Financial Institutions and Markets

1. Financial Institutions and Markets Money and interest rates

2. Outline of contents • A recap of topic 04 • Defining money • Measuring the amount of money that exists • Commercial banks and money creation • What are interest rates? • The loanable funds theory of interest rate determination • The liquidity preference theory of interest rate determination • Interest rates and bonds • Learning outcomes • Further work • References

3. Money and Interest Rates Defining money

4. Life before money • An odd statement from an economist… • Money is not necessary • People can produce and consume (and survive) without any money • Self sufficiency • Self-sufficiency is possible, but you may wish to trade with others • Inability to produce some goods / services • Badly produced goods / services • Benefits of economies of scale

5. We still don’t need money • It is possible to trade without using money • Goods or services are swapped as payment for each other • This is a barter economy • Problems: • Double coincidence of wants • Simultaneity of transactions • Arguments over relative values

6. A barter example • Alison owns good 1 and wants good 2 • Brenda wants good 1 and owns good 3 • Claire wants good 3 and owns good 2

7. Defining money • Money is a generally accepted means of payment • A medium of exchange • Makes the double coincidence of wants unnecessary • A store of value • You can sell a good one day and buy something the next day • Transactions do not need to be simultaneous • A unit of account / measurement • No matter what the item being bought or sold, there should be a good understanding of its value in terms of the money

8. Properties of money • Properties of money • It should be available in small pieces / easily divisible • It should be durable • It should have a stable value • It should be homogeneous • It should be portable • Commodity money • When money takes the form of something with intrinsic value • Fiat money • When money takes the form of something with no intrinsic value

9. Money and Interest Rates Measuring the amount of money that exists

10. What is money, in practice? • Cash (notes & coins) are obviously considered to be money • This is cash / currency in circulation • But there are other ways of paying for goods and services • Debit cards, etc. • Credit cards • Are these money? No, just a means of deferring payment • What about savings accounts and financial instruments?

11. Categorising the money supply • The money supply is the amount of money within the economy • All ways of measuring the money supply fall into 2 categories: • Narrow money • Broad money • Narrow money is also termed the monetary base: this is the part that the Central Bank can actually influence

12. The measurements • In practice, the money supply is measured in a number of ways • M0 (UK) • M1 (UK – discontinued series; M2 now used in the UK instead) • M1 (ECB) • M2 (ECB) • M3 (ECB) • M4 (UK)

13. M0 and M1ECB = narrow money M0 (=UK definition of narrow money) • Cash in circulation outside the Bank of England plus banks’ operational deposits with the Bank of England • I.e. notes and coins + banks’ reserves M1 (ECB) • Currency in circulation plus overnight deposits

14. M1UK(D), M2, M3 & M4 = broad money M1 (UK, discontinued) • M0 + deposits M2 (ECB; used instead of UK M1) • M1ECB + deposits with an agreed maturity of up to 2 years + deposits redeemable at notice of up to 3 months M3 • M2 + repurchase agreements + money market fund shares / units + debt securities of up to 2 years M4 • Cash in circulation – reserves + private sector retail & wholesale deposits + sterling certificates of deposit

15. UK Monetary Aggregates (end July 2008)

16. UK Monetary Aggregates (end July 2008)

17. UK Monetary Aggregates (end July 2008)

18. UK Money Supply using ECB measures (end July 2008)

19. UK Money Supply using ECB measures (end July 2008)

20. UK Money Supply using ECB measures (end July 2008)

21. Quick recap • In groups, explain the 3 properties money must have, in your own words

22. Money and Interest Rates Commercial banks and money creation

23. Fractional reserve banking • Reserves are the deposits received by banks that have not been loaned out • The simplest bank is 100% reserve banking • But how likely is it that all customers will want to withdraw all their money at the same time? • Massively unlikely • So the bank lends a portion of the deposits in order to make profits • This is fractional reserve banking

24. The reserve ratio • The proportion of reserves to total deposits is called the reserve ratio • This is dependent on several things: • How much does the bank anticipate will be withdrawn by customers? • What are the legal requirements? • Banks will aim to operate with the lowest reserve ratio they believe to be prudent

25. Credit creation (1) • By operating with a fractional reserve, a bank may increase the money supply (the amount of money in the economy) • Deposits stay constant but circulating cash increases • Bank A receives a deposit of £100 • Assume a reserve ratio of 10%

26. Credit creation (2) • But the story does not end there… • The loan may pay for goods / services & the funds return to the banking system through bank B • Again a loan is made & the money returns to the banking system through bank C

27. Credit creation (3-∞) • This process continues indefinitely • We can use a multiplier to identify the total effect of a change in deposits

28. Money and Interest Rates What are interest rates?

29. RECAP • Narrow money • Monetary base • Fractional reserve banking

30. Defining the interest rate • We have already seen that an interest rate is a form of yield on financial instruments • “The interest rate” assumes that a single rate exists, which is representative of all other rates • The appropriate rate will vary depending on context • It is implied that the interest rate structure is stable (i.e. the relationship between rates on loans of different maturities) • It is implied that all interest rates in the economy are likely to move in the same direction • It should be possible to explain in general interest rate determination

