The need for money arises from uncertainty in exchange. In a world without perfect information, transactors face risks, particularly the risk of default from the counterparty. Money, as a universally accepted asset with a known value, eliminates the need for personal information about the credit standing of the purchaser. It solves the problem of a lack of trust between strangers, allowing for efficient, impersonal exchange.
Source: Goodhart (1989), pp. 27-29
A 'means of payment' (e.g., fiat currency) finalizes a transaction, leaving the seller with no further claim on the buyer. A 'medium of exchange' is a broader term for any asset or claim that allows a sale to proceed but does not necessarily represent final payment (e.g., trade credit). When a seller accepts a medium of exchange that is not a means of payment, they still hold a claim for future payment.
Source: Goodhart (1989), p. 26
Source: EC3115 - Ch 3 Demand for money-1.pdf, p. 31
The model frames the demand for money as an inventory management problem. The individual must balance two costs:
1. The opportunity cost of holding money, which is the interest income foregone by not holding interest-bearing assets (bonds).
2. The transaction cost (or 'brokerage fee') of converting bonds into money.
Holding more money reduces transaction costs (fewer trips to the bank) but increases foregone interest, and vice versa.
Source: Laidler (1993), p. 76
The model's key result is that the demand for real money balances is proportional to the square root of the volume of real transactions (income) and inversely proportional to the square root of the nominal interest rate. The formula is:
\( M^d = \sqrt{\frac{2bT}{i}} \)
This implies an income elasticity of +0.5 and an interest rate elasticity of -0.5, indicating economies of scale in money holding.
Source: Laidler (1993), p. 77
Keynes assumed that individuals held their expectations about future interest rate movements with certainty. Given this, an individual would compare the current interest rate to their expected 'normal' rate. If they expected rates to rise (bond prices to fall), they would hold 100% of their speculative balances in money. If they expected rates to fall (bond prices to rise), they would hold 100% in bonds. They would 'plunge' for all money or all bonds, which contradicts the observation that people hold diversified portfolios.
Source: EC3115 - Ch 3 Demand for money-1.pdf, p. 35
Tobin replaced Keynes's assumption of certain expectations with the idea that investors are uncertain about future capital gains or losses on bonds. He posited that investors are generally risk-averse. They dislike risk (variance of return) but like expected return. Money is a safe asset (zero risk, zero return), while bonds are a risky asset (positive expected return, positive risk). A risk-averse investor will choose to hold a diversified portfolio of both money and bonds to achieve their optimal trade-off between risk and return, thus avoiding the 'plunger' outcome.
Source: Laidler (1993), p. 89
The liquidity trap is a situation, hypothesized by Keynes, where at a very low level of interest rates, the demand for money becomes perfectly elastic. At this point, everyone expects interest rates to rise, so nobody is willing to hold bonds due to the fear of capital losses. The central bank's attempts to increase the money supply are simply absorbed into idle cash balances, without any further decrease in interest rates, rendering monetary policy ineffective.
Source: Laidler (1993), p. 67
Starting around 1974, previously stable and reliable econometric models of the demand for M1 in the United States began to consistently and significantly over-predict the amount of money people were actually holding. For any given level of income and interest rates, the public was holding less money than the models predicted. This discrepancy was famously dubbed 'the case of the missing money' by Stephen Goldfeld.
Source: Mizen (2000), p. 281; Goldfeld (1976)
The leading explanation is that the high inflation and high interest rates of the 1970s created a powerful incentive for firms and households to economize on non-interest-bearing M1 balances. This spurred a wave of financial innovation, including new cash management techniques, money market mutual funds, and sweep accounts, which allowed the public to conduct their transactions with lower average M1 holdings. The old models, based on data from before these innovations, failed to capture this structural shift.
Source: Mizen (2000), p. 281; EC3115 - Ch 3 Demand for money-1.pdf, p. 39
This approach views money balances as a buffer to absorb unexpected shocks to income and expenditure. It posits that individuals and firms do not continuously adjust their money holdings to their long-run desired level. Instead, they allow balances to fluctuate within a certain range. Only when a shock pushes balances outside this range is an adjustment made. This allows for temporary, rational disequilibrium in money holdings.
Source: Mizen (2000), p. 282
The key difference is the treatment of cash flows.
• Baumol-Tobin assumes a perfectly predictable, steady stream of expenditures. It is a model of transactions demand under certainty.
• Miller-Orr assumes that net cash flows are stochastic and follow a random walk (unpredictable). It is a model of precautionary demand under uncertainty. It uses control limits (upper and lower bounds) to trigger transfers.
Source: Laidler (1993), pp. 58, 76
This assumption means that the demand for money is a demand for real purchasing power. If all prices and nominal incomes double, the demand for nominal money balances should also double, leaving the demand for real money balances unchanged. It implies that individuals are rational and do not suffer from 'money illusion' (i.e., they do not mistake a nominal change for a real change).
Source: Laidler (1993), p. 89
The Lucas Critique (1976) is the argument that econometric models estimated under a specific policy regime will become unreliable for forecasting if the policy regime changes. This is because rational agents will change their expectations and behavior in response to the new policy. This was highly relevant to the breakdown of money demand functions in the 1970s, as it suggested that the shift in monetary policy focus may have contributed to the instability of the previously observed relationships.
Source: Goodhart (1989), p. 25
"Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes." In the context of monetary policy, this means that as soon as a central bank tries to exploit a stable relationship (like that between M1 and GDP) by targeting the monetary aggregate, the relationship itself is likely to break down as banks and the public find ways to circumvent the control.
Source: Goodhart (1989), p. 76
This refers to the explicit interest paid on assets that are included in a given definition of money. Historically, for M1 (currency and checking deposits), this rate was zero. However, financial deregulation since the 1980s has led to the widespread introduction of interest-bearing checking accounts (e.g., NOW accounts). The opportunity cost of holding money is therefore more accurately measured as the difference between the yield on an alternative asset and this 'own rate'.
