ECON 141: Macroeconomics Ch 5: Money and Banking Mohammed Alwosabi

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1 Chapter 5 MONEY, BANKING, AND MONETARY POLICY 1 WHAT IS MONEY Money is anything that is generally accepted as a measure of payment and settling of debt. Money is a stock concept. It is a certain amount at a given point in time. Money is distinct from wealth or income. Wealth of a person (or nation) is the value of assets owned minus the value of liabilities owed at a point in time. Income refers to the flow of earnings per unit of time 2 FUNCTIONS OF MONEY Money has three main functions: (1) medium of exchange, (2) unit of account, and (3) store of value. Of these three functions, its function as a medium of exchange is what distinguishes money from other assets such as stocks, bonds, and houses. (1)Medium of Exchange: Money is used as a medium of exchange in the form of currency or checks. It is used to pay for goods and services. For example, When you buy a meal for lunch you are using money as a medium of exchange The use of money as a medium of exchange promotes economic efficiency by minimizing the time spent in exchanging goods and services, which is called transaction cost. 3 4 Without money as medium of exchange, goods and services must be exchanged directly for other goods and services. This is called barter. Barter requires a double coincidence of wants, in which you have to find someone who not only has a good or service you want but also wants the good or service you have to offer. For example if you have CDs and you want to get orange juice, you must find someone who has orange juice and is looking for CDs. 5 It is very difficult to find another individual who has what you want, and wants what you have. With the invention of money, you no longer need to find another individual who has what you want, and wants what you have. All you need to do is to find someone who has what you want, and you buy it from him/her with "money". Hence, the problem of double coincidence of wants is avoided. Money reduces the high search costs that are characteristic of barter exchanges. 6 1

2 The use of money as a medium of exchange also promotes economic efficiency by allowing people to specialize in what they do best. Specialization increases productivity. 7 (2) Unit of Account Unit of Account refers to the use of money to measure value in the economy, i.e., to quote prices of goods and services. The unit of account in Bahrain is Bahraini Dinar. People quote prices in Dinar. A seller tells you the price of TV is BD300 not 30 shirts (even though they may amount to the same thing). A BD10000 price tag on a new car is an example of money as a unit of account. 8 (3) Store of Value A store of value is any good or asset that people can store while it maintains its value or most of its value. The function of money as a store of value refers to the use of money to save purchasing power from the time income received until the time it is spent. This function facilitates the exchange of goods and services over time. Money is not unique as a store of value. There are many other assets can be used as a store of value such as stocks, bonds, real estate, collectibles, arts, etc. In fact many such assets have advantages over money as a store of value. They earn a return while money (as cash) does not earn a return However, money is the most liquid of all assets because it is the medium of exchange; it does not need to be converted into anything else to make purchase. Other assets involve transaction costs when they are converted into money. The problem of money as a store of values is that it loses value during inflation. 11 TYPES OF MONEY: Money consists of 1.Currency: The paper notes and coins that people use in a country. They are money because government declares them so. (legal tender) 2.Deposits at banks and other depository institutions are also money. Deposits are money because they can be converted into currency and because they are used to settle debts. Currently, deposits are the largest 12 proportion of money. 2

3 Are Checks money? The answer is no. The check is only a way to instruct your bank to transfer money from your account to another person s account. However, deposit accounts are money Is credit card considered money? No. It is not. It does not make a final payment and the debt it created must eventually be settled by using money. Credit card is just an ID card that lets you take out a loan at 13 the moment you buy something. MEASURES OF MONEY: Economists and governments have a broader measure of what money is than cash. There are two main official measures of money. They go from most liquid asset to the least liquid id asset. Liquidity idi is the ease with which an asset can be converted into cash with little loss in value. 14 M1 The narrowest measure of money is M1, which includes assets that can be used directly as a medium of exchange. M1 = Currency outside banks +Traveler s Checks + Demand deposits + Other checkable deposits Note that the currency component of M1 includes only paper money and coins in the hands of the non-bank public (in circulation) and does not include cash that is held in ATMs or banks vaults. The traveler s checks component of M1 includes only traveler s checks not issued by banks. 15 The demand deposits component includes business checking accounts that do not pay interest as well as traveler s checks issued by banks. The other checkable deposits item includes all other checkable deposits, particularly checking accounts held by households that pay interest, such as NOW (negotiated order of withdrawal) and ATS (automatic transfer from savings). M1 is considered by the central bank perfectly liquid assets, i.e. pure medium of exchange. 16 M2 M2 is a broader measure of money than M1. It includes items that are contained in M1 and a few other items. M2 = M1 + savings deposits and + small denomination time deposits + Money market deposit accounts and money market mutual fund shares. Saving deposits are non-transactions deposits that can be added to or taken out at any time. Small denomination time deposits are certificates of deposit (CDs) with a denomination of less than $ , that can only be redeemed at a fixed maturity date without a penalty. Money market deposit accounts (i.e. interest bearing accounts) are short term accounts that pay interest and allow limited withdrawals. They are similar to money market mutual funds, but are issued by banks

