ParkinBade Chapter 25

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25
CHAPTER
Money, Banking, and Interest Rates Ratna K.
Shrestha
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Money Makes the World Go Around

• Money has taken many forms what is money now?
• What do banks do, and can they create money?
• What determines the amount of money that people
  stuff into their wallets and keep in the bank?
• What determines interest rates and what makes
  them rise and fall?

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What Is Money?

• Money is any commodity or token that is generally
  acceptable as a means of payment.
• Fiat Money Money in the world today is called
  fiat money, because the law orders them to be
  money. Money today is no longer backed by gold or
  is convertible to gold at a fixed rate. Many
  countries, including Canada, have abandoned gold
  standard.
• Money has three other functions
• Medium of exchange
• Unit of account
• Store of value

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What Is Money?

• Medium of Exchange
• A medium of exchange is an object that is
  generally accepted in exchange for goods and
  services.
• In the absence of money, people would need to
  exchange goods and services directly, which is
  called barter.
• Barter requires a double coincidence of wants,
  which is rare, so barter is costly.
• Unit of Account
• A unit of account is an agreed measure for
  stating the prices of goods and services.

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What Is Money?

• Store of Value
• As a store of value, money can be held for a time
  and later exchanged for goods and services.
• Money in Canada Today
• Money in Canada consists of
• Currency
• Deposits at banks and other financial
  institutions
• Currency is the general term for bills and coins.

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What Is Money?

• Official Measures of Money
• The two main official measures of money in Canada
  are M1 and M2.
• M1 consists of currency outside banks and demand
  deposits at chartered banks that are owned by
  individuals and businesses.
• M2 consists of M1 plus personal savings deposits
  at chartered banks, non-personal notice deposits
  at chartered banks, deposits at trust and
  mortgage loan companies, deposits at credit
  unions and deposits at other financial
  institutions.

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What Is Money?

• Figure 25.1 illustrates the composition of these
  two measures in June 2005 and shows the relative
  magnitudes of the components of money.

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What Is Money?

• The items in M1 clearly meet the definition of
  money the items in M2 do not do so quite so
  clearly but still are quite liquid.
• Liquidity is the property of being instantly
  convertible into a means of payment with little
  loss of value.
• Chequeable deposits are money, but cheques are
  not cheques are instructions to banks to
  transfer money.
• Credit cards are not money. Credit cards enable
  the holder to obtain a loan quickly, but the loan
  must be repaid with money.

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The Banking System

• The banking system consists of private and public
  institutions that create money and manage the
  nations monetary and payments system.
• The institutions in the banking system divide
  into
• Depository institutions
• The Bank of Canada
• The payments system

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The Banking System

• Depository Institutions
• A depository institution is a firm that accepts
  deposits from households and firms and uses the
  deposits to make loans to other households and
  firms.
• The deposits of three types of depository
  institution make up Canadas money
• Chartered banks
• Credit unions and caisses populaires
• Trust and mortgage loan companies

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The Banking System

• Chartered Banks
• A chartered bank is a private firm that is
  licensed to receive deposits and make loans.
• A chartered banks balance sheet summarizes its
  business and lists the banks assets,
  liabilities, and net worth.
• The objective of a chartered bank is to maximize
  the net worth of its stockholders (owners).

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The Banking System

• Credit Unions and Caisses Populaires
• A credit union is a co-operative organization
  that operates under the Co-operative Credit
  Association Act of 1992 and that receives
  deposits from and makes loans to its members.
• A caisse populaire is a credit union that
  operates in Quebec.
• In 2001, these institutions had deposits of 115
  billion.

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The Banking System

• Trust and Mortgage Loan Companies
• A trust and mortgage loan company is a privately
  owned depository institution that operates under
  the Trust and Loan Companies Act of 1992.
• These institutions receive deposits, make loans,
  and act as trustees for pension funds and
  estates.
• In 2001, these institutions had deposits of 8
  billion included in M2.

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The Banking System

• Profit and Prudence A Balancing Act
• To goal of any bank is to maximize the wealth of
  its owners. To achieve this objective, interest
  rate at which it lends exceeds the interest rate
  paid on deposits.
• But the banks must balance profit and prudence
  loans generate profit, but depositors must be
  able to obtain their funds when they want them.
• If depositors perceive the risk associated with
  lending and if they rush to withdraw their
  deposits, there might be bank runsleading to
  banks collapse. So to avoid such a situation,
  banks must be prudent in the way it uses its
  depositors funds.

