretischer und empirischer Forschung weiterhin nur l
uckenhaft
bekannt. (O. Issing 1995)
Transmission channels might change because of:
new financial products and intermediaries
increasing gloval integration of financial markets
changed behavior of banks due to regulation
specific economic situations (e.g. ZLB)
S.252
5.

(Mishkin (2006), p.619)
S.253
5.

S.254
5.

5.2.2 Quantity Theory as a Black-Box Approach
Quantity Theory:
M v =P Y
+ v = P
+ Y
M
+ Y
m
+ M0 + v = P
Forecasting: m,
v , Y
(e.g. close to zero)
Goal: P
Target: M0
Idea: M used for transactions in goods market Y D P

Price level changes determined by excess demand Y D Y .
It is not clear how the money affects the aggregated demand
(black box).
S.255
5.

In the standard IS-LM framework it is

assumed that the central bank determines
(via fixed multipliers) the money volume.
This induces a shift of the LM curve. An
(e.g.) excess supply of money leads to an
excess demand of bonds. Hence the bonds
price increases and the interest rate falls:
policy M i I (i) Y D .
LM
LM
IS
Y
However, (a) CB does not determine M (endogeneity of M), (b) most

CB consider i as the operating or intermediate target rather than M,
thus i could be seen as a policy instrument.
S.256
5.

The central banks discount rate c affects the market for

borrowed reserves (Lc ).
This affects the banks loans supply, and other dispositions

about the banks balance sheet structure and size.
Effects on bonds interest rates i, stock prices, and loan

interest rate . Portfolios are hence restructured.
In case of outright purchases of securities, there is an

immediate effect on the bonds price interest rate i.
Interest rate channels consider the effects of changing interest

rates on the aggregated demand.
S.257
5.

a) The standard interest rate effects
Demand for investment goods:
investors calculate whether to invest into a physical investment

project I or into bonds. Aggregated investment demand
depends on real interest rate:
i I (i pe , ) Y d ...
investors have to finance the physical investment projects by
bank loans:
I (, ) Y d ...
Demand for (durable) consumption goods, financed by loans:

C (, ) Y d ...
S.258
5.

b) The Tobin-q-effect
Firms hold a portfolio with different assets, especially physical

assets. They finance these assets by debt and equity.
The market value of a firm (MVF ) reflects the discounted

flow of expected returns from the asset side.
If there is a new enterprise = a new need for production

capacities, then it has to calculated whether
(i) it is more profitable to buy an existing firm (price = MVF )
or
(ii) to buy/produce new capital goods (price = costs for
financing capital goods, CC )
S.259
5.

Let R be the return from the new enterprise. Then the

effective return depends on the cases (i) and (ii):
R
r(i) =
MVF
R
r(ii) =
CC
The demand for new investment goods requires r(ii) > r(i) or
(in Tobins concept)
r(ii)
MVF
>1
(37)
=
q=
r(i)
CC
CB policy affects financing costs for capital as well as the

stock prices = market value of firm. An expansive policy leads
to lower interest rates and higher stock prices due to portfolio
rearrangements increase of Tobins q stimulates
investments aggregated demand.
S.260
5.

c) Exchange rate channel
If the domestic interest rate increases the domestic currency

becomes more attractive than foreign currencies. A change in
the interest rate differential leads to a change in the exchange
rate e:
i increases domestic currency is appecreiated (c.p.)

i decreases domestic currency is depreciated (c.p.)
The exchange rate affects exports and imports and hence the
trade balance NX = Ex Im which is a part of the
aggregated income.
i e NX (e) Y d
S.261
5.

d) Wealth effects
Monetary policy may have an effect on bonds and stock

prices. An increase in bonds/stock prices leads to an
increasing nominal level of financial wealth FW .
According to the Pigou effect a higher financial wealth FW

stimulates the consumption demand (shift in the
intertemporal consumption/saving decision in favor of
consumption because FW is kept on an optimal level).
stock/bonds prices FW C (FW , ) Y d
S.262
5.

Remarks:
The strength of the interest rate channels depend on the sensitivity...

