## Money and Banking Post 21: The Interest Rate

By Eric Tymoigne

In Post 20, a lot is said about the role that the rate of return on financial instruments—the interest rate—plays on the pricing on securities, but little was said about what determines that rate of return. Two competing theoretical frameworks explain what influences the interest rate, one of them emphasizes the role of real factors and the other emphasizes monetary factors.

Real Theory of Interest Rate: Natural Interest Rate and Expected Inflation

Gross Substitution and Indifference Condition: Determinant of the Nominal Interest Rate

The real exchange framework (Post 12) emphasizes the role played by real variables in the decision-making process of any rational economic unit. People are not fooled by mere improvement in monetary income because they only care about improvement in purchasing power given that only consumption provides utility. Monetary instruments have no other purpose than to smooth market transactions, and preoccupation about the liquidity of balance sheets and monetary outcomes are irrelevant. Capitalism is equivalent to a barter economy that uses monetary instruments.

## Money and Banking Post 20: Pricing Securities

A Small Detour: Savings Account and Interest Compounding

A typical way to think about interest rates is to study how a savings account works. Suppose Mr. X puts \$1000 in a savings account that provides a one percent annual interest rate. In that case, X will get at the end of:

• Year 1: \$1010 = \$1000(1 + 0.01)
• Year 2: \$1020.1 = \$1010(1 + 0.01) = \$1000(1.01)2
• Year 5: \$1051.01 = \$1000(1.01)5

Several things are worth noticing:

• The rate of return is fixed by the issuer of the account (1%)
• Principal rises over time: The longer X keeps the funds in his saving account, the greater, the total amount of principal due by a bank when X chooses to withdraw all its funds.
• Income rises over time: Interest income earned is automatically added to the outstanding amount of funds (\$1000, \$1010, etc.) so income earned changes every year as more funds are accumulated: \$10 the first year, \$10.1 the second year, \$10.2 the third year…

Most securities work quite differently.

## Money and Banking – Part 19 (A): Financial institutions: An overview

Erratum on Post 18: Figure 18.10 has reversed proportions: about 30 percent are issued by nonfinancial corporations.

Note: As I was afraid it would happen, someone emailed me to take issue with the way I use the term promissory note. “Promissory note” has a specific meaning in the law—it is a specific type of financial instruments—but Post 18 uses the term conceptually to mean any formal promise made by someone—a synonymous to financial instrument—, which may create some confusion. I am trying to find an alternative terms that contains the word “promise” (maybe promissory paper?, promissory contract? Contractual promise?) any suggestion welcome. For the moment, I will use the terms financial instrument, or promise…maybe that is good enough…

## Money and Banking – Part 19 (B): Financial institutions: An overview

Regulated Portfolio Management Companies: Mutual Funds and Others

Portfolio management companies provide a wide variety of placement opportunities to economic units with spare funds who do not want to, or cannot, directly buy securities or other assets. There are three broad types of portfolio management companies: mutual funds, closed-end funds, and unit investment trusts (UITs). One of the main differences between them is the characteristics of the shares they issue in terms of marketability and redeemability. Mutual fund shares are nonmarketable and redeemable on demand, closed-end fund shares are marketable and irredeemable, and UIT shares are marketable and redeemable on demand. Closed-end funds and UITs do not continuously offer their shares for sale. Rather, they sell a fixed number of shares in an initial public offering, after which the shares typically trade on a secondary market such as the New York Stock Exchange or through the sponsor (for UIT). The price of closed-end funds is determined by the market and may differ greatly from the net asset value per share (see below). Another main different is the type of asset they are allowed to acquire, with closed-end funds allowed to buy more illiquid assets than mutual funds.

## Money and Banking – Part 19 (C): Financial institutions: An overview

Farmer Mac, Fannie Mae, Freddie Mac, and Sallie Mae

This section closes the presentation of government-sponsored enterprise with a quick look at other GSEs. They work in a similar fashion to the FCS, by issuing securities and using the proceeds to buy or to back illiquid financial instruments held by financial institutions. The goal is once again to lower the level and volatility of interest rates on specific financial instruments and to encourage credit for specific economic activities.

## Money and Banking—Part 18 (B): Overview of the Financial System: A World of Promises

Due to the size of this post, it  has been split into 2. You can find part A here.

