Microsoft word - eco102-ch29-money and banking.doc

PRINCIPLES OF MACROECONOMICS
Chapter 29
Money and Banking

Overview
Beginning with this chapter we develop the financial side of the economy. Students will develop an
understanding of what money is and what forms money takes. An understanding of money is important
because the quantity of money affects inflation and interest rates in the long run, and production and
employment in the short run. First we describe what money looks like, its functions and attributes (in case it
is a while since you have seen any up close!?). We then look at the role of banks in creating money, the
question of the money multiplier and money supply, and how the central bank controls the quantity of
money. We briefly examine the different measures of money, and the role of the commercial banks. Finally
we begin to examine motives for holding money, and look at how money demand depends on output, prices
and interest rates.

Learning Objectives
By the end of this chapter, students should understand:
¾ what money is and what functions money has in the economy.
¾ the role and functions of Central Banks
¾ how the banking system helps determine the supply of money.
¾ what tools Central Banks uses to alter the supply of money.
Key Points

1. The
money refers to assets that people regularly use to buy goods and services. 2. Money serves three functions. As a medium of exchange, it provides the item used to make transactions. As a unit of account, it provides the way in which prices and other economic values are recorded. As a store of value, it provides a way of transferring purchasing power from the present to the future. 3. Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money. 4. Money takes the form of currency and various types of bank deposits, such as checking accounts. 5. Central banks are responsible for regulating the monetary system of their countries. 6. Central banks control the money supply primarily through open-market operations. The purchase of government bonds increases the money supply, and the sale of government bonds decreases the money supply. Central banks can also expand the money supply by lowering reserve requirements or decreasing the discount rate, and it can contract the money supply by raising reserve requirements or increasing the discount rate. Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
7. When banks loan out some of their deposits, they increase the quantity of money in the economy.
Money and its Functions
Money is defined as the medium through which people exchange goods and services. Money is the set of
assets in an economy that people regularly use to buy goods and services from other people. It can
be any generally accepted means of payment for the delivery of goods or settlement of debt. In the absence
of money, goods must be exchanged for each other in a barter system. In addition to its role as means of
exchange, money also serves as a unit of account, and a store of value.
The three functions of money:
a. A medium of exchange: money is given by buyers to sellers when they want to purchase
goods and services.
b. A unit of account: money is used by people as a yardstick to post prices and record debts.
c. A store of value: money is used by people to transfer purchasing power from the present to
the future.

One of the key characteristics of money is that it is a liquid asset. Liquidity is the ease with which an asset
can be converted into the economy’s medium of exchange. Money is the most liquid asset available. Other
assets (such as stocks, bonds, and real estate) vary in their liquidity. When people decide in what forms to
hold their wealth, they have to balance the liquidity of each possible asset against the asset’s usefulness as
a store of value.
Historically there have been different types of money – commodity money (gold, cigarettes etc) which also
have an intrinsic value on their own due to alternative uses. In modern times we use token money – such as
banknotes, whose value as money greatly exceeds any intrinsic value it may otherwise have. Finally
supplementing token money we have IOU money – such as bank deposits, which the bank is obliged to pay
the beneficiary when he/she presents a cheque.
Different measures of money
The quantity of money circulating in Cyprus (and any other economy) is called the money stock or the
money supply. Included in the measure of the money stock are currency, demand deposits and other
monetary assets.
Why do we limit the money supply to cash in circulation outside banks plus bank deposits? Measuring what
we define as ‘money’ has changed over time and has been made more complex by changes in several
fields.
Firstly, the distinction between banks and savings and loan associations (or building societies, or
cooperative banks) is no longer clear. Secondly, we have seen increasing convergence of accounts such as
sight deposit and time deposit ones. Given the wide spectrum of liquidity, there is no good place to draw a
line. For simplicity we therefore follow the current norm and choose to concentrate on narrow money (the
monetary base – M1) and broad money – M2.

Money Supply is defined as the value of the stock of the medium of exchange (money) in circulation.

