Transcript Document

Chapter Fifteen
Money, the Banking System,
and Foreign Exchange
© 2003 South-Western/Thomson Learning
Chapter Fifteen Outline
1. Introduction
2. Money
3. Banking Crises
4. Foreign Exchange
5. Bringing It All Together
6. How a Flexible Exchange Rate Regime
Works
7. How a Fixed Rate Regime Works
2
Introduction
• This chapter will examine the markets for
money and foreign exchange and
• The effect of openness on the money market.
– Perhaps the most important key to understanding
policy options in the world macroeconomy.
– Most obvious effect involves the introduction of a
foreign exchange market.
3
What Is Money?
• Money is an asset that its owner can use
directly as a means of payment.
– Currency held by the public and deposits on
which checks can be written constitute a
country’s money stock.
• Nonmoney assets, such as stocks, bonds, real
estate, certificates of deposit, and diamonds, also
represent purchasing power to their owners, but
they typically cannot be used directly as a
means of payment.
4
What Is Money?
– In order to use the purchasing power of a
nonmoney asset to buy a new car, the
transaction would require two steps:
1. The individual must find someone to buy the
asset (exchanging the asset for money); and
2. The individual uses the money to buy the car.
– A nonmoney asset exchanged directly for
an automobile would be an example of a
barter exchange.
5
What Is Money?
• Nominal money stock (M): a country's money
stock measured in current dollars.
– “Stock” denotes the quantity of dollars existing at
a point in time.
• Real money stock: at any time equals the
nominal money stock divided by a price index
– the GDP deflator, P:
Real money stock = Nominal money stock/Price
index = M/P
6
Demand for Money
• The demand for money reflects the quantity of
currency and checkable deposits the public
wants to hold to make purchases.
– Real money balances: nominal money balances
divided by the price level.
– Differential between the interest paid on NOW
accounts and the interest paid on bonds still
represents an opportunity cost of holding money.
7
Demand for Money
• Figure 15.1 depicts the relationship among the
quantity of real money balances, the interest
rate, and income.
– The negative slope of each demand curve
represents the negative relationship between the
interest rate and the quantity demanded of real
money balances.
• Changes in income shift the demand curve for real
money balances.
See
Figure 15.1
8
Figure 15.1: The Demand for Real
Money Balances
i
(Q1 > Q0)
L(Q1, i)
L(Q0, i)
0
Quantity of Real
Money Balances
9
Where Does Money Come From?
• The central bank creates the basis for a country’s
money stock by buying nonmoney assets (such as
government bonds or foreign exchange) from the
public, using checks written by the central bank and
drawn on itself.
• Central-Bank Balance Sheet
– Balance sheet records the assets owned by an organization
as well as its liabilities, or what the organization owes to
others.
– Difference between an organization’s total assets and its
total liabilities equals its net worth.
10
Where Does Money Come From?
• Commercial Bank Balance Sheet
– Commercial banks hold at least three types of
assets:
1. The banks’ reserves (not to be confused with their
foreign reserves).
•
Under the fractional reserve banking system adopted by most
economies, banks can lend funds from their deposits –
required to hold only a fraction of their deposits on hand to
cover withdrawals by customers.
2. Loans
3. Other assets
•
Includes office buildings, real estate, government bonds, etc.
11
Where Does Money Come From?
• Changing the money stock by buying or selling
government bonds.
– Policies by which the central bank does this are
called open market operations.
• A central bank purchase of bonds increases the money
stock.
• Example of deposit expansion: Joe borrows $900 from
bank to buy stereo. Bank credits Joe’s account with
$900. Joe buys the stereo and the $900 moves into the
stereo dealer’s bank account. That bank must hold only
a fraction of the $900 in reserves and can lend out the
rest.
– At end of this process, the money stock will have grown by a
multiple (called the money multiplier).
12
Where Does Money Come From?
• Changing the money stock by buying or selling
foreign exchange.
– Th central bank can obtain exactly the same
effects on the money stock in the FX market as
using government bonds.
• Central bank can buy the excess foreign-currencydenominated assets from the public – it purchases them
with its special check.
