L1-2: Money and Banking

Course Information: 24ECA001 - Principles of Macroeconomics, Semester 2

Topic Focus: Money and Banking

Macroeconomics Study:

• Examines overall economic factors and trends. In layman's terms, it’s like looking at the whole country’s finances, not just your household budget.

• Utilizes data to reflect on macroeconomic inquiries. This is like using stats to understand where the economy is heading.

Reference Graphs:

• GDP metrics from World Bank (links provided). GDP is the total value of everything a country produces, like the ultimate scorecard of economic health. Economically speaking, it is the total market value of all final goods and services produced within a country in a given period. It's used as a broad indicator of a country's economic activity.

Topics Covered:

• Money and Banking: Determination of money supply and roles of central banks and commercial banks. In Lehman's terms this is about understanding how much cash is floating around and who’s in charge of controlling it. Economically, this involves studying monetary policy, banking regulations, and the overall structure of financial institutions.

• IS-LM model: Analysis of equilibrium in goods and money markets; impact of monetary policy. Balance between investment, savings, liquidity preference, and money supply. Monetary policy adjustments and effects. This model helps to understand how the goods market (IS curve) and the money market (LM curve) interact to determine interest rates and output in the short run.

• AD-AS Model: Understanding aggregate demand and supply along with inflation. This model focuses on the total demand and supply in an economy, and how they affect inflation. Aggregate demand represents the total demand for goods and services in an economy at a given price level, while aggregate supply represents the total supply of goods and services that firms plan to sell at a given price level.

• External Sector: Discussion of exchange rates, current account deficits, and international capital flows. Exchange rates affect import and export prices. Current account deficits indicate more imports than exports. International capital flows involve foreign investments.

• Trade and Globalization: Brief exploration of these concepts. Globalization encompasses increased international trade, investment, and information flows. Trade focuses on import and export activities between countries.

Office Hours: Friday, 3 - 5 PM, Office BE 1.66. Encouragement: Students are encouraged to attend.

Main Reference: "Economics (12th Edition)" by David Begg et al., Chapter 21.

Additional Reference: "Economics" by Lipsey and Chrystal, 13th edition, Chapter 18.

Supplementary: Videos related to the topic available.

What is Money?: Medium of exchange widely accepted for goods and services. In layman's terms, it is what you use to buy stuff. Economically, money reduces transaction costs, facilitates specialization, and is essential for the functioning of a modern economy.

Barter Economy Issues: Requires double coincidence of wants; illustrates the advancement with the introduction of money. Bartering requires both parties to want what the other has. Double coincidence of wants means that both parties must want what the other possesses at the same time for a transaction to occur, making it inefficient.

Historical Examples: Use of cigarettes in POW camps; gold and silver coins. These served as money when regular currency was unavailable. These examples highlight how anything that is widely accepted can function as money during times when formal currency systems break down.

Production Considerations: Use of a commodity as money limits its use elsewhere and requires resources for production. Using gold as money means less gold available for jewelry or electronics. This is known as the opportunity cost of using a commodity as money.

Token Money: E.g., a 20 GBP bill’s value surpasses production costs, necessitating restriction on supply rights. The paper and ink cost less than £20 to produce, so the government controls its supply. Token money's value is derived from its acceptance and controlled issuance, rather than its intrinsic material worth.

Roles of Money:

• Unit of account: Measure of value for transactions. This role allows for easy comparison of the relative values of different goods and services.

• Store of value: Saving purchasing power for future use. Money allows individuals to transfer purchasing power from the present to the future.

• Standard of deferred payment: Measure over time for loans. This function enables borrowing and lending, facilitating investment and economic growth.

Definition of Legal Tender: Must be accepted by law as payment (e.g., cash, bank cheques, debit cards). Legal tender laws mandate that certain forms of money must be accepted as payment for debts.

Video Resource: Additional learning on the nature of money.

Function of Banks: Connect depositors with borrowers. Banks take deposits from savers and lend to borrowers. Banks act as intermediaries, channeling funds from those who have surplus funds to those who need them.

• Role of banks in lending deposits. Banks profit by lending out deposited money. Banks earn revenue by charging interest on loans, which is higher than the interest paid on deposits.

Asset and Liability Overview:

• Assets: Loans to businesses/households, government securities. Loans and securities are what the bank owns. These assets generate income for the bank.

