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2 The Global Macroeconomy (Fach) / Lecture 4 - Money (Lektion)

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• M.1.3 Cryptocurrencies and Blockchains Total Market Capitalization: $500bn (~ 500 different currencies) Definition: Cryptocurrency is a medium of exchange, created and stored electronically in the blockchain, using cryptography to control creation of monetary units and to verify the transfer of funds Cryptocurrencies are more like a crypto asset than a currency: Digital asset using cryptography to secure its transactions and control creation of units Use decentralized control (blockchain) as opposed to centralized systems. Validation of transactions by Mining (no other authority); Typically bought to speculate and evade regulations (money laundering, terrorism) Anonymous Important for their valuation: What is the exit market?Today (centralized economy) = Regulation Bitcoin (by Satoshi Nakamoto, 2009) First cryptocurrency and is still the biggest Decentralized cash system as opposed to Trusted Third Party based system (such as Paypal) “Peer to peer cash system”, “non-trust based” Etherum (by V. Buterin) Validates transactions and complex contracts and programs ICO (Initial Coin Distribution) with smart contracts: crowdfunding; “IPO lite”
• M.1.1 Functions of Money Functions: (1) Medium of exchange (key function) Alternative: Boughter -> not an efficient way of trading -> Double-coincidence of wants (2) Unit of Account (3) Store of value - recognizable, not depreicatable 
• M.3 Central Bank Interest Rates (1) EONIA = Interbank rate of European Central Bank (2) Marginal lending Lending apart from auction by the ECB If bank is in urgent need for money the ECB charges a penalty rate (3) Main refinancing = Auction rate (4) Deposit rate = when banks deposit money at the central bank Bad times: Central bank lowers the interest rate, because they want borrowing and investment BUT: if too low (at 0%), it is like cash and there is no incentive to borrow rather than cash
• M.4 Inflation -The Quantity Theory of Money (Long-Run) Money is neutral in the long run (both time series and cross-country) Long run: Prices are flexible, potential output determined by inputs and technology Short run: Prices are fixed, output determined by aggregate demand; Real interest rate r - nominal interest rate i; Monetary policy has real effects (Keynes) Long Run: Quantity Theory of money applied -> Relationship holds M/P = Y/V(Friedman) M = M1 or M2, or the 2 broad money aggregates (liquid money) V = Velocity of Circulation (how often a note/ Bitcoin is used in transaction within a period; unobserved P= Price Level Y = GDP Long Run Monetary view of inflation: If I know M, Y and V, then I also know the price level Endogenous variables (variables determined by the model): P Exogenous variables (variables controlled by policymakers): M, Y and V. (careful V cannot be usually considered as exogenous! Why doesn’t it hold in the short-run? Endogenous movements in V No correlation between inflation and M growth due to endogenous movements in V
• M.4 Inflation in the UK (Retail Price Index 1271-1960) Prices increased around sevenfold over 650 years (with 200 years of stability) 13th Century - Price have been really constant for a long period of time 16th Century - A little bit of Inflation  18th Centrury - Industrial Revolution 1973/1974 - Bretton-Woods: Commodity-backed Money changed to Fiat Money Complete change in Price level by going from commodity backed to Fiat
• M.4 Hyperinflation More than 50% monthly inflation • Hyperinflation countries have nearly all revenue raised by issuing currency• Tend to a response to chronic failure to raise revenue.• Source of hyperinflation are fiscal problems; not monetary Hyperinflationary spiral: Government resorts to printing money as face value exceeds cost. However eventually reduces value of money so becomes necessary to print even more money to raise same revenue  - Hyperinflation Germany: Jun 1923 - Oct 1923  - Hyperinflation Zimbabwe: Q3 2007
