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UCL ECON7003 Money and Banking Lecture 11. Money and monetary policy: preliminaries.

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Inter-disciplinary: economic history, politics, world affairs. ... (2) Customers shift into cash; money leaks' out of the banking system. ... – PowerPoint PPT presentation

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Title: UCL ECON7003 Money and Banking Lecture 11. Money and monetary policy: preliminaries.


1
UCL ECON7003 Money and BankingLecture 11.Money
and monetary policy preliminaries.
  • Introduction to Part II of the module Money and
    monetary policy.
  • Preliminaries
  • Stylised history of banking.
  • Deposit creation.
  • Actors in the Money Supply process.
  • Multiple deposit creation.
  • The simple deposit multiplier and the assumptions
    underlying it.
  • Deposit creation and money supply.

2
  • From micro to macro
  • Unemployment, inflation, economic growth, and the
    balance of payments.
  • Inter-disciplinary economic history, politics,
    world affairs.
  • Macroeconomic debates as a whole briefly
    surveyed.

3
  • The course of debate in outline
  • Early modern times.
  • Keynes-versus-classics
  • 1979 to the present.
  • Three targets
  • Period Target
  • Late 1970s to early 1980s Monetary aggregates
  • Mid-1980s to 1992 Exchange rates
  • 1992 to present Inflation
  • i.e. thematic chronological.

4
  • The UK an open economy
  • Targets and international factors
  • exchange rate ? monetary aggregate targeting of
    Thatcher period unsustainable
  • ER by definition open economy.
  • inflation and international prices (oil, etc.)
    and international macroeconomic conditions
    generally.
  • ? course will reverse standard procedure
  • open-economy issues from beginning.

5
Unemployment in the UK, 1880-2005 time series.
Two traumatic periods for the UK macroeconomy
Early 90s recession
Stagflation 1970s
6
  • Stylised history of banking.
  • Owner of safe house storing gold takes in 100 in
    gold coins
  • Safe house
  • Assets Liabilities .
  • Gold coins 100 Deposit notes 100
  • Deposit notes become accepted in transactions
  • Substitute for payment in gold.
  • i.e. Gold (commodity money) ?customary money
    a financial instrument (bank note)

7
Safe house owner now makes loans to the value of
900. Safe house Assets Liabilities
. Gold coins 100 Deposit notes
1000 Loans issued 900 1000 Note
Trade-off in deciding golddeposit-note
ratio Profitability of loans and
liquidity. Liquidity insufficient to meet demands
for withdrawal of gold coins may ? run, or
panic.
8
Deposit creation. Bank of England makes open
market purchase of 100 from Bank I. Bank I uses
proceeds to make loan of 100, paid into
borrowers current account. Bank I
Assets Liabilities
. Securities - 100 Deposits 100 Reserves
100 Loans 100
. 100 100 Bank I has expanded
balance sheet through issuing credit / creating
deposit.
9
Bank now has ER of 100. BUT new deposit created
for purpose of loan. ? assumed the sum will soon
be withdrawn. ? bank cannot safely make further
loans / the 100 ER short term only. ? Likely net
outcome ?D0, ?R0, ?L100.
10
Bank Is customer uses loan to make purchase by
cheque. Firm receiving cheque pays it into its
account at Bank A. Bank A takes full advantage of
corresponding ER? to make loan to another
customer. Bank A Assets
Liabilities . Reserves 10
Deposits 100 Loans 90
. 100 100
11
Actors in money supply process (a) The
expansion of Bank Is deposit creation capacity
Bank Is deposit creation capacity was outcome
of decision by CB to expand MB. Controls MB with
certainty through OMOs. Commercial banks, their
borrowers, their depositors No part in this
decision.
12
Actors in money supply process (b) Bank Is
loan to its customer Bank Is own independent
decision. Its borrowers may have affected
decision through their level of demand for loans
? rL. CB no direct part in decision, though
influence or control over interest rates may have
affected it indirectly.
13
Actors in money supply process (c) Use the
customer makes of loan. Customers action
involved two decisions relevant to MS
process (a) use entire loan for purchase gt hold
as deposit (ß) make purchase by cheque gt cash
14
  • Multiple deposit creation.
  • Increase in deposits in banking system as a whole
    so far
  • Deposits created
  • Bk A receives 100 from customer of Bk I 100
  • Bk B receives 90 from customer of Bk A 90
  • Total deposits created 190

