a sneak peak introduction to English in Finance & Banking

1. Money, Banking, and Finance
Chapter 1: Introduction
© Dünhaupt, Dullien, Goodwin, Harris, Nelson, Roach, Torras

2. Learning Goals
 After today‘s lecture, you will be able to:
– Describe the consequences of inflation and deflation.
– Describe the functions and types of money.
– Describe the measures of the money supply
– Explain how banks create money.
– Describe the categories and functions of nonbank financial institutions.
– Explain the concept of “speculative bubble” and illustrate it with
concrete examples.
2

3. Chapter Outline
1. Why do we need Money?
2. What is Money?
3. The Banking System
4. Money and Finance
3

4. Why Money: Making Transactions Easier
 Imagine there was no money:
– You would need to barter
– If you want to get a certain good which you don‘t have and
want to exchange something else, you need to find
someone who wants just the opposite exchange
– Sometimes, goods are not easily divisible (imagine you want
to get some eggs, but only have a cow)
4

5. Money and Aggregate Demand
 Imagine you want to buy a house or make an
investment, but do not have the means to do so
 You go to a bank and ask for a loan
 If the bank gives you a loan, you will buy the house
 If the bank does not give you a loan or conditions are
too harsh, you will walk away not buying the house
 Hence, if the government can influence credit
conditions, it can influence aggregate demand!
Chapter 11 5

6. Some More Basic Thoughts About Money:
 This, however, is only true if inflation is low to
moderate
 In some cases, inflation becomes so high that money
is not generally accepted anymore
 In these cases, people might resort to barter as
money would lose value to quickly
 barter: exchange of goods, services, or assets directly
for other goods, services, or assets, without the use of
money.
Chapter 11 6

7. Where Do Hyperinflations Come From?
 Hyperinflation usually happens if the government starts
using the printing press to pay for its expenditure
(because it does not manage to collect sufficient revenue)
 If the economy is large and growing and there are not too
many newly printed bills, the money usually is just
absorbed
 However, if the governments prints too much money,
there will be hyperinflation
– Germany 1920s
– Zimbabwe in 2007
Chapter 11 7

8. What is the Danger of a Hyperinflation in Europe
Today?
 No real danger
 Governments are not allowed to use the printing
press to pay for their deficit (EU treaty)
 Even (recently agreed) purchases of government
bonds by the ECB are limited
 Money in modern, developed economies comes into
existence by other means (via the banking system)
Chapter 11 8

9. Why is Inflation Disliked Even if it is Lower?
 It redistributes from creditors to debtors
 It might wipe out savings
 It makes planning difficult
 It hurts those with nominally fixed incomes (people
on unemployment assistant, pensioners etc.)
 It creates “menu” costs
Chapter 11 9

10. What About Falling Prices – Do They Bring Problems
as Well?
 Deflation: when the aggregate price level falls
 Wealth is redistributed from debtors to creditors
 Debtors tend to be those who spend more – firms are
usually debtors
 This might lead to bankruptcies and problems in the
banking sector
 People might postpone spending
 There might thus be problems for aggregate demand
Chapter 11 10

11. What is Money?
 We usually define money by its functions:
– Medium of Exchange—promotes economic efficiency by minimizing time
spent in exchanging goods
and services
• Must be widely accepted
• Must be divisible
• Must be easy to carry
• Must not deteriorate quickly
– Store of Value — used to save purchasing power; most liquid of all assets
but loses value during inflation
– Unit of Account — used to measure value in
the economy
Chapter 11 11

12. What is NOT Money?
 A lot of things you might in everyday life call “money”
is NOT money in the eyes of economists
– Income: If someone has a high income (“he earns a lot of
money”), you would call this income, not money
– Wealth: If someone has a lot of stocks or bonds, he does
not have money in the economic meaning of the term
Chapter 11 12

13. Types of Money
 Commodity money: something that contains intrinsic
value and is used in exchange
– Coins made of gold or silver; sometimes cigarettes
developed into a medium of exchange in hard times
– To be used as money, a commodity must be generally
acceptable, standardized, durable, portable, scarce, and,
preferably, easily divisible
Chapter 11 13

