Money and Banking

1
Money and Banking

• ECN 111 Macroeconomic Principles
• Instructor Igor Lukashin Spring 2000
• Lecture 19.

2
Fundamental Questions

• What IS money?
• How is the U.S. money supply defined?
• How do countries pay for international
  transactions?
• Why are banks considered intermediaries?
• How does international banking differ from
  domestic banking?
• How do banks create money?
• How did recent technological advances affect
  money banking?

3
What is Money?

• Money is
• anything that is generally acceptable to sellers
  in exchange for goods and services
• cash vs goods what can you use to pay for stuff
  you want?
• If something is not a generally acceptable means
  of paying for other goods and services, we dont
  consider them to be money
• Money is the most liquid asset
• an asset that can easily be exchanged for goods
  and services.
• Think about what movie bank robbers usually
  demand Bearer bonds? Food stamps? Money orders?
  Bus transfers?
• What other characteristics must an asset have to
  be considered money?
• The Four (4) Functions of Money

4
The Four Functions of Money

• Medium of Exchange
• used in exchange for goods and services.
  Alternative barter, need double coincidence of
  wants, high transaction costs
• divisibility available in large and small
  denominations Yap Isle
• Unit of Account
• Goods services are priced in terms of money,
  allowing easy comparison of relative values,
  lowers information costs
• Store of Value (relates to willingness to hold m)
• Ability to retain the value over time durability
• Furs, Fish as money Fish spoils quicker, Furs
  retains value
• High inflation often leads to currency
  substitution
• Standard of Deferred Payment
• Debt obligations are written in terms of money
  values.
• Firstborn child? Community Service? Jail time?

5
The U.S. Money Supply

• Money supply is an important determinant of
• Interest rates, inflation other macroeconomic
  variables
• What do we want to measure as money supply?
• Spendable assets
• Should we include all bank deposits? No. Why?
• Deposits can be for spending or for saving
• Differentiate between assets on the basis of
• Liquidity
• Likelihood of the assets being spent
• Three (3) nested definitions of MS M1, M2, M3
• No best definition of MS, different definitions
  work better in different macroeconomic models
  (e.g. short-run vs. long-run)

6
M1 Money Supply

• Financial assets that are the most liquid
• currency, travelers checks, demand deposits and
  other checkable deposits
• demand and other checkable deposits are known as
  transaction accounts
• can be used to make direct payments to a third
  party
• Currency (39 of M1 in 1998)
• Not backed by anything fiduciary monetary
  system
• Commodity money Greshams Law
• Travelers Checks (less than 1 of M1 in 1998)
• Demand deposits (37 of M1 in 1998)
• checking accounts that do not bear interest bank
  have to pay the amount of the check immediately
  on demand
• Other Checkable Deposits (interest
  check-writing)

7
M2 Money Supply

• A broader definition of MS, includes some of the
  less liquid forms
• M1, savings deposits, small-denomination time
  deposits, and retail money market mutual fund
  balances PLUS overnight repurchase agreements
  and overnight Eurodollars
• Savings Deposits
• Accounts at banks and SL associations that pay
  interest but offer no check-writing privileges
• Small-denomination time deposits (CODs)
• small means less than 100,000 funds in these
  accounts must be deposited for a specific period
  of time
• Retail Money Market Mutual Fund Balances
• combine deposits of many individual and use them
  to invest in short-term securities. May grant
  check-writing, but limit the size and number of
  checks

8
M3 Money Supply

• An even broader definition of MS, includes some
  of the even less liquid forms
• M2, large time deposits, term repurchase
  agreements, term Eurodollar deposits and
  institution-only money market mutual fund
  balances
• A repurchase agreement (RP)
• an agreement between a bank and a customer under
  which the customer buys U.S. government
  securities from the bank one day and then sells
  them back to the bank later at a price that
  includes the interest earned overnight
• Eurodollar deposits
• deposits denominated in dollars but held outside
  the U.S. domestic bank industry

9
Global Money

• How do countries pay for international
  transactions?
• Each country has different domestic money
• Foreign exchange market (does what?)
• What currency are contracts usually written in?
• Trade between developed countries
• Domestic currency of the exporter. E.g. Ford
  sells 100 Mustangs to Japan, contract invoiced in
  US dollars
• Trade between developed and developing countries
• Domestic currency of the developed country (more
  stable, more widely traded)
• Trade between developing countries
• One of the major currencies
• International Reserve Currencies (Assets)
• currencies (assets) held by a government to
  settle international debt
• E.g. USD, DEM, JPY, FFR, ECU, SDR gold

10
Composite Currencies

• Composite Currency is an artificial unit of
  account that is an average of the values of
  several national currencies
• European Currency Unit (ECU, Euro)
• a unit of account used by western European
  nations as their official reserve asset
• is a weighted average of the values of the
  national currencies of Austria, Belgium, Denmark,
  Finland, France, Germany, Greece, Ireland, Italy,
  Luxembourg, the Netherlands, Spain and Portugal
• not an actual money, but accounting entity for
  now however, Euro will be soon (2002) circulated
  through the member countries, replacing national
  currencies
• Special Drawing Right (SDR)
• created in 1970 by the IMF
• a composite currency whose value is the average
  of the value of USD, FFR, DEM, JPY and GBP (look
  at www.oanda.com)