Currency: the paper bills and coins in the hands of the public.
Demand deposits: balances in bank accounts that depositors can access on demand by writing a check.
The following table shows a number of key monetary aggregates for Cyprus such as two different measures
of the money supply, deposits, loans and different interest rates. Money and Banking Statistics for Cyprus, 2001-2006
Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Money supply
Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
Credit and deposits
7677.71 8441.09 8852.42 9396.61 10236.36 11452.97 Interest rates
Overnight deposit facility rate 2.50 2.50 2.50 3.50 2.25 2.50 Marginal lending facility rate Money market interest rates (monthly average)
Retail Bank Interest rates
Deposit rates
Lending rates
Source: Central Bank of Cyprus. Available online at: http://www.centralbank.gov.cy/media/xls/STINE_INDICATORS220108.xls
In Cyprus currency accounts for less than 30 percent of the value of M1, with the remaining 70+ percent
being in the form of checking accounts (demand deposits). Thus, the majority of the money in the economy
is actually made up of account balances rather than currency in circulation or in the vaults of banks and the
central bank. Note additionally that the assets included in M1 and M2 differ in terms of their liquidity. .
The Central Bank of Cyprus
Just like in any economy, at the apex of the banking system in Cyprus is the Central Bank of Cyprus (CBC).
One of its key functions is the regulation of banks to ensure the health of the nation’s banking system. The
Central Bank of Cyprus monitors each bank's financial condition and facilitates bank transactions by clearing
checks, and if needed makes loans to banks when they want (or need) to borrow.
The second job of the CBC is to control the quantity of money available in the economy. The primary way in
which the central bank increases or decreases the supply of money is through open market operations
(which involve the purchase or sale of government bonds).
If the CBC wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public through the nation's bond markets. If the CBC wants to lower the supply of money, it sells government bonds from its portfolio to the public. Money is then taken out of the hands of the public and the supply of money falls.
Modern Banking
Banks are used to smooth the process of bringing the lender and the saver together - they are financial intermediaries. In addition, they can use the money deposited by lenders to further increase the money supply. Bank reserves: the money available in banks to meet possible withdrawals by depositors. Reserve ratio: the ratio of reserves to deposits. Banks lend a portion of their deposits as overdrafts, some is used to buy securities such as long term government bonds. Some is invested in more liquid assets, allowing banks to recover their money quickly if people withdraw a lot of money from their sight deposits. Finally some money is held as cash. Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
Some of the deposits can be withdrawn by customers ‘on sight’ (demand). Sight (or demand) deposits are those from which money can be withdrawn at short notice. Time deposits however, paying higher rates of interest, require more notice for withdrawal. How Banks Create Money

Example 1:
The Money Creation Process
Assume that the Central Bank of Cyprus buys from an individual a bond worth £10,000. The individual deposits the £10,000 in his checking account with his bank (Bank A). Assume that the legal reserve ratio is 20%. Bank A must keep 20% (or £2,000) on reserve (in its vaults or as deposit with the central bank) and can lend 80% or £8,000. The borrower buys a car, and the car dealer deposits the £8,000 in his checking account (say with Bank B). Bank B can lend 80% (or £6,400) and keep £1,600 on reserve. Assume that the borrower from Bank B pays his tuition at European University Cyprus. The University deposits the proceeds to its bank account, say Bank C. Bank C now has to keep 20% (or £1,280) as legal reserves and can lend out £5,120, … and the process goes on and on as shown in the schematic below: The Money Creation Process
Buys £10,000
Individual’s
Deposit a/c
+ £10,000
Reserves £2,000
Loans £8,000
Reserves £ 1,600
University’s
Car dealer’s
Deposit a/c
Deposit a/c
+ £6,400
+ £8,000
Keeps Reserves of £1,280
Makes loans of £5,120


And so on, and so on …
If we add all the additions to the money supply made at each stage, which are the amounts of additional demand deposits represented above by the gray boxes (i.e., at Bank A, Bank B, Bank C, etc), we will see that the money supply will increase by £50,000. Example 2:
Let’s assume that banks are required by the central bank to maintain a reserve ratio of 10 percent. Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
Stage One: To start the process of money creation, assume that we have an individual who wins
£1,000 in the lottery and decides to deposit the cheque of £1000 into his bank (Bank A) account. At this point, the private sector (represented by our lucky devil (!?) has additional assets of £1,000, while banks have additional liabilities of £1,000 in the form of the deposits. Î The addition to money supply (in the form of new deposit): £1,000. Stage Two: The profit maximizing Bank A decides to lend £900 of the new deposits to a car dealer,
keeping £100 (or 10%) in the form of liquid reserves as required by the central bank. The car dealer pays the mechanic who deposits his check to his bank (Bank B). Stage Three: Bank B lends out 90% of the new deposit, or £810, let’s say to a student to pay her
tuition at Cyprus College. The College deposits the cheque of £810 in the bank (Bank C). Stage Four: Bank C lends out 90% of this new deposit (or £729) to a bakery to pay his baker,
keeping the required 10% (or £81) in liquid form. The baker in turn deposits his cheque in his bank The above process continues until the last bank has no “free reserves” to lend out. If we add all the additions to money supply at each stage, we would find that the total change in the money

