Money and Banking
Module Convenor: Luke Buchanan-Hodgman
Contact: [email protected] Office: Keynes D2.12 Contact Hours: Thursday 10-11
Website: https://sites.google.com/site/buchananhodgman
Learning Objectives
1. LO1: Understand what money is and its central functions are
2. LO2: Examine how the quantity of money is currently measured in the UK
Some preliminaries
I Banks exist to bring borrowers and lenders together efficiently;
I Banks are licensed (by the BoE) to receivedeposits and make loans;
I A bank’s balance sheet lists its assets, liabilities and net worth;
I Assets are what a bank owns (cash etc);
Barter: ”Double Coincidence of Wants”
Without money we’d have to resort to trading goods directly with one another.
I ”Counter-trade” - where a commodity is exchanged directly with another commodity
I ”The Money Nexus” - where a commodity is exchanged for money, itself exchanged for a commodity
Money:
what
is it exactly?
Money is any commodity of ”token” that is acceptable as a medium of exchange, and a method of settling a debt. Its types;
I Commodity Money: shells (Africa and India); rice (Japan); knives (China); barley (Mesopotami); cigarettes (WWII POW camps) - valuable intrinsically
I Convertible Paper Money: typically this was backed by specie (i.e., gold and silver).
I Fiat (’Let it be done’) Money: Sterling, Dollars, Euros etc. - valuable because the government says so and that others will accept it.
I Private Debt Money (deposits).
Fiat Money:
what
is it exactly?
Fiat money is in the form of bank notes and coinage. Governments stand behind it: ”I promise to pay the bearer on demand the sum of [. . . ]”. However, notes and coinage are not the only monies;
I Depositsarealso money as they can be converted directly into money;
I Chequesare not money, only instructions to the depository institution to transfer money from one account to another;
I Debit cards are notmoney, acting similarly in function to cheques;
The Functions of Money
Money has a number of functions;
I ’Medium of Exchange’: the primary role of money and directly alleviates the need for barter. Many ’items’ could, and have, satisfied this role.
I ’Unit of Account’: those items, by custom or the force of circumstance, that come to be used as a medium of exchange provide themselves also as a unit of account. Goods come to be measured by a single standard, or ’price’, in these terms.
Official Monetary Aggregates in the UK: M0 and M4
In the UK, there are twoofficialmeasures of money: M0 and M4.
I M0 (Monetary Base or ’narrow money’)
This includes cash held by public plus cash and some deposits held by commercial banks at the Bank of England.
I M4 (Money Supply or ’broad money’)
Monetary Aggregate in the UK: M0 and M4
The Role of the Central Bank vis-`
a-vis Money Creation
The Bank of England exertsdirect control over the monetary base. The monetary base is also sometimes referred to as ”narrow money’, ’high powered money’ and the ’cash base’.
I The monetary base isexpanded by the BoE through its purchases of securities with newly issued high powered money
How does high-powered money get into the economy?
Entry via purchases of securities from thepublic
The BoE purchasesexisting
securities from the public with
newly issuedhigh-powered money
The publics holding of
high-powered money increases by an equivalent amount
Result: an increase in M0witha change in the composition of securities and money held by the public
Entry via purchases of securities from thegovernment
The BoE purchasesnewly issued
government securities (debt instruments) withnewly issued
high-powered money
The government finances a
component of its spending with the newly issued high-powered money
Result: an increase in M0
Example: purchase of securities from the public
I The BoE purchases£1 of securities from HSBC
I A cheque is received by HSBC from the BoE, thus increasing HSBC’s deposits by£1
I When the cheque is cleared, the HSBC’s deposits (bankers’ deposits) at the BoE increase by £1
How does the banking sector expand the money supply?
Let us examine a simple model of money creation: the ratios approach. Some initial assumptions for ease of exposition;
1. There is only onebank
2. The reserve ratio is 25%
How does the banking sector expand the money supply?
Deposit Multiplier
The deposit multiplier is the amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits;
Deposit multiplier = ∆deposits ∆reserves
The deposit multiplier is also linked to the desired reserve ratio;
Deposit multiplier = 1
Deposit Multiplier in the UK
Similar in some ways to the very simple example above. However, there are two central differences;
I Unlike the above example where we fixed the reserve ratio to be 25%, there isno required ratio. Instead, banks have varying desired reserves of highly liquid assets.
Summary
1. LO1: Understand what money is and its central functions are
X
2. LO2: Examine how the quantity of money is currently measured in the UK X