Monetary instruments

Monetary instruments are the last type of marketable promissory notes. Post 15 and Post 16 are devoted to their analysis. One of the main characteristics of monetary instruments is that their term to maturity is instantaneous, that is, they can be returned to the issuer at the will of the bearer. In terms of cash, that is physical monetary instruments, the Financial Accounts of the United States make a difference between currency, Treasury currency, and coins. Coins are not included in the Accounts, currency refers to cash issued by the Federal Reserve (Federal Reserve notes), and Treasury currency refers to cash issued by the US Treasury (the Treasury no longer issues any currency but some of it still circulates). Unless stated otherwise, the term “currency” will be used to include paper-made monetary instruments issued by both the Federal Reserve and the Treasury. In 2015, the outstanding dollar amount of currency was \$1.5 trillion and Figure 18.20 shows that 95 percent of it was held by the domestic non-federal sectors and the rest of the world. In 2015, about 40 percent of the US-dollar-denominated currency outstanding was held by the rest of the world, and about 55 percent was held by the domestic private sector. The ownership structure of Treasury currency outside the Federal Reserve is not provided by the Financial Accounts, but most of it must be held by the domestic private sector. The Federal Reserve is a significant holder of Treasury currency although the significance of its holding has shrink over time. In 1945, Federal Reserve’s holding of Treasury currency represented about 10 percent of outstanding currency, but, by 2015, it represented less than 5 percent of outstanding currency.

## Money and Banking—Part 18 (A): Overview of the Financial System: A World of Promises

Due to the size of this post, it was split in two. You can find Part B here.

The M&B series is back! The goal is to finish the first complete draft of the book by the time I need to teach my Money and Banking course. Over the coming months, the following topics will be covered.

1. Overview of the financial system
2. Federal Reserve System institutional analysis
3. Interest rate and interest rate structure
4. Pricing of securities
5. Off balance sheet: Securitization
6. Off balance sheet: Derivatives
7. Monetary policy in action (issues surrounding interest-rate rules, transmission channels, etc.)
8. International monetary arrangements and exchange rates
9. Modeling (theory of the circuit, including the money supply in models, stock-flow coherency, portfolio constraints, capital gains, using models, etc.)

With these new sections and the seventeen other chapters of the book (which I have already rewritten in part to take into account feedbacks from my students), one should have a solid alternative preliminary text (let me know if I should cover more topics). The incomplete draft was well received by my students and has been downloaded over 8000 times as of May 2017.

## Bill Clinton’s Surplus: Not Something to Celebrate

Video from Eric Tymoigne’s Modern Money students at Lewis and Clark College.

## Money and Banking Part 17: History of Monetary Systems

By Eric Tymoigne

This is the last post of this series. Many more topics need to be covered to make a full Money and Banking course, but the series should help those of us who are dissatisfied with the current Money & Banking textbooks.

Here is what is coming up in the near future: I will edit all the posts for typos (most of them hopefully) and to account for comments I received. Devin Smith kindly agreed to post the changes without changing any of the links. Formatting the text from a Word doc to a webpage is actually tedious work so many thanks to Devin. An M&B tag will be created at the top of the NEP homepage that will direct readers to links for each post. I will also make a fancy-looking pdf with all the posts, a table of content, etc. It will be more textbook-like and may be more appealing for some readers.

In the long term, there is a textbook coming. When? Difficult to say. I plan to write most of the first draft of the text next spring while on sabbatical. Then, several rounds of testing (and rewriting) must be done to include feedbacks from students. Test banks and exercises must be created and tested too. So there is some work to do.

## Money and Banking Part 16: FAQs about Monetary Systems

By Eric Tymoigne

The following answers a few question in order to illustrate Post 15 and to develop certain points.

Q1: Can a commodity be a monetary instrument? Or, does money grow on trees?

Let us tackle the idea that “gold is money”. Clearly, a gold ingot is not a monetary instrument. There is no issuer, no denomination, no term to maturity or any other financial characteristics. A gold ingot is just a commodity, a real asset not a financial asset. Gold coins have been monetary instruments and are still issued at times (Figure 1).

Figure 1. Gold (ingots) vs. Gold Coin (2009 \$50 American Buffalo Gold Coin)