Chapter 22 Money and banking

1. Chapter 22Money and banking David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

2. Some key questions • Why does society need money? • Why do governments wish to influence money supply? • How do financial markets interact with the ‘real’ economy? • What is the relationship between money and interest rates?

3. 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.

4. 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

5. 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

7. 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 coin, paying no interest • the most liquid of all assets • Bills • financial assets with less than one year until the known date at which they will be repurchased by the original owner • highly liquid • Bonds • longer term financial assets – less liquid because there is more uncertainty about the future income stream

8. A beginner’s guide to the financial markets (continued) • 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 • Industrial shares (equities) • entitlements to receive corporate dividends • not very liquid

9. 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 • suppose the public needs a fixed £10m for transactions • and the commercial bank maintains a 10% cash reserve

11. 110 20 90 110 18.2 10 120 1 2 110 11 99 110 10 19 129 3 119 20 99 119 16.8 10 129 n 200 20 180 200 10 10 210 Credit creation – example Commercial bank : Public cash holding Cash ratio % Money supply Liabilities Assets Cash Loans Total Deposits Initial position: 10 100 10 90 100 10 110 Central bank issues £10m extra; the public deposits it

12. 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

13. (cp + 1) So M = H (cp + cb) 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 Money supply = money multiplier × monetary base

14. Figure 22.1: Money supply determination