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Money and Banking


Why are banks considered intermediaries? ... offshore banks operate with little or no such restrictions, plus generally pay ... Banks CREATE money by LENDING money ... – PowerPoint PPT presentation

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Title: Money and Banking

Money and Banking
  • ECN 111 Macroeconomic Principles
  • Instructor Igor Lukashin Spring 2000
  • Lecture 19.

Fundamental Questions
  • What IS money?
  • How is the U.S. money supply defined?
  • How do countries pay for international
  • Why are banks considered intermediaries?
  • How does international banking differ from
    domestic banking?
  • How do banks create money?
  • How did recent technological advances affect
    money banking?

What is Money?
  • Money is
  • anything that is generally acceptable to sellers
    in exchange for goods and services
  • cash vs goods what can you use to pay for stuff
    you want?
  • If something is not a generally acceptable means
    of paying for other goods and services, we dont
    consider them to be money
  • Money is the most liquid asset
  • an asset that can easily be exchanged for goods
    and services.
  • Think about what movie bank robbers usually
    demand Bearer bonds? Food stamps? Money orders?
    Bus transfers?
  • What other characteristics must an asset have to
    be considered money?
  • The Four (4) Functions of Money

The Four Functions of Money
  • Medium of Exchange
  • used in exchange for goods and services.
    Alternative barter, need double coincidence of
    wants, high transaction costs
  • divisibility available in large and small
    denominations Yap Isle
  • Unit of Account
  • Goods services are priced in terms of money,
    allowing easy comparison of relative values,
    lowers information costs
  • Store of Value (relates to willingness to hold m)
  • Ability to retain the value over time durability
  • Furs, Fish as money Fish spoils quicker, Furs
    retains value
  • High inflation often leads to currency
  • Standard of Deferred Payment
  • Debt obligations are written in terms of money
  • Firstborn child? Community Service? Jail time?

The U.S. Money Supply
  • Money supply is an important determinant of
  • Interest rates, inflation other macroeconomic
  • What do we want to measure as money supply?
  • Spendable assets
  • Should we include all bank deposits? No. Why?
  • Deposits can be for spending or for saving
  • Differentiate between assets on the basis of
  • Liquidity
  • Likelihood of the assets being spent
  • Three (3) nested definitions of MS M1, M2, M3
  • No best definition of MS, different definitions
    work better in different macroeconomic models
    (e.g. short-run vs. long-run)

M1 Money Supply
  • Financial assets that are the most liquid
  • currency, travelers checks, demand deposits and
    other checkable deposits
  • demand and other checkable deposits are known as
    transaction accounts
  • can be used to make direct payments to a third
  • Currency (39 of M1 in 1998)
  • Not backed by anything fiduciary monetary
  • Commodity money Greshams Law
  • Travelers Checks (less than 1 of M1 in 1998)
  • Demand deposits (37 of M1 in 1998)
  • checking accounts that do not bear interest bank
    have to pay the amount of the check immediately
    on demand
  • Other Checkable Deposits (interest

M2 Money Supply
  • A broader definition of MS, includes some of the
    less liquid forms
  • M1, savings deposits, small-denomination time
    deposits, and retail money market mutual fund
    balances PLUS overnight repurchase agreements
    and overnight Eurodollars
  • Savings Deposits
  • Accounts at banks and SL associations that pay
    interest but offer no check-writing privileges
  • Small-denomination time deposits (CODs)
  • small means less than 100,000 funds in these
    accounts must be deposited for a specific period
    of time
  • Retail Money Market Mutual Fund Balances
  • combine deposits of many individual and use them
    to invest in short-term securities. May grant
    check-writing, but limit the size and number of

M3 Money Supply
  • An even broader definition of MS, includes some
    of the even less liquid forms
  • M2, large time deposits, term repurchase
    agreements, term Eurodollar deposits and
    institution-only money market mutual fund
  • A repurchase agreement (RP)
  • an agreement between a bank and a customer under
    which the customer buys U.S. government
    securities from the bank one day and then sells
    them back to the bank later at a price that
    includes the interest earned overnight
  • Eurodollar deposits
  • deposits denominated in dollars but held outside
    the U.S. domestic bank industry

Global Money
  • How do countries pay for international
  • Each country has different domestic money
  • Foreign exchange market (does what?)
  • What currency are contracts usually written in?
  • Trade between developed countries
  • Domestic currency of the exporter. E.g. Ford
    sells 100 Mustangs to Japan, contract invoiced in
    US dollars
  • Trade between developed and developing countries
  • Domestic currency of the developed country (more
    stable, more widely traded)
  • Trade between developing countries
  • One of the major currencies
  • International Reserve Currencies (Assets)
  • currencies (assets) held by a government to
    settle international debt
  • E.g. USD, DEM, JPY, FFR, ECU, SDR gold

Composite Currencies
  • Composite Currency is an artificial unit of
    account that is an average of the values of
    several national currencies
  • European Currency Unit (ECU, Euro)
  • a unit of account used by western European
    nations as their official reserve asset
  • is a weighted average of the values of the
    national currencies of Austria, Belgium, Denmark,
    Finland, France, Germany, Greece, Ireland, Italy,
    Luxembourg, the Netherlands, Spain and Portugal
  • not an actual money, but accounting entity for
    now however, Euro will be soon (2002) circulated
    through the member countries, replacing national
  • Special Drawing Right (SDR)
  • created in 1970 by the IMF
  • a composite currency whose value is the average
    of the value of USD, FFR, DEM, JPY and GBP (look