The Money-Creation Process
The central bank injects (reduces) currency or demand deposit (checking account) money into the economy
when it buys (sells) government securities on the open market. Buying securities means that the central bank exchanges paper certificates held by the public (individuals, firms, banks) for money. This is done by crediting the reserve account that the seller’s bank maintains with the central bank. Therefore, the money supply is increased as people now hold (and can spend) more money (currency and demand deposits). The final impact on the money supply is a multiple of this initial injection of reserves in the banking system because of the working of the money (or credit) multiplier, which is facilitated by the ability of banks to lend out part of these initial extra reserves, after meeting their legal reserve requirements. With the loans they receive from banks, the borrowing parties would presumably pay wages, pay suppliers for raw materials, etc. These people in turn would deposit the money they receive in their checking accounts at the banks, and another round of lending by banks begins. This is what we refer to as the money creation process. When M1 is measured, and the central bank totals the checking account balances in the entire banking system, the original $10,000 injection of free reserves (in the form of the bond seller’s deposit) will have created a total of $50,000 in deposits in the total banking system. Therefore, we see that with a 20% reserve requirement, the original deposit was multiplied by a factor of 5. Economists have determined that the value of the money multiplier can be expressed as the inverse of the required reserve ratio (RR) which is the Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
percentage that commercial banks are required to hold as liquid reserves (in their vaults or as deposits at the central bank). This is referred to as the fractional reserve banking system. Money (or credit) multiplier: m = 1 / RR
The higher the reserve ratio the fewer loans banks would be able to make, and therefore the multiplier process would be smaller. In the above example, if the reserve requirement had been 10%, the original injection of reserves of $10,000 by the central bank would have become $100,000 (a factor of 10 times). From the two examples above, we can quickly find the ultimate change in the money supply from an initial change (in the form a new deposits) using the formula: Total Change in Ms = 1 / RR (Initial change in Ms) In Example 1 we assumed that the reserve requirement is 20%, and the initial change in Ms (in the form of new deposit) is £10,000. Since the ratio 1/RR (the money multiplier) equals to 5 (1/20% or 1/0.20), additional money is created at a multiple of 5 times the initial change in Ms. Therefore, using the above formula, the In Example 2 the reserve requirement is 10%, and the initial change in Ms (in the form of new deposit) is £1,000. Therefore, using the above formula, the final change in Ms is: £10,000, since the ratio 1/RR = 1/0.10 In practice, reserve ratios are normally set by the Central Banks. What prevents financial panics, given that banks lend out more than they have in cash reserves? (bank-created money in the form of deposits is by far the largest part of the money supply in today’s economies). Essentially it is the role of the Central Bank, which will lend to commercial banks as the ‘banker or lender of last resort’ (we consider this in the next few chapters) thus providing a level of stability to the system. From monetary base to money multiplier
Here we need a few more definitions. The monetary base or stock of high powered money is the quantity of notes and coin in private circulation plus the quantity held by the banking system. How is the money supply related to the monetary base? To find out we use the money multiplier, defined as the ratio of the money Î i.e. the money stock = money multiplier x monetary base. What determines the money multiplier in real life? Two things: the ratio which the banks’ prefer in terms of cash reserves to total deposits, but also secondly the amount which the public wish to deposit in banks rather than holding as cash. What determines the banks’ preferences? If they can successfully achieve a large interest rate spread then they will want to lend more, and thus will wish to keep less cash reserves. Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
Banks will of course be careful not to have high-risk loans as well as keep enough free reserves to cover for the likelihood of unexpected withdrawals from the bank by depositors. From the side of the customer, the amount they will wish to deposit will depend on several factors such as willingness to use credit cards (which will reduce the wish for cash); trust in the banks; whether their wages are normally paid in cash or directly in to the bank etc . Monetary Policy Instruments
Monetary policy comprise the use of certain tools and instruments by the monetary authorities (usually the central bank of each country) by which they are able to directly influence the money supply (currency in circulation plus demand deposits in banks) in the economy, and by extension, through the monetary transmission mechanism, to influence the real side of the economy, in other words, income and employment conditions. The key monetary tools in the hands of central banks are: (a) Required Reserves (RR): This is the ratio of deposits that banks are required to hold in cash form),
which influences the size of the money multiplier and ultimately the money creation potential of the banking system. Raising or lowering the RR, the central bank can indirectly decrease or increase, respectively, the amount of money in the economy, by affecting the money creation capability of commercial banks. This is not frequently used. Reserve requirements change only irregularly and over long periods of time to reflect changing banking habits of people and to make the banking (b) Discount Rate: This is the rate determined by the central bank with which it lends money to
commercial banks, which affects short-term interest rates in the banking system, and therefore the cost of borrowing for the public. If the central bank wants to impose a restrictive (expansionary) monetary policy, it raises (lowers) the discount rate making it thus more expensive (less expensive) for commercial banks to raise needed liquidity. The discount rate directly affects the market interest
rate banks charge their customers for loans as well as the rate they offer for attracting deposits. the
interest rate that banks borrow from the central bank), (c) Open Market Operations: This is the buying and selling of government securities by the central
bank in the open market (the primary market). We briefly examined this above when we talked about the money creation process. This is the most frequently used policy instrument and perhaps one of the most effective. Central banks auction government securities (short-term Treasury bills and medium and long-dated bonds) on regular intervals (usually on a monthly, or even bi-weekly basis). (d) Credit controls and moral suasion (not frequently used in developed economies).
We have examined that when the central bank buys government securities on the open market it creates bank reserves. This in turn begins a multiple expansion of the money supply. This process shifts the money supply curve to the right, indicating that there is now surplus liquidity in the banking system. In their attempt to loan out as much of the excess money balances, profit-making commercial banks would compete amongst themselves and in the process would offer lower interest rates to their customers. A new equilibrium of the money market would take place at r2 and M2, as shown in the figure below. We see thus
that open market operations can and do affect the level of market interest rates. Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
Equilibrium in the Money Market
Rate of interest (%)
r2 E2
Quantity of Money
All the above policy instruments work indirectly in affecting the money supply and the level of interest rates by impacting on the money-creation ability of commercial banks. There are also some other less frequently used measures that a central bank may be forced to take. One such measure is the absolute restriction of credit expansion, which imposes a certain amount by which the loans may expand in a given period. This may be for the total credit expansion or may be specified separately for each sector of the economy. Moral suasion is another measure by which the central bank may contact directly the banks (through the media, by circulars or direct phone calls, or by sending bank examiners to commercial banks) to persuade them to follow the desired credit policy in order for monetary policy to be on target. In summary, Central Bank activities (monetary policy) tend to cause the following impact on money supply (Ms) and the level of interest rates (r), as presented in the following Table.
Impact on Ms and Interest Rate of Alternative Monetary Measures
Impact on Ms Impact on r
Restrictive Monetary Measures

