1. ` ` ` Money and Banking
Lecture 4

2. Money and its functions
1. the medium of exchange
2. the unit of account
3. a store of value
4. money as a standard of deferred payment

3. The medium of exchange Used as one-half of almost all exchanges
We want it to buy goods and services now or in the future
Makes the exchange of goods and services more efficient
A barter economy- one without any commonly accepted medium of exchange
A double coincidence of wants before exchange can take place in a barter economy: costly or not possible,
Could you imagine paying tuition in a barter economy?
time used to find goods which are acceptable = waste of resources

4. The unit of account
The unit in which prices are quoted and accounts are kept
What in the situation of a high inflation? Prices quoted in foreign money
Case of German economy prices kept in dollars but payments made in local currency

5. Money a store of value
Money is a store of value because it can be used to make purchases in the future
It has to be accepted in exchange
Houses, automobiles, stocks, stamp collections can also serve as stores of value, some time better than money
Money as a standard of deferred payment – future payments usually specified in terms of money

6. Medium of exchange function most important
Money need not be the unit of account or the standard of deferred payment, but it usually is

7. A commodity money
Is used as a medium of exchange and also bought or sold as an ordinary good
Cigarettes, cocoa, gold or silver
If cocoa would be more valuable as money no one would have drunk it.

8. Token money
Those means of payments whose value as money exceeds the cost of production and the value in alternative uses
What is the value 100$ bill as a piece of high quality paper?
Coins as token monies, but when prices of silver or copper went up banks offering $1.15 for a bag of 100 pennies
Control over the right to produce money
Modern money accepted because the law requires them to be accepted – what when the inflation very high?
Supply controlled by the state

9. An IOU money
Medium of exchange that is the debt of a private firm or person
An example: bank deposit, because the bank has to give the deposit holder euro, zloty whenever she demands them.
It is medium of exchange because people are willing to accept checks in payment
Traveler’s checks are IOU money

10. Banking Modern banks are profit making financial intermediaries
F.I. is the institution that stands between lenders and borrowers
A commercial bank borrows currency from the public, issuing deposits in exchange
Money that is borrowed used to make loans to firms , individuals or government
Other financial intermediaries: life insurance companies and pension funds
Banks as other businesses aim to maximize profit
To be competitive bank offers favorable terms to potential depositors: low fees , a free toaster perhaps?, high interest rate
To maximize profit –1)profitable ways of lending to others what it has been borrowed: a) reserves, b) credits to firms, c) part lent to students or people buying houses, d) securities; 2)good bank management: appropriate structure of loans

11. How money is created bank Required reserves 10% Excess reserves= loans
Demand deposits A
1000
9000
10.000
9.000 B
900
8100 C
810
7290 D
729
6561 E
656
5905 …
90.000

12. The money multiplier
gives the change in the money stock caused by the unit change of high-powered money
High-powered money (monetary base) – the most liquid money = the total amount of currency (coins + paper money) that is either circulated in the hands of the public or in the commercial banks deposits held in the central bank reserves
Money supply (money stock) = money multiplier x monetary base

13. How to calculate money multiplier?
Money stock M= C+D, where C –cash (currency) circulated in the hands of public, D – deposits of commercial banks
C=c x D,
M=c x D + D=D(c+1), where c =liquidity preference (how much currency (cash), how much deposits)
Monetary base H=cash (C) + banking reserves (R), where
R=rrr x D, rrr= required reserves ratio
Monetary base H=C+R =c x D + rrr x D= D(c +rrr)
Multiplier (change of money stock M caused by unit change of monetary base H)
multiplier=M/H= D(c + 1)/D(c + rrr)
Multiplier=(c+1)/(c + rrr) > 1

14. Factors having impact on money multiplier
Money multiplier = (c+1)/(rrr + c) is higher when:
1) liquidity preference (c) higher
2) reserve ratio (rrr) lower
An example:
c = 0.03, rrr = 0.008
M/H = 1.03/0.038 = 27

15. The role of the Central Bank
money supply control, cooperation with commercial banks, public debt management
Instruments used to control money stock: 1.reserve requirements, 2. discount rate, 3. open market operation
Instrument 1 and 2 have an impact on value of multiplier,
Instrument 3. is changing monetary base H = C + R

16. 1. Reserve requirements
Cash reserve ratio: central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits ( in form of cash in bank vault or deposits with central bank deposit
If amount of cash in commercial banks < reserve requirements → banks have to borrow cash
Reserve ratio a kind of tax diminishing amount of loans issued by banks

17. 2. The discount rate
The rate at which the central bank lends to banks borrowing to meet reserve shortfalls
If the discount rate > average interest rate→ banks motivated voluntary keep additional cash. Why?
An example: cash = 12% of deposits, interest rate 8%, reserve ratio=10%, discount rate 10%
No incentive to increase credits because of the possible losses in the situation when people would withdraw cash very fast.
Both instruments the reserve ratio and the discount rate are not used very often. The discount rate changed in line with market interest rate.