Source: Mizen (2000), p. 267
A Divisia aggregate is a sophisticated index of the money supply. Instead of simply summing its components (like M1 = currency + demand deposits), it weights each component asset based on its 'moneyness' or liquidity. The weight is derived from the asset's 'user cost'—the opportunity cost of holding it. Assets with lower opportunity costs (i.e., more liquid assets) receive a higher weight. This approach is designed to provide a more accurate measure of the economy's monetary services, especially during periods of financial innovation.
Source: Mizen (2000), p. 307
An Error Correction Model is an econometric specification used for time series that are cointegrated (i.e., share a long-run equilibrium relationship). The model describes the short-run dynamics of a variable as it adjusts towards this long-run equilibrium. It includes an 'error correction term', which is the lagged deviation from the long-run equilibrium, to explain how past disequilibria influence the current period's change in the variable.
Source: Mizen (2000), p. 294
In Tobin's model, as the interest rate rises, the slope of the budget constraint (the risk-return trade-off line) steepens. For a risk-averse investor with standard convex indifference curves, this leads to a substitution towards the now more attractive risky asset (bonds) and away from the safe asset (money). However, the shape of the indifference curves determines the extent of this substitution. The relationship is generally non-linear because the marginal rate of substitution between risk and return changes as the investor moves to higher levels of utility.
Source: Laidler (1993), pp. 92-93
The user cost of a monetary asset \(i\) is its opportunity cost in terms of foregone interest. It is calculated as the difference between the rate of return on a benchmark asset (\(R_b\)) and the own rate of return on the monetary asset itself (\(R_i\)). The benchmark asset is typically a high-yield asset assumed to provide no liquidity services. The formula is:
\( \pi_i = R_b - R_i \)
This user cost is the key to determining the weights in a Divisia index.
Source: Mizen (2000), p. 309
Seigniorage is the profit a government makes by issuing currency. It is the difference between the face value of a coin or note and its cost of production. For fiat money, where the production cost is very low, seigniorage can be a significant source of revenue. The ability to earn seigniorage gives the state a monopoly over the issuance of fiat currency.
Source: Goodhart (1989), p. 24
In its simplest form, the quantity theory of money, as expressed in the equation of exchange \(MV = PT\), posits that if the velocity of circulation (V) and the volume of transactions (T) are stable, then the price level (P) is directly proportional to the quantity of money (M). An increase in the money supply leads to a proportional increase in the price level.
Source: Laidler (1993), p. 56
The main criticism is that Fisher's approach is too mechanical. It focuses on the technological requirements of the payments system, treating the demand for money as something individuals *have to* hold. It largely ignores the element of individual choice, opportunity cost, and the influence of wealth and interest rates on the decision of how much money to *want to* hold, which is the focus of the Cambridge approach.
Source: Laidler (1993), p. 60
Economies of scale in money holding mean that as an individual's or firm's income (and thus transaction volume) increases, their demand for money increases by a less-than-proportional amount. For example, if income doubles, money demand less than doubles. This is a key prediction of the Baumol-Tobin model, which yields an income elasticity of 0.5.
Source: Laidler (1993), p. 80
The precautionary motive arises directly from uncertainty about the timing and size of future payments and receipts. Individuals hold a buffer of money, beyond their planned transaction needs, to cover unexpected emergencies (e.g., a medical bill) or unforeseen opportunities. The amount held depends on the degree of uncertainty and the cost of being caught without sufficient liquid funds.
Source: Laidler (1993), p. 81
In the Miller-Orr model, the optimal cash balance is a positive function of the variance of net cash flows. A higher variance (\(\sigma^2\)) means cash balances are more volatile and more likely to hit the upper or lower control limits. To minimize the frequency of costly transfers, the firm will widen the gap between the limits, which results in a higher average cash balance.
Source: Laidler (1993), p. 59
The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk (standard deviation). A rational, risk-averse investor will only choose a portfolio that lies on the efficient frontier, as any portfolio below the frontier is 'inefficient'—it is possible to get a higher return for the same risk, or the same return for less risk.
Source: Laidler (1993), p. 73
The interest elasticity depends on the degree of substitution between money and the alternative asset. It is often argued that short-term assets are closer substitutes for money than long-term assets. Therefore, a change in the short-term interest rate should provoke a larger shift in money holdings, implying a higher interest elasticity for short-term rates. Empirical results, however, have sometimes contradicted this.
Source: Mizen (2000), p. 277
A spurious regression occurs when a statistical relationship with a high R-squared and significant coefficients is found between two or more unrelated non-stationary time series. The relationship is not based on any underlying economic connection but is an artifact of the fact that both series have a stochastic trend (i.e., they are random walks). Cointegration analysis was developed to distinguish true long-run relationships from spurious ones.
Source: Mizen (2000), p. 291
The partial adjustment model assumes that due to adjustment costs, actual money balances (\(m_t\)) do not adjust immediately to the desired level (\(m^*_t\)). Instead, the change in money holdings in a period closes only a fraction (\(\theta\)) of the gap between the desired level and the previous period's actual level. The model is: \( \Delta m_t = \theta(m^*_t - m_{t-1}) \).
Source: Mizen (2000), p. 271
Risk aversion is the central behavioral assumption in Tobin's model. It means that individuals prefer less risk to more, for a given level of expected return. This is what drives them to hold a diversified portfolio. They are willing to sacrifice some potential return by holding the safe asset (money) in order to reduce the overall risk of their portfolio.
Source: Laidler (1993), p. 89
Transactions velocity (Fisher's \(V_T\)) is the total volume of all transactions in an economy (including intermediate and financial transactions) divided by the money stock. Income velocity (Cambridge's \(V_Y\)) is the level of nominal final income (GDP) divided by the money stock. Since the total volume of all transactions is much larger than GDP, \(V_T\) is always greater than \(V_Y\).
Source: Laidler (1993), p. 62
Disintermediation is the process of funds flowing out of financial intermediaries (like banks) and into direct financial markets. This often occurs when regulations, such as interest rate ceilings on deposits, prevent intermediaries from offering competitive rates, prompting savers to invest directly in market securities (like commercial paper or Treasury bills) to earn a higher return.