- Raise Reserve Requirements
Decrease
- Raise Discount Rate
Decrease
- Sell Government Bonds
Decrease
(Open Market Operations)

Expansionary Monetary Measures

- Lower reserve requirements
Increase
- Lower discount rate
Increase
- Buy Government Bonds
Increase
(Open Market Operations)

Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS
The Demand for Money
Having briefly defined the money supply, let’s now examine the factors that motivate people to hold money, i.e., what lies behind the demand for money? (defined as a demand for real money balances). Obviously various reasons would exist for this. Economists have identified three broad reasons/motives: (1)The transactions motive – the need to use money to conduct buying and selling transactions. (2) the precautionary motive (where money is held to meet possible future emergencies). (3) the asset motive, where money is held in order to avoid the risk of wealth being held in other, more risky (although possibly more lucrative) assets. Here the assumption is that the higher the real income, the higher are the transactions and precautionary motives likely to be. But what about the cost of holding money? This must, of course, be the interest rate forgone by not holding higher interest earning assets instead. Demand for and Supply of Money
Interest Rate
The above figure illustrates the relationship between the demand for holding real money balances and interest rates (the cost of holding money) and the Supply of money, which is aasumed to be fixed in the short run. At high interest rates the desire of people to hold idle balance (non-interest earning cash) is low. Put in a different way, the opportunity cost of holding cash is high. At these high interest rates, people would prefer to place their funds in bank deposits, bonds, stocks, etc in order to earn a return. As interest rates fall, the opportunity cost of holding cash decreases, and the demand for cash balances increases. In other words, we move down the Demand curve. Here the assumption is that the higher the real income, the higher are the transactions and precautionary motives likely to be. Equilibrium in the money market is reached where demand for money balances equals the supply of money. Dr. Savvas C Savvides-- School of Business, EUROPEAN UNIVERSITY CYPRUS

Source: http://faculty.euc.ac.cy/ssavvides/ECO102-NOTES.PDF/ECO102-Ch29-Money%20and%20Banking.pdf