• Short Run: Goods Market Equilibrium - IS Curve - Changes in Demand DD is function of i and Y since C and I are DD Y ↑ DD ↑ As income increases, so does desired demand from consumers: positive slope i ↑ DD ↑ If interest rate increases, the desired demand from consumers falls Desired Demand Equilibrium: When what people are demanding is equal to what is being produced: DD = Y --> We can represent this condition with a 45o line  The 45° Diagram “The Keynesian Cross”  (1) Y ↑ Exogenous increase in aggregate Demand: Outward Shift to the right (Increase Supply) (2) i ↑ Endogenous Increase in aggregate Demand - Interest Rate Increase -  If interest rate goes down, desired demand goes up I ↑ For the same level of output, the desire for investment increases.  Y ↑ Therefore, the DD curve shifts upward, leading an increase in output.  - Short-Run: Equilibrium output will change, if the interest rate changes  - IS curve derived by finding Y’s for all i’s - Downward Sloping - Goods Market equilibrium on the IS Curve  To the left of IS - Excess Demand for goods To the right of IS - Excess Supply of goods
• M.3 Monetary Policy In Practice Operational instrument = Almost always interest rates Intermediate targets = Money supply Credit Exchange rate Inflation forecast Final objectives = Inflation, Output Central Banks do not fix the market rates: only the official rates -> market rates Policy makers do NOT determine the market rates (the rate at which you can borrow, the interest you receive)  They can only affect The rate at which Banks can borrow liquidity from the Central Bank Indirectly the rate at which Banks can borrow and lend liquidity between themselves (interbank rate) These rates determine the costs of obtaining liquidity that Banks (and other financial institutions) face These costs in turn determine the rate at which Banks borrow and lend to their customers - i.e. effect on market rates Consumer credit = 4% above EONIA, Large Corporations 1% above EONIA, Small Corp. 2% above EONIA
• M.3 The Taylor Rule (How are interest rates set in practice?) R(t) = R(normal) + 1.5*(inflation(t) - inflation target) + 0.5*(output(t) - potential output) *Weight on inflation higher the more conservative the country FED: Fed increases the interest rate when inflation is high and when output is high ECB: No perfect fit of rule in EU area; in Switzerland is fits very well =>variations on this rule work  
• M.2 M/P - Money Supply M0 - Base Money: Cash held by public and banks M1 - Narrow Money: Cash and demand deposits M2 - Broad Money: M1 + money market shares + savings deposits M3 - M2 + time deposits and institutional funds Differences in  types of “money” are included central bank’s control of the money supply. The broader the definition the larger the money stock and the less the power of the central bank to control it
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• M.3 Balance Sheet of Central Bank Assets - Use of Funds 10% Foreign Assets 60% Loans to Commercial Banks 30% Securities Liabilities - Sources of Funds 15% Currency in Circulation 50% Deposits by Commercial Banks 20% Deposits by Government 5% Net Worth
• M.2 Balance Sheet of Commercial Bank Assets - Use of Funds 30% Vault Cash & Deposits at Central Bank 20% Securities 50% Loans Liabilities - Sources of Funds 15% Liabilities to Central Bank 80% Deposits by Customers 5% Net Worth
• M.3 The E-krona concept Digital currency such as the e-krona (Sweden) are totally different from cryptocurrencies. Cash used only in 15% of transactions in Sweden now. The e-krona constitutes a direct claim on the Central Bank Specified in Swedish kronor Can be held by the general public, financial institutions and companies Accessible in real time, 24 hours a day, seven days a week, 365 days a year. The e-krona does not accrue any interest, but should have a built-in function to make it possible to accrue interest at a later point. To Date: Central Banks use the “sandbox” approach. A lot is at stake for them. Professor view: they will regulate heavily. Race between banks, fintech and Central banks.
• Summary Central banks control the monetary base but commercial banks create money as well via the money multiplier The quantity theory of money is a simple relation between the level of output, the level of prices and the money stock. Money seems to be neutral in the long run. Hyperinflations are usually driven by fiscal deficiencies In the short run prices are sticky and output is driven by demand. Fiscal and monetary policy shift the IS (goods market equilibrium) and the LM (money market equilibrium) curves, respectively. A common monetary policy strategy is to fix the policy interest rate, which then influences the market rates. The monetary policy transmission mechanism is very complex and the interest setting process is complicated but, interestingly, monetary policy is usually well-proxied by a simple Taylor Rule (except for zero lower bound). Cryptocurrencies, digital currencies and block chain technologies may be disrupting the standard monetary framework.