Source: General Knowledge
The model shows that as income (T) increases, the optimal amount of cash to withdraw (Z) increases only by the square root of the increase in T. Since average cash holdings are Z/2, money demand rises by less than the proportional increase in income. A firm or person with twice the income does not need to hold twice the money, because the fixed cost of transfers can be spread over larger withdrawals.
Source: Laidler (1993), p. 80
CAPM is a theory that describes the relationship between systematic risk and expected return for assets. It states that the expected return on an asset is equal to the risk-free rate plus a risk premium. This premium is determined by the asset's 'beta' (\(\beta\))—a measure of its volatility relative to the overall market—and the market risk premium (the expected market return minus the risk-free rate).
Source: Laidler (1993), p. 74
If the brokerage fee (b) is interpreted as the time and trouble of making a transfer, its value is related to the opportunity cost of that time, which is the wage rate. A higher wage rate means a higher brokerage fee. According to the Baumol-Tobin formula \( M^d = \sqrt{2bT/i} \), a higher 'b' leads to a higher demand for money, as individuals make fewer, larger withdrawals to economize on the now more costly transfers.
Source: Laidler (1993), p. 79
A unit root is a feature of a stochastic process that makes it non-stationary. A time series with a unit root will have a time-dependent mean and its variance will grow over time. Such a series is often described as a 'random walk'. Standard regression analysis is not valid with unit root processes unless they are cointegrated.
Source: Mizen (2000), p. 292
Proposed by Milton Friedman, this hypothesis states that an individual's consumption decisions are based not on their current income, but on their long-term expected or 'permanent' income. In the context of money demand, Friedman argued that money, as an asset, should also be a function of this permanent income concept, which serves as a proxy for wealth.
Source: Laidler (1993), p. 69
Flow disequilibrium models reverse the causality of the standard model, assuming money is exogenous and another variable (like prices or interest rates) adjusts. Shock-absorber models, like Carr and Darby's, retain the standard causality but add a 'surprise' term. They argue that unexpected money supply shocks push real balances off the demand curve temporarily, with these balances acting as a shock-absorber.
Source: Mizen (2000), pp. 284, 286
Separability is a property of a utility function that allows for two-stage decision making. Weak separability of monetary assets means that the consumer's choice about the composition of their monetary portfolio can be analyzed independently of their choices about consumption and leisure. It is a necessary condition for aggregating a group of assets into a single monetary aggregate like a Divisia index.
Source: Mizen (2000), p. 309
In the Cambridge cash-balance approach to the quantity theory, the demand for money is expressed as \( M^d = kPY \). Here, 'k' represents the fraction of nominal income (PY) that the public desires to hold in the form of money balances. Unlike Fisher's V, 'k' is a behavioral parameter reflecting individual choice, influenced by factors like interest rates and wealth.
Source: Laidler (1993), p. 61
The equation of exchange is an accounting identity, \( MV = PT \), stating that the total value of money spent in an economy must equal the total value of transactions.
• \(M\) is the money supply.
• \(V\) is the transactions velocity of circulation.
• \(P\) is the average price level.
• \(T\) is the total volume of transactions.
The quantity theory of money turns this identity into a theory by making behavioral assumptions about V and T.
Source: Laidler (1993), p. 56
When the interest rate on alternative assets (like bonds) rises, the opportunity cost of holding money increases. The substitution effect is the incentive for individuals to substitute away from the now relatively more expensive good (holding money) and towards the now relatively more rewarding good (holding bonds). This effect always implies that a higher interest rate leads to lower money demand.
Source: Laidler (1993), p. 95
When the interest rate rises, the price of existing bonds falls, reducing the wealth of bondholders. The wealth effect is the change in the demand for money resulting from this change in wealth. If money is a normal good (demand increases with wealth), this effect will cause money demand to fall as wealth falls. This effect reinforces the substitution effect for existing bondholders.
Source: Laidler (1993), p. 95
Goldfeld (1973) and others found it difficult for several reasons:
1. Data Quality: Poor quality of data allocating money holdings between the household and business sectors.
2. Compensating Balances: The practice of holding deposits as informal payment for bank services complicates the relationship.
3. Complex Cash Management: Large firms use sophisticated cash management techniques not captured by simple models.
4. Scale Variable: Simple income or sales variables may not adequately capture the complex transaction needs of firms.
Source: Goldfeld (1973), p. 629; Duesenberry in Goldfeld (1973), p. 639
Two or more time series are said to be cointegrated if they share a common stochastic trend. Individually, they may be non-stationary (e.g., random walks), but a linear combination of them is stationary. This implies the existence of a stable, long-run equilibrium relationship between the variables. Finding cointegration between money, income, and interest rates is a modern way of testing for a stable long-run money demand function.
Source: Mizen (2000), p. 293
The random walk hypothesis suggests that stock market prices evolve according to a random walk and thus are unpredictable. In its weak form, it states that future prices cannot be predicted by analyzing past prices. This is a core tenet of the efficient-market hypothesis, which posits that all available information is already reflected in current prices.
Source: General Knowledge
A stock variable is measured at a specific point in time. Examples include wealth, the money supply, or the capital stock.
A flow variable is measured over a period of time. Examples include income, consumption, or investment.
Relating a stock (like money) to a flow (like income) is a common practice in money demand studies, but it raises theoretical questions.
Source: Mizen (2000), p. 266
The Almon lag is an econometric technique used to estimate distributed lag models. It assumes that the lag coefficients can be approximated by a polynomial of a certain degree. This reduces the number of parameters to be estimated and can help overcome multicollinearity problems that often arise when including many lagged variables in a regression.
Source: Goldfeld (1973), p. 603
The Cochrane-Orcutt procedure is an iterative econometric method used to estimate a linear regression model that has serially correlated errors. It transforms the model so that the error terms of the transformed equation are uncorrelated, allowing for more efficient estimation of the regression coefficients.
