13 CHAPTER Money, the Price Level and Inflation

© Pearson Education 2012 After studying this chapter you will be able to:  Define money and describe its functions  Explain what banks are and do  Describe the functions of a central bank  Explain how the banking system creates money  Explain how the demand for and supply of money determines the nominal interest rate  Explain how the quantity of money influences the price level and the inflation rate

© Pearson Education 2012 When you want to buy something, you use coins, notes, write a cheque or present a debt card or credit card. Are all these things money? When you deposit some coins or notes in a bank, is it still money? What happens when the bank lends your money to someone else? How can you get it back? Why does the amount of money in the economy matter? How does it affect the interest rate?

© Pearson Education 2012 What Is Money? Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three other functions:  Medium of exchange  Unit of account  Store of value

© Pearson Education 2012 What Is Money? Medium of Exchange A medium of exchange is an object that is generally accepted in exchange for goods and services. In the absence of money, people would need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. Unit of Account A unit of account is an agreed measure for stating the prices of goods and services.

© Pearson Education 2012 What Is Money? Store of Value As a store of value, money can be held for a time and later exchanged for goods and services.

© Pearson Education 2012 What Is Money? Currency is notes and coins held by individuals and businesses. M4 consists of currency held by the public plus bank deposits and building society deposits. M4 does not include notes and coins held by banks and building societies and it does not include bank deposits of the UK government.

© Pearson Education 2012 What Is Money? Are All the Components of M4 Really Money? Currency is the means of payment, so it is money. Sight deposits can be transferred from one person to another by writing a cheque or using a debit card, so sight deposits are money. Time deposits can easily be switched into sight deposits, so time deposits are money.

© Pearson Education 2012 What Is Money? Cheques, Debit Cards and Credit Cards Are Not Money Cheques are not money. A cheque is an instruction to your bank to move some funds from your account to someone else’s account. Debit cards are not money. Using a debit card is like writing a cheque except the transaction takes place in an instant. A debit card is not a means of payment. Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money. A credit card is not a means of payment.

© Pearson Education 2012 Monetary Financial Institutions A monetary financial institution is a financial firm that takes deposits from households and firms and makes loans to other households and firms. Types of Monetary Financial Institutions The main monetary financial institutions whose deposits are money are:  Commercial banks  Building societies

© Pearson Education 2012 Monetary Financial Institutions Commercial Banks A commercial bank is a private firm, licensed under the Banking Act of 1987, to take deposits and make loans. A commercial bank’s balance sheet lists the bank’s assets, liabilities and net worth. Liabilities + Net worth = Assets Among the bank’s liabilities are the deposits that are the main component of money.

© Pearson Education 2012 Monetary Financial Institutions Building Societies A building society is a private firm, licensed under the Building Societies Act 1986, to accept deposits and make loans. Differences between building societies and banks are:  A building society is usually owned by its depositors.  Deposits are usually saving accounts.  Loans are usually for house purchases.  Reserves are kept at commercial banks.

What Depository Institutions Do The goal of any bank is to maximize the wealth of its owners. To achieve this objective, the interest rate at which it lends exceeds the interest rate it pays on deposits. But the banks must balance profit and prudence:  Loans generate profit.  Depositors must be able to obtain their funds when they want them. Monetary Financial Institutions © Pearson Education 2012

A commercial bank puts the depositors’ funds into four types of assets: 1 Reserves: notes and coins in its vault or its deposit at the Bank of England 2Liquid assets: UK government Treasury bills and commercial bills 3 Securities: longer-term UK government bonds and other bonds such as mortgage-backed securities 4 Loans: commitments of fixed amounts of money for agreed-upon periods of time Monetary Financial Institutions © Pearson Education 2012

Monetary Financial Institutions Economic Benefits Provided by Monetary Financial Institutions All monetary financial institutions make a profit from the spread between the interest rate they pay on deposits and the interest rate at which they lend. Monetary financial institutions provide four services:  Creating liquidity  Pooling risk  Lower the cost of borrowing  Lower the cost of monitoring borrowers

How Monetary Financial Institutions Are Regulated Monetary financial institutions engage in risky business. To make the risk of failure small, commercial banks are required to hold levels of reserves and owners’ capital equal to or surpass ratios laid down by regulation. The required reserve ratio is the minimum percentage of deposits that a bank is required to hold in reserves. The required capital ratio is the minimum percentage of assets that must be financed by the bank’s owners. Monetary Financial Institutions © Pearson Education 2012

Creating Deposits by Making Loans When a bank receives a deposit, its reserves increase by the amount deposited. But the bank doesn’t hold all of the deposit as reserves, it loans some of the amount deposited. These loans end up as deposits. The banking system as a whole can increase loans and deposits with no change in reserves. The increase in deposits is an increase in money. How Banks Create Money

© Pearson Education 2012 How Banks Create Money What limits the amount of money that the banking system can create? The quantity of loans and deposits that the banking system can create are limited by three factors:  The monetary base  Desired reserves  Desired currency holding

© Pearson Education 2012 How Banks Create Money The Monetary Base The monetary base is the sum of Bank of England notes and banks’ deposits at the Bank of England plus coins issued by the Royal Mint. The monetary base limits the total amount of money that the banking system can create because banks have a desired level of reserves.

© Pearson Education 2012 How Banks Create Money Desired Reserves The fraction of a bank’s total deposits held as reserves is the reserve ratio. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Desired reserve ratio is the ratio of reserves to deposits that banks consider prudent to hold. Excess reserves equal actual reserves minus desired reserves.

© Pearson Education 2012 How Banks Create Money Desired Currency Holding People hold money in the form of currency and deposits. People have a definite view about the proportion of money they want to hold as currency based on expenditure plans. When the total quantity of money increases, people will want to hold more currency. So currency drains from the banking system. The currency drain ratio is the ratio of currency to deposits. The greater the currency drain ratio, the smaller is the quantity of money that the banking system can create.

© Pearson Education 2012 How Banks Create Money The Money Creating Process The money creating process begins when the monetary base increases and the banking system has excess reserves. The process is: 1 Banks have excess reserves. 2 Banks lend excess reserves. 3 The quantity of money increases. 4 New money is used to make payments. 5 Some new money remains on deposit.

© Pearson Education Some of the new money is a currency drain. 7 Desired reserves increase because deposits have increased. 8 Excess reserves decrease, but remain positive. Figure 13.3 on the next slide shows one round in the money creation process. How Banks Create Money

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