18. 3. Open market operation
Central bank changes monetary base H=C+R buying or selling government securities in the financial markets
Purchase of government securities by the central bank increases the money stock and allows banks to increase loans to firms and public.
Selling government securities →smaller C or R, less loans available

19. Central bank as lender of last resort
Lends to financial institutions and firms at times when panic threatens the financial system
Decreases uncertainty in the financial policy
An example: during last financial crisis US government expenditure of$700 billion to save US banks and financial institutions.
IMF ready to bail-out governments having high debts (Greece case)

20. The demand for money
The nominal demand for money – the number of dollars/ zloty individuals and firms want to hold
Two kinds of assets: money and bonds. Bonds asset that pays interest, while money does not pay any interest income
The opportunity cost of holding money rather than bonds is the amount of interest that is given up by holding money rather than bonds
motives to hold money: 1) the transaction motive, 2) precautionary motive, 3) portfolio motive

21. 1. Transaction motive
Effect of time lag between money received and transaction made
The volume of cash reserve depends on: a) transaction value, b) synchronization of incomes and expenditures
The demand for money is demand for real balances – value of money holdings measured in terms of their purchasing power
Real money balances=nominal money balances/price level
a) transactions motive stronger when real GDP is higher
b) behavior of people making transactions not changing significantly

22. 2. Precautionary motive
Linked to uncertainty in income/ expenditure time table
Holding some money in a liquid form to cover unexpected expenditure
Precautionary motive stronger when number of transactions larger/ real GPD higher

23. 3. Portfolio motive
Caused because of risk aversion: one gives up higher interest income in exchange of higher security of deposits
Two parts of portfolio: high and low risk assets

24. The demand for money
3 factors: 1) the price level, 2) interest rate, 3) real income
1) Money demand and the price level: nominal demand and demand for real balances – value of money holdings measured in terms of their purchasing power
Real money balances = nominal money balances/ price level
Increase in the quantity of money will often cause the price level to rise ( people hold more money than they want, they spend it, increased spending makes prices go up)

25. 2) Money demand and interest rates
Comparison of costs and benefits to hold money
Benefits explained by 3 motives to hold money
Costs: lost interest income – people hold money instead of some alternative assets
Alternative assets: savings and time deposit, money market mutual funds, bonds and stocks. All those assets called bonds for a simplification
The marginal benefit (MB) of holding money declines with the amount of money held. When the individual is holding so much money that there is no worry about running out of cash, holding an extra dollar brings very little benefit.
The marginal cost (MC) equals the forgone interest, holding one extra dollar costs the same, MC = interest rate
The optimal amount of money : marginal cost (MC) = marginal benefit (MB)
Demand for money is inversely related to the interest rate: demand low when the interest rate high; demand high when the interest rate low (show on the graph, graph presented during the lecture)

26. 3) Money demand and income
Money demand depends on spending
The level of spending depends on the real income households earn
Increased spending (higher income) → higher quantity of money demanded
Changes in spending ( income) shift the demand for money curve to the right or to the left

27. The demand for money Increase in price level Increase in real income
Increase in opportunity cost of holding money (interest rate)
Nominal money demand
Increases demand for nominal money balances proportionally
Increases demand
Reduces demand
Real money demand
Leaves demand for real balances unaffected

28. The money supply and equilibrium interest rates
The nominal money supply determined by central bank .
Equilibrium in the money market : money supply = demand for money
Central bank decision on the money supply = decision on the equilibrium interest rate ro
If the interest rate lower than ro – demand for money> money supply (show on the graph, graph presented during the lecture)

29. How the equilibrium is restored
To explain it the situation on bonds market has to be analyzed
people keep or money in a liquid form (Lo) or bonds (Bo)
Their planned demand for money = Ld and planned demand for bonds = Bd
Bo+Lo=real wealth =Bd+Ld
Bond supply surplus = Bo-Bd
Money demand surplus = Ld-Lo
Bo-Bd =Ld-Lo
Effects: prices for bonds going down and interest rate going up
Demand for bonds increasing and demand for money decreasing
Equilibrium restored on both markets, interest rate back to ro level

30. The interest rate and the equilibrium (graph presented during the lecture)
Initial equilibrium point E(Lo, ro)
Real supply of money goes down from Lo to L’
New equilibrium: interest rate goes up to r’ to adjust demand to lower supply
Or real income goes up –the shift of the demand curve LL to LL’
New equilibrium again; interest rate goes up ro to r’’ to keep money demand at the same level
Why? because the money supply did not change

31. Interest rate as a tool to control money supply(graph presented during the lecture)
Initial equilibrium: demand for money curve LL with given real income
Money supply set by Central Bank at Lo, equilibrium interest rate level ro
If C.B. sets the interest rate at ro level and supplies enough money to satisfy money demand, supply will be at Lo level
Attention: to control money supply using the interest rate C.B. has to know the position of the demand curve
If the interest rate set at r1 – the supply of money at L1
supply will go up to L1’ if the demand curve shifts to LL’