1

Alessandro Missale

MONEY AND FINANCE

2020

Welcome and Lecture 1

 Informations
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 Instructor: Alessandro Missale

 Online Lectures via Zoom platform: Links posted on Ariel website
 Office hours: By appointment; send me an email
 Email: [email protected]

 Assistant: Catalin Dragomirescu Gaina

 Office hours: by appointment
 Email: [email protected]
 Online Review Sessions: (Starting Week of September 28)
Links and calendar on Ariel website
 Course web page on Ariel: https://www.ariel.unimi.it
contains all communications and information
 Textbook and other references
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The textbook for the course is:

 Walsh, Carl E., Monetary Theory and Policy (3rd edition),
MIT press, 2010.
 https://mitpress.mit.edu/books/monetary-theory-and-policy

First Chapter downlodable

 Chapters: 1, 6, 8, 10, 11.

 For the AS-AD model see Mishkin, F. S., Macroeconomics: Policy

and Practice, 2nd Edition, Pearson 2015 Chap. 10-12.
 Additional references on specific topics and further readings
will be available or indicated on the course web page.
 Examination
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 There is a Final Oral Exam of 30 minutes.

The exam covers all the topics presented during lectures and
seminars and consists of open-ended questions which may
include explanation and/or technical analysis (graphs) and/or
simple calculations.
 Dates: December 14, January, March, May, July,
October/November (precise dates to be defined)
 A detailed Syllabus with more information about the exam can
be found on the course website. Please read it.
 Course objective
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 The course offers an introduction to the most important topics in

monetary economics and policy, focusing on ‘New-Keynesian’
general-equilibrium models with particular emphasis on the
policy implications of these models.
 It discusses the transmission mechanism of monetary policy,
focusing on the role of sticky prices; expectations; financial
frictions.
 Topics presented include: i) Instruments, targets, policy goals;
ii) monetary transmission mechanism (channels for MP effects);
iii) targeting regimes and policy rules; iii) the term structure of
interest rates; iv) financial frictions and the credit channel.
 Course Plan
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Introduction – The Basics

 Money Demand and Money Supply
 Policy Objectives, Instruments and Operating Procedures
 The Effects of Money in the AD-AS Model

First Part – New Keynesian Monetary Economics

 Empirical Evidence: Money, Inflation and Output
 Sticky Prices and the Monetary Transmission Mechanism
 Monetary Policy Analysis in New Keynesian Models
 Targeting Regimes and Policy Rules

Second Part – Monetary Policy and Financial Markets

 The Term Structure of Interest Rates
 Financial Frictions and the Credit Channel
 Lecture 1
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 Contents of the lecture

 Money Demand and Money Supply
 Functions of Money
 Monetary Aggregates
 Interest Rate determination
 Equilibrium in the money market and in the bond market
 The role of commercial banks in creating money
 Policy relevance: The interest rate is the main instrument that the
Central Bank has to control aggregate demand; it affects
consumption, investment demand and the exchange rate.

 Reference: Any Macroeconomics textbook, e.g. Blanchard, O.

Macroeconomics, Pearson Education, various editions, Chapter 4
 The definition of Money
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 Money is any financial asset that can be readly used to pay for
transactions; to buy goods and services directly.
 Functions of money:
 Medium of exchange (it facilitates transactions)
 Store of value (it allows to transfer purchasing power to future
periods of time)
 Unit of account (prices are expressed in Euro)
 The main function of money is to facilitate transactions that money
accomplishes because of its liquidity (spendibility).
 Liquidity is the property of a financial asset to be transformed into
a medium of exchange with the least loss of value.
 Monetary aggregates (in the US and EU)
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 There are various monetary aggregates that can play the role of money in
various degrees depending on their liquidity.
 Currency = coins and banknotes (cash) held by the nonbank public
 M0 = Monetary Base = Currency + Reserves (held by banking syst.)
 M1 = Currency + Demand Deposits (sight/checkable deposits)
 M2 (US) = M1 + Saving accounts + Small Time Deposits + Balances in
retail money market mutual funds.
 M2 (EU) = M1 + Deposits with an agreed maturity up to 2 years +
Deposits redeemable at a period of notice up to 3 months.
 M3 (EU) = M2 + Repurchase agreements + Money market fund shares +
Debt securities with initial maturity of up to 2 years (issued by MFIs)
 Conventionally: Money = M1; i.e. the sum of currency and demand (sight)
deposits at banks that can be spent with debit cards.
 Portfolio Choice, Money Demand
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 Consider a simple economy. No banks. Only 2 financial assets:

money and bonds (issued either by firms or by the government).
 At any point in time, people must decide how to allocate their financial
wealth between money and bonds.
 The level of wealth* is given; people must choose the composition of
their portfolio.
Money
 Can be used for transations (to buy goods and services directly), but
 it is dominated by bonds as a store of value either because bonds
pay positive interests or because bonds are safer.