Source: Goldfeld (1973), p. 582
Money illusion is the tendency of people to think of currency in nominal, rather than real, terms. An individual suffering from money illusion would feel richer if their nominal income doubled, even if the price level also doubled, leaving their real purchasing power unchanged. Economic theory generally assumes rational agents are free from money illusion.
Source: Laidler (1993), p. 89
The opportunity set represents all possible combinations of risk and expected return that an investor can achieve by forming portfolios from the available assets. In a simple two-asset (money and bonds) model, it is a straight line connecting the risk-return points of the two assets. With multiple risky assets, it is a region, the upper edge of which is the efficient frontier.
Source: Laidler (1993), p. 73
The rational expectations hypothesis assumes that individuals and firms form their expectations about the future by using all available information in the best possible way. Their expectations are, on average, correct and they do not make systematic errors. This has profound implications for policy, suggesting that predictable policy changes may have no real effect, as they will be fully anticipated by the public (policy ineffectiveness proposition).
Source: Goodhart (1989), p. 86
Gresham's Law is a monetary principle stating that if two forms of commodity money are in circulation and one is officially overvalued relative to the other, the overvalued money ("bad money") will tend to drive the undervalued money ("good money") out of circulation. People will hoard the "good" money and pass on the "bad" money in transactions.
Source: Goodhart (1989), p. 35
The real balance effect (or Pigou effect) describes how a change in the price level affects consumption through its impact on the real value of money holdings. A fall in the price level increases the real value of money, making people feel wealthier and thus stimulating them to increase their consumption spending. This can help stabilize the economy by boosting aggregate demand during a deflation.
Source: General Knowledge
A Negotiable Order of Withdrawal (NOW) account is a type of deposit account that pays interest and allows the depositor to write drafts (checks) against the balance. The introduction of NOW accounts in the US in the 1970s and 80s was a major financial innovation that blurred the line between M1 (transaction balances) and M2 (savings balances) and contributed to the instability of the M1 demand function.
Source: Mizen (2000), p. 88
The term structure of interest rates, often visualized as the yield curve, is the relationship between the interest rates or bond yields and their different terms to maturity. A normal yield curve is upward sloping, meaning longer-term bonds have a higher yield than shorter-term bonds. The shape of the yield curve is thought to reflect expectations of future interest rates and inflation.
Source: General Knowledge
Systematic risk, also known as market risk, is the risk inherent to the entire market or market segment. It is undiversifiable, meaning it cannot be eliminated by holding a diversified portfolio of assets. It is the risk that remains after diversification has eliminated all company-specific (unsystematic) risk. Beta (\(\beta\)) is a measure of an asset's systematic risk.
Source: Laidler (1993), p. 72
Unsystematic risk, also known as specific risk or idiosyncratic risk, is the risk that is unique to a specific company or industry. It can be reduced or eliminated through diversification. Examples include a strike at a company, a new patent, or a regulatory change affecting a single industry. In a well-diversified portfolio, unsystematic risk is negligible.
Source: General Knowledge
Associated with Thomas Sargent and Neil Wallace, this proposition, based on the theory of rational expectations, argues that systematic and predictable monetary policy actions will have no effect on real variables like output and employment. This is because rational agents will fully anticipate the policy's effects on prices and wages and adjust their behavior accordingly, neutralizing any real impact.
Source: General Knowledge
A sweep account is a cash management tool where funds are automatically transferred, or 'swept', overnight from a non-interest-bearing checking account into an interest-bearing investment vehicle (like a money market fund). This allows firms and individuals to earn interest on their idle cash while maintaining liquidity for transactions. The growth of sweep accounts was a major financial innovation that reduced the demand for M1.
Source: Mizen (2000), p. 298
The Chow test is a statistical test used in econometrics to determine whether the coefficients in a regression model are stable across different subsamples of the data. It is commonly used to test for a 'structural break' in a relationship at a particular point in time. Goldfeld used it to test for the stability of the money demand function before and after 1961.
Source: Goldfeld (1973), p. 592
Multicollinearity is a problem in regression analysis where two or more independent variables are highly correlated with each other. This makes it difficult or impossible to distinguish their individual effects on the dependent variable. It leads to unstable and unreliable estimates of the regression coefficients, with large standard errors.
Source: General Knowledge
The Fisher effect, derived from the Fisher equation (\(i = r + \pi^e\)), is the proposition that the nominal interest rate (i) adjusts one-for-one with changes in the expected inflation rate (\(\pi^e\)). If expected inflation rises by 1 percentage point, the nominal interest rate should also rise by 1 percentage point, leaving the real interest rate (r) unchanged.
Source: General Knowledge
Regulation Q was a US federal regulation that, among other things, prohibited banks from paying interest on demand deposits and imposed interest rate ceilings on other types of deposits. It was a major driver of financial innovation, as high market interest rates created incentives for banks and customers to find ways around these restrictions. It was phased out in the 1980s.
Source: Laidler (1993), p. 89
The transmission mechanism describes the channels through which monetary policy actions (like changing the policy interest rate or the money supply) affect the broader economy, particularly aggregate demand, output, and inflation. Key channels include the interest rate channel, the exchange rate channel, the credit channel, and the asset price channel.
Source: General Knowledge
The time inconsistency problem arises when a central bank has an incentive to deviate from its announced policy in the future. For example, a central bank might announce a zero-inflation policy to lower inflation expectations, but then be tempted to create surprise inflation later to boost output. Rational agents will anticipate this temptation, making the initial announcement not credible.
Source: Goodhart (1989), p. 46
Securitization is the financial practice of pooling various types of contractual debt (such as mortgages, auto loans, or credit card debt) and selling their related cash flows to third-party investors as securities. This process transforms illiquid assets into liquid, tradable securities, and is a major form of financial innovation.
Source: Mizen (2000), p. 302
The credit channel is a component of the monetary transmission mechanism that works through the supply of bank loans. A contractionary monetary policy, for example, can reduce banks' reserves and their ability to lend. This reduction in credit supply can have a direct impact on investment and consumption, especially for bank-dependent borrowers, amplifying the effect of the policy.