– The same deposit expansion process occurs.
– Current money stock (M) equals the money
multiplier (mm) times the government bonds (GB)
and FX reserves (FXR) held by the central bank.
13
Money Market Equilibrium
• Equilibrium in the money market requires that
the real money stock equal the quantity of real
money balances demanded by the public.
– Figure 15.2 illustrates this:
See Figure 15.2
• The equilibrium interest rate is the opportunity cost of
holding money at which individuals willingly hold the
existing stock of real money balances. Increases in
income raise demand for money and increase the
interest rate (panel [a]).
• Increases in the money stock produce a decline in the
interest rate, inducing individuals to hold the new
higher level of real money balances (panel [b]).
14
Figure 15.2: Money Market Equilibrium
(M0/P)
i
i
(M0/P) (M1/P)
(M1 > M0)
(Q1 > Q0 )
i1
i0
i0
i2
i2
L(Q1, i)
L(Q0, i)
0
Quantity of Real 0
Money Balances
(a) Money Market Equilibrium
L(Q0, i)
Quantity of Real
Money Balances
(b) Increase in Money Stock
15
The LM Curve
• LM Curve: the upward-sloping curve in Figure
15.3 (b) shows the combinations of income and
interest at which the money market is in
equilibrium.
– Rise in income increases the demand for money.
For quantity demanded to be reequated with the
fixed stock of money, a rise in interest rate is
necessary.
• Similarly, a rise in interest rate lowers the quantity
demanded of money.
16
The LM Curve
• LM Curve and Fig. 15.3 (cont.)
– With the stock of money fixed, income must rise to
increase the demand for money.
• Therefore, the interest rate and income combinations
are positively related. The curve summarizing this
positive relationship between I and Q is the LM curve,
because at each point on it the quantity demanded of
money (L) equals the money stock (M/P).
– To the right of the LM curve, the quantity demanded of money
exceeds the money stock – to the left of it, the quantity
demanded of money is less than the money stock.
See Figure 15.3
17
Figure 15.3a: The LM Curve Represents
Equilibrium in the Money Market
i
(M 0/P)
(a) Money Market
Equilibrium
(M 0/P) > L(Q 0, i1)
i1
II
(Q 1> Q 0 )
i0
I
(M 0/P) < L(Q 1, i0 )
L(Q1, i)
L(Q 0, i)
0
(M 0/P)
Quantity of Real
Money Balances
18
Figure 15.3b: The LM Curve Represents
Equilibrium in the Money Market
i
LM(M0/P)
(M0/P) > L(Q, i)
(b) LM Curve
i1
i0
(Q0 , i1)
(Q 1, i1)
(Q 0, i0)
(Q1 , i0)
(M0/P) < L(Q, i)
0
Q0
Q1
Q
19
The LM Curve
• Since we assume the price level is fixed, only a
change in the nominal money stock, M, can
cause a change in the real money stock.
– As illustrated in Figure 15.4, increases in the
nominal money stock shift the LM curve to the
right.
• Any given level of income now requires a lower interest
rate for money market equilibrium.
See
Figure
15.4
20
Figure 15.4a: Effects of an Increase in the Real
Money Stock on the LM Curve
i
(M0/P) (M1/P)
i1
i3
i0
i2
(a) Money Market
Equilibrium
(M1 > M0)
II
IV
I
III
L(Q1, i)
L(Q0, i)
0
(M0/P) (M1/P)
Quantity of Real
Money Balances
21
Figure 15.4b: Effects of an Increase in the Real Money
Stock on the LM Curve
i
LM(M0/P)
LM(M1/P)
II
i1
i3
IV
i0
I
i2
III
0
Q0
Q1
Q
(b) LM Curve
22
Banking Crises
• How important are banking problems?
– IMF reports that 130 countries experienced
“significant banking sector problems” between
1980 and 1996 (shown in Figure 15.5).
– Banking crises can impose large costs on an
economy (shown in Figure 15.6).
• The U.S. had costs of $180 billion in 1984-91 to correct
the savings & loan crisis.