4 Money market mutual fund shares are retail accounts on which households can write checks. Money market mutual funds are interest-bearing shares in pools of funds accumulated by investment companies. The funds are invested in short-term term securities. The components of M2 (other than M1) are considered as the assets that emphasize the function of money as a store of value. However, they can also be used as medium of exchange (with some delay). 19 There is another measurement of money which is M3. M3 is the broadest measure for money, includes some of the longer-term money market instruments. The components of M3 (other than M2) are assets of mostly large businesses and institutions. They are very non-liquid assets, and hence not used as medium of exchange. 20 A country has $3000 million as currency outside banks, $9000 as checking deposits, and $5000 as saving and time deposits. Calculate M1 and M2 M1 = =$12000 million M2 = = $17000 million In an economy there is $100 in currency held outside banks, $50 million in traveler s checks, $ million in currency held inside the banks, $150 million in checking deposits, $300 million in savings deposits, and $400 million in time deposits. The value of M1 is $300 and M2 equals to $ Suppose you have $2000 in your checking account and $5000 in your saving account. You transferred some money from saving to checking account. What is the impact on M1 and M2? M1 will increase but M2 will stay the same COMMERCIAL BANKS A depository institution is a firm that accepts deposits and makes loans. They minimize the cost of obtaining funds, create liquidity and pool risks. A commercial bank is a firm that is licensed by government to receive deposits and make loans. The commercial bank is a financial intermediary that stands between lenders and borrowers

5 Banks earn profits by lending the money that people deposit to the borrowers at higher interest rates than the interest rates the bank pays to the depositors. The balance sheet of a commercial bank is a summary of its business that lists its assets, and liabilities. Assets are what the bank owns. Assets include reserves and loans Liabilities are what the bank owes (debts and obligations to the public). Liabilities include deposits and net worth. 25 Net worth is the value of the bank to its stockholders. (Net Worth = Assets Liabilities) Your deposit at your bank is a liability to the bank and asset to you because the bank must pay your deposit whenever you decide to take your money out of the bank. The objective of a commercial bank is to maximize the net worth of its stockholders. 26 Reserves Actual Reserves consist of : 1.Cash in the bank s vault (notes and coins) to meet the bank s depositors demand for currency and to make payments to other banks. 2.Deposits required by the Central Bank: This part of the reserves kept at the central bank is also used to receive and make payments to other banks The fraction of a bank s total deposits that are held in reserves is called reserve ratio (RR=R/D), where R: reserves and D: deposits. The reserve ratio changes when a bank s customers make deposits or withdrawals. Making a deposit increases the reserve ratio, and making a withdrawal decrease the reserve ratio Banks are required to hold a level of reserves that does not fall below a specified percentage of total deposits. This percentage is the required reserve ratio. The required reserves ratio (RRR) is the ratio of reserves to deposits that banks are required to hold by regulations. RRR = RR / D Note that if RRR decreases, banks will be able to give more loans 29 Also note that the actual reserves are the reserves that banks actually keep which could be more or equal to the required reserves. If there is a difference between the actual reserves and the required reserves, this difference is called the excess reserves. Excess reserve = Actual reserve - Required reserve Whenever banks have excess reserves, they are able to create money and lend out additional fund. 30 5

6 Loans to business and individuals: A loan is a commitment of a fixed amount of money for agreed upon period of time. : Suppose a bank has the following balance sheet (in millions of dollars) Assets Liabilities Reserves 150 Deposits 500 Loans 350 Total 500 Total Suppose the required reserve ratio (RRR) is 10 %, then Actual reserves (AR) = 150 Required reserves (RR) = (RRR) (Deposits) = (0.10) (500) = 50 ER= AR RR = = 100 Since loans are the main source of profit for the bank, the bank in the current situation is not maximizing profit. The bank can provide more loans that equal to $100 million (the excess reserves) and thus increase its profit. 32 The new balance sheet shows a profit- maximizing balance sheet, after keeping only the required reserve. Assets Liabilities Reserves 50 Deposits 500 Loans 450 Total 500 Total : Assets Liabilities Reserves 100 Deposits 800 Loans 700 Total 800 Total 800 Suppose a customer deposits a $50 of currency into his current account. If the RRR is 7% the immediate excess reserve is equal to $ This excess reserve will be loaned to some borrowers. 34 How Banks Create Money Banks create deposits by making loans. The amount of deposits banks can create is limited by their reserves. To understand how banks create money we make the following assumptions 1. Banks are able to make as much loans as they want to 2. Banks always keeps reserves equal to required reserves to maximize profits People take loans and deposit these loans back to their banks 4. If M1 = C + D, where C = currency outside banks and D = checking deposits, then M1 = C C + D Suppose $100 million is taken from currency outside the banking system and deposited to the banks C C = 100 (and D D = 100). The first immediate effect is the increase in deposit by $100 and the increase in the actual reserve by $

