Money Supply and Banks

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Money Supply and Banks


An Overview of MoneyWhat Is Money?

Money is a means of payment, a store of value, and a unit of account.

A Means of Payment, or Medium of Exchange

barter The direct exchange of goods and services for other goods and services.

medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services.


Objectives

1. Understand the functions of money

2. Examine how banks create money

3. Explain how the Bank of England controls the money supply, and the instruments of control.

4. Give insights into the current policies of quantitative easing – a form of open market operations and interest rate management.


An Overview of MoneyWhat Is Money?

A Store of Value

store of value An asset that can be used to transport purchasing power from one time period to another.

liquidity property of money It is portable and readily accepted and thus easily exchanged for goods.

A Unit of Account

unit of account A standard unit that provides a consistent way of quoting prices.


An Overview of MoneyCommodity and Fiat Monies

commodity monies Items used as money that also have intrinsic value in some other use. Eg gold coins.

fiat, or token, money Items designated as money that are intrinsically worthless. Eg notes.

legal tender Money that a government has required to be accepted in settlement of debts.

currency debasement The decrease in the value of money that occurs when its supply is increased rapidly or hyperinflation reduces it’s real value in terms of exchange. Germany in the 1930s; Zimbabwe today.


An Overview of MoneyMeasuring the Supply of Money

M1: Transactions Money

M1, or transactions money Money that can be directly used for transactions.

M1 ≡ notes and coin + demand deposits


An Overview of MoneyMeasuring the Supply of Money

M3: Broad Money

near monies Close substitutes for transactions money, such as savings accounts and money market accounts.

M3, or broad money M1 plus savings accounts, money market accounts, and other near monies.

M3 ≡ M1 + savings accounts + money market accounts + other near monies


An Overview of MoneyThe Private Banking System

financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money.

The main types of financial intermediaries are commercial banks, followed by life insurance companies, and pension funds.


How Banks Create MoneyA Historical Perspective

run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time.

Today’s bankers differ from the early banks—today’s banks are subject to a “required reserve asset ratio.”

Early banks had no legal reserve requirements, although the amount they loaned out was subject to the restriction imposed on them by their fear of running out of gold.


How Banks Create MoneyThe Modern Banking System

A Brief Review of Accounting

The Bank of England The central bank of the UK, independent of the Government since 1997.

reserves The deposits that a bank has at the Bank of England plus its cash on hand.

required reserve asset ratio The percentage of its total deposits that a bank must keep as reserves at the Bank of England.

Assets − Liabilities ≡ Net Worthor

Assets ≡ Liabilities + Net Worth


How Banks Create MoneyThe Modern Banking System

A Brief Review of Accounting

Account for a Typical Bank (£bn)The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).


How Banks Create MoneyThe Creation of Money

excess reserves The difference between a bank’s actual reserves and its required reserves.

Balance Sheets of a Bank in a Single-Bank EconomyIn panel 2, there is an initial deposit of £100. In panel 3, the bank has made loans of £400.

excess reserves ≡ actual reserves − required reserves


How Banks Create Money

The Creation of Money When There Are Many BanksIn panel 1, there is an initial deposit of £100 in bank 1. In panel 2, bank 1 makes a loan of £80 by creating a deposit of £80. A cheque for £80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on. In the end, loans of £400 have been made and the total level of deposits is £500.


How Banks Create MoneyThe Money Multiplier

An increase in bank reserves leads to a multiple increase in the money supply.

Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier.

money multiplier The multiple by which deposits can increase for every £ increase in reserves; equal to 1 divided by the required reserve asset ratio.

ratio reserve required

1 multiplier money


The UK Banking SystemFunctions of the Bank of England

From a macroeconomic point of view, the Bank’s crucial role is to control the money supply.

The Bank also acts as a clearing system for interbank payments, and assists banks in a difficult financial position. From 2001 bank regulation has been in the hands of the Financial Services Authority, renamed the Financial Conduct Authority in 2013.

The Bank is also responsible for managing exchange rates and the nation’s foreign exchange reserves.

lender of last resort One of the functions of the Bank: It provides funds to troubled banks that cannot find any other sources of funds.


The Banking Crisis of 2007-8Expanded intervention in 2008

When housing prices began to fall in the USA in late 2005, the stage was set for a worldwide financial crisis, which essentially began in 2008.

There has been much political discussion of whether FSA should have been more active in its regulation of complex bad debts in 2003–2007, and whether it should be more active in its supervision of the private sector. Northern Rock was granting mortgages of 110% of the property value – if property prices fall, the bank is left with a bad debt and a loss after repossession.

The Bank of England has been much more active since 2008 – providing liquidity to the banking system through Quantitative Easing.


