Money and Monetary Institutions Chapter 20

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Money and Monetary InstitutionsChapter 20

• LIPSEY CHRYSTAL
• ECONOMICS 12e

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Learning Outcomes

• Money acts as a medium of exchange, a unit of
  account, and store of value.
• The existence of money facilitates a wider range
  of transactions than would otherwise be feasible.
• Money was originally composed on commodities such
  as gold and silver.

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Learning Outcomes

• Paper currency was originally convertible into
  gold or silver, but now has nothing backing it
  except its acceptability in payment.
• The money multiplier is the ratio of broad money
  to high-powered money.
• Bank deposits are now the biggest part of the
  total amount of money in the economy, so the
  behaviour of the banking system is central to
  determining that amount.

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Bank of England balance sheet (February 22nd 2006)
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Definitions of UK monetary aggregates

• Notes and coin. This measure refers to all the
  currency in circulation outside the Bank of
  England.
• Retail M4. This encompasses UK non-bank and
  non-building society holdings of notes and coins,
  plus sterling retail deposits with UK banks and
  building societies.

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Definitions of UK monetary aggregates

• M4. M4 is retail M4 plus all other private sector
  sterling interest bearing deposits at banks and
  building societies, plus sterling certificates of
  deposit (and other paper issued by banks and
  building societies of not more than five years
  original maturity).

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Definitions of UK monetary aggregates

• M3. This is a harmonized measure created to have
  standard money definitions throughout the EU. It
  is equal to M4 plus residents foreign currency
  deposits in UK banks and building societies plus
  public corporations sterling and foreign
  currency deposits in UK banks and building
  societies.

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UK money supply January 2010 (million)
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Credit creation

• We now present two models of the creation of
  deposit money.
• The first shows how banks can create a large
  volume of deposit money on the basis of a given
  amount of reserves.
• It is called the ratios approach to the creation
  of money and is best suited for showing the
  relation between reserves and deposit money.

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• The second shows how banks work in a competitive
  environment to attract the reserves they need in
  order to create deposit money.
• This model is better suited to understanding both
  the forces of competition between banks
  themselves and the competition between banks and
  other channels of financial intermediation (such
  as securities markets).

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• If you deposit cash with a bank, that deposit is
  an asset to you and a liability to the
  bankbecause the bank owes that amount to you.
  Because the bank has the cash as an asset, its
  assets equal its liabilities.
• If a bank gives you a loan, it writes an extra
  balance into your account.
• This creates a deposit for you, but it is also a
  loan that you have to repay.

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Note!

• In general, banks deposits are their
  liabilities, and whatever loans they make, or
  securities they purchase, constitute their assets.

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• Suppose that, in a system with many banks, each
  bank obtains new deposits in cash.
• Say, for example, that there are ten banks of
  equal size and that each receives a new deposit
  of 100 in cash.

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• The banks are on a fractional reserve system, and
  we assume for purposes of this illustration that
  they wish to hold 10 per cent cash reserves
  against all deposits.
• The new deposits put the banks into
  disequilibrium, since they each have 100 per cent
  reserves against these new deposits.

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How banks make credit!
Stage Deposit () Cash () 10 Loan ()
0 100 10 90
1 90 9 81
2 81 8.10 72.90
3 79.20 7.20 65.70
4 65.70 6.57 59.13

Final stage 1000 100 900
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The ratios approach to the determination of the
money supply

High-powered Money (cash)
A
D
Cash held by banks
Total cash In economy (monetary Base)
G
E
Cash held by public
B
C
F
Deposits
Deposits
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High powered money, deposits, and money supply
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High-powered money, deposits, and the money supply

• For a given stock of high-powered money the
  amount of bank deposits created will be the
  amount which is consistent with the banks
  reserve ratio and the non-bank publics
  cash-deposit ratio.
• The table sets out a range of desired positions
  for banks and the non-bank public independently.
• Only one of these positions satisfies the
  positions for both the banks and the public such
  that the deposits the banks wish to create are
  the same as the deposits the public wishes to
  hold.

