ECO 120 Macroeconomics

Week 8

Money and the Banking System LecturerDr. Rod Duncan

Topics

• 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?• 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 “high-powered 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 exchange2. Unit of account3. 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 expensive- giving 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 downward-sloping 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.

Interestrate

Money

D

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 + …

• 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.

Supply of money

• The supply of money depends on– Monetary base; and– Reserve ratio

• But not on the interest rate, so the supply of money is vertical in i.

Interestrate

Money

S

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.

Interestrate

Money

D

S

i*

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.