Macroeconomics - Lecture 6

Reading for Today

  • Textbook:
    • Sloman, Garratt, Guest (11th ed.), Ch. 18.1, pp. 561-563
    • Sloman, Garratt, Guest (11th ed.), Ch. 18.2, pp. 563-574
  • Supplementary reading:
    • Sloman economics news site
    • Money market
    • The Financial Times (6/5/2025)

The Role of Money and Financial Institutions

  • Money and financial institutions play an important role in the economy.
    • Changes in the amount of money can impact inflation, unemployment, economic growth, interest rates, exchange rates, and the balance of payments.
  • Systemic importance of financial institutions revealed in financial crises.
    • How, if at all, can we avoid financial crises?
    • Are some financial institutions still too big to fail?
    • Can we prevent financial institutions from fueling credit bubbles?
    • Can we better align incentives of banks and the wider community?

Aim of this Lecture

  • Introduce the meaning and functions of money
  • Examine the operation of the financial sector
  • Discuss bank liquidity, profitability, and capital adequacy

Meaning and Functions of Money

  • Meaning of money:
    • Money is more than cash (notes and coin).
    • Main component of money supply is not cash, but bank deposits that appear merely as bookkeeping entries.
    • Will a bank have enough cash to meet its customers’ demands? Normally, yes.
    • Most transactions done without cash, transferring money between bank accounts.
  • Functions and attributes of money:
    • Functions of money:
      • Medium of exchange: is acceptable in exchange for goods and services.
      • Store of wealth: holds its value over time.
      • Unit of account: allows the value of goods, services or assets to be compared.
    • Attributes of money:
      • Durability: withstand repeated usage
      • Divisibility: come in a number of denominations
      • Transportability: light enough to be carried around
      • Non-counterfeitability: hard to forge
  • Money supply:
    • What should count as money?
      • The narrowest definition of money includes just cash (notes and coins).
      • Broader definitions of money include various types of bank account, and even broader definitions include various financial assets as well.
    • Money supply vs national income and wealth:
      • If money supply increases will national income increase by the same amount? No; rise in national income > rise in money supply, as extra money spent more than once per year.
      • Is the money supply the same as national wealth? No; nation’s wealth consists of real assets: land, buildings, machines, etc.
  • Is cryptocurrency money? Discuss.

The Financial System

  • The role of the financial sector:
    • Financial intermediaries channel funds from depositors to borrowers.
    • Expert advice: investment and borrowing.
    • Expertise in channelling funds: assess risk and seek highest return.
    • Maturity transformation: exchanging deposits into loans of a longer maturity.
    • Risk transformation: spreading risk by having many borrowers.
    • Transmission of funds: transferring money without the use of cash.
  • The banking system:
    • Monetary financial institutions (MFIs): deposit-taking institutions including banks, building societies, and the Bank of England.
      • Retail banks: retail deposits and loans to individuals and businesses.
      • Wholesale banks: wholesale deposits and loans to companies and other banks.
      • Universal banks: conducting retail and wholesale banking.
      • Building societies: loans (mortgages) for house purchase.
    • Financial deregulation – removal/reduction in legal rules and regulations governing the activities of financial institutions – blurred the distinction between these MFIs.
  • Deposit taking and lending:
    • MFIs provide financial instruments – financial claims by one party over the other.
      • Customers’ claims on the bank (e.g. deposits).
      • Bank’s claims on its customers (e.g. loans).
    • Balance sheets itemise liabilities and assets.
      • Liabilities are all legal claims for payment that outsiders have on an institution.
      • Assets are possessions or claims on others.
    • Significance of banks: total assets of UK MFIs in 2023 were around 4 times the UK’s annual GDP.
  • Financial liabilities:
    • Major types of financial liabilities:
      • Sight deposits can be withdrawn on demand without penalty.
      • Time deposits require notice of withdrawal; fee charged for withdrawals on demand.
      • Certificates of deposit are issued by banks for large, fixed-term interest-bearing deposits (e.g. £100,000 for 18 months); can be resold by owner.
      • ‘Repos’: agreements to sell and then repurchase assets at a fixed price and date.
      • Capital and other funds: largely share capital in banks.
  • Financial assets:
    • Major types of financial assets:
      • Cash and balances in the central bank.
      • Market loans are short term loans (typically days or weeks) to other financial institutions.
      • Bills of exchange are certificates promising to pay the holder a specified sum on a particular date, typically 3 months after issue; sold at discount, redeemed at face value; commercial bills (loans to companies) or treasury bills (loans to government).
      • Longer-term loans: e.g. fixed-term loans (6 months to 5 years), mortgages (20-30 years).
      • Investments: government bonds (gilts); subsidiary financial institutions.
  • Balance sheet of UK banks: January 2024
    • Source: Based on data in Bankstats (Bank of England), Table B1.4, data published 2 April 2024
    • Sterling Liabilities and Assets are detailed in a table (see original document for exact values). Examples include:
      • Sight deposits
      • Time deposits
      • Repos
      • Certificates of deposit & bonds
      • Advances
      • Notes and coin
      • Balances with Bank of England
      • Market loans
      • Bills of exchange
      • Investments
  • Aggregate balance sheet of UK banks and building societies
    • (see original document for exact values)

Liquidity, Profitability and Capital Adequacy

  • Banks make profits by lending money out at a higher rate of interest than that paid to depositors.
  • Liquidity: the ease with which an asset can be converted into cash without loss.
    • Cash, by definition, is perfectly liquid.
    • Banks must maintain sufficient liquidity to meet the demand of money withdrawals.
    • Balance between liquidity and profitability.
    • Maturity gap: The difference in the average maturity of loans and deposits.
    • Liquidity ratio: The proportion of a bank’s total assets held in liquid form.
  • Capital adequacy ratio: The ratio of a bank’s capital (reserves and shares) to its risk-weighted assets.
    • Risk weights: inter-bank loans < mortgages < personal loans, credit cards

Lecture Summary

  • Money’s main function is as a medium of exchange; what counts as money depends on how narrowly it is defined.
  • Bank’s balance sheets (liabilities and assets) consist of financial instruments.
  • Banks aim to make profits, but they must also have a sufficient capital base and maintain sufficient liquidity.