See Figures
15.5 & 15.6
23
Figure 15.5: Countries Experiencing Banking Sector
Problems, 1980-1996
Banking Crisis
Significant Banking Problems
No Significant Banking Problems/Insufficient
Information
24
Figure 15.6: Direct Cost to Government of Banking
Crisis (Percent of GDP)
Argentina 1980 –82
Chile 1981 –83
Uruguay 1981 –84
Israel 1977 –83
Côte d'Ivoire 1988 –91
Venezuela 1994 –95
Senegal 1988 –91
Benin 1988 –90
Spain 1977 –85
Mexico 1995
Mauritania 1984 –93
Bulgaria 1995 –96
Tanzania 1987 –93
Hungary 1991 –93
Finland 1991 –93
Brazil 1994 –95
Sweden 1991
Ghana 1982 –89
Sri Lanka 1989 –93
Colombia 1982 –87
Malaysia 1985 –88
Norway 1987 –89
United States 1984–91
Direct Cost of Banking Crisis
(Percent of GDP)
0
10
20
30
40
50
60
25
Banking Crises
• What does it mean for a bank to be
“unsound”?
– Bank can be unsound in one of two ways:
1. Illiquidity occurs when a bank’s assets are sufficient to
cover its liabilities, but there is a time-horizon
mismatch.
– Liabilities are due now, but revenue from the assets are not
available until later.
2. Insolvency: occurs when the value of a bank’s assets is
insufficient to cover the value of its liabilities.
– Net worth is negative.
– Bank must then be “recapitalized,” bailed out by the
government or taxpayers.
26
Banking Crises
• What are some of the main recipes for bankingsystem problems?
–
–
–
–
A run on an individual bank
Economy-wide bank runs
Bad loans
Declines in value of non-loan assets
• Examples: corporate stock, bonds, or real estate.
• Figure 15.7 reports banks’ local real estate holdings in
1997 for economies most affected by financial crisis.
• Figure 15.8 reports declines of Asian stock indices
between mid-1997 and mid-1998.
See Figures 15.7 & 15.8
27
Figure 15.7: Estimates of Asian Banks’ Loans to
Property Sector (% of Total Loans, End of 1997)
Philippines
South Korea
Indonesia
Malaysia
Thailand
Singapore
Hong Kong
0
10 20 30 40 50 60 70 80 90 100
Percent
28
Figure 15.8: Asian Stock Prices, June 30, 1997
to May 8, 1998 (Percent Change)
Singapore
6/30/97–12/31/97
1/1/98–5/8/98
6/30/97–5/8/98
Taiwan
South Korea
Hong Kong
Philippines
Indonesia
Malaysia
Thailand
250
240
230
220
210
0
10
20
29
Banking Crises
• What are some of the main recipes for bankingsystem problems (cont.)?
– Corruption and political favors
• When corruption affects a banking system, the economy’s most
productive firms may have trouble getting loans, which go
instead to the politically well connected.
• Figure 15.9 presents data on corruption in various countries.
– Foreign-exchange problems
• Figure 15.10 indicates the currency movements of several
Asian economies during their recent financial crisis.
See
Figures 15.9 & 15.10
30
Figure 15.9: Corruption Index, 2001
10
Finland
9
8
7
Corruption
Index,
2001
Singapore
Hong Kong
Chile
6
3
2
1
0
United States
Japan
Taiwan
Malaysia
5
4
LEAST CORRUPT
Brazil
Argentina
Philippines
Russia
South Korea
China
Thailand
India
Indonesia
Nigeria
MOST CORRUPT
31
Figure 15.10: Asian Currencies Against the Dollar,
June 30, 1997 to May 8, 1998 (% Change)
Singapore
Taiwan
South Korea
Hong Kong
6/30/97 –12/31/97
1/1/98 – 5/8/98
6/30/97 –5/6/98
Philippines
Indonesia
Malaysia
Thailand
280 270 260 250 240 230 220 210
0
10
20
30
32
Banking Crises
• Why do banks matter so much?