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Run On A Bank
What's going on in these pictures? It's an
old-fashioned run on a bank! In Nov 2007, over 4
billion was withdrawn from Northern Rock Bank in
England. More recently, the criminal
investigation of cricket tycoon Sir Allen Stanrod
sowed panic in the Caribbean and Latin America,
especially Antigua on Feb 17, 2009.
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The Banking System

• Reserves and Loans
• To achieve security for its depositors, a bank
  divides its funds into two parts reserves and
  loans.
• Reserves are the cash in a banks vault and
  deposits at the Bank of Canada.
• Bank lending takes the form of
• Overnight loans
• Liquid assets
• Investment securities
• Loans

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The Banking System

• The Economic Functions of Banks
• Depository institutions make a profit from the
  spread between the interest rate they pay on
  their deposits and the interest rate they charge
  on their loans.
• This spread exists because depository
  institutions
• Create liquidity.
• lower the cost of lending and borrowing.
• Pool risk.
• Make payments.

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10.2 THE MONETARY SYSTEM

• 1. Create Liquidity
• A bank creates liquid assets by borrowing short
  and lending long.
• Borrowing short means accepting deposits and
  standing ready to repay them on depositors
  demand.
• Lending long means making loan commitments for a
  long term.
• Banks earn profits by being able to charge higher
  interest rates on their loans than on deposits
  they receive.

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10.2 THE MONETARY SYSTEM

• 2. Lower Costs
• Banks lower the cost of lending and borrowing.
• People with funds to lend can easily find the
  type of bank deposit that matches their plans.
• People who want to borrow can do so by using the
  facilities offered by banks.
• Without bank services, borrowing and lending can
  be costly in terms of search costs (search for
  lenders and borrowers).

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10.2 THE MONETARY SYSTEM

• 3. Pool Risk
• By lending to a large number of businesses and
  individuals, a bank lowers the average risk of
  default it faces.
• The interest rate on a bank loan is set to
  ensure that the amount earned on the loans that
  do get repaid is sufficiently high to pay for
  ones that dont get repaid.
• This provides a significant security for the
  depositors, which is not possible without a
  banking system.

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10.2 THE MONETARY SYSTEM

• 4. Make Payments
• Banks provide the payments system.
• For example,
• (a) the cheque-clearing system.
• (b) The credit card payment system
• Banks collect fees for these services.

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The Banking System

• Bank of Canada
• The Bank of Canada is Canadas central bank.
• A central bank is the public authority that
  supervises financial institutions and markets and
  conducts monetary policy.
• The Bank of Canada is
• a Banker to the banks and government
• Lender of last resort
• Sole issuer of bank notes

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How Banks Create Money

• Banker to Banks and Government
• The Bank of Canada accepts deposits from
  depository institutions that make up the payments
  system and the government of Canada.
• Lender of Last Resort
• The Bank of Canada is the lender of last resort,
  which means that it stands ready to make loans
  when the banking system as a whole is short of
  reserves.
• If some banks have surplus reserves and others
  are short of reserves, the overnight loans market
  moves funds from one bank to another.

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How Banks Create Money

• Sole Issuer of Bank Notes
• The Bank of Canada is the only bank that is
  permitted to issue bank notes. The BOC has a
  monopoly on this activity.
• The Bank of Canadas Balance Sheet
• The Bank of Canadas assets are government
  securities and last-resort loans to banks.
• Its liabilities are Bank of Canada notes and
  deposits of banks and the government.

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The Banking System

• The Payments System
• The payments system is the system through which
  banks make payments to each other to settle
  transactions by their customers.
• The payments system is owned by the Canadian
  Payments Association (CPA) and it operates two
  national payments systems
• Large Value Transfer System
• Automated Clearing Settlement System

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The Banking System

• Large Value Transfer System
• The Large Value Transfer System (LVTS) is an
  electronic payments that enables financial
  institutions and their customers to make large
  payments instantly and with sure knowledge that
  the payment has been made.
• Automated Clearing Settlements System
• The Automated Clearing Settlements System (ACSS)
  is the system through which all payments not
  processed by the LVTS are handled. These payments
  include debit card and ABM transactions.

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How Banks Create Money?

• Creating Deposits by Making Loans
• Banks create deposits when they make loans and
  the new deposits created are new money.
• The quantity of deposits that banks can create is
  limited by three factors
• The monetary base
• Desired reserves
• Desired currency holding

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How Banks Create Money

• Monetary Base
• The liabilities of the BOC (plus coins issued by
  the Canadian Mint) form the monetary base.
• The monetary base is the sum of BOC notes and
  coins outside the Bank of Canada (held by
  households, firms, and banks) and banks deposits
  at the BOC.