(a) ...how portfolio depend on changes in relative prices. Also
liquidity and other considerations may be important for the
portfolio structure.
(b) ...how sensitive demand depends on interest rates and wealth
effects. In a recession the investment behavior is more
determined by pessimistic expectations rather than interest
rates.
Change/Reduction of the discount rate...

(a) ...only has an effect when it is not significantly larger than the
money market interest rate. The behavior of agents on the
money market then determines the effectiveness of policy.
(b) ... is only possible if it is larger than zero negative lending
rates?
S.263
5.

Basic idea:
In contrast to interest rate channels which depend on changes

in relative prices and portfolio rearrangements, the credit
channels are related to the volume of lending acrtivity.
Therefore the commercial bank sector (financial

intermediates) plays a central role.
S.264
5.

a) Bank lending channel
The idea is that an expansion of reserves stimulates the

multiplier process: deposits and loans supply increases.
Consumption and investments which have to be financed by
loans should then be stimulated because it is easier to get
loans (no quantitative restriction)
reserves deposits availability of loans I , C Y d
Even if this process may be accompanyied by a change of the

loans interest rate the focus is on the quantitative effect.
S.265
5.

Problem:
The demand for loans depends on

the loans interest rate, the income,
and eventually on the bonds
interest rate (Ld (, i, y )). It is not
reasonable to argue why a credit
expansion should take place, since
an increase in reserves does not
directly affect the loans demand.
If the bonds interest rate i
decreases, this may induce a
contractive effect on the loans
demand (bonds and loans as
substitutes). As a result the effect
on loans is unclear (see figure).
L(1c )
L(2c )
c i
Ld (i2 )
Ld (i1 )
L
S.266
5.

Another justification:
Assume that there are

rationing effects due to
adverse selection. Some firms
do not receive loans and there
is no tendency to adapt interest
rates to the market equilibrium.
An expansion of reserves shifts
loans supply function so that
without changes in the interest
rate the loans volume
increases by alleviating the
rationing effect.
L(1c )
LL(2c )
rationing
Ld
L
S.267
5.

b) Balance Sheet Channels
The channel is based on the adverse selection and moral

hazard effects. These effects lead to credit rationing. The
rationing effect can be alleviated e.g. by collaterals, net worth,
and own capital.
Since monetary policy has an effect on stock prices, this also

affects the value of collaterals and net worth. Furthermore the
ratio between the value of debt and the value of equity + net
worth changes.
This leads to a lower rationing effects and hence credit

expansion.
stock/bonds prices adverse selection/moral hazard

lending I Y d
S.268
5.

c) Cash Flow Channels
Monetary policy affects the interest rates to be paid in debt

contracts. Lower debt payments = higher cash flow, more
liquidity. This works similar as in the balance sheet channel:
The soundness of the firm increases and the rationing effect is
alleviated.
d) Liquidity effect
Increasing nominal financial wealth by increasing stock prices

reduces the likelihood of financial distress. The soundness of
the household/firm is improved. Hence it is easier to receive a
loans contract.
S.269
5.

Remarks:
Several channels depend on the effect on stock prices as well

on the bonds interest rate (and hence the bonds prices).
Expansive monetary policy leads to higher asset prices which

serve as a channel for the effects of monetary policy on the
real sphere (see ECB transmission scheme).
But higher nominal asset prices are asset price inflation!

Inflation is measured usually in terms of the price for
(consumption) goods and services. Asset price inflation may
also be a source of a loss of efficiency and welfare.
If asset prices properly reflect the discounted net revenues, an

increase in asset prices due to monetary policy implies higher
expected future prices (= inflation in the future).
S.270
5.

Prices and wages are more or less rigid in the short run:
Transaction/menu costs of price changes

Negotiation costs (wage contracts) long-term contracts
Uncertainty whether costs and/or demand has changed
systematically or due to stochastic fluctuation
If monetary policy affects demand, it has effects on quantities

but almost no price effects in the short run.
Downward sloped short run Phillips curve (see section 6)!
S.271
5.