• Short Run: Money Market Equilibrium - LM Curve - Changes in Money Demand Money Market View - Money as cash or very liquid deposits, not a synonym for wealth  What drives the demand for money/liquidity? (1) People’s income Y: the more income a person has, the more money it will want to have (for purchases, e.g.) (2) Interest rate i: by keeping money on wallets or bank accounts instead of buying a bond for example, a person is sacrificing the returns Let these 2 first factors be L = i & Y  (3) The price level: the higher is the price level, the more money people need to buy the same amount of goods. Since what people care about is the real amount of goods they can buy, we will be thinking of demand for real money. M - What drives the supply of money? -> The Central Bank So, we will have later in equilibrium: L = M/P  The Short-Run - M = Real Money Supply, Vertical, Determined by Central Bank - L = depends on i (Negatively) and Y (positively) Y ↑ If output increases, people‘s demand for real money also increases  i ↑  If output increases, interest rate determined by Money Market increases (1) Exogenous increase in money supply (Right Shift) Suddenly people have more real money/cash than they wanted for the previous level of income  They will buy bonds to get rid of that money  By buying bonds, their price goes up and the interest rate goes down (2) Alternative way to think: the only way to “convince” people not to buy more bonds and keep all the cash that is out there is to decrease the interest rates so that bonds are now not as appealing as before  Thus, an increase in the money supply leads to a decrease in the interest rate.  LM curve derived by finding i’s for all Y’s, Holding the money supply constant LM Curve thus upward sloping (Output, i)
• M.4 How To Stop Hyperinflations Change inflationary expectations of economic agents is Key! Credible fiscal commitment Stop printing money Fire the management! Sometimes: nominal anchor; temporary price cap 
• M.1.3 How Cryptocurrencies work Someone requests transaction requested transaction is broadcast to P2P network consisting of computers known as nodes Validation: Network of nodes validate the transaction and user's status using known algorithms A verified transaction can involve cryptocurrency, contracts, records and other information Once verifies, the transaction is combined with other transactions to create a new block of data for the ledger The new vlock is then added to the existing blockchain, in a way that is permanent and unalterable Cryptocurrency
• M.1.2 Types of Money (1) Commodity money - Money is worth a specified amount of a given commodity. e.g. silver, gold (Gold-Standard) Until Bretton Woods in Britain (70s): UK was the big economic power due to industrial revolution in the 19th century - Sterling as good as gold (2) Fiat or paper money - Bits of paper become valuable because somewone with legal authority decrees it so
• M.2 Money Creation (1) By government ECB can issue reserves and increase Monetary Base = Cash + Reserves Need to understand what Multiplier m is to be able to influence  Pre-Bretton Woods: Change in money supply depends on flow of new precious metal available for minting (2) By banks (other financial institutions) Extension of credit in a fractional reserve system Degree of m (multiplier) of the Monetary Base depends on monetary policy Banks can increase m by lending a large fraction of their deposit ->  more loans in economy -> money in economy will be multiplied Policy can influence m
• M.2 Links in the Chain Of Money Creation M0 (Cash + Reserves) - High Central-bank ability to intervene {market operations} m "Money Multiplier" - Restricted but not controlled by reserve requirements {Regulation} -> Size of commercial banks' balance sheets Money Supply: Bank balance sheet closely linked to Money Supply, but still elastic due to shadow banking, etc. {Regulation} Price level: Money Supply closely linked to Price level in stable times, but still elastic because of changes in velocity of circulation - Low Central-bank ability to intervene directly
• M.1.3 Cryptocurrencies and Monetary Policy Today: Centralized System Currency issued by a central bank at rate that matches growth of the amount of goods to ensure stable P Money supply controlled by a central bank; Fed increases M by issuing currency, increasing the amount banks have on reserve or by a process called Quantitative Easing. To Date: Central Banks use the “sandbox” approach. A lot is at stake for them. Professor view: they will regulate heavily. Race between banks, fintech and Central banks. Bitcoin World = Deflation World P = V x M / Y No central authority that regulates the monetary base; Currency is created by the nodes of a peer-to-peer network. Bitcoin generation algorithm / decreasing-supply algorithm was chosen because it approximates the rate at which commodities like gold are mined Any currency that is generated by a malicious user that does not follow the rules will be rejected Fixed Money supply cap: number of bitcoins in existence is not expected to exceed 21 million Number of bitcoins generated per block is set to decrease geometrically No Inflation as no growth of M However, if M is fixed and output grows, prices will have to go down as output grows if we had a Bitcoin world we would be in a Deflation World P = V x M / Y Because we are still creating Bitcoin: Inflation at ~4% but steadily trends downwards. Today: block reward given to miners is made up of newly-created bitcoins plus transaction fees As inflation goes to zero miners will obtain an income only from transaction fees which will provide an incentive to keep mining to make transactions irreversible.

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