Source: General Knowledge
Hyperinflation is a very high and typically accelerating rate of inflation. A common rule of thumb, proposed by Phillip Cagan, is a monthly inflation rate exceeding 50%. It is often caused by a rapid and massive increase in the money supply not supported by corresponding growth in real output, usually when a government prints money to finance its expenditures.
Source: Goodhart (1989), p. 36
The principle of long-run neutrality of money states that a change in the stock of money affects only nominal variables (like prices, wages, and exchange rates) but has no long-run effect on real variables (like real GDP, employment, and real interest rates). While monetary policy can have short-run real effects, in the long run, the economy's productive capacity is determined by real factors like technology and capital.
Source: General Knowledge
The Taylor Principle states that for a central bank to stabilize inflation, it must raise the nominal interest rate by more than one-for-one in response to an increase in the inflation rate. This ensures that the real interest rate (nominal rate minus inflation) rises, which cools down the economy and brings inflation back to target. It is a key feature of the Taylor Rule.
Source: Mizen (2000), p. 248
Financial repression refers to government policies that divert funds to themselves that would otherwise go elsewhere. This can include measures like interest rate ceilings, high reserve requirements, and capital controls. These policies effectively create a captive source of demand for government debt and allow the government to finance its borrowing at a low cost.
Source: General Knowledge
The EMH asserts that financial markets are 'informationally efficient'. This means that asset prices fully reflect all available information. As a result, it is impossible to consistently 'beat the market' by using any information that the market already knows. The hypothesis comes in three forms: weak (past prices), semi-strong (public information), and strong (public and private information).
Source: Goodhart (1989), p. 86
Moral hazard is a situation where one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. In finance, deposit insurance can create moral hazard, as it may encourage banks to take on excessive risk, knowing that their depositors are protected by the government if the bank fails.
Source: General Knowledge
Adverse selection is a problem that arises from asymmetric information before a transaction occurs. It happens when sellers have information that buyers do not (or vice versa). For example, in the loan market, the borrowers with the highest risk are the most likely to seek loans, creating an 'adverse selection' of borrowers for the lender.
Source: General Knowledge
This approach analyzes the change in the money supply (a liability of the banking system) by looking at the changes in the assets on the other side of the banking sector's balance sheet. It decomposes the change in money into its counterparts, such as bank lending to the public sector, bank lending to the private sector, and changes in net foreign assets. This is used to understand the sources of money growth.
Source: Goodhart (1989), p. 81
The theory of endogenous money posits that the money supply is not exogenously controlled by the central bank, but is instead determined by the demand for credit from the economy. In this view, banks first make loans to creditworthy borrowers and then find the necessary reserves to support those loans. The money supply is therefore 'demand-determined'.
Source: General Knowledge
The theory of exogenous money posits that the central bank has direct control over the monetary base (currency plus reserves) and can, through the money multiplier, determine the overall money supply independently of the demand for it. In this view, the money supply is a policy variable set by the central bank.
Source: General Knowledge
The money multiplier is the ratio of the money supply (e.g., M1) to the monetary base (high-powered money). It describes the maximum amount of money that the banking system can create for a given unit of central bank money. Its size is determined by the public's currency-deposit ratio and the banking system's reserve-deposit ratio.
Source: General Knowledge
Quantitative easing is a form of unconventional monetary policy where a central bank purchases long-term securities or other assets from the open market in order to increase the money supply and encourage lending and investment. QE is typically used when short-term interest rates are already at or near zero, and aims to lower long-term interest rates.
Source: General Knowledge
Forward guidance is a communication tool used by central banks to influence market expectations about the future path of monetary policy, particularly the policy interest rate. By signaling its future intentions, a central bank can influence current long-term interest rates and financial conditions.
Source: General Knowledge
The natural rate of interest, a concept introduced by Knut Wicksell, is the real interest rate that is consistent with stable inflation and the economy operating at its full potential (i.e., zero output gap). It is the rate at which saving equals investment. It is an unobservable, long-run equilibrium concept.
Source: General Knowledge
The NAIRU is the specific level of unemployment at which the inflation rate is stable. If unemployment falls below the NAIRU, inflation is expected to accelerate. If it rises above the NAIRU, inflation is expected to decelerate. It is a modern equivalent of the 'natural rate of unemployment'.
Source: Mizen (2000), p. 249
Bracket creep, or fiscal drag, is the process by which inflation pushes taxpayers into higher income tax brackets, leading to an increase in their average tax rate and real tax burden, even if their real income has not increased. This happens in a progressive tax system where tax brackets are not indexed to inflation.
Source: General Knowledge
Sterilization is a central bank operation to offset the impact of its foreign exchange interventions on the domestic money supply. For example, if a central bank buys foreign currency (which increases the domestic money supply), it can 'sterilize' this by selling government bonds in an open market operation to absorb the excess liquidity.
Source: General Knowledge
The J-curve effect describes the typical time path of a country's trade balance following a currency devaluation or depreciation. In the short run, the trade balance often worsens before it improves. This is because import and export volumes are slow to adjust, so the immediate effect is that the import bill rises in domestic currency terms. Over time, as volumes adjust, the trade balance improves, tracing a 'J' shape.
Source: General Knowledge
PPP is a theory of exchange rate determination. In its absolute form, it states that the exchange rate between two currencies should equal the ratio of the two countries' price levels for a fixed basket of goods. In its relative form, it states that the rate of change of the exchange rate is determined by the difference in the two countries' inflation rates.
Source: General Knowledge
UIP is a parity condition stating that the difference in interest rates between two countries should be equal to the expected change in the exchange rate between the two countries' currencies. If UIP holds, an investor would expect to earn the same return by investing domestically or by investing in the foreign country (after accounting for the expected currency movement).