What happens when these future price changes are expected

(expected inflation)?
Forming expectations: static, extrapolative, adaptive, rational

expectations.
Economic agents will incorporate their inflation expectations

into their contracts.
The expectation augmented Phillips curve shifts. The real

effects of monetary policy decrease (to zero).
Hence, monetary policy aims to keep inflation expectations on

a low level!
The central bank policy has to be credible! All changes in

policy variables may induce changing inflation expectations.
S.272
5.
5.2

Transmission Mechanisms (Channels)
Some empirical findings:

Recent findings on monetary policy transmission in the euro
area, ECB Monthly Bulletin, October 2002, pp.43-53
Monetary policy works; no real effects in the long run.
Difficult to decompose the transmission effects.
Significant interest rate effects on investments, also cash flow

and liquidity effects play a (minor) role; less evidence for bank
lending channels.
After financial crisis and European debt crisis (Euro crisis)

it is highly questionable whether transmission channels work
in th same way!
S.273
5.
5.3

Targets, Strategies, and Rules
Outline:
5.3.1 Which targets to choose?
5.3.2 Targeting the money volume
5.3.3 Targeting the exchange rate
5.3.4 Inflation Targeting
5.3.5 The Taylor Rule
Literature:
Mishkin (2006), chapter 18, 21
S.274
5.
5.3 Targets, Strategies, and Rules

Since the final goals could not be achieved directly by

monetary policy there is a need for intermediate and
operational targets.
These targets should have the following properties:
Measurability
Controllability
Predictive effects on the goals (this depends on the adopted
transmission theory)
Not too long delays of the effects
Targets may also be referred to as indicators
Monetary policy should be reliable and transparent. The

strategy is not to design an optimal monetary policy based
on very complicated transmission models, but to find good
performing simple rules.
S.275
5.

Operating targets:
Intermediate targets:
money market rate

interest ratess (loans, bonds) and their structure
money volume (M1, M2, M3)
exchange rate
output gap
Final target:
Price level target or inflation rate target?
S.276
5.

Intermediate targets may be conflicting!

Remind the price-theoretic model by Bofinger:
Targeting the loans interest rate

then the loans volume = money volume changes.
Targeting the loans volume

then the loans interest rate changes.
S.277
5.

Price level target or inflation rate target?
Price level target: pt (example: pt = p )
Inflation rate target: p (example: p = 0)
Both targets are equivalent in case of perfect controllability!
Differences occur in case of imperfect control (control errors)
S.278
5.

Evolution of the price level with a fixed inflation rate p in

continous time:
pt = e p t p0
ln pt = ln p0 + p t
In one time step with realized inflation rate pt = p + t :

ln pt+1 = ln pt + pt
ln pt+1 = ln pt + p + t
and the control error t has the property E [t ] = 0, Var [t ] > 0

and it is serially uncorrelated. How to respond to these errors?
S.279
5.

Inflation rate goal p = 0: Price level follows a Random

Walk, since the control error is neutral there is no need to
adapt policy measures:
ln pt+1 = ln pt + t
Price level goal p : Random deviations from the price level

lead to adaptions of the policy measures:
ln pt+1 = ln pt + (ln p ln pt ) + t ,
(0, 1)
Result of control errors:
Price level is more volatile in case of inflation goal
Inflation rate is more volatile in case of a price level goal
S.280
5.

The monetary policy of the Deutsche Bundesbank (before

the monetary union) was primarly based on money volume
targets.
Possible in a regime of flexible exchange rates (after Bretton
Woods)
Stable demand for money L(y , i), that means stable
functional form and parameters. This has empirically proven
to be the case for M3.
Stable relation between interest rate i and the target M: Since
changes in interest rates lead to a restructuring of assets (e.g.
overnight deposits, time deposits etc.), M1 and M2 seem to
be too volatile. The Deutsche Bundebank had chosen M0
(1974-1988), and later M3 (from 1988-2001).
and goal P
in the long run.
Stable relation between target M
S.281
5.

In accordance to quantity theory we have the

potential formula
+ v trend = P
goal + Y pot
M3
where Y pot is the (estimated) production potential. The
monetary policy has been oriented on the long run growth
path.
The current velocity v depends on the busniness cycle

(increasing in boom, decreasing in recession). An orientation
on the trend of v means that the policy does not respond to
business cycles.
as the unavoidable inflation rate is 1-2 %.
The goal P
S.282
5.

is formulated
The targets for M3
for a certain period: e.g. 1 year

= 6% should be
as an average goal (the target e.g. M3
achieved at the end of 1 year, fluctautions within this year
dont matter) or as a permanent goal (the target is controlled
within the period, e.g. every month higher transparency of
the policy)
= 6%) or as a target corridor
as a dot target (exactly M3
= 6% x%). A dot target will be violated with a
(M3
probability of nearly 100%. A broad corridor target will
rarely be violated but is not a meaningful target anymore.
S.283
5.