14. The System of Gold-Backed Currencies
 Gold and silver coins inconvenient to carry around in large
quantities
 Paper monies were issued representing claims on actual
commodities
 Starting in the late 1830s, most European countries had
their national currencies by law backed by gold
 Exchange rate between different currencies was
computed from their respective value relative to gold, and
international transactions were finally settled in gold
reserves
 System of gold-backed currencies broke down with the
start of World War I
Chapter 11 14

15. What is the Basis of Value of the Coins and Euro
Banknotes we use Today?
 The basis of value is—precisely and no more than—
the expectation that the euro bill will be acceptable in
exchange.
 Fiat money
– A euro bill is money because the government declares it to
be money
– Fiat money possesses exchange value
– The value of the goods or services that such money can pay
for in the market
Chapter 11 15

16. Nowadays, You Are Likely to Make Many of Your
Transactions by Other Means
 Type of money which is purely based on a promise to
pay by someone other than the central bank, is called
credit money
– Your deposit in a checking account
Chapter 11 16

17. Figure 11.1 The Liquidity Continuum
Currency Real Estate
Checking Account
Share of Stock
Precious Metal
More
Liquid
Less
Liquid
Liquidity Continuum
Chapter 11 17
 Items more to the left are more liquid or, in other words, more easily used to
purchase something of value. The farther to the right on this continuum, the less
liquid the item is. Currency is as liquid as it gets, and real estate is usually about the
most difficult asset to convert to money (seldom taking less than a few months).

18. Do You Use Money if You Use a Credit Card to Make a
Purchase?
No!
 one is taking out a temporary loan from the credit
card company
 only one day a month, when you send a check or
electronic transfer to your credit card company from
your checking account, you make a “money”
transaction
Chapter 11 18

19. Bank Deposits and Money
 Dank deposits fulfill the criteria for money
– Store of value
– Widely accepted in payment
– Unit of account
 But: deposits have a different degree of liquidity; not
all can be used for payment
 What do we count as money?
– Pragmatic solution: different monetary aggregates which
include bank deposits with different kinds of maturities
Chapter 11 19

20. Monetary Aggregates: The Example of the euro area,
in Billion €
Chapter 11 20
Mid 2009 March 2013
Cash in Circulation 733.6 866.7
+ Overnight Deposits 3606.7 4336.0
= M1 4340.3 5202.7
+ Deposits with agreed maturity up to 2 years 2134.9 1784.9
+ Deposits redeemable at a period of notice up to
3 month
1722.9 2102.2
= M2 8198.2 9089.7
+ Repurchase agreements 331.0 122.3
+ Money market fund (MMF) shares/units 745.0 457.8
+ Debt securities up to 2 years 171.8 140.0
= M3 9445.9 9809.9

21. The Banking System

22. Table 11.1 A Simplified Balance Sheet of a Commercial Bank
Assets Liabilities
Reserves €10 million Deposits €100 million
Government bonds €20 million
Loans €70 million
22
bank reserves: funds not loaned out by a private bank, but kept
as vault cash or as deposit at the central bank
In most countries, banks are required to keep some share of
their deposits as reserves – this is called required reserves

23. How Commercial Banks Earn Profits
 Government bonds
– Earn interest by lending money to national governments
– Relatively safe and liquid
 Portfolio of loans
– Funds that are owed to the bank by businesses, households,
nonprofits, or nonfederal levels of government
– Less liquid than government bonds
– Major asset and major way to make earnings
Chapter 11 23

24. Table 11.2 Bank Types
Chief Functions
Retail banks Safekeeping of money, checking accounts, loans
Savings banks Similar to retail bank but specializing in loans, particularly
mortgages and loans to small and medium sized businesses
Cooperative banks Same as a retail bank, but cooperatively owned by customers
Private banks Caters almost exclusively to high net worth individuals; functions
extend beyond traditional banking into variety of financial
services
Investment banks No traditional banking functions; involved in underwriting and
issuing securities, assistance with company mergers and
acquisitions, market making, and general advice to corporations
Universal banks Covering both investment and retail banking services
Central banks Overseeing the monetary stability of the national economy by
setting interest rates and providing liquidity to commercial banks
Chapter 11 24

