Chapter 18 Money and banking ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Some key questions Why does society need money? Why do governments wish to influence the money supply? How do financial markets interact with the ‘real’ economy? What is the relationship between money and interest rates? ©McGraw-Hill Companies, 2010 2

©McGraw-Hill Companies, 2010 Money Any generally accepted means of payment for delivery of goods or the settlement of debt Legal money notes and coins Customary money IOU money based on private debt of the individual e.g. bank deposit. ©McGraw-Hill Companies, 2010 3

Money and its functions Medium of exchange money provides a medium for the exchange of goods and services which is more efficient than barter Unit of account a unit in which prices are quoted and accounts are kept Store of value money can be used to make purchases in the future Standard of deferred payment a unit of account over time: this enables borrowing and lending ©McGraw-Hill Companies, 2010 4

©McGraw-Hill Companies, 2010 Modern banking A financial intermediary an institution that specialises in bringing lenders and borrowers together e.g. a commercial bank, which has a government licence to make loans and issue deposits including deposits against which cheques can be written Clearing system a set of arrangements in which debts between banks are settled ©McGraw-Hill Companies, 2010 5

A beginner’s guide to the financial markets Financial asset a piece of paper entitling the owner to a specified stream of interest payments over a specified period Cash notes and coins, paying no interest the most liquid of all assets Bills Short-term financial assets paying no interest directly but with a known date of repurchase by the original borrower at a known price. highly liquid ©McGraw-Hill Companies, 2010 6

A beginner’s guide to the financial markets (2) Bonds longer term financial assets – less liquid because there is more uncertainty about the future income stream Perpetuities an extreme form of bond, never repurchased by the original issuer, who pays interest forever e.g. Consols Gilt-edged securities government bonds in the UK Company shares (equities) entitlements to receive corporate dividends not very liquid ©McGraw-Hill Companies, 2010 7

Credit creation by banks Commercial banks need to hold only a proportion of assets as cash reserves. This enables them to create credit by lending. Example: Assume banks use a reserve ratio of 10 per cent. Suppose, initially, the non-bank private sector has wealth of £1000 held in cash: ©McGraw-Hill Companies, 2010 8

Credit creation by banks (2) ©McGraw-Hill Companies, 2010 9

©McGraw-Hill Companies, 2010 Financial crises A financial panic is a self-fulfilling prophecy. Believing a bank will be unable to pay, people rush to get their money out. But this makes the bank go bankrupt. In a solvency crisis, an institution’s assets have become less than its liabilities. In a liquidity crisis, an institution is temporarily unable to meet immediate requests for payment. ©McGraw-Hill Companies, 2010 10

©McGraw-Hill Companies, 2010 The subprime crisis A subprime mortgage is a housing loan to a low-income high-risk person. Most of these mortgages were at variable interest rates: although initially low and ‘affordable’, they could subsequently be raised US house prices peaked in 2006. As they then fell, lenders became worried and began to raise mortgage interest rates, driving many of the poor to default. Suddenly, these subprime mortgages were worth a lot less than had been thought. ©McGraw-Hill Companies, 2010 11

©McGraw-Hill Companies, 2010 Securitisation Securitisation transformed this into a global problem. Financiers had bundled lots of individual subprime mortgages into large bundles and sold them on to new buyers in London, Frankfurt and Mumbai. The market was convinced that although one poor subprime household might default, they would not all do so together. However buyers of securitized mortgages had miscalculated. ©McGraw-Hill Companies, 2010 12

©McGraw-Hill Companies, 2010 The Credit Crisis It was quite likely that circumstances could arise in which all subprime borrowers got into trouble at the same time. And so they did. As US house prices fell sharply, banks found their assets worth much less than they had thought.   As the solvency of banks came into question, people became reluctant to lend to banks, and banks themselves became reluctant to lend to anyone else ©McGraw-Hill Companies, 2010 13

UK interest rates: Jan 2000-Sep 2010 Source: Bank of England ©McGraw-Hill Companies, 2010 14

The Gap between the Bank rate and the LIBOR The bank rate is the interest rate at which commercial banks can borrow from the Bank of England LIBOR, the London interbank offer rate is the rate at which banks lend to other banks. In normal times the difference is very small. The graph also shows how sharply interest rates fell as the Bank of England reacted to the crisis. ©McGraw-Hill Companies, 2010 15

Interest rate spread: LIBOR-Bank rate ©McGraw-Hill Companies, 2010 16

The monetary base and the money multiplier The monetary base or stock of high-powered money the quantity of notes and coin in private circulation plus the quantity held by the banking system The money multiplier the change in the money stock for a £1 change in the quantity of the monetary base ©McGraw-Hill Companies, 2010 17

©McGraw-Hill Companies, 2010 The money multiplier The money multiplier is M / (R+Cp), the broad money supply M divided by banks’ reserves R and cash held by the public Cp. The Crisis caused a sharp decline The bank deposit multiplier M/R is several times larger. Just before the crisis, the bank deposit multiplier was around 90. Banks had £90 of deposits for every £1 in reserves. ©McGraw-Hill Companies, 2010 18

Narrow and broad money in the UK, December 2009 £billion cash in circulation (outside central bank) 46 + retail deposits in banks and building societies 1134 + wholesale deposits 867 = Money supply M4 (broad money) 2047 Source: Bank of England UK statistics distinguish retail and wholesale deposits. Retail deposits are made in high street branches at the advertised rate of interest. Wholesale deposits, big one-off deals between a corporate depositor and a bank at a negotiated interest rate. ©McGraw-Hill Companies, 2010 19

Motives for holding money Transactions Motive payments and receipts are not perfectly synchronised: so money is held to finance known transactions depends upon income and payment arrangements Precautionary Motive because of uncertainty: people hold money to meet unforeseen contingencies depends upon the (nominal) interest rate ©McGraw-Hill Companies, 2010 20

Motives for holding money (2) Asset Motive people dislike risk, so may hold money as a low-risk component of a mixed portfolio depends upon the opportunity cost (the nominal interest rate) ©McGraw-Hill Companies, 2010 21

The demand for money: summary Quantity Effect of rise in: Demanded Price Real Interest level Income rate Nominal Rises in Rises Falls Money proportion Real Not Rises Falls Money affected ©McGraw-Hill Companies, 2010 22

Some maths: The money multiplier Suppose the banks wish to hold cash reserves R as as fraction (cb) of deposits (D), and the private sector wish to hold cash (C) as a fraction (cp) of bank deposits (D). Then R = cbD and C = cp D Monetary base H = C + R = (cb + cp) D Money supply = C + D = (cp + 1) D (1) So M = (cp + 1) (cp + cb) H Note: insert D=H/((cb + cp) Into (1) Money supply = money multiplier × monetary base ©McGraw-Hill Companies, 2010 23