ECO 120
Macroeconomics
Week 8
Money and the Banking
System
Lecturer
Dr. Rod Duncan
Topics
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What do we mean by “money”?
Equilibrium in the money market
Demand for money
How private banks affects the supply of
money
• The money multiplier, m
What does money do?
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We define money by “what it does”.
Money has three main functions in the
economy.
1. Money is a medium of exchange. We exchange
money when we buy/sell to each other.
2. Money is a unit of account. Money is an agreed
measure for stating the value of other goods and
services.
3. Money is a store of value. Money can be kept under
the bed or inside a jar and used to exchange for
goods and services in the future.
Medium of exchange
• So what things can constitute money?
• As a medium of exchange, many things have
been used- gold or other precious metal coins,
salt (Roman legionnaires), large stone wheels or
rare seashells (some Pacific Islands) and many
more.
• In our economy, we use currency (coins and
notes) to buy and sell. But we also use
cheques, debit cards, credit cards and even
game tokens at video arcades.
• “Liquidity” measures how readily you can use
the items as a means of exchange.
Medium of exchange
• So which of these is money? By a
“medium of exchange”, we mean
something that is widely recognized and
readily accepted as a means of payment.
– Currency is money.
– Debit cards might be money.
– Credit cards and cheques might be money.
– Game tokens are not money- not recognized
outside the video arcade.
What is money?
• What’s the difference between a
DEBIT card and a CREDIT card?
• Answer: The use of a debit card
withdraws (debits) money from your bank
account. The use of a credit card
borrows money from your bank.
Unit of account
• What about “money as a unit of account”?
• By this we mean that prices in our economy are
all written in terms of Australian dollars. Ie. a
loaf of bread is $3.50.
• We could just as easily use anything else, like a
weight in gold as a unit of account.
• In some countries, when they have monetary
difficulties, they switch to other units of account,
such as U.S. dollars.
Store of value
• What about “money as a store of value”?
• We mean that money has some inherent value
that holds over time.
– Currency is a store of value- but only as long as the
government backs the money. What about all those
Saddam Hussein era “dinars”?
– Coins used to have an intrinsic value, as you could
melt them down to a fixed weight of precious metals.
– What is the intrinsic value of the materials used in our
currency?
What is money?
• What about debit cards, cheques and credit
cards?
• Can a chequebook sitting on your kitchen table
be “money”?
– How much money? They are blank cheques.
– Millions and millions of blank cheques in our
economy- they can’t all be money.
• What about debit cards? How much money is
each debit card worth?
• How about all those credit cards being offered
around the economy?
What about cheques and debit
cards?
• The key is that cheques and debit cards
only represent “money” to the extent to
which they are backed by a bank account.
– You have $5,000 in your bank account. After
you pay $5,000 in cheques or debit card
withdrawals, your cheques and debit cards
become worthless.
• So the money is not the cheques or debit
cards, it is bank account behind them.
The bank accounts are money.
Are credit cards money?
• How about credit cards?
• Remember that use of a credit card
borrows money from your bank, so a credit
card is simply an easy way to get a loan.
• So credit cards are not money, since they
do not represent any store of value.
What is money?
• Currency is definitely money.
• Bank accounts are probably money- can be
used in exchange through debit cards or
cheques.
• Debit cards, cheques and credit cards are not
money- although they may represent money.
• What about a retirement account that issues a
debit card?
• There are many definitions of money.
Official measures of money
• M1 is the amount of notes and coins
(“currency”) in circulation plus current
deposits with banks- cheque-book
accounts.
• M3 is M1 plus all other bank deposits.
• There are other Ms, generally the lower
Ms are smaller or “more narrow”
definitions of money.
Monetary base
• The monetary base is the most narrow
definition of money. It includes only
currency held by the public and banks plus
the deposits of banks with the Reserve
Bank of Australia (which we will discuss
later today).
• The monetary base is also called “highpowered money” or “base money”.
Equilibrium in the money market
• Equilibrium in the money market means
supply of money equals demand for
money.
• Supply of money
• Demand for money
Demand for money
•
What do people need money for? When we
defined money, we identified three roles for
money:
1. Unit of exchange
2. Unit of account
3. Store of value
•
There is no need for actual money to exist to
be a unit of account, but people do need to
have money to use in exchange or as a store
of value.
Transactions demand
• Transactions demand is the demand for money
for use in exchange- to buy and sell things.
• Transactions demand for money depends on the
nominal value of GDP. Transactions demand
increases as:
– Average level of prices, P, rises; and
– Real GDP, Y, rises.
• Since we don’t barter, every exchange in our
economy involves passing money from one
person to another in exchange for things.
Asset demand
• Asset demand for money is the demand for
money to be used to store value over time.
– People hold currency in jars or under their beds.
– People hold money in low interest chequebook
accounts or savings accounts (investors often call this
“cash”).
• The return on savings as currency or cash is low
(zero for currency or low for savings accounts)
• Instead people could have their wealth invested
in high interest accounts or the stockmarket, but
these forms of wealth are less liquid.
Asset demand
• How else could people hold their wealth?
• People could put their money in bonds, in
property, in mutual or investment funds, in the
stockmarket, in retirement accounts and many
other forms.