25. Banks and Their Activities Have Been and Still Are
Heavily Regulated
 Rules about
– minimum reserves, capital requirement, qualification of the
management
 After WWII, binding ceilings for interest rates on
deposits and loans
 USA: Banking Act (Glass-Steagall Act) of 1933:
separation of commercial and investment banking
 Wave of deregulation in the 1990s
 Re-regulations after the financial and economic crisis
2008-09
Chapter 11 25

26. How Commercial Banks Create Money
 When a commercial bank decides to make a loan, it
credits the amount to the checking account
– With the stroke of a key, deposit money is created!
– This increases M1
 Hence, commercial banks can create money!
Chapter 11 26

27. The Central Bank and Commercial Banks‘ Money Creation
 In the euro area (and other jurisdictions), commercial
banks are required to hold a certain share of their
deposits as reserves
 Banks need to borrow these reserves
– From other banks
– From the ECB
 These reserves do not need to be available at the time
when a deposit or a loan is made, but have to be put in
the account within a certain time
 If commercial banks need cash, they have to borrow it
from the ECB
Chapter 11 27

28. Chapter 11 28
Central Bank
Commercial
Bank A
Commercial
Bank B
Borrower
Bank makes loan
Increase Money Supply M1

29. Chapter 11 29
Central Bank
Commercial
Bank A
Commercial
Bank B
Borrower
Commercial
Bank hold
certain share
of deposits at
Central Bank
Reserve Requirement
reserves do
not need to
be available
at the time
when a
deposit or a
loan is made!
Bank makes loan
Bank A/B borrows reserves from Bank B/A
or Bank A/B borrows from
Central Bank against collateral
and interest rate

30. 30
Central Bank
Commercial
Bank A
Commercial
Bank B
Borrower
CB provides
cash
Commercial
Bank
provides
collateral and
pays interest
ATM
Commercial Bank provides Cash NO increase in M1

31. Money and Finance

32. Functions of Finance
 Provision of money to support investment in real
capital
 Portfolio investment, i.e. investing funds in securities
such as stocks or bonds
 another form of saving, a means of postponing
consumption
Chapter 11 32

33. Speculation as Investment
 Exploit changes in prices to achieve short-term profit
 Economic impact of risking their own funds is limited
 Speculators may borrow money in order to exploit
what they see as market opportunities based on
short-term price movements
 Leverage—investments based on borrowed funds
Chapter 11 33

34. Nonbank Financial Institutions
Chapter 11 34
a financial institution that performs a number of
services similar to those offered by banks but that is
not a licensed bank and is not subject to banking
regulations
 An industry that has been growing in size and importance
relative to banking
 Activities do not directly affect the money supply
 Loans from these entities, unlike transactions using bank
accounts, are not liquid  “nonmoney assets”

35. Nonbank Financial Institutions
 Collective investment vehicle or pooled fund
– an investment vehicle that pools investments from many different
sources, making investment decisions for them all as a group
 Index fund
– a type of pooled fund that tries to replicate a common stock or bond
market index. As this fund does not require active management by a
manager, fees are usually lower than in other types of pooled funds
 Hedge fund
– a type of pooled fund that often engages in highly speculative
investments and to which access is generally restricted to wealthy
clients
Chapter 11 35

36. Nonbank Financial Institutions
 Pension fund
– a fund with the exclusive purpose of paying retirement benefits
 Insurance company
– a company that pays to cover all or part of the cost of specific
risks against which individuals and companies chose to insure
themselves
 Reinsurer
– a company that sells insurance to insurance companies to share
the risk in case of large damages caused e.g. through natural
disasters.
Chapter 11 36

37. Nonbank Financial Institutions
 Securities broker
– an agent responsible for finding a buyer for sellers of different
securities, thereby offering enhanced liquidity to the seller
 Building society
– a financial institution which collects savings from its customers
and offers them at preferential rates to other customers so that
they can buy or build a residence
 Shadow bank
– credit intermediation that involves entities and activities outside
the regular banking system
Chapter 11 37