Composite Currencies Example
  • Suppose we want to create a single currency in
    North America, the NAMU, as a weighted average of
    U.S. dollar (USD), Mexican Peso (MXP) and
    Canadian dollar (CAD)
  • Assume the following weights of national
    currencies in the composite currency
  • USD 70, CAD 20, and MXP 10
  • The exchange rates between USD, CAD and MXP are
    approximately as follows as of 04/06/00
  • 1 CAD 0.7 USD 1 MXP 0.10 USD
  • To find the value of the composite currency,
    NAMU, you can calculate the exchange rate
    vis-à-vis the USD
  • 1 NAMU .7 1 USD .2 (1 CAD) .1 (1 MXP)
  • .7 1 USD .2 (0.7 USD) .2 (.1 USD)
    .7 .14 .02 .86
  • That is, 1 NAMU 0.86 USD, or .86/.7 1.23
    CAD, or .86/.1 8.6 MXP

  • Commercial banks offer checkable deposits
  • Thrift Institutions historically only savings
  • Now offer similar services because of the 1980
    Depository Institutions Deregulation and Monetary
    Control Act
  • Commercial banks and thrift institutions are
    financial intermediaries
  • middlemen between savers and borrowers
  • Savers prefer short-term deposits
  • Borrowers prefer long-term loans (mortgages, car
    loans, etc.)
  • Financial intermediary hopes to earn profits on
    the activity (or spread between borrowing and
    lending rates). Islamic banks?
  • E.g. offer 2 on the savings accounts, and lend
    money at prime rate of 10.
  • If you have on average 1 million USD in deposits
    per year and you can lend 900k of it, the revenue
    per year is 900k (.10 -.02) 900k .08 72k

Banking Structure Failures
  • 67k bank offices operating in the US at the end
    of 1996
  • Half operated by national banks (chartered by the
    federal government) the other half by state
  • Federal regulations used to be tougher than state
    before 1980
  • Interstate Banking
  • Historically banks were allowed to operate only
    in one state (and sometimes only in one location!
    unit banking)
  • National banking is the future (ATMs, mergers)
  • more than 1/4 of all ATM transaction occur at a
    different banks ATM
  • Failures 1980s lots of bad loans bank runs
  • unexpected bad business conditions oil
  • Federal Deposit Insurance Corporation (FDIC)
  • insures small (up to 100k) deposits against bank

International Banking
  • International banks are financial intermediaries
  • Operate in a different legal environment
  • Much less regulated then domestic banks
  • Can offer better rates to both depositors and
  • Eurocurrency market (offshore banking)
  • Originated in Europe, but now is a worldwide
  • the market for deposits and loans generally
    denominated in a currency other than the currency
    of the country in which the transactions occur
  • Domestic vs. Euro dollar deposits loans
  • Domestic banking requires reserves against
    deposits, deposit insurance, mandated credit or
    interest rate restrictions
  • offshore banks operate with little or no such
    restrictions, plus generally pay lower taxes gt
    cost advantage gt competitive rates
  • Eurocurrency is riskier (subject to control of
    more governments)
  • International Banking Facility (IBF) Eurodollars
    in the US

Banks and the Money Supply
  • Banks CREATE money by LENDING money
  • Banks are required to keep a portion of deposits
    on hand as a reserve to meet the demand for
  • Fractional Reserve Banking System
  • a system in which banks keep less than 100 of
    the deposits available for withdrawal. (good or
  • Required reserves
  • the cash reserves (a percentage of deposits) the
    bank must keep on hand (according to regulations)
  • If RR 10 (or .1), then out of 1 M USD of
    deposits, the bank would have to keep 10 1 M
    100k USD on hand
  • Excess reserves
  • the cash reserves in excess of required these
    can be used for loans
  • Balance sheet
  • Assets (reserves plus loans left side)
    Liabilities (deposits, right)

Deposit Expansion Multiplier
  • Banks CREATE money by LENDING money
  • Banks are required to keep a portion of deposits
    on hand as a reserve to meet the demand for
    withdrawals (say, 25)
  • Suppose a bank receives a deposit of 100
  • Has to keep 25 as required reserves, can lend
  • The loan is used to pay for a dress seller
    deposits 75
  • Bank has to keep 25, or 18.75, can lend 57.25
  • The loan is used to pay for food seller deposits
  • Bank has to keep 25, or 14.31, can lend 42.94
    and so on
  • Deposit expansion multiplier 1/reserve
  • shows maximum increase in money supply given
    initial deposit
  • DEM excess reserves maximum MS increase
  • A single bank increases MS by lending out its
    excess reserves banking system increases MS by
    the deposit expansion multiplier times the excess
    reserves of the system

Deposit Expansion Multiplier Example
  • First bank has cash reserves of 200,000, loans
    of 800,000 and deposits of 1,000,000.
  • Prepare the Balance sheet for the bank
  • Assets Liabilities
  • Cash 200,000 Deposits 1,000,000
  • Loans 800,000
  • Total 1,000,000 Total 1,000,000
  • If the bank maintains a reserve requirement of
    12, what is the largest loan it can make?
  • To find out required cash reserves, multiply the
    deposits by the reserve requirement 1,000,000
    .12 120,000
  • The bank can only loan out the excess reserves,
    or the cash reserves above 120,000. That is
    200,000 - 120,000 80k
  • What is the maximum amount of money supply can be
    increased as the result of this new loan?
  • DEM 1/RR 1/0.12 8.(3)
  • Max MS increase Loan DEM 80k 8.(3)