Lecture 10: Money and Banking

1. Lecture 10: Money and Banking

2. The meaning and functions of money • Money supply and aggregate demand • The functions of money • medium of exchange • means of storing wealth • means of establishing value of future claims and payments

3. The meaning and functions of money • What should count as money? • narrow definitions of money • broad definitions of money • The ideal attributes of money • durability • divisibility • transportability • non-counterfeitability

4. The Financial System • The banking system • types of bank • retail banks: retail deposits and loans • wholesale banks: wholesale deposits and loans • universal banks: conducting retail and wholesale banking • building societies • monetary financial institutions (MFIs) • financial instruments • balance sheets

5. The Financial System • Balance sheets • liabilities and assets • sterling liabilities • sight deposits • time deposits • certificates of deposit • repos (sale and repurchase agreements) • capital and other funds

6. QWhich of the following arranges assets in descending order of liquidity (most liquid first)? Bonds; cash; shares; land A house; cash; shares; savings account deposits Shares; land; savings account deposits; bonds Current account deposits; savings account deposits; shares; a house Cash; savings account deposits; current account deposits; bonds

7. QWhich of the following describes a ‘repo’? Where a bank agrees to buy certain assets from an institution for cash in return for being able to borrow from that institution in the future. Where a bank sells some assets (e.g. bonds) and agrees to buy them back at a particular price after a set period of time. Where bank X lends to bank Y provided that bank Y is prepared to lend to bank X in the future. Where a bank sells assets to person or institution X in return for buying assets from person or institution Y.

8. The Financial System • Balance sheets (cont.) • sterling assets • cash and balances in the central bank • short-term loans • longer-term loans • bank levy • full rate and half rate • certain liabilities excluded • offset specific highly liquid assets against taxable liabilities

9. The Financial System • Liquidity and profitability • profitability • liquidity • capital adequacy • the capital adequacy ratio (CAR) • Basel accords • capital adequacy requirements

10. The Financial System • Liquidity and profitability • profitability • liquidity • capital adequacy • the capital adequacy ratio (CAR) • Basel accords • capital adequacy requirements • macro-prudential regulation • the balance between liquidity and profitability • maturity gap • liquidity ratio

11. QThe liquidity ratio of a bank refers to its ratio of: Treasury bills to government bonds. liquid to illiquid assets. cash to advances. liquid assets to total liabilities. total assets to total liabilities.

12. Secondary marketing of assets certificates of deposit (CDs) securitisation special purpose vehicles (SPVs) The Financial System

13. Securitisation chain Originator / Lender Sale of assets Special purpose vehicle (SPV) Sells secured assets Bond holders (noteholders) Proceeds from notes (£) Cash (£)

14. Secondary marketing of assets certificates of deposit (CDs) securitisation special purpose vehicles (SPVs) The Financial System • The dangers of secondary marketing • the sub-prime mortgage experience

15. QIf a bank discovers that it has more‘toxic’ assets on its books than previously thought, it is likely to: increase its liquidity ratio and thus cut back on lending. decrease its liquidity ratio and thus cut back on lending. increase its liquidity ratio and thus increase lending. decrease its liquidity ratio and thus increase lending.

16. The Financial System • The central bank • issues notes • acts as a bank • government • banks • overseas central banks • provider of liquidity to banks • oversees the activities of banks and other financial institutions • operates monetary policy • operates exchange rate policy and manages reserves

17. The Supply of Money • Definitions of the money supply • monetary base • broad money • definitions in the UK • Cash in circulation, M4 • eurozone definitions • M1, M2, M3

18. The creation of credit simple illustration The Supply of Money

19. Credit creation: Banks’ original balance sheet

20. Credit creation: Effect of a new deposit of £10bn

21. Credit creation: Full effect of a new deposit of £10bn

22. The creation of credit simple illustration The Supply of Money • bank multiplier: 1/L • money multiplier:m = MS/MB = (D +C) / (R +C)

23. QIf an extra £100m is deposited in the banking system and the bank multiplier is 5, by how much will credit expand? £80m £180m £400m £500m

24. The creation of credit in the real world banks’ liquidity ratio may vary banks may hold a higher level of liquid assets when they perceive increased risk customers may not take up all the credit on offer banks may not operate a simple liquidity ratio how much of the extra cash will be withdrawn by the public? The Supply of Money

25. Causes of increases in money supply banks reduce liquidity ratio households and firms choose to hold less cash public-sector deficit inflow of funds from abroad The Supply of Money

26. Money supply: exogenous or endogenous? relationship between money supply and the rate of interest The Supply of Money

27. The supply of money curve: (a) exogenous money supply MS Money supply determined independently of the demand for money and interest rates Rate of interest O Quantity of money

28. QWhich of the following would NOT cause a rise in money supply (assume ceteris paribus)? An increase in government spending financed by borrowing from the banking sector. An increase in the proportion of the national debt financed by bills rather than by bonds. The central bank imposes a statutory liquidity ratio on banks (above their current ratio). A rise in demand for money and the central bank does not change interest rates. The government finances the budget deficit by selling securities to the central bank.

29. The Demand for Money • The motives for holding money • transactions and precautionary motive • assets or speculative motive • the total demand for money • Determinants of demand for money • money national income • frequency with which people are paid • financial innovations • speculation about future return on assets • rate of interest • The demand for money curve

30. The demand for money curve Md Rate of interest O Money

31. QWhat do we mean by the term the ‘demand for money’? Is it: the proportion of people’s income held as wealth? a means of controlling the money supply? a term used by the Bank of England to refer to the demands placed upon it by the banking sector? the desire by individuals and firms to spend, given their level of income. the demand to hold assets in money form?

32. Monetary Equilibrium • Equilibrium in the money market • equilibrium rate of interest • effects of changes in the money supply or demand on the rate of interest

33. Equilibrium in the money market MS L Rate of interest re O Me Money

34. Interest rate  Investment  Saving  Aggregate demand  Monetary transmission mechanisms Interest-rate transmission mechanism Money supply

35. GDP  Prices  D for foreign assets  Exchange rate  Exports  Imports  Monetary transmission mechanisms Interest-rate transmission mechanism Interest rate  Investment  Saving  Money supply Aggregate demand  Exchange-rate transmission mechanism

36. QAssuming that interest rates and exchange rates are determined by the market, a reduction in money supply will result in: a fall in both interest rates and exchange rates. a rise in both interest rates and exchange rates. a rise in interest rates and a fall in exchange rates. a fall in interest rates and a rise in exchange rates.

37. Monetary Equilibrium • Effects of changes in money supply on national income • effect on interest rates • Ms  r • effects of changes in interest rates on investment • r  I • effects of changes in interest rates on the exchange rate, and imports and exports • r  er X, M • effects of changes in investment, imports and exports on national income • I, X, M  Y

38. The end… (kind of!) Any Questions?