• Liabilities: Deposits from customers. Deposits are what the bank owes to its customers. Deposits represent the bank's obligations to its depositors.

Types of Deposits: Sight deposits (checking accounts) and time deposits (savings accounts). Sight deposits are readily accessible, while time deposits have restrictions on withdrawals.

Bank Profit Model: Difference between interest paid to depositors and charged to borrowers (spread). Banks make money on the spread between deposit interest and loan interest. The interest rate spread is a key determinant of a bank's profitability.

Other Financial Intermediaries: Include insurance companies and pension funds, but banks uniquely use liabilities as means of payment. Unlike other intermediaries, banks let you pay others using their liabilities (deposits). This unique function allows banks to create credit and expand the money supply.

Money Creation Table: Demonstrates assets and liabilities at various stages (initial, intermediate, final).

Reserve Ratio: Percentage of deposits not lent out (e.g., hypothetical 10%). Banks keep 10% of deposits in reserve. The reserve ratio is the fraction of deposits that banks are required to hold in reserve.

Wealth Example: 1000 GBP deposited; banks utilize part for loans.

Fractional Reserve Banking: Banks create more money through lending than what they hold in reserves. Banks lend out most deposits, creating more money in the system. This system allows banks to create credit and expand the money supply.

Example Process: Initial deposits enable further loans, leading to increased deposit total.

Reserve Management: Influence over money supply via reserves maintained or exceeded. Banks can control how much they lend based on their reserves. Banks can adjust their lending based on their reserve holdings to influence the money supply.

Money Multiplier Concept: Ratio of total money generated to reserves held. This shows how much the money supply can increase from an initial deposit. The money multiplier quantifies the maximum potential increase in the money supply resulting from an initial deposit.

Components of Money Supply: Cash and deposits at banks; monetary base held in reserves or circulation. Money supply includes all cash and deposits. The money supply includes various forms of money, from physical currency to bank deposits.

Central Bank Influence: Mechanisms to adjust monetary base without direct cash distribution.

Broad Money (M4) Calculation: Total cash and retail/wholesale deposits (e.g., 2377 billion GBP).

Definitions of Money Measures:

• Monetary base: the total amount of a currency that is in general circulation in the hands of the public or in the commercial banks’ reserves held in the central bank

• M1, M2, M3 measures based on deposits and cash. These measures vary in their components and liquidity, providing different perspectives on the money supply.

Monetary Base Control: Central banks manage base, impacting broader measures (M1, M2), influenced by banking behavior.

Post-2008 Trends: Decline in money multiplier due to reduced lending and borrowing appetite. After 2008, banks were less willing to lend. The financial crisis led to changes in banking behavior and a decline in the money multiplier.

FRED Graph: Demonstrates M2 and monetary base trends over time, highlighting lending behaviors.

Historic Trends: Observations on M1 multiplier behaviors post-2000s.

Central Bank Functions: Management of monetary policy pivotal to economic stability. Central banks keep the economy stable. Central banks use various tools to influence interest rates, inflation, and economic growth.

History: Greater government control over central banks from 20th century onwards.

Balance Sheet Overview: Assets and liabilities of the Eurosystem detailing reserves and loans.

Reserve Ratio Adjustment: How central banks manage cash reserves within the banking system.

Open Market Operations (OMOs): Direct impact on money supply through bond transactions. Buying or selling bonds changes the money supply. Open market operations are a primary tool used by central banks to implement monetary policy.

Video on Interest Rate Control: Central banks' strategies via OMOs.

Distinction in Bank Risks: Liquidity vs. insolvency risk impacts on depositors; potential bank runs. Banks face the risk of not having enough cash (liquidity) or having more debts than assets (insolvency).

Regulatory Necessities: Managing risks associated with bank behavior and systemic stability.

Bond Functionality: Relationship between bond prices and interest rates. Bonds pay interest and can be bought or sold. Bond prices and interest rates are inversely related; when one increases, the other decreases.

Market Equations: Illustration of price changes due to interest rate variations.

Major Discussion Points:

• Definition and functions of money.

• Mechanisms of commercial banks in money creation.

• Role of the money multiplier and central bank control.

• Necessity of deposit insurance.

• Inverse relationship between bond prices and interest rates.