– Answer lies in recognizing the many central roles
that banks play in an economy:
See
Figure
15.11
• Banks allocate capital – they channel savers’ funds to
firms to finance investment projects.
• Banks play key role in economy’s monetary policy –
interact with both central bank and public .
• Strong banks allow country’s policy makers to carry out
the macroeconomic policies needed by rest of economy.
• Banks play major role in financial intermediation
(channeling saving to investors).
– Figure 15.11 reports 1994 figures for several countries.
33
Figure 15.11: Banks’ Share in Total
Financial Intermediation, 1994
Argentina
Brazil
Hong Kong
Venezuela
Indonesia
Mexico
Colombia
Taiwan
India
Japan
Germany
Thailand
Singapore
Malaysia
Chile
South Korea
United States
0
10 20 30 40 50 60 70 80 90 100
Percent
34
Foreign Exchange
• Equilibrium in the foreign exchange
market…again.
– Let CAB denote the current-account balance and
KAB denote the capital-account balance…
• When the sum of the current-account and capitalaccount balances equals zero, the overall balance of
payments is in equilibrium.
– The foreign exchange market is also in equilibrium, since the
quantity demanded of foreign-currency-denominated assets
equals the quantity available:
CAB + KAB = 0 for BOP equilibrium
Also: CAB = -KAB for BOP equilibrium
35
Foreign Exchange
• Figure 15.12 represents graphically this
requirement for equilibrium in the balance of
payments or the foreign exchange market by a
negatively sloped 45-degree line.
– Below and to the left of the line, there is a deficit.
– Above and to the right of the line, the BOP is in
surplus.
See Figure 15.12
36
Figure 15.12: Balance of Payments Equilibrium
Requires that the CAB & KAB Sum to Zero
BOP = 0
+*
(Q
CAB , Q, R)
1
BOP > 0
(Surplus)
2
6
45o
+
KAB i*, i, ee,ef)
3
BOP < 0
(Deficit)
5
(
4
CAB = – KAB
37
Foreign Exchange
• For the remainder of this chapter, we assume
that foreign income, relative prices of domestic
and foreign goods and services, foreign interest
rates, the spot exchange rate, the forward rate,
and the expected future spot exchange rate are
fixed.
– Will examine relationship between domestic
income and interest rate that must hold for
equilibrium in the foreign exchange market.
38
Foreign Exchange
• Figure 15.13 illustrates the effects of domestic
income and interest on the market for foreign
exchange.
– Starting from a point of BOP equilibrium (point I) in panel
(a), an increase in domestic income moves the CAB toward
a deficit, resulting in a BOP deficit at an unchanged interest
rate (point II).
• To cause increased capital inflows with which to offset
the decreased current-account surplus, the interest rate
must rise (point III).
• At point III, the BOP is again in equilibrium, but with a
smaller current-account surplus and capital-account
deficit than at point I.
See Figure 15.13
39
Figure 15.13a: Effects of Domestic Income and Interest
on the Market for Foreign Exchange
_
BOP = 0
I
()
CAB Q
Surplus
CAB(Q0)
III
II
Deficit
KAB(i0)
KAB(i1)
CAB(Q1)
45o
+
KAB(i)
BOP = 0
(a) Balance-of-Payments Equilibrium
40
Foreign Exchange
• The BOP Curve
– The upward-sloping line of Figure 15.13 panel (b).
• Reflects all combinations of income and interest rates
that correspond to BOP (and FX) equilibrium.
• Because increases in income move the CAB toward a
deficit while increases in interest rates move the KAB
toward a surplus, the BOP line is upward sloping.
– Points I and III in panel (b) refer to those combinations of
income and interest resulting in equilibrium points I and III in
panel (a).
41
Figure 15.13b: Effects of Domestic Income and Interest
on the Market for Foreign Exchange
i
(b) BOP Curve
BOP > 0
BOP
III
i1
I
i0
II
BOP < 0
0
Q0
Q1
Q
42
The BOP Curve (cont.)
• Increases in the foreign interest rate, expected
depreciations of the domestic currency, or
increases in the forward rate encourage capital
outflows, moving the KAB toward a deficit.