31. Lending versus borrowing rates • From ordinary life, you should know that there is a difference between the offer rate and the bid rate • Offer rate: rate at which the entity is willing to lend • Bid rate: rate at which the entity is willing to borrow • The spread exists for several reasons: • To cover administrative costs • A risk premium • To develop profits

32. Fisher equation: Nominal versus real rates • Quoted interest rates are always nominal • Real means that the effects of inflation have been removed • Lenders set nominal rates by considering expected inflation, such that real rates are expected to stay constant or to increase over time • The conversion (approximation) • The conversion (accurate)

33. Money and Interest Rates The loanable funds theory of interest rate determination

34. LOANABLE FUNDS • According to this theory, individuals (and firms) aim to make the best use of available resources across a lifetime

35. Aims and goals: borrowers • According to this theory, individuals (and firms) aim to make the best use of available resources across a lifetime • Future real income may be increased by borrowing today in order to make a productive investment • Assuming return on investment > cost of borrowing • So borrowers will not be willing to pay a real interest rate higher than the real rate of return on capital (= MP of capital)

36. Aims and goals: savers • According to this theory, individuals (and firms) aim to make the best use of available resources across a lifetime • Savers can increase future consumption by giving up current consumption to lend to investors • They will only do this if there is a real rate of return on savings, allowing them to consume more in the future than they otherwise could • The interest rate is the reward for postponing consumption • The required reward depends on the individual’s time preference

37. Time preference • The extent to which a person is willing to give up satisfaction from present consumption in order to increase consumption in the future • We are acknowledging that saving involves an initial sacrifice– consumption today versus consumption tomorrow

38. Loanable funds • Loanable funds are just the sums of money offered for lending and demanded by consumers / investors within a given period • The interest rate is determined by interactions between potential borrowers and potential lenders • The real interest rate, however, tends to remain fairly stable over time

39. Demand for and supply of loanable funds Without inflation (1) • Assuming (for now) no inflation… Nominal interest rate Supply r* Demand Loanable funds L*

40. Demand for and supply of loanable funds Without inflation (2) • The underlying influences of borrowers & savers are not subject to frequent changes • Nominal interest rates are stable • Investment depends on the link between interest rates and the marginal productivity of capital (MPK) • MPK depends on quantity and quality of the economy’s FoPs • Limited changes over time; all changes are gradual • Savings at a given interest rate are dependent on time preference throughout the economy • Few changes over time; any changes are gradual

41. Loanable funds and nominal interest rates • A continued assumption is that people think in real terms • However, now the real value of financial assets changes with inflation • It becomes important for people to move quickly between asset types to protect their real wealth • Some of their assets must be held in liquid form • Some borrowing therefore takes place to enable a build-up of liquid reserves: so individuals might simultaneously borrow and save, in order to preserve liquidity

42. shifters Supply: • Monetary policy: an open market purchase by the Central Bank would increase supply Demand: • Government budget deficit would increase demand • Increase in profitable endeavors would also increase demand

43. Demand for and supply of loanable funds with inflation (1) Nominal interest rate Supply0 Supply1 r1* r0* Demand1 Demand0 Loanable funds L1* L0*

44. Analysing this picture • For the economy as a whole, we can identify that: Demand for loanable funds = net investment + net additions to liquid reserves Supply of loanable funds = net savings + increases in the money supply • D0 and S0 are the curves when inflation is zero, as seen before Now increase the money supply-- this increases the supply of loanable funds to S1 Ultimately in the classical / monetarist models, an increase in the money supply only generates inflation erodes the value of a currency • People & firms now need to borrow more in order to purchase the same quantities of consumer and capital goods • Demand for loanable funds shifts to the right • This pushes up the NOMINAL rate of interest • Nominal interest should only increase due to inflation, i.e. the real rate of interest should stay the same The adjustments will take time to complete, while adjustments occur, there may be a change in the real interest rate

45. Assumptions of the model • People care only about real interest rates • The monetary authorities have full control over the money supply • It is exogenously determined • Real interest rates change only gradually over time • The expected rate of inflation has no impact in the long run on real interest rates • The only significant disturbances to market interest rates come from poorly devised policy of the monetary authorities

46. Problems with the model (1) • Even if real interest rates are negative, people continue to save • According to loanable funds, this can only happen due to money illusion (where people consider nominal rather than real values) • This can only happen in disequilibrium  short run • The model does not perform well when required to explain short run changes • Economists’ short run may last for years!

47. Problems with the model (2) • Real and nominal rates of interest are both capable of changing very rapidly • The model’s long run focus understates the role of the monetary authorities in a modern economy • They may aim to change real interest rates on a regular basis in order to manage the economy • Inflationary expectations do affect the willingness to save and to borrow • Although the impact of this is uncertain (there are conflicting impacts)

48. Money and Interest Rates The liquidity preference theory of interest rate determination

49. Defining the demand for money • This refers to the desire to hold money • Rather than holding illiquid assets • There are 3 key reasons for holding assets in the form of money: • The transactions motive • The precautionary motive • The speculative motive

50. Demand for money Nominal interest rate Demand0 Quantity of Money, or Money Balances