Source: General Knowledge
The Mundell-Fleming model is an extension of the IS-LM model to an open economy. It analyzes the effectiveness of monetary and fiscal policy under different exchange rate regimes (fixed vs. floating) and different degrees of capital mobility. A key result is that under a floating exchange rate and perfect capital mobility, monetary policy is highly effective, while fiscal policy is ineffective.
Source: General Knowledge
The impossible trinity states that a country cannot simultaneously have all three of the following:
1. A fixed exchange rate.
2. Free capital movement.
3. An independent monetary policy.
A country must choose two out of the three and give up the third.
Source: General Knowledge
Hot money refers to capital that is frequently transferred between financial institutions in an attempt to capitalize on the highest short-term interest rates. These short-term capital flows are highly sensitive to interest rate differentials and expectations of exchange rate changes, and can be a source of financial instability.
Source: General Knowledge
The carry trade is a trading strategy that involves borrowing in a low-interest-rate currency and investing the proceeds in a high-interest-rate currency, in an attempt to profit from the interest rate differential. The strategy is profitable as long as the high-yielding currency does not depreciate by more than the interest rate differential.
Source: General Knowledge
Inflation targeting is a monetary policy framework where the central bank publicly announces a specific target, or target range, for the inflation rate over a certain period and commits to using its policy tools to achieve that target. It is characterized by transparency and accountability.
Source: Mizen (2000), p. 250
The output gap is the difference between the actual output (GDP) of an economy and its potential output. Potential output is the maximum level of output an economy can sustain without generating inflationary pressure. A positive output gap (actual > potential) indicates an overheating economy, while a negative output gap indicates slack.
Source: Mizen (2000), p. 248
The Phillips curve describes an inverse relationship between the rate of unemployment and the rate of inflation. The original curve suggested a stable trade-off: policymakers could choose lower unemployment at the cost of higher inflation. The modern, expectations-augmented Phillips curve argues that this trade-off only exists in the short run, and there is no long-run trade-off.
Source: Mizen (2000), p. 282
Stagflation is a portmanteau of stagnation and inflation. It describes a situation where an economy experiences both high inflation and high unemployment (stagnant economic growth) simultaneously. The stagflation of the 1970s challenged the traditional Phillips curve, which implied a trade-off between the two.
Source: General Knowledge
The natural rate of unemployment is the rate of unemployment that exists in long-run equilibrium, when cyclical unemployment is zero. It consists of frictional and structural unemployment. It is the unemployment rate consistent with stable inflation (the NAIRU).
Source: General Knowledge
Frictional unemployment is the temporary unemployment that occurs when people are in the process of moving from one job to another. It is a natural and unavoidable part of a dynamic labor market as workers search for jobs that best match their skills and preferences.
Source: General Knowledge
Structural unemployment is a longer-lasting form of unemployment caused by a mismatch between the skills that workers have and the skills that employers need. It can be caused by technological changes, shifts in the economy, or geographical mismatches.
Source: General Knowledge
Cyclical unemployment is the component of unemployment that is due to fluctuations in the business cycle. It rises during economic downturns (recessions) and falls during economic expansions. It is the difference between the actual unemployment rate and the natural rate of unemployment.
Source: General Knowledge
Okun's Law describes the empirical relationship between unemployment and the output gap. It states that for every 1% increase in the unemployment rate above the natural rate, a country's GDP will be roughly an additional 2% lower than its potential GDP.
Source: General Knowledge
Ricardian equivalence is a proposition that suggests that financing government spending through debt is equivalent to financing it through taxes. This is because rational taxpayers will anticipate that the government debt will have to be repaid with future taxes, so they will save now to pay for the future tax liability, offsetting the expansionary effect of the debt-financed spending.
Source: General Knowledge
Crowding out is the phenomenon where increased government borrowing to finance its spending drives up interest rates, which in turn reduces or 'crowds out' private investment. This can offset the expansionary effect of the government spending.
Source: General Knowledge
The Laffer curve is a theoretical representation of the relationship between tax rates and the amount of tax revenue collected by governments. The curve shows that as tax rates increase from 0%, tax revenue will increase, but only up to a certain point. Beyond this point, further increases in tax rates will cause tax revenue to fall, as the high rates discourage work and encourage tax avoidance.
Source: General Knowledge
Menu costs are the costs to firms of changing their prices. The name comes from the cost a restaurant incurs to print new menus, but it applies more broadly to the costs of repricing items, updating computer systems, and communicating new prices to customers. In the presence of menu costs, firms may be slow to adjust prices in response to changes in demand or costs.
Source: General Knowledge
A time deposit (or term deposit) is an interest-bearing bank deposit that has a specified date of maturity. Funds cannot be withdrawn before the maturity date without incurring a penalty. Certificates of Deposit (CDs) are a common form of time deposit. They are generally less liquid than demand deposits (checking accounts).
Source: Goldfeld (1973), p. 582
A demand deposit is a bank account from which deposited funds can be withdrawn at any time, without advance notice. Checking accounts are the most common form of demand deposit. They are highly liquid and form the deposit component of the M1 money supply.
Source: Goldfeld (1973), p. 582
The monetary base, also known as high-powered money, consists of currency in circulation (notes and coins held by the public) plus the reserves held by commercial banks at the central bank. It is the portion of the money supply that is under the direct control of the central bank.
Source: Mizen (2000), p. 265
The IS (Investment-Saving) curve represents the locus of all combinations of interest rates and real output (GDP) such that the goods market is in equilibrium. This occurs when total spending (consumption + investment + government spending) equals total output. The IS curve is downward sloping because a lower interest rate encourages investment, which increases aggregate demand and equilibrium output.
Source: General Knowledge
The LM (Liquidity preference-Money supply) curve represents the locus of all combinations of interest rates and real output (GDP) such that the money market is in equilibrium. This occurs when the demand for real money balances equals the real money supply. The LM curve is upward sloping because a higher level of output increases the demand for money, requiring a higher interest rate to keep money demand equal to the fixed money supply.
Source: General Knowledge
Walras' Law states that in a general equilibrium model with n markets, if n-1 of the markets are in equilibrium, then the nth market must also be in equilibrium. This implies that we do not need to analyze all markets to determine general equilibrium; one market can be omitted.