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The ratios approach to the determination of the
money supply

• The money supply is determined by the stock of
  high-powered money (monetary base), the reserve
  ration of the banks, and the cash-deposit ratio
  of the non-bank public.
• The diagram illustrates the size of deposit
  creation, given the banks reserve ration x
  (ACICB), the publics cash-deposit ratio b
  (ECICF), and the total cash in economy AC.

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The ratios approach to the determination of the
money supply

• Deposits plus cash held by the public make up the
  total money supply.
• The total stock of high-powered money, or cash,
  in the economy has to be held by either the banks
  or the public.
• At point A the public holds all the cash
  available, so there are no bank deposits, and the
  total money supply is just AC, which is all cash.
  
• At point C the banks hold all the cash, and on
  that reserve base they create deposits of CB.
• The line AB thus plots the level of deposit
  creation resulting from each level of cash
  reserves.
• The banks reserve ratio ACICB is thus equal to
  (minus) the slope of AB.

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The ratios approach to the determination of the
money supply

• The line CB represents the cash deposit ratio
  for the non-bank public. Its slope, measured by
  ECICF, is equal to that cash deposit ratio.
• For a given base of high-powered money, deposit
  creation will be determined at the point where
  these two ratios are both satisfied.
• This will be where CD and AB intersect. So the
  actual outcome is at point G, where banks have AE
  cash in reserves and create CF of deposits.
• The public holds EC of cash and CF of deposits.
• The total money supply at G is given by CF plus
  EC.

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Competitive banking supply of and demand for
loans

Supply of loans
Supply of deposits
Ii
Spread
Rate of Interest
id
Demand for loans
Volume of loans and deposits
A
0
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Competitive banking supply of and demand for
loans

• The volume of bank loans is determined by the
  intersection of the supply curve of loans and the
  demand curve for loans.
• The diagram shows the positively sloped supply
  curve of loans and the negatively sloped demand
  curve for loans.
• The supply curve of loans is determined by the
  supply curve of deposits and the spread, or the
  interest margin that banks require to cover costs
  and risk.

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Competitive banking supply of and demand for
loans

• For given interest rates elsewhere in the
  economy, the supply curve of deposits is
  positively sloped because higher interest will
  attract more savings.
• The demand curve for loans is negatively sloped
  high interest rates discourage borrowing and low
  rates encourage borrowing.

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Competitive banking supply of and demand for
loans

• Competition in banking drives the margin between
  deposit and loan rate to a level such as Ii-Id
  where the spread is just enough to allow banks to
  cover costs and make a normal return on capital.
• With the demand and supply curves shown, there
  will be 0A deposits and loans, and depositors
  will receive an interest rate of Id while
  borrowers pay the loan rate Ii.

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MONEY AND MONETARY INSTITUTIONS

• Money and the economy
• In the classical dichotomy, money affected the
  price level but it did not affect real activity.
• The nature of money
• Money is a medium of exchange, a unit of account,
  and a store of value.
• Money avoids the need for a double coincidence of
  wants and thus facilitates a wider range of
  transactions.

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MONEY AND MONETARY INSTITUTIONS

• The origins of money
• Money has evolved from being based primarily on a
  precious metal to being mainly in the form of
  bank deposits.
• Early moneys were based on commodities, and
  especially precious metals like gold and silver.
• Paper currency started as a claim to a deposit of
  precious metal.
• Bank deposits account for most of modern money.

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MONEY AND MONETARY INSTITUTIONS

• How does money get into the economy?
• Central banks create the monetary base or
  high-powered money, which is made up of notes and
  coins and bankers deposits at the central bank.
• Banks create deposit money by expanding loans and
  deposits.

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MONEY AND MONETARY INSTITUTIONS

• Two models of banking
• Banks create deposits to some multiple of their
  cash reserves.
• In a competitive market in which banks pay
  interest on deposits and charge interest on
  loans, banks behaviour is best understood in
  terms of demand and supply curves of deposits and
  loans. Banks must pay competitive interest rates
  to attract deposits, and they must charge
  competitive rates on their loans.