7 However, since banks keep only the required reserve, from this extra $100 million deposit only 10% (equal to $10 million) must go to reserves. The remaining $90 million is considered excess reserves that can be loaned. Thus, the initial increase in loans is $90 million. 37 But the story does not end here. This new $90 million loans will be deposited back in the banking system and 10% of it which is $9 million will be added to the required reserves. The remaining $81 million will be the new excess reserves that can be loaned to public. This new $81 million loans will be deposited back in the banking system and 10% of it will be added to the required reserves. The remaining amount will be the new excess reserves that can be loaned to public. This process will continue until there are 38 no more extra loans that can be given. To calculate the total increase in deposits, reserves, loans and thus the money we use the money multiplier. Money multiplier = m = 1 / RRR = 1/ = 10 If D is the initial deposit, R is the initial reserves, and L is the initial loan then Total increase in Deposits = D x m = 100 x 10 =1000 Total increase in Reserves = R x m = 10 x 10 = 100 Total increase in Loans = L x m 90 x 10 = The change in quantity of money = change in currency + the final change in deposits. M1 = C + D = = 900 Note the change in quantity of money is equal to the total change in loans. Quantity of money increases by $900 million as a result of the total increase in loans by that amount. The banks can increase their loans as deposits increase 40 THE CENTRAL BANK AND THE MONETARY POLICY The central bank of any country is a government authority in charge of regulating the country s financial institutions and controlling the quantity of money. The central bank is the bank of the banks and the bank of government. It does not provide general banking services to individual citizens and business firms. There is only one central bank for each 41 country. The central bank s goals are to keep 1. low rate of inflation, 2. maintain full employment, and 3. contribute toward achieving long-term economic growth. To help achieving these goals the central bank conducts the country s monetary policy through adjustments of the quantity of money in circulation and the interest rates. The central bank uses three main tools to conduct the monetary policy: required reserve ratios discount rate and open 42 7

8 The central bank uses three main tools to conduct the monetary policy: required reserve ratios, discount rate, and open market operations Required Reserve Ratio All depository institutions i i in the country are required to hold a minimum percentage of deposits as reserves. This minimum percentage is known as a required reserve ratio. To reduce inflation, the central bank conducts a contractionary monetary policy using the required reserve ratio. It requires depository institutions to hold more reserves which results in increasing the reserves and thus reducing the amount they are able to lend Loans decrease money supply (quantity of money) decreases AD decreases AD curve shifts leftward To reduce unemployment, the central bank conducts an expansionary monetary policy using the required reserve ratio. Required reserves decrease loans increase Ms (Qm) increase AD increase AD curve shifts rightward. Discount Rate The discount rate is the interest rate the central bank charges the commercial banks and other depository institutions when they borrow reserves from it. To reduce inflation, the central bank conducts a contractionary monetary policy using the discount rate It increases the discount rate higher cost of borrowing reserves banks borrow less reserves from central bank but with a given required reserves banks decrease their lending to decrease their borrowed reserves Loans decrease money supply (quantity of money) decreases AD decreases AD curve shifts leftward. To reduce unemployment, the central bank conducts an expansionary monetary policy using the discount rate. It decreases the discount rate lower cost of borrowing reserves banks borrow more reserves from central bank banks increase their lending Loans increase money supply (Qm) increases AD increases AD curve shifts rightward

9 Open Market Operations (OMO) An open market operation is the purchase or sale of government securities by the central bank in the open market. To reduce inflation, the central bank conducts a contractionary monetary policy using the open market operation. Central bank sells government securities people pay money to buy government securities from the central bank banks deposit decreases banks reserves decrease Loans decrease money supply (Ms) decreases AD decreases AD curve shifts leftward. 49 To reduce unemployment, the central bank conducts an expansionary monetary policy using the open market operation. Central bank buys government securities people receive money from the central bank banks deposit increases banks reserves increase Loans increase money supply (Ms) increases AD increases AD curve shifts rightward. 50 In conclusion, To increase commercial bank lending the central bank can lower the required reserve ratio, lower the discount rate, or buy government securities. To decrease commercial bank lending the central lb bank can raise the required reserve ratio, raise the discount rate, or sell government securities