Chapter 7: Money, Banking and Monetary Policies

Money

medium of exchange used 2 purchase G/S

ability to act as a store of value.

Money has mainly three functions:

1. Exchange mechanism
2. Stores wealth: maintain/save wealth
3. Measurement tool: measure value of G/S comparisons btw goods’ values.

Money

medium of exchange used 2 purchase G/S

ability to act as a store of value.

Money has mainly three functions:

1. Exchange mechanism
2. Stores wealth: maintain/save wealth
3. Measurement tool: measure value of G/S comparisons btw goods’ values.

barter economy

goods/commodities are exchanged directly for other goods

barter economy has many drawbacks:

1. Uncertainty: w goods willing 2 be exchanged
2. Not easy 2 value goods traded/exchanged

Commodity money

physical asset that has intrinsic value and is exchanged for other goods

commodity money requirements

•Durable (non-perishable)
•Easily transportable
•Divisible
•Homogeneous
•Of limited supply

Examples of commodity money

salt, spices, coffee beans, precious metals
(gold), wheat

Beginning of Fiduciary money

leaving of commodity money in goldsmiths' safe deposit boxes.
Issued receipt→ best 2 pay w receipt and not with the precious metal.

Examples of fiduciary money

paper cheques, banknotes, or electronic credit.

Fiduciary money

backed by nothing more than trust between the two parties in a transaction

Fiat money forms

metallic currency (coins) or banknotes (paper bills) accepted by legal imperative (also known as cash)

banking money:

bank deposits: mobilized through checks, debit cards, electronic payment systems accepted as payment.

Fiat money

Currency w no intrinsic value (not backed by gold/ silver) value from trust/confidence

Gov issued: legal tender by a government decree.

Diff btw Fiat and Fiduciary money

Fiat money: government-issued legal tender backed by law and public trust

Fiduciary money is accepted based on trust alone and is not legal tender.

Principal

The original amount of money borrowed or loaned.

Interest

Extra money paid by the borrower to the lender as a cost for using the borrowed money

Interest Rate

percentage or proportion over the principal to be paid periodically

Periodic Payment

How often interest is paid (e.g., annually, monthly, quarterly).

Why do we ask for an interest rate in exchange for lending money?

The lender asks for compensation (interests) because:
1. Lender forgoing use of the $ lent for a time
2. Lender assuming a risk (borrower might not return $)
3. $ value loss bc of inflation (purchasing power goes down)

Inflation r8 higher than interest r8=

Lenders purchasing power goes down

What determines the interest rate?

supply and demand.

low demand→lower interest r8

Reference Interest r8

Base interest r8 set by European Central Bank (ECB) that eurozone banks pay when borrowing money from it

Eurozone banks must charge more than reference interest r8 2 make profit

Interest r8 considerations when banks lend 2 borrowers…

borrowers risk: higher risk=higher interest r8

loan duration: longer duration=higher interest r8

demand for money

quantity of money ppl R willing to have in the form of cash or deposits

Real assets

material goods bought w the objective of obtaining profit (art pieces, real estate, etc).

Financial assets

Non physical contracts/claims

Represent ownership or debt; used for investment or saving (Stocks/bank deposits/loans)

demand for money depends on:

Income: more income a person has→more goods they buy→ inc. demand 4 $

Interest rates: low interest r8→less investment→more $ demand

Uncertainty: Higher uncertainty→ investing risky→demand 4 $ inc.

supply of money

quantity of $ that circulating in an economy: includes sum of cash (coins/bills), banking deposits, public debt issued by governments
that can become money in circulation in the short term.

supply of money includes…

-cash (coins and bills)

-banking deposits/public debt issued by gov→become $ in circulation in short term

4 types of monetary bases

M0, M1, M2 and M3

M0 :

-currency in circulation (cash and paper bills)

-commercial bank’s reserves (deposits bank forced 2 keep/not lend)

M1 :

M0 + checking accounts and sight deposits.

M2 :

M1 + saving accounts and fixed-term deposits.