Money volume targets have rarely been achieved. Nevertheless, the

Bundesbank policy was successful regarding the final goal.
(Gischer/Herz/Menkhoff (2005), p.308)
S.284
5.

The relation between the development of M and the development

of the price level P is
very close
in case of very high inflation

in the (very) long run
not very close
in case of low inflation
As remarked above there is also a relation to asset prices (money

used for transactions on asset markets rather than goods markets).
S.285
5.

The long run relationship between inflation and monetary

expansion is an argument for the neutrality of money.
all 110 countries

Subsamples:
21 OECD countries
14 latin american countries
Correlation with
M0
M1
M2
0.925 0.958 0.950
0.894
0.973
0.940
0.992
0.958
0.993
(Source: McCandless/Weber (1995), Some Monetary Facts, in: Federal Reserve

Bank of Minneapolis Quarterly Review, Vol.19, M.3, pp.2-11)
S.286
5.

In the short run and/or in countries with low inflation rates the
correlation is not very strong:
(Spahn (2006), p.116)
S.287
5.

(Mishkin (2006), p.10)
S.288
5.

This approach may be reasonable for small open economies

with high inflation rates.
Targeting the exchange rate (to a country with low inflation
rate) means to import stability.
The idea is that there exists a relation between the exchange
rate and the price level (PT = price level of tradable goods,
indicates the foreign country):
PT = ePT
P = PT + (1 )PN
(38)
(39)
Hence, the exchange rate e changes with the difference of

inflation rates:
T P
e = P
T
If is large then targeting e 0 leads to similar inflation rate

than in the foreign country.
S.289
5.

Another mechanism is based on the interest rate parity : If the

owner of a financial fund has to decide whether to invest in
domesitic or foreign opportunities the no-arbitrage-condition
reads like
i i = eexpected
Monetary policy has to take the depreciation expectations into

consideration. Targeting the exchange rate and thus lowering
eexpected makes domestic capital markets more attractive and
the interest rate is accomodated to i .
Problem: Speculative attacks against the central bank if the

targeted exchange rate is expected to be not fundamentally
justified.
S.290
5.

The idea is that due to the complexity of the transmission

process and the limited knowledge about it the operational
target or the policy instrument should directly respond to
expected deviations of the inflation rate and the targeted
inflation rate:
e P
target ),
i = (P
>0
The central bank is committed to an inflation target. Since

could be estimated from central banks behavior, this policy
rule provides a high transparency.
Problem:
no theoretical considrations about the transmission process

low flexibility
S.291
5.

Inflation targeting has been a successful policy strategy e.g. in New

Zealand, United Kingdom, Sweden, Canada.
(Mishkin (2006), p.503)
S.292
5.

(Mishkin (2006), p.503)
S.293
5.

Taylor, J.B. (1993), Discretion versus Policy Rules in Practice.

Carnegie Rochester Conference Series on Public Policy 9(4),
195-314
The operating target (real money market interest rate i P)

should respond to the equilibrium real interest rate r0 , the
deviation of current and targeted inflation rate, as well as to
the output gap Y Y p .
t + (P
t P
target ) + (Yt Ytp )
ittarget = r0 + P
In case of accelerating inflation the central bank increases the

target rate (by 1 + ). In case of a boom where the output
gap becomes positive the target rate is also increased (by ).
S.294
5.

Taylor (and several others) has shown that the rule is a good
empirical description for the behavior of most central banks. For
target = 2,
the USA Taylor showed that the rule with r = 2, P
= 0.5, = 0.5 is a good predictor for the Fed policy.
(Mishkin (2006), p.430)
S.295
5.

The results for Germany:
(Gischer/Herz/Menkhoff (2005), p.317)
S.296
5.

