Money and Banking

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Money and Banking

• Begg, Fischer Dornbusch
• 7th Edition
• Chapter 22 23

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Some key questions

• Why does society need money?
• Why do governments wish to influence money
  supply?
• How do financial markets interact with the real
  economy?
• What is the relationship between money and
  interest rates?

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Money
Money is any generally accepted means of payment
for delivery of goods or settlement of debt.

• Different kinds of money
• Commodity money e.g. gold
• Token money
• Legal tender
• IOU money
• E.g. bank deposits

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Money and its functions

• Medium of exchange
• money provides a medium for the exchange of goods
  and services which is more efficient than barter
• Unit of account
• a unit in which prices are quoted and accounts
  are kept
• Store of value
• money can be used to make purchases in the future
• Standard of deferred payment
• a unit of account over time this enables
  borrowing and lending

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Characteristics of Money

• Acceptable to all
• Portable
• Durable
• Divisible
• Limited
• Difficult to forge

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Modern banking

• A financial intermediary
• an institution that specialises in bringing
  lenders and borrowers together
• e.g. a commercial bank, which has a government
  licence to make loans and issue deposits
  including deposits against which cheques can be
  written
• also insurance companies, pension funds and
  building societies
• Clearing system
• a set of arrangements in which debts between
  banks are settled

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Modern banking key definitions

• Bank reserves are the money available in the bank
  to meet possible withdrawals by depositors
• The reserve ratio is the ratio of reserves to
  deposits.
• The money supply is the value of the stock of the
  medium of exchange in circulation.
• Liquidity is the cheapness, speed and certainty
  with which asset values can be converted back
  into money.
• The money in sight deposits can be withdrawn on
  sight without prior notice. Time deposits
  paying higher interest rates, require the
  depositor to give notice before withdrawing money.

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A beginners guide to financial markets

• Financial asset
• a piece of paper entitling the owner to a
  specified stream of interest payments over a
  specified period
• Cash
• notes and coin, paying no interest
• the most liquid of all assets
• Bills
• financial assets with less than one year until
  the known date at which they will be repurchased
  by the original owner
• highly liquid
• Bonds
• longer term financial assets less liquid
  because there is more uncertainty about the
  future income stream

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A beginners guide to the financial markets
(continued)

• Perpetuities
• an extreme form of bond, never repurchased by the
  original issuer, who pays interest forever
• e.g. Consols
• Gilt-edged securities
• government bonds in the UK
• Industrial shares (equities)
• entitlements to receive corporate dividends
• not very liquid

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How banks create money

• Simplifying assumptions-
• There is only one bank.
• The public holds enough money to satisfy all
  their wants so any new money will be deposited
  with the bank.
• The bank is legally required to hold 10 of its
  deposits in cash.
• Why do the banks need to hold money at all?

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The Monetary Base the Money Multiplier

• The monetary base or stock of high-powered money
  is
• the quantity of notes and coin in private
  circulation plus the quantity held by the banking
  system
• The money multiplier is
• the ratio of the money stock to the monetary base
• Money stock money multiplier X monetary base

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The Money Multiplier
Suppose the banks wish to hold cash reserves R
as as fraction (cb) of deposits (D), and the
private sector wish to hold cash (C) as a
fraction (cp) of bank deposits (D).
Then R cbD and C cp D
Monetary base H C R (cb cp) D
Money supply C D (cp 1) D
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The Money Multiplier

• The value of the final increase can be calculated
  more easily by multiplying the initial cash
  injection by the credit multiplier
•  
•  
• In practice the credit multiplier is smaller than
  the above formula would suggest since
• The public does not redeposit all the cash they
  receive, keeping some back for day to day
  transactions.
• The reserve ratio is a minimum legal requirement.
  The banks may wish to keep slightly more. This
  is unlikely, as it would reduce profitability.

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Measures of money
The money supply is the total amount of money
circulating in the economy.
Narrow money that which can be used as a Medium
of Exchange.
Broad money narrow money plus near monies.
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Narrow money
Notes coins in circulation
Private sector interest bearing sterling sight
deposits
plus
Private sector interest bearing retail sterling
bank deposits
Banks till money
plus
plus
Private sector holdings of retail building
society deposits
Banks operational balances at the Bank of
England
plus
plus
equals
M2
M0
equals
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Broad money
M2
Private sector wholesale sterling bank and
building society deposits including Certificates
of Deposit
plus
Private sector retail sterling building society
shares
plus
equals
M4
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The demand for money

• The opportunity cost of holding money is the
  interest given up by holding money rather than
  bonds.
• People will only hold money if there is a benefit
  to offset that opportunity cost.
• What is that motive?