How the Bank Controls the Money SupplyIf the Bank of England wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves.

Three tools are available to the Bank for changing the money supply:

1. Changing the required reserve ratio.

2. Changing the interest rate at which it lends to banks overnight.

3. Engaging in open market operations – quantitative easing (QE).


How the Bank of England Controls the Money Supply

The Required Reserve Ratio

A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent Increases the Supply

of Money (All Figures in £bn)

Panel 1: Required Reserve Ratio = 20%

Bank of England Commercial Banks

Assets Liabilities Assets Liabilities

Government 200 100 Reserves Reserves 100 500 Deposits

securities 100 Currency Loans 400

Note: Money supply (M1) = Currency + Deposits = 600.

Panel 2: Required Reserve Ratio = 12.5%



Government 200 100 Reserves Reserves 100 800 Deposits

securities 100 Currency Loans

(+ 300)

700 (+ 300)

Note: Money supply (M1) = currency + deposits = 900.



The Required Reserve Asset Ratio

Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves.

As banks create more deposits by making loans, the supply of money (notes, coin + deposits) increases.

The reverse is also true: If the Bank wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans.

The result is a decrease in the money supply.



The Discount Rate

discount rate The interest rate that banks pay to the Bank to borrow from it.

moral suasion The pressure that in the past the Bank exerted on member banks to discourage them from borrowing heavily from the Bank.


How the Bank Controls the Money SupplyThe Discount Rate

The Effect on the Money Supply of Commercial Bank Borrowing from the Bank (£bn)

Panel 1: No Commercial Bank Borrowing from the Bank of England



Securities 160 80 Reserves Reserves 80 400 Deposits

80 Currency Loans 320

Note: Money supply (M1) = currency + deposits = 480.

Panel 2: Commercial Bank Borrowing £20bn from the Bank of England



Securities 160 100 Reserves

(+ 20)

Reserves

(+ 20)

100 500 Deposits

(+ 300)

Loans 20 80 Currency Loans

(+ 100)

420 20 Amount owed to

B of E(+ 20)

Note: Money supply (M1) = currency + deposits = $580.


How the Bank Controls the Money SupplyOpen Market Operations

open market operations The purchase and sale by the Bank of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

Two Branches of Government Deal in Government Securities

The Treasury is responsible for collecting taxes and paying the government’s bills.

The Bank is not the Treasury. It is an independent agency authorised by Parliament to buy and sell outstanding UK government securities on the open market.



The Mechanics of Open Market OperationsOpen Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences

between Those Panels and Panel 1. (£bn)

Panel 1

B of E Commercial Banks Jane Q. Public

Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities 100 20 Reserves Reserves 20 $100 Deposits Deposits 5 0 Debts

80 Currency Loans 80 5 Net WorthNote: Money supply (M1) = Currency + Deposits = 180.

Panel 2


Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities

(- 5)

95 15 Reserves

(- 5)

Reserves

(- 5)

15 95 Deposits

(- 5)

Deposits

(-5)

0 0 Debts

80 Currency Loans 80 Securities

(+ 5)

5 5 Net Worth

Note: Money supply (M1) = Currency + Deposits = 175.

Panel 3


Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities

(- 5)

95 15 Reserves

(- 5)

Reserves

(- 5)

15 75 Deposits

(- 25)

Deposits

(- 5)

0 0 Debts

80 Currency Loans

(-20)

60 Securities

(+ 5)

5 5 Net Worth

Note: Money supply (M1) = Currency + Deposits = $155.



The Mechanics of Open Market Operations

■ An open market purchase of securities by

the Bank results in an increase in cash reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves. This is ‘quantitative easing’.

■ An open market sale of securities by the

Bank results in a decrease in cash reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.


How the Bank Controls the Money SupplyExcess Reserves and the Supply Curve for Money

The Supply of MoneyIf the Bank’s money supply behaviour is not influenced by the interest rate, the money supply curve is a vertical line. Through its three tools, the Bank can cause the money supply be whatever value it wants.


Key terms• barter• commodity monies• currency debasement• discount rate• excess reserves• fiat, or token, money• financial intermediaries• legal tender• lender of last resort• liquidity property of money• M1, or transactions money• M3, or broad money• medium of exchange, or means of

payment• money multiplier

• moral suasion• near monies• open market operations• required reserve ratio• reserves• run on a bank• store of value• unit of account• 1. M1 ≡ notes and coin + demand

deposits • 2. M3 ≡ M1 + savings accounts + money

market accounts • 3. Assets ≡ Liabilities + Net Worth• 4. Excess reserves ≡ actual reserves −

required reserves• 5. Money multiplier ≡ ratio reserve required

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Money Supply and Banks

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