UNIVERSITY OF THE PHILIPPINES SCHOOL OF ECONOMICS

ECONOMICS 100.1 Introduction to Macroeconomic Theory and Policy

Study Guide No. 3

Prof. Monsod / Mariano 1st Semester AY 2010-2011

Money and the Financial System

I. Learning Objectives
1. 2. 3. 4. Develop an overview of the mechanism by which the effects of monetary policy are transmitted to the rest of the economy. Understand the differences between M1 and M2. Describe the three functions of money and explain their role in supporting the transactions demand and the assets demand for money. Describe the process by which a banking system built on fractional reserves can create money. Understand the dynamics behind the resulting money multiplier, and define the two qualifications upon which its precise computation is dependent.

II. Summary (Chapter 23 of Samuelson and Nordhaus [2010])

The monetary transmission mechanism describes the mechanisms by which monetary policy affects economic conditions, such as interest rates, output, employment, and inflation. Given the central banks policy objectives and the current and expected future state of the economy, the central bank chooses a policy (e.g. short-term interest rate target) and implements it through central bank operations. The policy actions affect financial variables (such as asset prices, exchange rates), which in turn affect macroeconomic behavior (for example, the behavior of consumption, investment and net exports). The monetary transmission mechanism can be studied through the lens of our AS-AD framework. 1. The Modern Financial System a. The financial system plays a critical part in our modern economy. The major functions include: i. A transfer of resources across time, sectors, and regions. This allows investors with money to invest in the most productive opportunities whether that opportunity is in Indian or India. ii. Investors who will help manage risk. This function moves risk from those people or sectors that most need to reduce their risk to others who are better able to whether risk taking. iii. Pooling and subdividing funds. This allows investors with limited resources to participate in investing opportunities that would not be open to them under other circumstances. iv. A clearinghouse function. This allows money to be transferred from one part to another part of the country in an efficient way. b. Financial assets are monetary claims by one party against another party. The main financial instruments include: i. Money which is a barren asset i.e., does not pay a rate of return. ii. Savings accounts which usually pay a guaranteed return and are insured by a federal agency.

iii. Government securities which represents money borrowed by the central and local governments. These are considered safe investments. iv. Equities which represent ownership rights to companies. This type of financial instrument is commonly called stock in a company. v. Financial derivatives whose values are based on or derived from the values of other assets. The most widely known type of derivative are stock options i.e., puts and calls. vi. Pension funds, which represent ownership in the assets that are held by companies or pension plans. Workers and companies contribute to these funds during working years, and the funds are then drawn down to pay pensions during retirement. c. The flow of funds diagram captures the essence of financial markets, showing the interdependence between savers and investors. Interest rates are the price of borrowing money. If you save, you may view the interest you earn as a payment, or return to saving. It can also be considered as the price others (usually banks) are willing to pay you for the use of your money. Similarly, if you borrow, you must pay interest to compensate the lender for giving up the opportunity to use the money (that you borrowed) in some alternative use.

d.

2.

The Special Case of Money a. The money used in most economies has no intrinsic value, but its supply has an enormous effect on the nations output, employment, and price level. It would be difficult to overstate its importance. b. Economies based primarily on a barter system of transactions do not work very well. Individuals spend too many precious (and scarce!) resources lining up trading partners and less time producing goods and services. The primary measure of money that we will use in our model of the economy is transactions money, or M1. M1 includes coin and currency in circulation (i.e., not held by banks), plus demand and other checkable deposits. Our focus on money that is in circulation stems from our concern for money that can be used to facilitate economic transactions. Money held by banks has little influence on the pace of economic activity. The term demand deposits is used synonymously with checking accounts since you have access to this money anytime and anywhere you are, as long as you have your checkbook. The money is available upon (your) demand, as long as the recipient of the money is willing to accept your check. NOW accounts are an example of bother checkable deposits. The acronym stands for Negotiable Order of Withdrawal. These are interest-bearing accounts that allow depositors to write checks. While M1 is the most appropriate measure of money as a means of payment, a broader monetary aggregate, M2, is also watched very closely. M2 includes M1 plus savings accounts and small timedeposits. Savings accounts and time deposits earn interest and are slightly less liquid than the components of M1. Over the past 10 years, this broader definition of money has been a more stable indicator of money supply growth than has M1. This is due, in part, to all the new kinds of checking instruments that have been created by banks. Money has no usefulness as a commodity. We cannot eat it or wear it or use it for shelter. We demand money so that we can use it to purchase the commodities we need or want. There are three basic functions that money performs. It serves as i. a medium of exchange ii. a unit of account iii. a store of value The medium of exchange function is the most basic. If people do not universally accept the money (at least within a country) as a means of payment, then we are back to barter. It is that simple.

c.

d.

e.

Unit of account means that whatever we use as money should also be used to measure prices or value. It would be silly to have peso as our money and then measure prices in terms of apples or donuts or Mexican pesos. Money serves as a store of value in that it does not physically deteriorate over time (this was a problem with some forms of commodity money) or lose its acceptability. Money is less risky than other form of wealth, such as stocks, real estate, and gold. f. The cost of holding wealth or assets as money is the forgone opportunity to earn higher rates of return or interest on other financial investments. There are two main reasons why people hold wealth as money: (a) transactions demand and (b) asset demand. The transactions demand goes hand in hand with the medium of exchange function of money, while the asset demand matches up with the store of value function. While other assets may pay higher rates of interest, most portfolio managers diversify their wealth among different types of assets.

g.

3.