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Motives for holding money

• Transactions
• payments and receipts are not perfectly
  synchronised
• so money is held to finance known transactions
• depends upon income and payment arrangements
• Precautionary
• because of uncertainty
• people hold money to meet unforeseen
  contingencies
• depends upon the (nominal) interest rate

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Motives for holding money

• Asset
• people dislike risk
• so may hold money as a low-risk component of a
  mixed portfolio
• depends upon opportunity cost (the nominal
  interest rate)
• people may hold money rather than bonds if bond
  prices are expected to fall i.e. the interest
  rate is expected to rise depends upon the rate of
  interest and on expectations about bond prices

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The demand for money summary

• The demand for money is a demand for real money
  balances
• It depends upon
• real income
• nominal interest rate (the opportunity cost of
  holding money)
• the price level (currently assumed fixed)
• expectations about future interest rates

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Functions of the Bank of England
CONTROL OF NOTE ISSUE
SUPERVISION OF MONETARY SECTOR
FUNCTIONS OF THE BANK OF ENGLAND
CONTROLS EXCHANGE RATES through Exchange
Equalisation Account
CONTROLS MONETARY POLICY through Interest Rates
Money Supply
BANKERS BANK
GOVERNMENTS BANK
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Other functions of the Bank

• Lender of last resort
• the bank stands ready to lend to banks and other
  financial institutions when financial panic
  threatens
• Banker to the government
• the bank ensures that the government can meet its
  payments when running a budget deficit
• Setting monetary policy to control inflation
• more of this later

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The Bank the money supply

• Three ways in which the central bank MAY
  influence money supply
• Reserve requirements
• central bank sets a minimum ratio of cash
  reserves to deposits that commercial banks must
  meet
• Discount rate
• the interest rate that the central bank charges
  when the commercial banks want to borrow
• setting this at a penalty rate may encourage
  commercial banks to hold more excess reserves
• Open market operations
• actions to alter the monetary base by buying or
  selling financial securities in the open market

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Money market equilibrium
Interest rate
Real money balances
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Monetary control
Given the money demand schedule
The central bank can ...
EITHER set the interest rate at r0 and allow
money supply to adjust to L0
Interest rates
r0
OR set money supply at L0 and allow the market
rate of interest adjust to r0
LL
BUT cannot set both money supply and
interest rate independently.
L0
Real money balances
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The transmission mechanism
The transmission mechanism of monetary policy is
the channel through which it affects output and
employment
In a closed economy, monetary policy works
through the impact of real interest rates on
consumption and investment demand.
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Consumption demand- the wealth affect
A simple version of the consumption function is
C A cY

• The wealth effect occurs in two ways
• directly, through an increase in the real money
  supply (part of wealth is kept in the form of
  money)
• indirectly, through the effect of interest rates
  on share prices as interest rates fall, the
  price of bonds and shares rises making stock
  holders feel wealthier

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Consumption demand consumer credit and durable
goods

• Consumption is affected by two aspects of
  consumer credit
• the quantity of credit an increase in the
  quantity of credit increases autonomous
  consumption and vice versa
• the cost of credit households will borrow less
  at higher interest rates thus reducing autonomous
  consumption and vice versa
• these points are well illustrated by the UK
  housing market.

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Consumption and the Life-cycle
Income, consumption
0
Death
Age
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Consumption, Wealth and the Life-cycle
Actual income
Given the households initial estimation of
his/her wealth, permanent income is OD.
D
B
Income, consumption
Say the household consumes its permanent income.
Then the two As (plus any interest) would be
offset by B.
D
A
A
Permanent income
This shortfall can be met from the extra wealth.
0
Death
Age
Thus wealth and interest rates may influence
consumption.
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Investment demand

• Investment spending includes
• fixed capital
• Transport equipment
• Machinery other equipment
• Dwellings
• Other buildings
• Intangibles
• working capital
• stocks (inventories)
• work in progress
• and is undertaken by private and public sectors

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The demand for fixed investment

• Investment entails present sacrifice for future
  gains
• firms incur costs in the short run
• but reap gains in the long run
• Expected returns must outweigh the opportunity
  cost if a project is to be undertaken
• so at relatively high interest rates, less
  investment projects are viable.

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The Investment Demand Schedule
The investment demand schedule suggests that
ceteris paribus lower interest rates increase the
volume of investment projects and vice versa.
Changes in the price of capital goods and
expectations about profit streams at given
interest rates shift the schedule up or down.
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Investment in Working Capital

• Reasons for investment in working capital-
• The firm may be betting on price changes
• Many production processes take time
• Stocks help smooth costly adjustments in output
• Cost of investment in working capital
• Interest forgone on the money spent or unearned
• Storage charges