monetary economics literature lecture 5 onwards

Sticky prices

It has often been argued that prices are sticky in the United States. However, the empirical papers that have claimed to support this view have not reflected any formal behavioral theory. This paper presents a theory that justifies price stickiness, namely, that firms, fearing to upset their customers, attribute a cost to price changes. The rational expectations equilibrium of an economy with many such firms is presented, estimated with postwar U.S. data, and tested against alternative hypotheses. The results largely support the model. Furthermore, the hypothesis that prices are not sticky is rejected by U.S. data.

Inflation tax real business cycle model

Money is incorporated into a real business cycle model using a cash-in-advance constraint. The model economy is used to analyze whether the business cycle is different in high inflation and low inflation economies and to analyze the impact of variability in the growth rate of money. In addition, the welfare cost of the inflation tax is measured and the steady-state properties of high and low inflation economies are compared.

Money and interest in a cash in advance economy

In this paper we analyze an aggregate general equilibrium model in which the use of money is motivated by a cash-in-advance constraint, applied to purchases of a subset of consumption goods. The system is subject to both real and monetary shocks, which are economy-wide and observed by all. We develop methods for verifying the existence of, characterizing, and explicitly calculating equilibria

Money and asset prices in a cash in advance society

An asset-pricing model with money introduced via a cash-in-advance constraint is presented. The monetary velocity is variable; hence money demand does not obey the trivial quantity equation. The effects of disturbances in output and money growth on real balances, the price level, and interest rates are examined. Monetary policy has effects on real asset prices. The Fisher relation and the premium on nominal bonds are discussed. The precise role of the timing of information and transactions for properties of price levels and interest rates are clarified

Monopolistic competition and optimum product diversity

Monopolistic Competition and Optimum Product Diversity By AVINASH K. DIXIT AND JOSEPH E. STIGLITZ* The basic issue concerning production in welfare economics is whether a market solution will yield the socially optimum kinds and quantities of commodities. It is well known that problems can arise for three broad reasons: distributive justice; external effects; and scale economies. This paper is concerned with the last of these. The basic principle is easily stated.' A commodity should be produced if the costs can be covered by the sum of revenues and a properly defined measure of consumer's surplus. The optimum amount is then found by equating the demand price and the marginal cost. Such an optimum can be realized in a market if perfectly discriminatory pricing is possible. Otherwise we face conflicting problems. A competitive market fulfilling the marginal condition would be unsustainable because total profits would be negative. An element of monopoly would allow positive profits, but would violate the marginal condition.2 Thus we expect a market solution to be suboptimal. However, a much more precise structure must be put on the problem if we are to understand the nature of the bias involved. It is useful to think of the question as one of quantity versus diversity. With scale economies, resources can be saved by producing fewer goods and larger quantities of each. However, this leaves less variety, which entails some welfare loss. It is easy and probably not too unrealistic to model scale economies by supposing that each potential commodity involves some fixed set-up cost and has a constant marginal cost. Modeling the desirability of variety has been thought to be difficult, and several indirect approaches have been adopted. The Hotelling spatial model, Lancaster's product characteristics approach, and the mean-variance portfolio selection model have all been put to use.3 These lead to results involving transport costs or correlations among commodities or securities, and are hard to interpret in general terms. We therefore take a direct route, noting that the convexity of indifference surfaces of a conventional utility function defined over the quantities of all potential commodities already embodies the desirability of variety. Thus, a consumer who is indifferent between the quantities (1,0) and (0,1) of two commodities prefers the mix (1/2,1/2) to either extreme. The advantage of this view is that the results involve the familiar ownand cross-elasticities of demand functions, and are therefore easier to comprehend. There is one case of particular interest on which we concentrate. This is where potential commodities in a group or sector or industry are good substitutes among themselves, but poor substitutes for the other commodities in the economy. Then we are led to examining the market solution in relation to an optimum, both as regards biases within the group, and between the group and the rest of the economy. We expect the answer to depend on the intra- and intersector elasticities of substitution. To demonstrate the point as simply as possible, we shall aggregate the rest of the economy into one good labeled 0, chosen as the numeraire. The economy's endowment of it is normalized at unity; it can be thought of as the time at the disposal of the consumers.

Central bank balance sheets

The central bank’s balance sheet plays a critical role in the functioning of the economy. The main liabilities of the central bank (banknotes and commercial bank reserves) form the ultimate means of settlement for all transactions in the economy. Despite this critical role the central bank’s balance sheet remains an arcane concept to many observers. Recently, the huge increases in many central bank’s balance sheets, as a result of responses to the global financial crisis and the implementation of unconventional monetary policy, has led to renewed interest, although misconceptions remain regarding their structure and many of their main components. Although most central banks have moved from quantitative targets for monetary policy operations to price targets, where the domestic interest rate and/or the exchange rate are the operational target for monetary policy, the central bank’s balance sheet remains the best place to understand policy implementation. Central banks control the price of money by adjusting the terms and availability of their liabilities. The availability of liabilities is influenced both by changes in the remaining components on the balance sheet and by how the central bank chooses to respond through its operations. Therefore an understanding of the whole balance sheet is required to fully understand central bank policy actions. An understanding of the structure of the central bank’s balance sheet can provide significant insights into the goals that the central bank is attempting to achieve, be it as an inflation targeter, an exchange rate targeter or if the central bank is responding to a financial crisis. Changes in the balance sheet through time can also reveal how successful the central bank has been in achieving its goals and how sustainable its current policy objectives are.

