Money, banking and financial
markets
Lecture by
Neven Mates
Money
• Medium of exchange
• Unit of account
• Store of value
Medium of exchange
• Barter: At the beginning of market economy,
people were occasionally exchanging surpluses
of their production: surplus of wheat for surplus
of wool, etc.
• As soon as producers started specializing, barter
became impractical
• One or several goods started to be used as the
medium of exchange
• One would exchange his product for the medium
of exchange, and later would use this medium to
purchase a third product.
Unit of account
• Instead of measuring value of a unit of one
good in units of all other goods (one sheep
is x kg of wheat, y kg. of barley, z kg of
mushrooms), people started measuring
everything in a quantity of only one
commodity: either gold, silver, copper,
wheat.
Store of value
• If we do not want to consume everything that we
produced today, we want to save.
• If we are producing wheat, we can save wheat for
consumption next year. Not so if we produce ice-cream.
• One option is to save in the medium of exchange, which
can later be exchanged for any good.
• As a store of value, money intermediates between
production today and consumption tomorrow.
• But it is only one form of storing value.
First form of money: Commodity
money
• To be used as the medium of exchange, the particular
commodity has to have the following qualities:
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easy to transport
easy to measure
easy to keep in storage
accepted by large number of individuals.
Historical examples: Gold, silver, copper, shells, precious and
semiprecious stones.
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1 Troy ounce: 31.08.. grams
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Value:1 troy oz. fine gold
Mass 33.93 g (1.09 troy oz)
Diameter 32.6 mm (1.28 in)
Thickness 2.84 mm (0.11 in)
Composition Gold (91.67% Au, 8.33% Cu)
Years of minting1967-Present
Representative money
• Even gold is not easy to carry.
• You can give it to someone whom you trust to treasure it.
He would give you a receipt.
• Instead of paying with a golden coin, you can pay with
this receipt. Various forms of receipts:
– Banknote — a promissory note issued by a bank that the holder
is entitled to receive gold from the banker (person who is storing
gold). Invented in China, later in Europe (17th century).
– Letter of credit.
– Deposits, recorded in bank books. Payments can then be made
by transferring funds kept in deposit: You tell our bank to pay
either by writing a transfer order or a cheque.
Various types of money:
• Commodity money
• Paper money (banknotes)
• Banking money (deposits)
At the time of the golden standard, all these forms
of money represented claims that could, if
requested, be exchanged into gold.
The golden standard dominated until World War I.
Banking and credit
• Bankers were originally individuals with whom people were able to
deposit commodity money (gold).
• But banks do not need to keep all gold deposited with them in
storage. All depositors will not come at the same moment to request
redemption of banknotes or the payout of deposits.
• Banks can therefore extent credit to borrowers, and keep only part
of the deposits as a liquid reserve. This is called fractional reserve
banking.
• By extending credit, banks increase deposits of their other
customers.
• In this way they create money.
• Now the quantity of money is no longer equal to the quantity of gold
(which might be consider to be the ultimate money), but it is equal to
the quantity of gold in circulation (i.e. not in banks) plus the amount
of deposits.
How is money created by credit?
• Phase 1
• Person has 100 golden coins. Total amount of money is 100
guldens.
• Phase 2
• He deposits 100 guldens in the bank and receives 100 banknotes,
each promising the payment of one gulden. The quantity of money
in hands of non-banking individuals is still only 100, but now it is in
the form of banknotes.
• Phase 3
• Banks approves 75 guldens as credit and pays the coins out.
• The total amount of money:
• 75 guldens in coins held by non-banks + 100 guldens in
banknotes=175
• The bank keeps 25 guldens as a reserve.
How is money created by credit 2
• Phase 4
• Those that have received guldens as borrowers
take them to other banks and they get
banknotes. Total amount of money remains 175
• Phase 5
• Other banks keep 25% of deposits as reserves,
but use the rest to extend credit.
• End result:
• If nobody insists on holding coins, the total
amount of banknotes (and money) equals 400.
Banks held 100 coins as reserves.
Central banking
• Banknotes were originally issued by many banks.
• They were an attractive source of funding, because banknotes do
not carry interest. But depositors do not have to pay for storing their
gold with banks.