15
Bank As customer uses loan to make purchase by
cheque from a further firm. Firm pays this into
its account at Bank B. Bank B takes full
advantage of ER? to make loan to another
customer. Bank B Assets
Liabilities . Reserves 9 Deposits
90 Loans 81 . 90 90
16
Increase in deposits in banking system as a whole
so far Deposits created Bk A
receives 100 from customer of Bk I 100 Bk B
receives 90 from customer of Bk A 90 Bk C
receives 81 from customer of Bk B 81 Total
deposits created 271
17
Series of further transactions involving loans by
Banks C, D, E,F. Assumption Banks make loans to
full amount of ER. Bank ?D ?R ?Loans
I 0.00 0.00 100.00
A 100.00 10.00 90.00 B 90.00
9.00 81.00 C 81.00 8.10 72.90
D 72.90 7.29 65.61 E 65.61
6.56 59.05 F 59.05 5.91 53.14
? 8 ? 0 ? 0 ? 0
1000.00 100.00 1000.00 Or ?D 100 1
0.9 (0.9)2 (0.9)3 (0.9)4 . . . (0.9)n
18
Simple deposit multiplier. R RR ER, and RR
r.D, where r RRR ER 0 ? R RR r.D R
r.D ? D (1/r).R ? ?D (1/r).?R Simple
deposit multiplier
19
Equilibrium Point at which process ends, i.e.
deposit creation ceases In terms of number of
transactions in chain Reached at limit as n ?
8 i.e. as (0.9)n ? 0. In terms of level of ER
in banking system Reached at limit as all ER
exhausted i.e. as ER ? 0. In terms of total R in
banking system R RR ER ER ? 0 ? R ? RR
r.D i.e. ER exhausted, R reaches min. level
consistent with RRR.
20
OMP of 100 ? 900 expansion of deposits in
banking system Banking System
Assets Liabilities . Securities -
100 Deposits 900 Reserves 100 Loans
900 . 900 900 ER not yet
exhausted ER 10 gt 0. Equivalently R not yet
? equilibrium level R 100 gt r.D 90. i.e.
Simple deposit multiplication process has not yet
reached equilibrium.
21
Once process has reached equilibrium, we
have. Banking System Assets
Liabilities . Securities - 100 Deposits
1000 Reserves 100 Loans 1000 .
1000 1000 ?D (1/r).?R r 0.10 and ?R
100 ? ?D (1/0.10).100 10.(100) 1000
22
Now banks use 50 of ER to purchase secs. gt make
loans. No difference to deposit creation process
/ equilibrium! Banking System
Assets Liabilities . Securities -
100 Deposits 1000 Reserves
100 Securities 500 Loans 500 .
1000 1000 Or, simplifying Banking
System Assets Liabilities . Reserve
s 100 Deposits 1000 Securities
400 Loans 500 . 1000 1000
23
The assumptions underlying the simple deposit
multiplier. Note Money here defined as M1 C
bank deposits (1) All banks exhaust ER in making
loans. i.e. till ER 0, or equivalently to
maximum extent consistent with RRR (i.e. R
r.D). (2) All transactions are carried out by
cheque. ? Amount of currency in circulation
unaffected (?C 0). Lifting these
assumptions Deposit creation process is
interrupted (1) Banks retain ER gt lend to full
amount possible consistent with RRR (2) Customers
shift into cash money leaks out of the
banking system.
24
Deposit creation and money supply M M1 C
D ? deposit creation is supply of money. Extent
to which the two processes proceed MS process
is interrupted before deposit creation ?
equilibrium of SDM. Assumptions on which it rests
are unrealistic.
25
If the two assumptions underlying the SDM held,
CB would have full control over MS
process Assumption (1) BB continue deposit
creation until ER exhausted. i.e. the process
continues till equilibrium implied by SDM. i.e.
with certainty, given the level of R in the
economy. Assumption (2) CB can control R with
certainty, since MB R C, and ?C 0. The CB
is thus sole actor with determining role in MS
process.
26
Lifting the assumptions, we have CB no longer
has full control of MS process Assumption
(1) If BB decide not to issue loans to full
extent of ER resulting from OMP, and instead to
hold ER gt 0 Some of the ?R from the OMP leak
out of the deposit creation process. Process is
interrupted / does not reach equilibrium level
implied by SDM.
27
Assumption (2) If banks borrowers decide to
shift from cheque to cash transactions ?C gt 0
and some of the ?R from the OMP leaks out of
the banking system, ? out of deposit creation
process. i.e. Lifting the assumptions ? CB
no longer sole actor in MS process Decisions of
banks, depositors, borrowers now also affect
extent to which process proceeds.
28
To allow for lifting of these assumptions, 2
additional ratios Lifting of assumption (1), we
need e ER / D excess reserve ratio Lifting
of assumption (2), we need c C / D currency
ratio Model that will incorporate these
ratios. The money multiplier m m (1 c)
/ (r e c)
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