Introduction As noted by Bindseil (2004a), ‘whenever a central bank transacts with the rest of the world — that is when it issues currency, conducts foreign exchange operations, invests its own funds, engages in emergency liquidity assistance, and, last but not least conducts monetary policy operations — all of these operations affect its balance sheet’. Therefore the balance sheet of the central bank is critical to everything the central bank does. Despite this, as many central banks moved away from pursuing quantitative targets of monetary policy towards price targets, interest in the central bank’s balance sheet waned in many economies and the literature too. Despite some renewed interest in the central bank’s balance sheet during the global financial crisis, the format and evolution of the central bank balance sheet is still unappreciated by many observers. The differences between the form and the frequency of publication of balance sheets by central banks around the world do little to dispel this mystique. Nonetheless, the structure and evolution of a central bank’s balance sheet remains a crucial tool in understanding the policy goals that the central bank is aiming to achieve and its effectiveness in doing so. The primary purpose of this handbook is to provide a framework for understanding a central bank’s balance sheet. Section 1 introduces the critical role that the central bank plays in the wider economy, in particular how its liabilities provide the ultimate means of settlement for transactions. Section 2 looks at how the central bank’s balance sheet became an arcane concept in many economies and how the financial crisis revived interest. Section 3 reviews the main components of the central bank’s balance sheet. Section 4 examines how the components evolve over time and how the evolution of the central bank’s balance sheet can provide insights into the effectiveness of the central bank in achieving its goals. Finally Section 5 looks at how the structure of the central bank’s balance sheet affects its income flow and discusses how important a positive capital level is for a central bank to achieve its policy goals. 1 Role of the central bank balance sheet Ultimate means of settlement To understand the role that the central bank’s balance sheet plays in an economy it is important to understand the role of money. The central bank’s balance sheet is important as its main liabilities — banknotes and commercial bank reserves — are both a form of money in a modern economy and in fact underpin nearly all other forms of money. As noted by McLeay, Radia and Thomas (2014a) money is a form of IOU which allows agents to settle transactions. Ultimately anything can be used as a means of transaction between two agents in an economy if both are willing and able to agree to the transaction. Money, however, is special as it a means of transaction between agents that does not require them to necessarily trust each other. Agents should always be willing to accept money, as both a store of value and a unit of account, as long as they trust the issuer of such money. The central bank’s balance sheet plays a vital role in providing the trust that underpins most forms of money in an economy. For those transactions that settle in banknotes it is fairly easy to see the role of the central bank. In many countries, by law the central bank is the only issuer of banknotes.(1) Hence all transactions that settle using banknotes are done so because agents trust the value of banknotes. That is they trust the central bank to maintain and honour the value of banknotes. While banknotes play an important transactional role, in most economies they do not make up the majority of money by value. Instead commercial bank deposits form the majority of money by value. These are balances held by economic agents at commercial banks. These balances can be transferred electronically between agents as means of settlement. While this may suggest that people’s confidence in this form of money depends on their trust in the commercial bank where they hold the deposit, the central bank balance sheet is still vital in underpinning such money for reasons explained later. In most cases balances held in commercial banks are exchangeable on demand for banknotes; this guarantee of direct convertibility into a form of central bank liability provides some degree of trust in the value of such money. More pertinently commercial banks will often need to settle

 Brunnermeier Euro Crisis

The macroeconomic crises of the past twenty years have been predominantly macrofinancial crises. Both the 2001-02 and the 2007-09 U.S. recessions started with shocks to domestic financial markets, while crises in emerging markets, from Argentina to Turkey, typically had sudden stops of capital flows and changes in sovereign yields. Unsurprisingly, new economic concepts have been developed to understand these crises. These ideas are familiar to researchers, but they have not yet seeped through to textbooks. As a result, policymakers and students often have some vague familiarity with several of these models but lack an understanding of how they precisely work, how they can be applied, and how they fit together. The goal of this paper is to introduce these ideas at the intersection of macroeconomics and finance. Together they provide a richer, and more accurate, account of past and future macro-financial crises. We apply the concepts to the euro crisis of 2010-12. It serves this role well for a few reasons. First, because it features both a deep banking sector and large capital flows, two defining features of crises in developed and developing countries, respectively. Second, analyses of the euro crisis using traditional concepts, like optimal currency areas, downward rigid wages, or fiscal multipliers are already well-covered in textbooks. Applying the modern concepts to the euro crisis makes clear what traditional accounts are missing.1 Third, avoiding a new crisis in the euro area is a priority, but institutional reforms have been slow and remain incomplete. Building a good understanding of what was behind the crisis in the first place can help guide the efforts to prevent another crisis. With these goals in mind, this paper neither covers traditional ideas that are already well-covered in the textbooks, nor provides a full historical account of the sequence of events of the euro crisis.2 Instead, each section introduces one important concept in macro-finance aided by one novel diagram, and then applies this concept to a stage in the euro crisis illustrated with one new figure with data. Each section is mostly self contained, and assumes familiarity only with economics at the intermediate level. It pedagogically illustrates economic concepts rather than present them in their generality. Alternative ways to present the material are to either skip the euro crisis applications, for a more theoretical primer on the ingredients of macro-financial crises, or instead to put the euro crisis application together for a full and uninterrupted account of those events