• Typically the return on these forms of
investments is much higher than “cash”
investments- currency or savings accounts.
• The trade-off is that these investments are less
“liquid”- harder to get your wealth out.
Asset demand
• The “opportunity cost” of holding cash is the
higher interest rate you could earn on other
investments.
• As the interest rates (return on bonds, mutual
funds, stockmarket etc) in an economy rises, the
option of holding “cash” is more expensivegiving up the higher returns.
• So we would expect that asset demand for
money falls as the interest rate in an economy
rises.
Demand for money
• The total demand for money is the sum of
transactions and asset demand.
• Transactions demand rises in P and Y. As i
rises, people will try to minimize the use of cash
in purchases, so transactions demand does not
rise in i, and perhaps even falls in i. (We will
assume it does not depend on i for simplicity.)
• As the asset demand falls as i rises and
transactions demand at least does not rise, we
expect the demand for money is downwardsloping in i.
Demand for money
• The total demand for
money is the sum of
transactions and
asset demand.
• Total demand rises in
P and Y. Total
demand falls in i.
Interest
rate
D
Money
Supply of money
• The general definition of money that we will use
is the M3 definition- currency plus deposits at
banks.
• The Reserve Bank of Australia (RBA) controls
the amount of currency in the economy, but what
controls the amount of deposits at banks?
• Why is there only a limited level of deposits?
Surely banks can make more money simply by
loaning out more and more?
How banks work
• To understand how deposits work, you have to
understand how banks make money.
• Banks make money from the difference between
the interest rate they pay to depositors and the
interest rate they charge to borrowers.
• When you deposit money at a bank, where does
it go? It goes out as a loan to someone else.
• Every bank has a big vault. How much money
does a bank have in that vault? None, or as little
as it can manage.
How banks work
• Imagine if there was a rumour that Bank XXX
was badly-run and was going to collapse.
• So what would happen if 20% of the depositors
at a bank came and demanded their deposits?
• The bank would collapse as it couldn’t force
payments of the loans it has made to its
borrowers.
• The rumour doesn’t even need to be true!
• If you ever watch the old B&W movie “It’s a
Wonderful Life”, Jimmy Stewart’s character talks
about this.
How banks work
• A banking crisis (plus monetary policy
mismanagement) was the true cause of the
Great Depression in the 1930s- not the
stockmarket collapse!
• Since the Great Depression, governments now
insure banks. If a bank has a “run” on deposits,
the government will step in and pay the
depositors (and even take over the bank).
• In return for insurance, banks have to maintain a
“reserve ratio”.
Reserve ratio
• For every $1 in loans that a bank has on
its books, the bank must maintain $R in
deposits at the Reserve Bank of Australia.
• The reserve ratio, R, is a lot less than $1.
• The deposits at the RBA are used to make
payments between banks.
• The interest paid by the RBA on deposits
is a lot less than other interest rates in the
economy.
Money multiplier
• What happens when you take $1 cash to a
bank to deposit it?
(1) You deposit the cash in the bank, and the bank
creates an account for you with $1 in it.
Money = $1
(2) The bank doesn’t keep the cash. Instead the bank
has to keep R (0 < R < 1) of the $1 as reserves and
then loans out $(1 - R).
(3) The person who receives the loan of $(1-R) spends
the cash, and the merchant who receives the $(1-R)
puts that in his bank. This increases the merchant’s
account by $(1-R).
Money = $1 + $(1-R)
Money multiplier
(4) The second bank keeps $R(1-R) as reserves and
loans out $(1-R)(1-R) = $(1-R)2 as new loans.
Money = $1 + $(1-R) + $(1-R) 2 + …
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If this process continues, the value of money
created is 1/R = 1 + (1-R) + (1-R)2 + ...
So for every $1 floating in the economy in
currency, we have $1/R in currency plus
deposits in the economy. This ratio m = 1/R is
called the “simple money multiplier”. For every
$1 in currency that the government prints, the
money supply increases by m.
Sample question
Question
Assume we have a simple economy where we
ignore everything except the reserve ratio
which is 0.2.
(a) What is the simple money multiplier?
(b) The government prints $1m in new money to
give to farmers for drought relief. By how
much does the money supply rise? [Hint:
Much more than $1m.]
Supply of money
• The supply of money
depends on
– Monetary base; and
– Reserve ratio
Interest
rate
S
• But not on the interest
rate, so the supply of
money is vertical in i.
Money
Equilibrium in the money market
• Equilibrium in the money market means supply
of money equals demand for money.
• We need to determine what we mean by:
– Supply of money
• Supply of money depends on the monetary base and the
money multiplier, but NOT on the interest rate.
– Demand for money
• Demand for money (transactions plus asset) depends on
prices, real GDP and the interest rate.
Equilibrium in the money market
• The supply of money
does not depend on
the interest rate, so it
is vertical.
• The interest rate is
the price of holding
wealth as cash, so
money demand falls
as i rises.
Interest
rate
S
i*
D
Money
Monetary policy
• Monetary policy is simply the RBA
intervening in the money market to affect
interest rates and then the rest of the
economy.
• We will discuss monetary policy next
week.