Money and Monetary Institutions Chapter 20 LIPSEY & CHRYSTAL ECONOMICS 12e

Learning Outcomes Money acts as a medium of exchange, a unit of account, and store of value. The existence of money facilitates a wider range of transactions than would otherwise be feasible. Money was originally composed on commodities such as gold and silver.

Learning Outcomes Paper currency was originally convertible into gold or silver, but now has nothing backing it except its acceptability in payment. The money multiplier is the ratio of broad money to high-powered money. Bank deposits are now the biggest part of the total amount of money in the economy, so the behaviour of the banking system is central to determining that amount.

Bank of England balance sheet (February 22nd 2006)

Definitions of UK monetary aggregates Notes and coin. This measure refers to all the currency in circulation outside the Bank of England. Retail M4. This encompasses UK non-bank and non-building society holdings of notes and coins, plus sterling retail deposits with UK banks and building societies.

Definitions of UK monetary aggregates M4. M4 is retail M4 plus all other private sector sterling interest bearing deposits at banks and building societies, plus sterling certificates of deposit (and other paper issued by banks and building societies of not more than five years’ original maturity).

Definitions of UK monetary aggregates M3. This is a harmonized measure created to have standard money definitions throughout the EU. It is equal to M4 plus residents’ foreign currency deposits in UK banks and building societies plus public corporations’ sterling and foreign currency deposits in UK banks and building societies.

UK money supply – January 2010 (£million)

Credit creation We now present two models of the creation of deposit money. The first shows how banks can create a large volume of deposit money on the basis of a given amount of reserves. It is called the ratios approach to the creation of money and is best suited for showing the relation between reserves and deposit money.

The second shows how banks work in a competitive environment to attract the reserves they need in order to create deposit money. This model is better suited to understanding both the forces of competition between banks themselves and the competition between banks and other channels of financial intermediation (such as securities markets).

If you deposit cash with a bank, that deposit is an asset to you and a liability to the bank—because the bank owes that amount to you. Because the bank has the cash as an asset, its assets equal its liabilities. If a bank gives you a loan, it writes an extra balance into your account. This creates a deposit for you, but it is also a loan that you have to repay.

Note! In general, banks’ deposits are their liabilities, and whatever loans they make, or securities they purchase, constitute their assets.

Suppose that, in a system with many banks, each bank obtains new deposits in cash. Say, for example, that there are ten banks of equal size and that each receives a new deposit of £100 in cash.

The banks are on a fractional reserve system, and we assume for purposes of this illustration that they wish to hold 10 per cent cash reserves against all deposits. The new deposits put the banks into disequilibrium, since they each have 100 per cent reserves against these new deposits.

How banks make credit! Stage Deposit (£) Cash (£) 10% Loan (£) 100 10 100 10 90 1 9 81 2 8.10 72.90 3 79.20 7.20 65.70 4 6.57 59.13 “ Final stage 1000 900

The ratios approach to the determination of the money supply High-powered Money (cash) A D Cash held by banks Total cash In economy (monetary Base) G E Cash held by public B C F Deposits Deposits

High powered money, deposits, and money supply

High-powered money, deposits, and the money supply For a given stock of high-powered money the amount of bank deposits created will be the amount which is consistent with the banks’ reserve ratio and the non-bank public’s cash-deposit ratio. The table sets out a range of desired positions for banks and the non-bank public independently. Only one of these positions satisfies the positions for both the banks and the public; such that the deposits the banks wish to create are the same as the deposits the public wishes to hold.

The ratios approach to the determination of the money supply The money supply is determined by the stock of high-powered money (monetary base), the reserve ration of the banks, and the cash-deposit ratio of the non-bank public. The diagram illustrates the size of deposit creation, given the bank’s reserve ration x (=ACICB), the public’s cash-deposit ratio b (=ECICF), and the total cash in economy AC.

Deposits plus cash held by the public make up the total money supply. The ratios approach to the determination of the money supply Deposits plus cash held by the public make up the total money supply. The total stock of high-powered money, or cash, in the economy has to be held by either the banks or the public. At point A the public holds all the cash available, so there are no bank deposits, and the total money supply is just AC, which is all cash. At point C the banks hold all the cash, and on that reserve base they create deposits of CB. The line AB thus plots the level of deposit creation resulting from each level of cash reserves. The banks’ reserve ratio ACICB is thus equal to (minus) the slope of AB.

The public holds EC of cash and CF of deposits. The ratios approach to the determination of the money supply The line CB represents the cash – deposit ratio for the non-bank public. Its slope, measured by ECICF, is equal to that cash – deposit ratio. For a given base of high-powered money, deposit creation will be determined at the point where these two ratios are both satisfied. This will be where CD and AB intersect. So the actual outcome is at point G, where banks have AE cash in reserves and create CF of deposits. The public holds EC of cash and CF of deposits. The total money supply at G is given by CF plus EC.

Competitive banking: supply of and demand for loans Supply of loans Supply of deposits Ii Spread Rate of Interest id Demand for loans Volume of loans and deposits A

Competitive banking: supply of and demand for loans The volume of bank loans is determined by the intersection of the supply curve of loans and the demand curve for loans. The diagram shows the positively sloped supply curve of loans and the negatively sloped demand curve for loans. The supply curve of loans is determined by the supply curve of deposits and the spread, or the interest margin that banks require to cover costs and risk.

Competitive banking: supply of and demand for loans For given interest rates elsewhere in the economy, the supply curve of deposits is positively sloped because higher interest will attract more savings. The demand curve for loans is negatively sloped – high interest rates discourage borrowing and low rates encourage borrowing.

Competitive banking: supply of and demand for loans Competition in banking drives the margin between deposit and loan rate to a level such as Ii-Id where the spread is just enough to allow banks to cover costs and make a normal return on capital. With the demand and supply curves shown, there will be 0A deposits and loans, and depositors will receive an interest rate of Id while borrowers pay the loan rate Ii.

MONEY AND MONETARY INSTITUTIONS Money and the economy In the classical dichotomy, money affected the price level but it did not affect real activity. The nature of money Money is a medium of exchange, a unit of account, and a store of value. Money avoids the need for a double coincidence of wants and thus facilitates a wider range of transactions.

MONEY AND MONETARY INSTITUTIONS The origins of money Money has evolved from being based primarily on a precious metal to being mainly in the form of bank deposits. Early moneys were based on commodities, and especially precious metals like gold and silver. Paper currency started as a claim to a deposit of precious metal. Bank deposits account for most of modern money.

MONEY AND MONETARY INSTITUTIONS How does money get into the economy? Central banks create the monetary base or high-powered money, which is made up of notes and coins and bankers’ deposits at the central bank. Banks create deposit money by expanding loans and deposits.

MONEY AND MONETARY INSTITUTIONS Two models of banking Banks create deposits to some multiple of their cash reserves. In a competitive market in which banks pay interest on deposits and charge interest on loans, banks’ behaviour is best understood in terms of demand and supply curves of deposits and loans. Banks must pay competitive interest rates to attract deposits, and they must charge competitive rates on their loans.