• Governments soon starter to monopolize the issuance of banknotes.
• They did that by granting the exclusive right of issuing banknotes to
only one bank.
• In return, this bank would often become creditor to the government.
• Later, governments would also impose obligation on other banks to
keep some percentage of their deposits with the bank authorized to
issue banknotes.
• This is called the reserve requirement, and such bank is called the
central bank. Take note that originally, many central banks were
privately owned.
• Governments also gradually introduced restrictions on bank
holdings of gold.
Golden standard
• Under the golden standard, all other forms of money were ultimately
exchangeable into gold.
• By creating paper and bank money, countries were able to save
resources for production of gold.
• Governments soon found ways to discourage people from holding
gold, either as specie or in golden coins.
• This was achieved by introducing the legal tender: Governments
proclaimed by law that all contractual obligations were to be settled
with banknotes.
• Commercial banks were also encouraged to settle their net
payments via accounts held with the central bank, and not by gold.
• Less demand there was for gold, more credit could be given to the
government and more gold could be used for payments abroad.
• As long as the quantity of money created was roughly in line with
demand, the situation was stable.
On the way to fiat money I
• During World War I, most countries suspended
conversion of banknotes into golden coins or bullion.
• Some countries later re-introduced the possibility of
conversion into gold, but at different rate than the original
one.
• In some countries, banks were forbidden to hold gold.
• The US in 1933 forbid by law that citizens hold more
than very limited quantity of golden coins.
• Gold lost the status of legal tender in domestic
payments. This function was given to banknotes, issued
by the central bank of the country. Other banks already
lost right to issue banknotes.
On the way to fiat money II
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After the Great Depression, the gold convertibility still applied in international
payments, but golden content of the currencies was occasionally adjusted.
The US honored that other central banks can request that their holdings of dollar be
converted into gold all the way to 1971.
But then, after the US ran a large budget deficit during the Vietnam war and as a
result lost huge amount of its golden reserves, the convertibility of the U.S. $ was
abandoned.
Money in all countries ceased to be linked to gold. Money became fiat money, i.e. its
quantity become determined by the banking system, with no link to any specific
commodity.
In such system, the central bank creates reserve money via credit or by buying
foreign reserves.
By extending credit, commercial banks create bank money.
In this way, money used by the public is much larger than reserve money created by
the central bank. The ratio of money to reserve money is called the monetary
multiplier.
How is the fiat money created?
Phase 1
Assets
20 reserves with central bank
20 Treasury bills
60 loans
Liabilities
80 deposits
20 capital
Reserve requirement is 25%. The bank is just meeting the requirement.
The bank cannot lend.
Phase 2: The central bank purchases T-bills
Assets
Liabilities
40 reserves with the central bank 80 deposits
60 loans
20 capital
The amount of reserves has gone up by 20. Bank has free
reserves of 20. It can lend.
How is fiat money created 2
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Phase 3: Bank lends free reserves
Assets
Liabilities
40 reserves
100 deposits
80 loans
20 capital
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Take note that the amount of deposits has gone up from 80 to 100.
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Phase 4: Borrowers make payments to customers of another bank.
Assets
Liabilities
20 reserves
80 deposits
80 loans
20 capital
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Take note: Reserves have been transferred to the other bank. They now
have 20 more in reserves and 20 in new deposits. The reserve requirement
on new deposits is 5 (25% of 20). Their free reserves are 15. They can lend.
Money multiplier
• System with no cash:
Multiplier=M/R=1/RR
where
M is money (total of deposits)
R is reserve money (claims of banks on the
central bank)
RR is the required reserve ratio. It might be
mandatory or voluntary.
Money multiplier
• System with cash
Multiplier= M/R= (1+CD)/(RR+CD)
where
CD is cash/deposit ratio.
Outflow of reserve money into cash reduces
the multiplier.
Reserve requirement reduces the multiplier.
Free reserves reduce the multiplier.
What determines the aggregate price level under the
golden standard in a closed economy?
Relative prices of all goods and the gold were determined
by the relative costs of production.