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How Banks Create Money

• Reserves
• The fraction of a banks total deposits held as
  reserves is the reserve ratio.
• The desired reserve ratio is the ratio of
  reserves to deposits that banks want to hold.
  Reserves are not required, so bank are free to
  determine the prudent level of reserves. Reserves
  are held so that banks can stay ready to pay in
  case depositors want to withdraw their deposits.
• Excess reserves equal actual reserves minus
  desired reserves. Banks can loan all of excess
  reserves.

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How Banks Create Money

• Desired Currency Holding
• We hold money in the form of currency and bank
  deposits and people hold some fraction of their
  money as currency.
• The fraction of deposits held as currency is
  called the currency drain ratio and is the ratio
  of currency to deposits.

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HOW BANKS CREATE MONEY?

• When a bank receives deposits, it keeps v in
  reserves (desired reserve) and lends the
  remaining excess reserve (1 v) . The amount
  loaned becomes a new deposit at another bank.
• The next bank in the sequence keeps v of the
  deposits and lends (1-v) , and the process
  continues until the banking system has created
  enough deposits to eliminate its excess reserves.
• At the end of the process, an additional 100,000
  of reserves creates an additional 400,000 of
  deposits (loans reserves) at the desired
  reserve ratio v 25. as shown in the running
  tally of the next slide.

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Multiple Creation of Bank Deposits
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HOW BANKS CREATE MONEY?

• At each stage the new loan/deposit is (1 v)
  of the previous loan/deposit.
• If L is that proportion then the complete
  sequence is 1 L L2 L3 and so on.
• The total increase in deposits
• initial deposits x (1 L L2 L3 )
• initial deposits/(1 L)
• (Note the above series is called convergent
  geometric series. Let S (1 L L2 L3 )
  then LS L L2 L3 .. Now S LS 1 which
  proves that S 1/(1 L))
• In this example ?D 100,000/(1 0.75)
• 400, 000

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HOW BANKS CREATE MONEY

• The Deposit Multiplier
• If v desired reserve ratio, then a new deposit
  in the banking system will increase the total
  deposit by 1/v times the initial new deposits
  (?R), provided that there is no cash/currency
  drain. That is,
• Where, 1/v 1/(1 L) is the Deposit Multiplier.
• ? Loan ?Deposits - ?Reserve

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HOW BANKS CREATE MONEY?

• The two simplifying assumptions in our previous
  example of deposit creation are
• (1) banks loan all of their excess reserves and
• (2) there exists no Currency Drain.
• If banks dont choose to lend their excess
  reserves, there will be no expansion of deposits.

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How Banks Create Money?

• In the presence of currency drain, the money
  creation will be slower (than in its absence).
• To see how the process of money creation works,
  suppose that the desired reserve ratio is 10
  and the currency drain ratio is 50 .
• The process starts when all banks have zero
  excess reserves except one bank and it has excess
  reserves of 100,000.
• Figure 25.3 in the next slide illustrates the
  process and keeps track of the numbers.

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How Banks Create Money

• The bank with excess reserves of 100,000 loans
  them.
• Of the amount loaned, 33,333 (50 of deposits)
  drains from the bank as currency and 66,667
  remains on deposit.

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How Banks Create Money

• The banks reserves and deposits have increased
  by 66,667, so the bank keeps 6,667 (10 ) as
  reserves and loans out the remaining excess
  reserve of 60,000.

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How Banks Create Money

• 20,000 (50) drains off as currency and 40,000
  remain on deposit.

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How Banks Create Money

• The process repeats until the banks have created
  enough deposits to eliminate the excess reserves.
• 100,000 of excess reserves creates 250,000 of
  money.

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How Banks Create Money

• The Money Multiplier
• The money multiplier is the ratio of the change
  in the quantity of money to the change in the
  monetary base.
• In our example, when the monetary base increased
  by 100,000, the quantity of money increased by
  250,000, so the money multiplier is 2.5.
• Monetary base, MB Currency Desired Reserve.
• Money or Loan, M Currency Deposits.
• Let currency drain ratio a and desired reserve
  b, then Currency a X Deposits and Desired
  Reserve b X Deposits.