*NB: Financial Wealth is a stock variable; it is given at a moment in time.

Wealth changes over time because of saving (and financial investment).
 Bonds
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Bonds (are issued by firms or government – here no difference)

 cannot be used for transactions (liquidity lower than money)
 gives a return (positive or negative) whose rate is called the
interest rate, , or the yield to maturity
 Consider just one type of bond; a 1-year ‘zero-coupon’ bond.
The return on such bond –if held until maturity– is given by the difference
between its redemption value (or face value) conventionally normalized
to 100 and the current price at which the bond can be purchased.
This rate of return is the interest rate:

 When the price increases the interest rate falls

 Choosing between money and bonds
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 The portfolio choice of how to allocate financial wealth between

money and bonds can be examined either by looking at the demand
for money or at the demand for bonds since, for any given level of
wealth, , the demand for any of the two assets implies the demand
for the other:

 Note also that, if the money market is in equilibrium, then the bond
market is also in equilibrium, and vice-versa:
 and thus
 It is a particular case of Walras’ Law
 Focusing on just one market allows to derive equilibrium conditions for
both markets.
 Choosing between money and bonds
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Money Market – Portfolio Choice

Determinants of the portfolio choice between money and bonds
 The level of transactions
 The need to hold money increases with the level of transactions.

 The interest rate on bonds

 The convenience/willingness to hold bonds increases with the interest
rate on bonds.
 The peception of risk?

 The interest rate represents the opportunity cost of holding money;

i.e. how much we give up by holding money instead of bonds
 The demand for money
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 The demand for money, , is the sum of the individual demands by

people in the economy.
 It positively depends on the overall level of transactions that should
be roughly proportional to nominal income, .
 It negatively depends on the opportunity cost of holding money; i.e.
the interest rate on bonds,

 where is a positive function of , and a negative function of .

An increase in the interest rate decreases the demand for money since
people wants to put more of their wealth into bonds.
 The demand for money
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An increase in nominal income

At a given interest rate an
increase in nominal income
shifts the demand for money
to the right.

For a given level of nominal

income a higher interest rate
decreases the demand for
money
 The determination of the interest rate
(when the CB controls the money supply)
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The equilibrium on the money market

 Suppose the Central Bank supplies an amount of money equal to ,
that is
 (As there are no commercial banks, deposits = 0, M = Currency)

The condition for financial markets to be in equilibrium is:

• Money Supply = Money Demand
•

 The interest rate adjusts so as to make the demand for money

equal to the supply of money.
 When the money market is in equilibrium the bond market is also in
equilibrium.
 The equilibrium interest rate
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Equilibrium on the money market

When the Central Bank

controls the Money Supply:
The interest rate must be such
that people are willing to hold
(demand) the amount of money
supplied by the Central Bank
 An increase in the money supply
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The effects of an increase in the money supply

An increase in the supply of
money reduces the interest rate

The opportunity cost of

holding money must fall
to convince people to
hold more money and less
bonds
 Open market operations
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The Central Bank controls the supply of money usually by means of

 Repurchase Agreements (called main refinancing operations in case
of the ECB)
 It is easier to think in term of Open market operations purchases and
sales of bonds in exchange for money like Quantitative Easing
• When the CB buys bonds, it pays for them by creating money
 the CB increases the supply of money
• When the CB sells bonds, it removes money from circulation
 the CB reduces the amount of money
 The former is an expansionary OMO the latter a contractionary OMO

 NB: OMOs lead to equal changes in the assets and liabilites of the
Central Bank’s balance sheet:
 The bond market and the effect of OMO
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Note that the total amount of bonds is equal to the sum of bonds on the
market, say , and those held by the CB, say,
Central Bank Balance Sheet
Assets Liabilities
𝑪𝑩 𝑺

The financial wealth on the markets is equal to:



 When the CB buys bonds and and money



OMOs change the relative supply of money and bonds on the market
and lead to an excess demand for bonds:
the price of bonds increases and the interest rate falls
The price of bonds and the interest rate
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Interest rate determination

 The demand and supply for bonds determine the price of bonds.
 The interest rate is derived from the price of bonds.