M3:

M2 + other assets

sovereign debt (public/gov debt)

sovereign debt

(public or government debt) converted into circulating $ by selling the asset (debt) 2 others in secondary market

Checking accounts & sight deposits (M1)

little/no interest r8 is very small
High seq/liquidity (easily convertible 2 cash)
Deposits can be accessed any time w checks/debit card
Customer can cancel these accounts anytime

Savings deposits/savings accounts (M2)

Higher remuneration (interest rate)
Money only withdrawn w a savings book

Fixed-term deposits (M2)

-Borrower maintains amount borrowed 4 period of time
-Cannot be withdrawn (penalty).
-Higher remuneration interest r8

Public debt

money a government borrows when it doesn’t have enough money to pay 4 schools, roads, hospitals etc.

Who lends money for public debt

Banks

Investors

Other countries: by buying gov bonds/loans

What happens when government debt is sold in the secondary market?

The new buyer pays for the debt and receives the future interest payments and final repayment from the government.

How does the government repay public debt?

Gov. pays interest regularly and gives back full amount borrowed (the principal) at end of loan.

creation of money agents

central banks

commercial banks

people’s decisions

The central banks

-Inject/“print” legal money into circulation
as coins/banknotes
-Decide on req. reserves 2 be held by commercial banks (% of deposits that cannot be loaned)

Central banks inject/“print” legal money into circulation
as coins/banknotes by…

• lending money 2 commercial banks
• open market operations (buy public debt from investors).

Commercial banks

create new money by using the money customers deposit to give out loans

ppls decisions: creation of money

choosing 2 keep money in bank account (deposits) instead spending→ banks have more funds 2 grant loans→creates new money

peoples decisions creation of money

more money ppl leave in banks→more banks can lend→more money is created in the economy through this lending process.

Bank reserves

cash minimums that financial institutions must save 2 meet central bank req (ej. 200/1000$)

Adds security/stability to the financial system

reserve requirement ratio:

% of deposits banks keep as reserves @ all times.
The rest used 2 grant loans 2 families/companies

central vs commercial banks

Commercial banks: customer banking services, serve individuals/buinsnesses

Central banks: national monetary policy and economic stability, serve gov./financial institutions

money multiplier

initial deposit in a bank leads 2 inc. in economy’s money supply

banks lend a portion of the deposit→money is redeposited& lent again

Money Multiplier=

1/Reserve Requirement Ratio (RRR)

divided by*

Reserve requirement is 10% (or 0.10), the money multiplier would be:

1 / 0.10= 10

This means that for every €1 deposited, up to €10 can be created in the economy through the lending process.

Bank Run

many customer withdrawal deposits from a bank at the same time

leads 2 bank collapse if it doesn't have enough cash 2 meet withdrawal requests

The Eurosystem

European Central Bank (ECB) and the national central banks of eurozone countries,(that have adopted the euro)

Bank of Spain

national central bank in spain

The functions of the eurosystem are:

1. Issue all coins/bills in eurozone.
2. Compile statistics (interest r8s etc).
3. Ensure functioning of payment systems
(debit cards, checks, etc).
4. Manage foreign currencies
5. Carry out monetary policy.

MONETARY POLICY

set of measures taken by ECB to…

-control amount of $ in circulation (monetary supply)
-influence agg. demand 2 achieve macro objectives

macroeconomic objectives

-growth

-employment

-price stability

-budgetary/external balance

Objectives of the ECB

Main: price stability, (2% level inflation r8).

Secondary: GDP growth/employment

ECB instruments 2 achieve macro objectives

1. Interest rates:
2. Open market operations (OMOs):
3. Setting reserve requirement ratio:

Interest rates: ECB…

lends/borrows money w commercial banks @ certain interest r8s. lower lending r8→ higher the economy's spending→can lead to inflation.

Open market operations (OMOs):

ECB injects/withdraws money by buying/selling public debt, respectively

Setting reserve requirement ratio ECB

Lower RRR→ more $ banks can loan 2 public

Using three instruments, ECB can carry out…

expansionary and contractionary fiscal policy

Expansionary monetary policies:

Policies that increase the monetary supply.