– An offsetting move toward a surplus in the
current account requires a fall in domestic income
to reduce imports.
• Because a lower level of domestic income is required at
each interest rate, the BOP curve shifts to the left.
– Figure 15.14 summarizes these results.
See Figure 15.14
43
Figure 15.14: Changes in Foreign Income,
Relatives Prices . . . Shift the BOP Curve
i
Decrease in Q*
Increase in R
Increase in *i
Increase in e e or ef
BOP'
BOP
BOP"
Increase in Q *
Decrease in R
Decrease in i *
Decrease in e e or e f
0
Q
44
The BOP Curve (cont.)
• Two special cases: capital mobility and the
BOP curve.
– Figure 15.15 shows how the degree of capital
mobility determines the slope of the BOP curve.
• Perfectly mobile capital means no transactions occur in
the nonofficial capital account in response to changes in
i or i*.
– The BOP includes only the CAB, which equals zero at a single
level of income, Qca, in panel (a).
– Perfectly mobile capital means that small changes in the
interest rate generate large global capital flows, implying a
horizontal BOP curve as in panel (b).
See Figure 15.15
45
Figure 15.15: The Degree of Capital Mobility
Determines the Slope of the BOP Curve
i
i
BOP
(BOP > 0)
A
(BOP < 0)
(BOP > 0)
B
BOP
(BOP < 0)
0
Qca
(a) Perfectly Immobile Capital
Q
0
Q
(b) Perfectly Mobile Capital
46
Bringing It All Together
• Figure 15.16 brings together the IS, LM, and
BOP curves that represent equilibrium in the
markets for goods and services, money, and
foreign exchange, respectively.
– A general equilibrium requires that the three
curves share a common point of intersection.
• At such a point, the markets for goods and services,
money, and FX are all in equilibrium simultaneously at
the given combination of Q, i, and e.
See Figure 15.16
47
Figure 15.16: Combining the IS, LM, and BOP
Curves
i
LM
BOP
IS
0
Q
48
How a Flexible Exchange Rate Regime Works
• Under a perfectly flexible exchange rate
regime, the exchange rate continually adjusts
to keep the BOP in equilibrium and,
equivalently, to keep the quantity demanded of
FX equal to the quantity supplied.
– Figure 15.17 indicates how this happens: the BOP
surplus at point I causes the domestic currency to
appreciate, shifting the BOP and IS curves to the
left.
• Point II represents equilibrium with income equal to Q1,
the interest rate at i1, and the domestic-currency price of
foreign currency at e1.
See Figure 15.17
49
Figure 15.17: Automatic Adjustment from Position of
BOP Surplus under a Flexible Exchange Rate
i
LM
BOP(e1)
I
BOP(e0)
i0
II
i1
(e1< e0)
IS'(e1)
0
Q1
Q0
IS(e0)
Q
50
How a Flexible Exchange Rate Regime
Works
• General observations about this process of
shifting the IS, LM, and BOP curves:
1. A general equilibrium requires a combination of
income, interest rate, and exchange rate such that
all three markets are in equilibrium
simultaneously.
2. Even with prices held fixed, the economy contains
self-adjusting mechanisms for bringing the three
major markets into equilibrium.
3. The model highlights the pitfalls of drawing
conclusions from analysis of only one market.
51
How a Fixed Exchange Rate Regime Works
• Fixed exchange rates and the nominal money
stock.
– Within a fixed exchange rate regime, the central
bank maintains the pegged exchange rate by
intervening to buy any excess supply of foreign
exchange or to sell foreign exchange to cover any
excess demand.
• Such intervening restores FX market equilibrium at the
pegged exchange rate.
52
How a Fixed Exchange Rate Regime Works
• Figure 15.18 shows the effect of intervention
on the money stock under a fixed exchange
rate.
– At the pegged rate, ep, the quantity of foreign
exchange supplied exceeds the quantity demanded.
• To prevent the dollar from appreciating, the U.S. central
bank must buy the excess pounds.
– The purchased pounds are added to the central bank’s foreign
exchange reserves.