 Example: 1-year zero-coupon bond (Treasury bill)

Current price:
Redemption value: 100
 The interest rate (the rate of return of buying the bond today and
holding it for a year) is:

The higher is the current price, the lower the interest rate
 Open market operation (revisited)
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OMO from the perspective of the Bond market

 By means of open market operations the Central Bank changes the
relative supply of bonds and money in the market.
 When the CB buys bonds, it creates an excess demand for bonds,
their price increases and the interest rate falls. Intuitively, the
demand for bonds by the CB raises their price.
 When the CB sells bonds, it creates an excess supply of bonds, their
price falls and the interest rate rises. Intuitively, if the CB increases
the supply of bonds their price must fall.
 An increase in nominal income
(when the CB holds money constant)
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An increase in nominal income raises the interest rate

The demand for money increases but,
given a fixed money supply, the
opportunity cost of holding money must
raise to make people willing to hold
the same amount of money

As income increases, people try to sell

their bonds to get the money they
need for increased transactions.
However, their attempt to sell bonds
makes the bond price fall and the
interest rate rise until it is so high to
discourage the sale of bonds.
 More realistically CBs decide the interest rate
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More realistically, nowadays, Central Banks decide the interest rate

and let the money supply adjust so as to ensure that the interest rate is
on target
When the CB controls the interest
rate the money supply
becomes endogenous
Like a Monopolist who can
decide the price or the quantity
but not both, if the CB chooses
the interest rate it cannot control
the money supply.
Money Supply
For a realistic description of the money market we must introduce
commercial banks
 Commercial Banks
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Now we introduce commercial banks

 Banks are a special type of financial intermediaries, in that their
liabilities –deposits– are money: M1 = Currency + Deposits.
 Banks receives funds from firms and individuals either from direct
deposits or through transfers from other banks.
 Banks keep as reserves part of the funds they receive. Reserves are
only in part held in cash; most reserves are held in an account at the
Central Bank which they can draw on, if they need liquidity.
 Banks use the funds that they receive to buy bonds (financial assets) or
to make loans to firms and people.
 As banks buy bonds or lend the funds that they receive, they create
new deposits, they increase the supply of money in the economy:
M1 = Currency + Deposits.
 The role of banks’ reserves
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 Banks keep part of the funds they receive as reserves in the form of cash
or highly liquid funds held at the CB in order to meet cash/liquidity
needs that may arise from imbalances between withdrawals and
deposits, transfers made and received.
 Besides liquidity needs, banks are subject to minimum reserve
requirements that require banks to hold a minimum amount of reserves
in some proportion of their short-term liabilities
 In Switzerland the required reserve coefficient (or ratio) is 2.5%;

 In Europe the req. reserve ratio is 1% since 2012 (down from 2%);
 In the US it depends on the amount of net transaction accounts (ie checking
deposits); the ratio goes from 0% to 3% up to 10%.
 The CB balance sheet revisited and
the Balance Sheet of Banks (Banking Sector)
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The liabilities of the CB

are given by the money it
has issued that is called
Monetary Base or M0 or
= Monetary Base High Powered Money
New feature: Not all of
central bank money is
Demand
held as Currency by
Bank capital people. Some of it is held
as Reserves by banks
The Banking sector holds reserves, bonds and assets. Its liabilities are
made of deposits and equity capital because interbank loans sum up to
zero for the banking sector as a whole.
 The Money Supply
Outside and Inside Money
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Commercial banks create inside money: as they buy bonds, and

make loans, deposit increase (the funds provided are deposited).
Money used for transactions, M1, includes demand deposits:
 M1 = Deposits + Currency

The CB issues the Monetary Base, M0, outside money (or high
powered money):
Assets Liabilities
 M0 = Reserves + Currency

Inside money: Reserves = R Deposits = D

 M1 – M0 = Deposits – Reserves = Loans
+ = L Capital = W
= Bonds + Loans – W Bonds
 The reserve ratio
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The reserve ratio is the ratio of reserve to deposits:

 Reserves = Required + Excess Reserves

 It is the fraction of deposits that banks want to hold liquid for, say,
precautionary reasons or future opportunities.
 As the reserve ratio increases, inside money decreases because
banks do not invest deposits buying bonds or giving loans:
Inside money:
 M1 – M0 = Deposits – Reserves

 M1 – M0 = Reserves

 As inside money goes to zero

 Intuition for the inside money creation
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The intuition for the inside money creation by banks is as follows:

 Every time a bank extends a loan or buys a bond (part of) the funds

it uses to buy the bond are credited on the bank account of the
counterpart (a firm or an individual).
 Then, the recipient bank keeps as reserves part of the deposits and
(may use the remaining part to) buy a bond or make a loan. In turn,
the proceeds from the sale of the bond are deposited in a third
bank that, etc. etc…
This way deposits are multiplied and money is created
 Equilibrium in the Money Market
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 To understand the money market equilibrium (and the determination of

the interest rate) it is useful to think in terms of supply and demand for
the monetary base, M0, issued by the Central Bank
Think in terms of supply and demand of the monetary base :
 Supply M0 = Reserves + Currency = Demand
 But, as the demand for currency is predictable , the
equilibrium can be represented in terms of demand and supply
of banks’ reserves:

Supply = Demand
 Equilibrium on the interbank market for reserves: supply = demand.
 The interest rate that the CB controls is the interest rate that clears the
market for banks’ reserves.
 The Federal Funds Rate and the EONIA
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 Equilibrium is in terms of supply and demand of banks’ reserves:

 This way of looking at the equilibrium is equivalent to that in , but

is more realistic because:
1. In most countries there is a market for reserves (while there is no
market for currency) where banks borrow and lend overnight
2. The interest rate that the CB controls is the interest rate that clears
the market for banks’ reserves.
 In the US the overnight market for reserves is the Federal funds market
which is cleared by the Federal funds rate while in Europe the interest
rate on the interbank market for reserves is called EONIA (Euro
Overnight Index Average).
 Demand for Central Bank money H =M0
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Reserves = Deposits
 The equilibrium interest rate
(when the CB controls reserves)
34

Equilibrium on the market for Reserves (or Monetary Base, M0-CU)

Supply of CB
Reserves The equilibrium interest rate
makes the demand for
reserves equal to its supply;
i.e. it makes banks willing to
hold reserves
Demand for CB
Reserves
Note that an increase in the
reserve ratio, , shifts the
demand to the right and leads
to a higher interest rate
CB Reserves
 The Central Bank decides the interest rate
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Nowadays Central Banks decide the interest rate, ie the target ,

and let the money supply (reserves) adjust to match money demand.
Supply of CB Money supply is endogenous
Reserves With repurchase agreements
(repos), in practice, banks demand
money in a temporary exchange
for bonds bidding a repurchase
price and thus an interest rate. The
Demand for R
CB acts as a monopolist.
Since the crises, the ECB fixes the
𝒅
𝑴𝟎 =
repurchase price, ie the price at
which it sells back the bonds, and
M0 thus it fixes the interest rate.
CB Reserves
 Technically
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 Commercial banks temporarily sell bonds to the CB in exchange

for reserves and agree on the higher price, , at which they
repurchase the bonds. This determines the interest rate that
commercial banks pay on reserves:

 Commercial banks used to bid a repurchase price for the

bonds they sell to the CB temporarely. Since the crisis the
repurchase price is fixed and set by the CB, so that is also fixed.
 In the case of the ECB such operations are called main refinancing
operations. Technically such operations are reverse transactions
under repurchase agreements.
 Discount window lending
37

 Commercial banks can obtain reserves from the Central Bank

through other instruments, besides OMO or repos.
 In the US the Fed has a discount window from which commercial
banks can borrow reserves at a slightly higher interest rate -the
discount rate- (50 basis points above the target for Fed Funds)
using bonds as collateral.
 In the EU the ECB provides a marginal lending facility from which
banks can borrow. Considering these Discount Loans:

Discount Loans
 Borrowed and nonborrowed reserves
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 In the US it is customary to distinguish between nonborrowed

reserves obtained through OMOs and borrowed reserves
obtained by borrowing at the discount window.
 The reason for such distinction is that nonborrowed reserves are
the part of the monetary base that the CB controls while
borrowed reserves are chosen by commercial banks.
 Such distinction has lost importance since the CB now sets the
interest rates and gives up control of the monetary base as the
latter adjusts to match commercial banks’ demand.
USA: M1 versus MO
logarthmic scale – monthly data 1/1990-2/2014
Source: FRED – Federal Reserve Bank of St. Louis
https://research.stlouisfed.org/fred2/
SWITZERLAND: M1 versus MO
CHF monthly data 1/2005 - 5/2012
Source: Swiss National Bank
http://www.snb.ch/en/iabout/stat/statpub/statmon/stats/statmon