More money in circulation→greater the economy's spending (more aggregate demand)→increase GDP/employment→ higher inflation.

contractionary monetary policy

reduces amount of $ in circulation 2 control inflation, creation of money, & spending

3 types interest rates ECB

a) Deposit facility’s interest rate:
b) Marginal lending facility’s interest rate:
c) Main refinancing operations’ interest r8/discount

ECB Monetary Policy March 2025

Lower interest r8s 2 stimulate economic activity/manage inflation in euro area.

Reducing borrowing costs→encourage lending investment →economic growth

💰ECB Deposit Facility Rate

Interest the ECB pays 2 banks when Banks deposit their money @ ECB overnight.

High r8 → banks want 2 save more w the ECB & lend less 2 people

Marginal Lending Facility Rate ECB

The interest banks pay if they want 2 borrow $ from the ECB overnight (short-term emergency loan 2 banks

High R8 → banks borrow less from the ECB

Main Refinancing Operations (MRO) Rate ECB

Main interest rate banks pay 2 borrow money from ECB 4 one week (standard loan)

Affects the loans and mortgages- in news

Low ECB Interest R8s

→ banks borrow cheaply → they offer cheaper loans to people → people spend more → economy grows

Setting low interest rates

borrowing cheaper→encourages spending →
agg. demand inc. → GDP/employment inc.→stimulate economy.

Might put inflationary pressure.

after the COVID-19 pandemic

High R8s Inflation reached (over ideal 2% level)

due 2 growing demand (demand-driven inflation) and higher energy and food prices (cost-driven inflation)

Central Banks after Covid-19

contractionary monetary policy 2 control inflation
by setting high interest rates

Contradictory fiscal policy after COVID-19

higher interest r8s→ more expensive 2 borrow→less money circulating → less consumption & investment→ less agg demand → inflationary pressure reduced

interest rate

cost of borrowing money or the return on investment for savings or loans

. Open Market Operation OMOs

Tool ECB uses 2 control money in the economy

By buying/selling gov. debt 2 investors (commercial banks)

OMOs 2 increase Money Supply (Expansionary Policy)

ECB buys government debt from investors (commercial banks).

ECB pays investors in cash→inc. $ in circulation→Higher spending/GDP→Lower unemployment

OMOs 2 Reduce the Money Supply (Contractionary Policy)

ECB sells government debt 2 investors (com. banks)

Investors buy gov. debt w deposits/cash→Less $ circulating → Reduced inflation

Why OMOs Matter:

Primary tool for controlling the economy through monetary policy.

Conducted any time in secondary markets to adjust the money supply.

2 OMOs ECB

• Buying government debt = More money in the economy (stimulating the economy).

• Selling government debt = Less money in the economy (reducing inflation).

3 monetary policies ECB

1. Interest r8s

2. Open Market Operations (omo)

3. Reserve requirement ratio

Reserve requirement ratio: ECB Monetary Policy

decisions on min. amount of reserves that banks must hold to back up their deposits.

increase in reserve req. ratio→bank has less funds available 2 lend→capacity to create money.

ECB Expansionary monetary policy:

A) Reducing the interest rates
B) Purchasing public debt in open/secondary market
C) Reducing reserve requirement ratio
*Lead 2 inc. $ in circulation→inc. spending→ inc GDP → inc. employment

*Danger of rising prices (inflation)

Contractionary monetary policy

A) Increasing interest rates
B) Selling gov. debt in the open/secondary market
C) Inc. reserve requirement ratio
Lower $ circulating→less spending → Prices fall

expansionary monetary policy agg demand shift

2 the right

through an inc. in quantity of money in circulation.

contradictory monetary policy agg demand shift

2 the left

through a decrease in quantity of money in circulation

ECB Limitations

decisions might benefit the situation of certain countries and be detrimental 2 others

(diff levels inflation)