11
Composite Currencies Example

• Suppose we want to create a single currency in
  North America, the NAMU, as a weighted average of
  U.S. dollar (USD), Mexican Peso (MXP) and
  Canadian dollar (CAD)
• Assume the following weights of national
  currencies in the composite currency
• USD 70, CAD 20, and MXP 10
• The exchange rates between USD, CAD and MXP are
  approximately as follows as of 04/06/00
• 1 CAD 0.7 USD 1 MXP 0.10 USD
• To find the value of the composite currency,
  NAMU, you can calculate the exchange rate
  vis-à-vis the USD
• 1 NAMU .7 1 USD .2 (1 CAD) .1 (1 MXP)
  
• .7 1 USD .2 (0.7 USD) .2 (.1 USD)
  .7 .14 .02 .86
• That is, 1 NAMU 0.86 USD, or .86/.7 1.23
  CAD, or .86/.1 8.6 MXP

12
Banking

• Commercial banks offer checkable deposits
• Thrift Institutions historically only savings
  accounts
• Now offer similar services because of the 1980
  Depository Institutions Deregulation and Monetary
  Control Act
• Commercial banks and thrift institutions are
  financial intermediaries
• middlemen between savers and borrowers
• Savers prefer short-term deposits
• Borrowers prefer long-term loans (mortgages, car
  loans, etc.)
• Financial intermediary hopes to earn profits on
  the activity (or spread between borrowing and
  lending rates). Islamic banks?
• E.g. offer 2 on the savings accounts, and lend
  money at prime rate of 10.
• If you have on average 1 million USD in deposits
  per year and you can lend 900k of it, the revenue
  per year is 900k (.10 -.02) 900k .08 72k

13
Banking Structure Failures

• 67k bank offices operating in the US at the end
  of 1996
• Half operated by national banks (chartered by the
  federal government) the other half by state
  banks
• Federal regulations used to be tougher than state
  before 1980
• Interstate Banking
• Historically banks were allowed to operate only
  in one state (and sometimes only in one location!
  unit banking)
• National banking is the future (ATMs, mergers)
• more than 1/4 of all ATM transaction occur at a
  different banks ATM
• Failures 1980s lots of bad loans bank runs
• unexpected bad business conditions oil
  agriculture
• Federal Deposit Insurance Corporation (FDIC)
• insures small (up to 100k) deposits against bank
  failures

14
International Banking

• International banks are financial intermediaries
• Operate in a different legal environment
• Much less regulated then domestic banks
• Can offer better rates to both depositors and
  borrowers
• Eurocurrency market (offshore banking)
• Originated in Europe, but now is a worldwide
  phenomenon
• the market for deposits and loans generally
  denominated in a currency other than the currency
  of the country in which the transactions occur
• Domestic vs. Euro dollar deposits loans
• Domestic banking requires reserves against
  deposits, deposit insurance, mandated credit or
  interest rate restrictions
• offshore banks operate with little or no such
  restrictions, plus generally pay lower taxes gt
  cost advantage gt competitive rates
• Eurocurrency is riskier (subject to control of
  more governments)
• International Banking Facility (IBF) Eurodollars
  in the US

15
Banks and the Money Supply

• Banks CREATE money by LENDING money
• Banks are required to keep a portion of deposits
  on hand as a reserve to meet the demand for
  withdrawals
• Fractional Reserve Banking System
• a system in which banks keep less than 100 of
  the deposits available for withdrawal. (good or
  bad?)
• Required reserves
• the cash reserves (a percentage of deposits) the
  bank must keep on hand (according to regulations)
• If RR 10 (or .1), then out of 1 M USD of
  deposits, the bank would have to keep 10 1 M
  100k USD on hand
• Excess reserves
• the cash reserves in excess of required these
  can be used for loans
• Balance sheet
• Assets (reserves plus loans left side)
  Liabilities (deposits, right)

16
Deposit Expansion Multiplier

• Banks CREATE money by LENDING money
• Banks are required to keep a portion of deposits
  on hand as a reserve to meet the demand for
  withdrawals (say, 25)
• Suppose a bank receives a deposit of 100
• Has to keep 25 as required reserves, can lend
  75
• The loan is used to pay for a dress seller
  deposits 75
• Bank has to keep 25, or 18.75, can lend 57.25
• The loan is used to pay for food seller deposits
  57.25
• Bank has to keep 25, or 14.31, can lend 42.94
  and so on
• Deposit expansion multiplier 1/reserve
  requirement
• shows maximum increase in money supply given
  initial deposit
• DEM excess reserves maximum MS increase
• A single bank increases MS by lending out its
  excess reserves banking system increases MS by
  the deposit expansion multiplier times the excess
  reserves of the system

17
Deposit Expansion Multiplier Example

• First bank has cash reserves of 200,000, loans
  of 800,000 and deposits of 1,000,000.
• Prepare the Balance sheet for the bank
• Assets Liabilities
• Cash 200,000 Deposits 1,000,000
• Loans 800,000
• Total 1,000,000 Total 1,000,000
• If the bank maintains a reserve requirement of
  12, what is the largest loan it can make?
• To find out required cash reserves, multiply the
  deposits by the reserve requirement 1,000,000
  .12 120,000
• The bank can only loan out the excess reserves,
  or the cash reserves above 120,000. That is
  200,000 - 120,000 80k
• What is the maximum amount of money supply can be
  increased as the result of this new loan?
• DEM 1/RR 1/0.12 8.(3)
• Max MS increase Loan DEM 80k 8.(3)
  666.(6)k