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How Banks Create Money

• So, MB (a b) X deposits and
• M (1 a) X Deposits.
• From the above two equations,
• M (1 a)/(a b) X MB
• In our example, a 0.5 and b 0.1, so
• New Money, M (1 0.5)/(0.5 0.1) x MB
• 2.5 x MB.
• The money multiplier (1 a)/(a b)

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The Demand for Money

• How much money do people want to hold?
• The Influences on Money Holding
• The quantity of money that people plan to hold
  depends on four main factors
• The price level
• The interest rate
• Real GDP
• Financial innovation

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The Demand for Money

• The Price Level
• A rise in the price level increases the nominal
  quantity of money (but doesnt change the real
  quantity of money) that people plan to hold.
• Nominal money is the amount of money measured in
  dollars.
• The quantity of nominal money demanded is
  proportional to the price levela 10 rise in
  the price level increases the quantity of nominal
  money demanded by 10.

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The Demand for Money

• The Interest Rate
• The interest rate is the opportunity cost of
  holding money that you could have earned on other
  assets such as saving deposits, bonds (that you
  could have bought with money).
• The opportunity cost of holding money nominal
  interest rate, not real interest rate, Why?
• This is because when you hold money you give up
  not only the real interest you could have earned
  in an alternative asset but also lose the buying
  power due to inflation. A rise in the nominal
  interest rate decreases the quantity of money
  that people plan to hold.

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The Demand for Money

• Real GDP
• An increase in real GDP increases the volume of
  expenditure, which increases the quantity of real
  money that people plan to hold.
• Financial Innovation
• Financial innovation that lowers the cost of
  switching between money and interest-bearing
  assets decreases the quantity of money that
  people plan to hold. For example, credit cards,
  ATM, etc.. reduces the amount of money people
  want to hold.

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The Demand for Money

• Figure 25.4 illustrates the demand for money
  curve.
• A rise in the interest rate brings a decrease in
  the quantity of money demanded.

A fall in the interest rate brings an increase in
the quantity of money demanded.
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The Demand for Money

• Shift in Demand Curve
• A decrease in real GDP or a financial innovation
  decreases the demand for money and shifts the
  demand curve leftward.
• An increase in real GDP increases the demand for
  money and shifts the demand curve rightward.

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Interest Rate Determination

• An interest rate is the amount received by a
  lender and paid by a borrower expressed a s
  percentage of the amount of the loan.
• The price of a bond (a financial asset) and the
  interest rate on it are inversely related.
• If the price of a bond falls, the interest rate
  rises.
• If the price of a bond rises, the interest rate
  falls.
• We can study the forces that determine the
  interest rate in the market for money.

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Bond Price and Interest Rate An example

• If the government issues a bond that pays 100
  each year, what is the interest rate, r, on this
  bond?
• The answer depends on the price, p, you pay for
  the bond.
• If p 1,000, then r 10 a year.
• If p 500, then r 20 a year.
• In the market for bonds, an increase in the
  demand for bonds will raise its price and lower
  the interest rate.

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Interest Rate Determination

• Money Market Equilibrium
• The supply of and the demand for money determine
  the interest rate.
• The actions of the BOC and the banking system
  determine the supply of money.
• The BOC is the sole supplier of monetary base and
  it can choose the terms on which currency and
  reserves for the banks are supplied.

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Interest Rate Changes with Money Supply
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Interest Rate Determination

• The BOC can choose to
• Target the quantity of money
• Target the interest rate
• Quantity of Money Target
• If the Bank of Canada targets the quantity of
  money, then the quantity of money supplied is
  fixed and the money supply curve is the vertical.

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Interest Rate Determination

• With a fixed quantity of money, the interest rate
  adjusts to make the quantity of money demanded
  equal to the quantity supplied.

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Interest Rate Determination

• If the interest rate is above the equilibrium,
  the quantity of money that people are willing to
  hold is less than the quantity supplied.
• They try to get rid of their excess money they
  are holding by buying bonds.
• This action raises the price of a bond, which
  lowers the interest rate.

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Interest Rate Determination

• If the interest rate is below the equilibrium,
  the quantity of money that people want to hold
  exceeds the quantity supplied.
• They try to get more money by selling bonds.
• This action lowers the price of a bond, which
  raises the interest rate.

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Interest Rate Determination

• Interest Rate Target
• If the Bank of Canada targets the interest rate,
  then the quantity of money supplied by the
  banking system must equal the quantity of money
  demanded at the chosen interest rate.
• To achieve this quantity of money supplied, the
  BOC adjusts the monetary base.

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Interest Rate Determination

• With a 5 interest rate target, the quantity of
  money demanded is 600 billion and BOC sets the
  monetary base so that the quantity of money
  supplied by the banking system is 600 billion.

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Interest Rate Determination

• If the Bank of Canada wants to lower the interest
  rate to 4, the Bank of Canada must increase the
  monetary base such that the quantity of money
  supplied by the banking system increases to 650
  billion equal to the quantity of money demanded.