Banks and the Supply of Money a. Banks are fundamentally businesses. A commercial bank is essentially in the business of attracting deposits from customers and then using them make to loans. It profits by charging interest on the loans. Note that a commercial bank cannot lend out the entire amount of deposits it receives. It must hold some percentage of the deposits in the form of (non-interest-earning) reserves in the event that customers wish to withdraw some cash, among other events. The precise percentage or fraction of deposits that a commercial bank must hold in reserves depends on the law and hence is referred to as the legal reserve requirement. If the legal reserve requirement is 10%, then for each Php1 of deposit received, the bank must set aside at least 10 centavos, and can invest up to 90 centavos in the forms of loans to customers or other businesses. b. The fractional-reserve banking system (i.e. where reserves are a fraction of deposits) has an important influence on the role of the banking system in causing expansions (or contractions) in the money supply. As the money that is lent out is re-deposited in another bank (or in the same bank that issued the loan), the bank can make additional new loans, after setting aside some of the new deposits into its reserves. Thus the process continues, and more and more loans, and more and more deposits are created. Since deposits are part of money supply, the supply of money expands as more and more deposits are created. Ultimately, the total money creation is some multiple of the initial change in reserves. We would therefore observe the following relationship among reserves, bank money, and the legal reserve requirement ratio: 1 Bank Money = Total Reserves x required reserve ratio In reality, the money creation process will be diminished if banks hold excess reserves; that is, they do not lend the full amount that they are entitled to. For example, if a customer deposits Php100 and the reserve requirement ratio is 25%, the bank can lend up Php75 and set aside Php25 in reserves. But if the bank lends less (say Php60) and thereby keeps more in reserves (Php40), they are holding excess reserves (in the amount of Php15). The money creation process will also be diminished if customers do not deposit all the new money in banks (for example, customers might keep them under the mattress). Banks make loans in order to make profits. If bankers are pessimistic about the economy or the creditworthiness of loan applicants, they will make fewer loans and hold excess reserves. It is preferable to make no money (on reserves) than to lose money on bad loans. The money creation process assumes that at each step along the way, the newly created money is deposited in someones checking account. If, instead, the money is held outside of banks (it could even leave the country), then the expansion process will slow down. As pointed out in Chapter 9 of the textbook, a real world complication that may arise is if nominal interest rates fall towards zero, a situation which occurred during the Great Depression, and which

c.

d.

e.

economists characterize as a liquidity trap. In that case, banks are very likely to hold excess reserves (or in other words, not use the deposits theyve received to make loans). Why lend when the interest rate is that low? What incentive do banks have to lend when they get such a low return? Because they dont lend, the private sector is unable to borrow (to buy homes, cars, or to start a business, expand a factory, etc.). With few loans and tight credit, economic activity cannot be as vibrant; or if the economy is in a recession/depression, the lack of credit and lending makes it harder for an economy to recover. In that sense, the economy is stuck in a trap, unable to recover. This is why, as discussed elsewhere in the text, deflation and liquidity traps are something that policymakers, particularly Central Bankers, are very wary about.

III. Helpful Hints (Chapter 23 of Samuelson and Nordhaus [2010])

1. The financial system acts as the circulatory system that makes an economy run more smoothly and efficiently. For the financial system to function well, the underlying system must not only be fundamentally strong but people must have confidence in it. Both factors are related (people wont trust a system that isnt sound) but at times in past history or in other countries, they have deviated due to a credibility gap. Because policy authorities may have mismanaged the system in the past, even though strong financial reforms were undertaken, it may take time for financial institutions to gain the publics confidence. There are other definitions of money beyond M1 and M2. As you move to higher definitions the additional components of money become less and less liquid. Each new broader definition of money includes the components of the lower-numbered definition that precedes it. Laypersons sometimes puzzle at the term demand for money. Dont we all want as much money as possible? Isnt the quantity of money demanded infinite? How can we have a well-defined money demand concept? Laypersons are confusing money and wealth. Of course, people like to be richer or wealthier (but even then wealth accumulation activity entails costs and benefits). But money is one form of wealth. So are stocks, bonds, and real estate. Depending on the risk levels and rates of return on these different financial assets, and what peoples goals are, people should wisely choose the composition of wealth between money and other assets. In that sense, the demand for money is finite and well-defined. As discussed in the text, if interest rates on bonds or on savings accounts are higher, the opportunity cost of holding money is higher (since you would forgo higher interest). Thus higher interest rates, holding other factors constant, would reduce the quantity of money demanded. You are willing to go to the trouble of lining up at the bank or ATM machine rather than carry around a lot of cash even if you have frequent shopping needs if interest rates are high. But if they are low, you would want to hold more money. Remember that the demand deposits of customers are their assets but the liabilities of the bank. When the bank lends a sum of money to you, the loan is your liability but is the banks asset. When analyzing commercial bank balance sheets, make sure that in the final equilibrium, reserves are x% of demand deposits, where x = legal reserve requirement ratio. If reserves are greater than that, banks can lend more (and the banking system is not in equilibrium). If the reserves are less, banks will have to call back loans (and again the system is not at rest). Usually when you do one of the fractional-reserve banking exercises, examine what the initial reserves are. Decide whether the bank can lend more or not by seeing if those reserves are in excess of what the bank needs to hold. What the bank needs to hold is again just x% of the deposits. If the reserves exceed what they need to hold, then the bank can lend out the difference, and keep on lending until the actual reserves equal the required reserves. In the final equilibrium, the demand deposits will be (1/x) times the reserves (compare Table 9-4 and Table 9-7 in your textbook). When bankers and portfolio managers use the term investment they are probably not using it in our economic sense of the word. To avoid confusion, think of the assets these professionals work with as financial investments. Remember, to economists investment means the purchase of something tangible that adds to the productivity capability of the economy. Companies may use the funds they receive from selling stocks and bonds to make investment purchases (new equipment, factories, etc.), but the stocks and bonds themselves are not considered investment. They are part of savings.

2.

3.

4. 5.

6.