– The central bank check with which the pounds are bought
creates the basis for an expansion of the U.S. money stock.
See Figure 15.18
53
Figure 15.18: Effect of Intervention on the Money Stock
under a Fixed Exchange Rate
e = $/£
S£
Intervention
ep
D FXR
D M = mm • D FXR
D£
0
Quantity of
£-Denominated
54
How a Fixed Exchange Rate Regime Works
• Figure 15.19 illustrates the effect of
intervention on money and foreign exchange
markets.
• When the central bank intervenes by buying the excess
supply of foreign-currency-denominated deposits in the
FX market (panel [b]), the domestic money stock rises
(panel [a]).
See
Figure
15.19
– The larger domestic money stock pushes down the equilibrium
interest rate in (a), lowers the rate of return on domesticcurrency deposits, and raises the demand for foreign-currency
deposits in (b).
• The intervention restores interest parity at the original rate
(ep) and a lower domestic interest rate.
55
Figure 15.19a: Effect of Intervention on the Money
Market and Foreign Exchange Rate
i
(M0/P)
(M1/P)
mm D FXR
(a) Money Market
i0
i1
L(Q0,i)
0
Quantity of
Real Money
Balances
56
Figure 15.19b: Effect of Intervention on the Money
Market and Foreign Exchange Rate
e
S£
(b) Foreign Exchange
Market
D FXR
ep
D£(i1, i*, ee, ef )
D£(i0, i*, ee, ef )
0
Quantity of
Pound-Denominated
Deposits
57
How a Fixed Exchange Rate Regime Works
• The money stock and automatic adjustment.
– As long as a BOP surplus exists, the central bank’s
FX market intervention will cause the money stock
to expand, shifting the LM curve to the right (just
the opposite for a BOP deficit).
• These adjustments ensure that the LM curve will move
to the point of intersection with the IS and BOP curves,
resulting in a general equilibrium for the economy.
58
How a Fixed Exchange Rate Regime Works
• The money stock and automatic adjustment
(cont.).
– Figure 15.20 graphically shows how a surplus in
the BOP causes the money stock to rise, shifting
the LM curve to the right.
• The BOP surplus corresponds to an excess supply of FX.
To maintain the pegged exchange rate, the central bank
intervenes and buys FX and adding it to the bank’s
reserves.
– The increase in reserves raises the domestic money stock from
M0 to M1.
See Figure 15.20
59
Figure 15.20: A Surplus in the BOP Causes the Money
Stock to Rise, Shifting LM Curve
i
LM(M 0/P)
LM'(M1/P)
i0
BOP
I
i1
II
IS
0
Q0
Q1
Q
60
How a Fixed Exchange Rate Regime
Works
• Figure 15.21 represents how a deficit in the
BOP causes the money stock to fall, shifting
the LM curve to the left.
– The deficit corresponds to an excess demand for
FX. To maintain the pegged exchange rate, the
central bank must intervene, supplying FX from
its reserves.
• The loss of reserves lowers the domestic money stock
from M0 to M1.
See Figure 15.21
61
Figure 15.21: A Deficit in the BOP Causes the Money
Stock to Fall, Shifting the LM Curve
i
(M1 < M0)
LM' (M1 /P)
BOP
LM (M0/P)
i1
II
I
i0
IS
0
Q1
Q0
Q
62
Note for Case Two: Where the Foreign
Exchange Reserves Are
• Central banks hold foreign reserves in case they
want to intervene in the foreign exchange market.
• Figure 15.22 reports the 6 countries with the largest
reserve holdings, including gold, in 1999.
– Of all foreign exchange held in reserves, dollars make up
about 68% of the total, down from about 80% twenty
years ago.
See
Figure 15.22
63
Figure 15.22: Foreign Exchange Reserves Including
Gold, 1999 ($Billions)
64
Key Terms in Chapter 15
• Money
• Barter
• Nominal money stock
• Real money stock
• Real money balances
• Opportunity cost of holding money
• Fractional reserve banking system
65
Key Terms in Chapter 15
• Deposit expansion
• Money multiplier
• Open market operation
• LM curve
• BOP curve
66