Operationalizing the Taylor rule:
Inflation is measured e.g. by the HCPI.

Income is measured e.g. by the nominal GDP while the
production potential has to be estimated (e.g. econometric
estimation of a production function).
Targets for the inflation rate and the equilibrium real
interest rate may be theoretically justified.
Different lag structures may be chosen.
An additional goal may be to smooth interest rates. Hence
the Taylor interest rate should not fluctuate too much.
Possible smoothing rule:
itsmooth = ittarget + (1 )it1
S.297
5.

The main advantages:
Very simple and transparent rule.
Combines inflation targeting with anticyclical policy. It

compromises rule-binding with a certain degree of flexibility.
Different macroeconomic views of the transmission process are

compatible with the rule (i.e. it does not depend critically on
a specific macroeconomic paradigm).
Empirically robust description of central bank behavior.
Main problem: How to determine r0 ?
S.298
5.

Variants of the Taylor rule:
One problem is that in the original version the central bank

responds to realized (=past) changes in the variables.
Due to lags there is the danger of procyclical results.
It is reasonable that the central bank responds to expected

values instead:
pot,e
e
e
e
t+1
t+1
target ) + (Yt+1
i target = r + P
+ (P
P
Yt+1
)
S.299
5.

Remark:
With given values for Y pot and r the Taylor rule provides a
stable relation between i, Y , and P. Hence the Taylor rule is a
proper replacement of the LM curve in the (i, Y )-diagram.
Course Monetary Macroeconomics.
S.300

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Money and Financial Markets

2. Theory of Financial Structure

3. The Money Supply Process

Function and Measurement of Money

4. Theory of Money Demand

5. Central Banking and Transmission of Policy

Goals of Monetary Policy

Mishkin, Frederic S. (2012), The Economics of Money,

Bailey, Roy E. (2005), The Economics of Financial Markets,

Bofinger, Peter (2001), Monetary Policy: Goals, Institutions,

References to more specific literature can be found in the slide

Preliminary time schedule (summer 2015):

1.1 Overview over Financial Markets

(Financial) Asset: Money Financial Assets All Assets

1.1 Overview over Financial Markets

Asset markets: In contrast to goods markets (producer,

How do different types of agents (e.g. banks, non-banks)

How can the price movements in aggregated markets be

1.1 Overview over Financial Markets

a) Debt and Equity Markets

Contractual agreement, where the borrower pays the holder of

The maturity of a debt is the time until the expiration date

Examples: Consumer loans/credits, mortgages, bonds

Depending on the contract, the borrower can sell the asset,

1.1 Overview over Financial Markets

The buyer of an equity has a claim to share the net income

Example: Stock shares

1.1 Overview over Financial Markets

Advantages and disadvantages:

1.1 Overview over Financial Markets

Advantages and disadvantages: (cont.)

1.1 Overview over Financial Markets

b) Primary, Secondary and Derivative Markets

New issues of assets are sold to initial buyers.

1.1 Overview over Financial Markets

Secondary markets make assets more liquid: contract can be

On secondary markets the price is determined by the flow of

1.1 Overview over Financial Markets

c) Exchanges and OTC Markets ( secondary markets):

Organized, centralized, regulated trading of assets, high

Over the counter (OTC):

Decentralized market where the seller sells the assets over

1.1 Overview over Financial Markets

d) Money and Capital Markets:

Short-term contracts (maturity < 1 year) with high liquidity

Long-term contracts (maturity > 1 year, assets without

Note, that this definition of a money market differs from the

1.1 Overview over Financial Markets

Bonds are issued by firms (corporate bonds) or by government

Coupon-bond: owner of the bond receives a fixed payment

Discount bond (zero-coupon bond): There is no coupon

1.1 Overview over Financial Markets

Interest rate i when holding the bond until maturity:

with P0 = bonds price in t = 0, F = face value, C = coupon rate,

where Pt+1 is the expected bonds price in t + 1.

1.1 Overview over Financial Markets

In both formulas there is an inverse relationship between

If the interest rate is lower than expected return it would be

1.1 Overview over Financial Markets

Slope of demand and supply curves:

The demand for bonds is negatively related to the bonds

1.1 Overview over Financial Markets

1.1 Overview over Financial Markets