Simplified: If it takes 100 hours to produce 1 g of hold and
50 hours to produce 1 tone of wheat, then the price of
wheat is 0.5 g of gold.
If production costs of gold go up, relative prices of all other
goods go down. Aggregate price level then declines.
In 12th and in 15th century, new silver mines were
discovered, which led to a decline in costs of producing
silver. This resulted in inflation, as many countries at the
time were on silver standard.
What determines the aggregate price level under
the fiat money in a closed economy?
• As long as the money was linked to some commodity,
the aggregate price level depended on costs of
producing goods that enter GDP relative to the cost of
producing that commodity.
• Once the link has been severed, the aggregate price
level becomes determined by the relation between
demand and supply of money.
• If supply surpasses demand, there is an inflationary
pressure. If demand for money is higher than supply,
there is deflationary pressure.
• Supply is influenced by the central bank: This creates
scope for monetary policy, about which you will learn
more in one of the next lectures.
Money: Degrees of liquidity
Croatia: Monetary survey
in mlrd KRK
Assets
Foreign assets
Domestic credit
to government
to other non-financial institutions
to other financial insitutions
Liabilities
Currency in circulation
Current accounts
Saving and time deposits
Foreign currency deposits
Bonds and simmilar instruments
Restricted and blocked deposits
Capital accounts and other items net
Source: HNB Bulletin 174
August 2011
327
42
29
252
4
327
18
36
39
145
2
3
84
M1
M1
M2
M3
M4
Narrow Money
Narrow Money
Broad money
Quasi money
Quasi money
Quasi money
Money: Degrees of liquidity
• Money: The medium of exchange and the store of value
• Medium of exchange: Only the most liquid forms of
money: Cash in circulation plus current account deposits
- M1
• Store of value: Includes also less liquids forms – time
deposits. Together M2.
• Store of value: Also foreign currency deposits. Altogether
– Broad money
• Reserve money: Cash (in circulation and in bank vaults)
+ bank accounts with the central bank.
• Also called base money or high-powered money.
How central banks affect the quantity of money—
closed economy or open economy with floating ER
• CB sells and buys government or other safe
paper, which increases or reduces free reserves
of banks.
• Ample free reserves: Banks lend more, and vice
versa.
• CB can target either quantity of money or the
level of interest rates. It cannot do both.
• Under inflation targeting, the CBs set the level of
interest rate at which they are willing to lend.
How central banks affect the quantity of money—
closed economy or open economy with floating ER
• Excess liquidity but banks not willing to
lend?
• The only option available is then that the
CB buys assets, takes over credit risk, and
reduces interest rates in selected markets.
• Called Quantitative Easing.
ECB rates
How central banks affect the quantity of
money—open economy with fixed ER
• The CB keeps the exchange rate stable by
buying and selling forex.
• The balance of payments (the sum of the
external current and capital account) then
determines changes in free reserves of
banks.
• Ample reserves—more credit—more
domestic demand+lower domestic interest
rates= correction in BoP, and vice versa.
Open economy with fixed ER—Sterilized
interventions
• BoP ouflows: Contraction in liquidity, but CB can
offset this by extending credit to banks. But this
causes soon even larger loss of reserves.
• BoP inflows: Supply of liquidity. The CB tries to
sterilize this by placing its securities in the
market. However, this soon becomes expensive.
• It can also increase reserve requirements, which
imposes regulatory costs.
• But in general not very effective. Credit moves
outside of the banking system.
Broad financial sector
• So far we focused on banks, which are always in
the centre of financial system.
• In addition to bank deposits, households and
corporations keep other forms of financial
instruments: Bonds and shares. In this way
savers and borrowers circumvent the banking
system
• Households can often let various investment
funds to handle their assets. This allows them to
participate in a larger number of securities.
What determines the choice of
financial assets by investors?
• Expected return
– The average return
– Volatility (variability of the rate of return, including the
possibility of default)
Fixed income instruments:
– Nominal interest i
– Real interest r= (1+i)/(1+CPI) – 1
Variable income instruments: Indexed securities, bonds
As a rule, assets with higher average return are also
more volatile.
Dow industrial index
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Dow Industrial Index
Current interest rates
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