Lecture 5
BEEM119 Economics of Banking
Jan Auerbach
Department of Economics University of Exeter
Contents
1 Financial Institutions and Key Concepts
1 Institutions and Concepts.
2 Understanding Interest Rates.
3 The Risk and Term Structure of Interest Rates.
4 The Efficient Markets Hypothesis.
2 Money
1 What is Money?
2 The Money Supply Process.
3 Quantitative Theory, Inflation, and the Demand for Money.
3 Banking and Financial Intermediation
1 An Economic Analysis of Financial Structure.
2 Banking Industry: Structure and Competition.
4 Banking and Policy
1 Economic Analysis of Financial Regulation.
2 Financial Crises.
Money
(Mishkin, chapter 3)
Barter vs. Monetary Exchange
A barter exchange consists of a quid pro quo swap of goods/services (goods not designed to circulate).
It requires a coincidence of wants.
Monetary exchange refers to the phenomenon of exchanging goods for money, and then money for goods.
Monetary exchange is sequential (intertemporal) in nature.
The fundamental exchange is between current goods for future goods (money is not the ultimate goal).
Money circulates as a medium of exchange (so it necessarily serves as a store of value).
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Functions of Money
1 Medium of Exchange:
• It eliminates the need for a double coincidence of wants.
• It reduces transaction costs and thereby promotes specialization.
(A medium of exchange must be: 1.) easily standardized, 2.) widely accepted, 3.) divisible, 4.) easy to carry, and 5.) not losing its value too quickly.)
2 Unit of Account:
• It is used to measure value in the economy.
3 Store of Value:
• It is used to save purchasing power over time.
• While other assets also serve this function, money is the most liquid of all assets. But loses value during inflation
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Evolution of the Payments System
Commodity Money:
Payment instruments with a physical form and intrinsic value. Easily standardized and divisible commodities.
Classic examples are precious metals (gold, silver, copper), salt and cigarettes.
Fiat Money:
Paper money decreed by governments as legal tender.
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Commodity Money
Using commodities like gold or silver as money has serious shortcomings:
• Metals are heavy; storing large amounts is risky and expensive; and carrying them around is dangerous.
• If uncoined, it is difficult to determine the value (quality, weight). • If gold is coined, people created savings using practices like
“Shaving”: filing a bit off coins before passing them on for face value. “Sweating”: shaking many coins in a leather bag to chip off tiny flakes.
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Commodity Money
In response to these deficiencies, banks evolved in 16th and 17th century England.
The goldsmiths were an occupation that often evolved into bankers.
Other merchants needed places to temporarily store large amounts of gold, and they chose to store them with the goldsmiths because the goldsmiths had the best security systems of the day.
When merchants stored gold, the goldsmith would give them a statement indicating how much gold the merchant had deposited.
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From gold to paper money
When a merchant wanted to buy something, he could:
• return to the goldsmith and reclaim his gold, or
• sign over the statement he had from the goldsmith to someone else and let that person collect the gold!
The second option was popular. So goldsmiths innovated and
• issued statements not specificly to a person, so that
• whoever presented the statement could collect the gold.
The goldsmith’s statement was money. People used it to buy things.
For some purposes, paper money had more desirable qualities as a money than metals. It was a successful innovation.
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From gold to paper money
So:
First, buyers withdrew gold for a receipt, bought goods and paid with gold, and sellers deposit the gold for a receipt.
As trades became more and more frequent and the goldsmith’s reputation more and more established, people started using receipts as a means of payment.
As long as people trusted the goldsmith, the receipts were money.
As the exchange of receipts became more and more common, the goldsmith’s gold inventory became less and less volatile.
The goldsmith could lend some of the gold kept to some entrepreneurs for a fee (“interest”).
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From gold to paper money
The gold standard
Although these notes should be convertible into gold on demand, some banks could be more trustworthy than others.
In the US, until early 19th century, the use of any individual bank’s notes were confined to a small geographic area.
To facilitate the more wide spread use of their notes, some banks started a voluntary redemption arrangement:
“You (bank A) maintain some gold on account with us (bank B) and we will accept your bank notes from people.”
Bank notes became more liquid.
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From gold to paper money
In most countries, the government (“the central bank”) eventually took the right of issuing notes and became a single note-issuer.
In most countries, other (commercial) banks do not issue bank notes.
In the UK, Hong Kong, and Macao, some other banks issued notes. They were not supported by gold but by the central bank’s notes.
In the 1930s, countries abolished the gold standard. The bank notes could no longer be converted into gold.
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Measuring Money
How do we measure money? Which particular assets can be called “money?”
Construct monetary aggregates using the concept of liquidity:
M1: (most liquid assets) = currency + traveler’s checks + demand deposits + other checkable deposits.
M2: (adds to M1 other assets that are not so liquid) = M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares.
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Measuring Money
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M1 vs. M2
Does it matter which measure of money is considered?
M1 and M2 can move in different directions in the short run. The choice of monetary aggregate is important for policymakers!
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Money and Liquidity
Liquidity of an asset: “How quickly can it be converted into cash.”
Liquid assets can be sold quickly–or even be used in transaction.
Illiquid assets don’t sell quickly–or sell at a “discount.”
All else equal, short-maturity assets tend to be more liquid than long-maturity assets.
All else equal, low credit risk assets tend to be more liquid than high credit risk assets.
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Money and Liquidity
Asset–Interest–Saving
Money–Liquidity–Transaction
Asset returns are (opportunity) cost, or price, of holding money. The interest rate is negatively related to the asset price.
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Money supply and interest rates
Money demand and money supply determine the interest rate.
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Money supply and interest rates
Interest rates assets yield are the ‘price for money’ because they are the ‘opportunity cost of holding money.’
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