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Banking and money

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  • 1. Money and the banking system• Functions of money• Key aspects of the banking system• Money supply / money base and multiplier• Equilibrium in financial markets
  • 2. The functions of money1. Medium of exchange: it facilitates efficient trading2. Unit of account3. Store of value: it can be used to make purchases in the future
  • 3. The banking system• In earlier times precious metals like gold or silver were used as a medium of exchange• Later paper currency issued. Only central banks were allowed to issue paper currency that was convertible into gold• Abandonment of the gold standard: currencies were no longer convertible by law into anything valuable• Today almost all currency is fiat money. Fiat money is widely accepted because it is declared by government to be legal tender
  • 4. • Central banks are the providers of high-powered money• High powered money = currency (bank notes and coins) in private circulation plus the quantity held by the banking system in deposits held with the Central Bank . Also referred to as the monetary base or M0• High powered money is an asset to anyone in the private sector who holds it but is a liability of the Central Bank• Monetary conditions in an economy can be influenced by altering the stock of high powered money
  • 5. • The Central Bank can increase the amount of high powered money in the economy through open- market operations – This involves the purchase of securities (usually government bonds) undertaken with newly issued high- powered money – The government guarantees to pay a fixed interest per year and repay the principal at some future date – Government bonds considered to carry less risk than private sector bonds
  • 6. The ratios approach to the creation of deposit money• Two ratios are important in the determination of the level of deposit creation: – Commercial banks’ reserve ratio – Ratio of currency to deposits held by the public• Define R as the cash held in bank reserves• Define C the cash held by the non-bank public• Define H the level of high-powered money in the economy• then: C + R = H
  • 7. C+R=H• Desired reserve ratio (i.e. reserves as a proportion of deposits, D) of banks is given by r R = rD• The public hold a fraction c of its bank deposits in cash C = cD• Hence: cD + rD = H• Solving for D yields D = H/(c+r)• if c=0, and r = 0.1, then deposits would be 10x the cash in the economy D = H/0.1 ⇒ 10D = H• as c ⇑, the value of deposits becomes smaller. E.g suppose c=0.2, then, D = H/(0.1+0.1) ⇒ D = H/(0.2) ⇒ 5D = H
  • 8. • An expression for money supply (M) and H can be obtained by noting that the total supply of money is the sum of deposits (D) and currency (C). Thus: M=C+D M = cD + H/(c+r) M = cH/(c+r) + H/(c+r) M = H(c+1)/(c+r)• (c+1)/(c+r) is know as the money multiplier• It tells us how much bigger is the money supply to the cash base of the system• Money supply = money multiplier x monetary base• In the UK banking system the reserve ratio is 0.005 and the cash ratio is 0.033 therefore the value of the money multiplier is just over 27
  • 9. Narrow and Broad Money in the UK(£’s billion)Wide Monetary Base (M0) 24.4- Banks Cash &Balance at Central Bank 3.1= Notes and Coins in Circulation 21.3+ Banks’ Retail Deposits 228.2+ Building Society’s Deposits & Shares 205.0+ Wholesale Deposits 211.6= Money Supply (M4) 661.1
  • 10. Changing the money supply• If the central bank wants to raise money supply, it can use the following instruments: a) it can lower the required reserve ratio b) it can lower its discount rate (a) and (b) affect the money multiplier c) it can engage in open market operations This affects the monetary base
  • 11. The demand for money•Individuals can only hold two assets: money or bonds•Money does not pay any interest whereas bonds are interest-bearing assets•There are benefits to holding money, but there are also costs– the interest foregone by not holding an interest bearingasset • Three motives for holding money: – Transactions motive (related to income) – Precautionary motive (related to income) – Asset motive (risk aversion)
  • 12. Marginal cost, For a given level of realmarginal benefits income, The marginal benefit of holding money falls as money holdings increase E** MC’ MC E E* MB’ MB L Real money holdings
  • 13. Is the opportunity cost of holding money the real or nominal interest rate on bonds ? – Real interest rates measure the real return on lending in terms of the increase in purchasing power over goods as a result of postponing spending – If the rate of inflation is given by π and the return on bonds is r, then the real return on bonds is r - π – Since money is non interest bearing asset, the real return on money is 0 - π• The opportunity cost of holding money is the differential between the real return on bonds and the real return on money• This is (r - π) - (0- π) = r (the nominal rate of interest)
  • 14. We could thus write an expression for demand for real money balances as follows: M/P = f(Y/P, r)where, M is nominal money demand, p is the price level, Y is nominal income, and r is the nominal rate of interest
  • 15. Money market equilibriumInterest Rate Supply of real balances At r0 there is excess demand for money, ∴individuals sell bonds, this lowers the price of bonds, r* which thus raises the interest rate E r0 A B LL= demand for real balances L* Real money holdings