38. Modern Economies Are Much More Dependent Than
Ever on Finance
 In the euro area, total financial assets banking sector
roughly doubled from 2003 to 2013 to a total of €57
trillion (almost six times euro area annual GDP)
 In the UK and US, financial assets have surpassed the
equivalent of ten times the respective national GDP
 Financial transactions is even larger. For the U.S., this
value was 73 times GDP already in 2009, primarily a
result of rapid growth in high-frequency trading
Chapter 11 38

39. Is Too Much Finance Bad for the Economy?
 When economies grow on the basis of mass
investment in assets with questionable foundations,
yet rise in price, the growth is unstable and destined
to be of short duration
 Such irrational speculative price rises are called
bubbles
Chapter 11 39

40. The Dutch Tulip Frenzy (Tulip Mania)
1636-37
 Different tulip types had different values
 Mass speculation
– first: only wealthy Dutch were buying them
– eventually, everyone was buying tulips
 Rapid increase in prices
– peak: March 1637
– some select bulbs sold for several times the yearly
income of a skilled craftsman
– shortly thereafter, confidence in their value vanished
 Almost overnight, the tulip market crashed, and many
speculators were ruined.
Chapter 11 40

41. Stock Market Bubble 1929
 “new reality”
– establishment of the Federal Reserve in 1913
– government policies to extend free trade, fight inflation,
relaxation of antitrust laws
 1920s: everyone is buying shares
– consumer debt was taken on to buy stock shares (instead of
consumer goods)
 October 1929: the stock market crash
 The Great Depression
Chapter 11 41

42. Dow-Jones Industrial Stock Price Index for USA, 1914-
1942
Chapter 11 42
0
50
100
150
200
250
300
350
400
Dollars
per
Share
Source: National Bureau of Economic Analysis

43. Since the 1970s, Many Other Bubbles Developed…
 East Asia 1997
 “Dot-com” stock market bubble 1999/2000
 Housing bubbles in the US, UK, Ireland, Spain and
other European countries late 2000s
 Bubbles are characterized by a rapid increase in prices
that are not generally accompanied by an equally
rapid improvement in economic conditions
 buying begets more buying
 appreciation in the asset values is fleeting
Chapter 11 43

44. Why Do We Fail to Learn From Past Mistakes?
Speculative bubbles form for psychological and
economic reasons
 Psychological reasons
– faith or “blind optimism”
– herd behaviour
 Economic reasons
– easy credit
– borrowing for purchases of stocks or real estate
– inflation of a financial bubble
Chapter 11 44

45. How Exactly Are All These Possibilities of Bank-Based
and Non-Bank-Based Finance Linked to the
Macroeconomy?
Finance is crucial to realize investment plans of firms
 no savings have to be collected prior to the
investment undertaking
 banks can create deposit money by extending loans
with “the stroke of a pen”
 investment plans depend on banks and non-banks
willingness and ability to provide funds to firms and
households
Chapter 11 45

46. Figure 11.2 Credit and Aggregate Demand
Aggregate Expenditure
Credit
Volume
Less
financialized
economy
More
financialized
economy
Chapter 11 46
 A larger amount of credit disbursed tends to lead to more aggregate demand:
Money is usually borrowed by households and firms to finance spending on
consumer goods, residential properties or new equipment.
 However, the more
finalized an economy,
the more of the credit
goes into non-
productive activities
without an impact on
aggregate demand. For
a financialized
economy, therefore,
the Credit-AE-curve is
further to the left.

47. The International Aspect of Finance: Cross-Border
Trading of Financial Assets
 Some invest in foreign assets because of good
performance of – for example – a Japanese car
company
 Others invest abroad to speculate on changes in the
exchange rate
 Trading financial assets across borders means that
one country borrows and another country acquires
claims
Chapter 11 47

48. What to Take Home (I)
 Hyperinflation comes from running the printing press
 Deflation is a fall in aggregate price levels
 Money is a store of value, a medium of exchange, and
a unit of account
 Economists differentiate between commodity money
and fiat money
 Commercial banks make profits through collecting
deposits and investing in a portfolio of loans as well as
miscellaneous securities
 Deposit money is created when banks make loans
Chapter 11 48

49. What to Take Home (II)
 Nonbank financial institutions are not subject to
banking regulations
 Economies became financialized
 Irrational speculative real estate or asset price rises
are called bubbles
 Finance is crucial to realize investment plans of firms
49