Source: General Knowledge
Say's Law is a principle of classical economics which states that the production of goods (supply) creates an equivalent amount of income, which in turn generates the spending (demand) needed to purchase those goods. In its strongest form, it implies that there cannot be a general glut of goods or a deficiency of aggregate demand.
Source: General Knowledge
The classical dichotomy is the idea in classical economics that real variables (like output, employment, and real interest rates) can be analyzed completely separately from nominal variables (like the price level and the money supply). This is based on the principle of the neutrality of money, which states that money only affects nominal variables in the long run.
Source: General Knowledge
The Pigou effect, also known as the real balance effect, is the stimulation of output and employment caused by a rising real value of wealth during a period of falling prices. As the price level falls, the real value of money holdings increases, making people feel wealthier and causing them to increase their consumption, which boosts aggregate demand.
Source: General Knowledge
The Keynes effect describes an indirect transmission mechanism where a fall in the price level increases the real money supply, which leads to a fall in the interest rate (a shift in the LM curve). The lower interest rate then stimulates investment spending, thereby increasing aggregate demand.
Source: General Knowledge
A Minsky moment is a sudden, major collapse of asset values which is part of the credit cycle. It occurs when a long period of prosperity and rising asset prices encourages investors to take on excessive debt and risk. The 'moment' is the point at which creditors begin to call in their loans, forcing borrowers to sell even their less speculative assets to meet their obligations, leading to a cascade of selling and a collapse in asset prices.
Source: General Knowledge
'Animal spirits' is a term used by John Maynard Keynes to describe the instincts, proclivities, and emotions that influence human behavior and can be measured in terms of consumer confidence. He argued that investment decisions are often driven by these spontaneous urges and waves of optimism or pessimism, rather than purely by rational calculation of expected profitability.
Source: General Knowledge
The paradox of thrift is a Keynesian concept which states that if everyone in an economy tries to save more during a recession, aggregate demand will fall. This fall in demand will lead to a fall in total output and income. As a result, the total amount of saving in the economy may end up being lower than it was before everyone tried to save more.
Source: General Knowledge
Coined by Joseph Schumpeter, 'creative destruction' is the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. It describes how new innovations and technologies lead to the demise of old industries and firms, clearing the way for new, more efficient ones. It is seen as an essential driver of capitalist dynamism and long-term growth.
Source: General Knowledge
This law states that as a person consumes more and more units of a particular good, the additional satisfaction (marginal utility) they derive from each successive unit will eventually decline. This is a fundamental principle in microeconomics used to explain consumer behavior and the downward slope of demand curves.
Source: General Knowledge
A Giffen good is a rare type of inferior good for which an increase in its price leads to an increase in the quantity demanded, violating the law of demand. This occurs when the income effect of the price increase (which encourages more consumption of the inferior good) is so strong that it outweighs the substitution effect (which encourages less consumption).
Source: General Knowledge
A Veblen good is a luxury good for which the demand increases as the price increases, in apparent contradiction of the law of demand. This is due to its nature as a status symbol; a higher price makes the good more desirable as an indicator of wealth and social standing. This is known as 'conspicuous consumption'.
Source: General Knowledge
Described by George Akerlof, the 'lemons problem' is a classic example of adverse selection. In the used car market, sellers know the quality of their cars, but buyers do not. Buyers, fearing they will get a low-quality car (a 'lemon'), are only willing to pay a price reflecting the average quality. This low price drives sellers of high-quality cars out of the market, leading to market failure where only 'lemons' are traded.
Source: Goodhart (1989), p. 21
The principal-agent problem occurs when one person or entity (the 'agent') is able to make decisions on behalf of another person or entity (the 'principal'). The problem arises because the agent may have different incentives than the principal and may have more information, allowing them to act in their own self-interest, potentially to the detriment of the principal.
Source: General Knowledge
A situation is Pareto efficient if it is impossible to make any one individual better off without making at least one individual worse off. It is a standard for judging the efficiency of a resource allocation. A competitive market equilibrium is typically Pareto efficient under certain ideal conditions (no externalities, perfect information, etc.).
Source: Goodhart (1989), p. 29
An externality is a cost or benefit that is imposed on a third party who is not directly involved in a transaction or activity. A negative externality is a cost (e.g., pollution from a factory), while a positive externality is a benefit (e.g., a beekeeper's bees pollinating a nearby orchard). Markets often fail to produce an efficient outcome in the presence of externalities.
Source: General Knowledge
The Coase theorem states that if property rights are well-defined and transaction costs are sufficiently low, private parties can bargain to an efficient outcome in the presence of an externality, regardless of the initial allocation of property rights. The theorem suggests that private solutions to externalities can be found without government intervention.
Source: General Knowledge
A public good is a good that is both non-rivalrous (one person's consumption does not reduce its availability to others) and non-excludable (it is not possible to prevent people who have not paid for it from having access to it). Examples include national defense and street lighting. Public goods are subject to the 'free-rider problem', and are often under-provided by the private market.
Source: General Knowledge
The free-rider problem is a market failure that occurs when those who benefit from a resource, good, or service do not pay for it, which results in an under-provision of those goods or services. It is commonly associated with public goods, which are non-excludable.
Source: General Knowledge
The tragedy of the commons describes a situation where multiple individuals, acting independently and rationally in their own self-interest, will ultimately deplete a shared, limited resource, even when it is clear that it is not in anyone's long-term interest for this to happen. It occurs with common-pool resources, which are rivalrous but non-excludable.
Source: General Knowledge
Dutch disease is an economic concept that describes the apparent causal relationship between the increase in the economic development of a specific sector (e.g., natural resources) and a decline in other sectors (like manufacturing). The boom in the resource sector leads to a currency appreciation, making other exports less competitive, and draws labor and capital away from the manufacturing sector.
Source: General Knowledge
Baumol's cost disease describes the rise of salaries in jobs that have experienced no or low increase in labor productivity, in response to rising salaries in other sectors that have experienced higher productivity growth. This is often used to explain the rising costs of services like healthcare and education, where productivity growth is inherently slow.
Source: General Knowledge
The time value of money is the concept that a sum of money is worth more now than the same sum will be at a future date due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.
Source: General Knowledge
Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. The formula for the present value of a single future amount (FV) is: \( PV = \frac{FV}{(1+i)^n} \)
Source: General Knowledge
A perpetuity is a type of annuity that pays a constant stream of cash flows for an infinite period. The present value of a perpetuity is calculated with a simple formula: \( PV = \frac{C}{i} \), where C is the amount of the periodic payment and i is the interest rate.
Source: General Knowledge
An annuity is a financial product that pays out a fixed stream of payments to an individual, and is primarily used as an income stream for retirees. More generally, it is a series of equal payments made at equal intervals over a finite period of time.
Source: General Knowledge
Beta (\(\beta\)) is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means the security will be less volatile than the market, and a beta of more than 1 indicates it will be more volatile.
Source: Laidler (1993), p. 74 (in context of CAPM)
The Sharpe ratio measures the performance of an investment compared to a risk-free asset, after adjusting for its risk. It is the average return earned in excess of the risk-free rate per unit of volatility or total risk (standard deviation). A higher Sharpe ratio indicates a better risk-adjusted return.
Source: General Knowledge
Arbitrage is the practice of simultaneously buying and selling an asset in different markets to profit from a price discrepancy. It is a risk-free profit, and the actions of arbitrageurs cause the prices in different markets to converge, enforcing the 'law of one price'.
Source: General Knowledge
The law of one price states that in the absence of trade frictions (like transaction costs and tariffs), and under conditions of free competition, identical goods sold in different locations must sell for the same price when expressed in a common currency. It is the foundation of the theory of purchasing power parity.
Source: General Knowledge
A derivative is a financial contract that derives its value from an underlying asset, group of assets, or benchmark. Common derivatives include futures, forwards, options, and swaps. They are often used for hedging risk or for speculation.
Source: General Knowledge
A futures contract is a standardized legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures contracts are traded on exchanges and are used for both hedging and speculation.
Source: General Knowledge
An option is a contract that gives the buyer the right, but not the obligation, to buy (a 'call' option) or sell (a 'put' option) an underlying asset at a specified price on or before a certain date. The seller of the option has the corresponding obligation to fulfill the transaction if the buyer exercises the option.
Source: General Knowledge
A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount such as an interest rate or currency. An interest rate swap, for example, might involve exchanging a fixed interest rate payment stream for a floating rate stream.
Source: General Knowledge
Hedging is an investment strategy designed to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract or an option.
Source: General Knowledge
Speculation is the practice of engaging in risky financial transactions in an attempt to profit from short-term fluctuations in the market value of a tradable financial instrument. Speculators bet on the direction of future price movements, and their activities can provide liquidity to markets but also contribute to volatility.
Source: General Knowledge
The bid-ask spread is the difference between the price at which a market maker is willing to buy a security (the 'bid' price) and the price at which they are willing to sell it (the 'ask' price). The spread represents the market maker's profit and is a measure of the liquidity of the market; a narrower spread implies higher liquidity.
Source: Goodhart (1989), p. 21
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. Money is the most liquid asset. Assets like real estate are relatively illiquid.
Source: Laidler (1993), p. 52
Solvency is the ability of a company or individual to meet their long-term financial obligations. A solvent entity has positive net worth, meaning its total assets exceed its total liabilities. This is distinct from liquidity, which refers to the ability to meet short-term obligations.
Source: General Knowledge
The money market is the segment of the financial market where short-term borrowing and lending occur, with maturities typically ranging from overnight to one year. It involves large-scale transactions of short-term, highly liquid debt instruments like Treasury bills, commercial paper, and certificates of deposit.
Source: General Knowledge
The capital market is the segment of the financial market where long-term funds are raised through the buying and selling of long-term debt (bonds) and equity (stocks). It channels savings and investment between suppliers of capital and those who are in need of long-term funds.
Source: General Knowledge
Commercial paper is a short-term, unsecured promissory note issued by large corporations to raise funds for short-term liabilities like payroll and inventory. It is typically issued at a discount to face value and has a maturity of less than 270 days. It is a key instrument in the money market.
Source: Goldfeld (1973), p. 582
A Treasury bill is a short-term debt obligation backed by the government with a maturity of one year or less. T-bills are sold at a discount from their face value, and the difference represents the interest earned. They are considered one of the safest investments in the world.
Source: General Knowledge
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). The borrower is obligated to pay interest (the 'coupon') to the bondholder and to repay the principal amount at a later date, known as the maturity date. Bond prices have an inverse relationship with interest rates.
Source: Laidler (1993), p. 64
Equity, typically in the form of common stock, represents an ownership interest in a company. Equity holders are residual claimants, meaning they are entitled to the company's profits only after all creditors have been paid. Equity is generally considered riskier than debt.
Source: General Knowledge
A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. Its primary functions typically include formulating monetary policy, managing the currency and money supply, and overseeing the banking system. Examples include the US Federal Reserve, the European Central Bank, and the Bank of England.
Source: General Knowledge
Open market operations are the primary tool used by a central bank to implement monetary policy. They involve the buying and selling of government securities in the open market. Buying securities increases the money supply and lowers interest rates, while selling securities does the opposite.
Source: General Knowledge
The discount rate is the interest rate at which commercial banks can borrow money directly from the central bank through its 'discount window'. Changes in the discount rate can signal the central bank's policy stance, but it is now a less important tool than the policy rate used for open market operations (e.g., the Fed Funds Rate).
Source: General Knowledge
Reserve requirements are central bank regulations that set the minimum amount of reserves that a commercial bank must hold. These reserves are typically held as vault cash or as deposits at the central bank. Changes in reserve requirements can be a powerful tool of monetary policy, but they are used infrequently as they are disruptive to bank operations.
Source: General Knowledge