Macro 4

1.Understanding Money
Functions of Money
1. Medium of exchange
- Used for making transactions
- Helps avoid the inefficiencies of barter trades
2. Unit of account
- Used as a measuring stick
- For valuations, comparisons, and record keeping
3. Store of value
- Store purchasing power for future use
- A financial asset

Commodity-backed money
- Certificates representing a claim on commodities (has intrinsic value)

Fiat-money = money that has no intrinsic value

- Value of fiat money depends on peoples’ willingness to accept it in payment
- Govt. can create acceptability by decreeing a fiat currency to be legal tender
- But ultimately it’s up to people to accept it
- With fiat money, govt. can potentially finance budget deficits by printing money
but undisciplined money creation leads to hyperinflation (sustained inflation
rate > 50%/month)

Central Banks
- Power to create money is delegated to an independent Central Bank, e.g.: MAS,
US Federal Reserve
- For all Central Banks, “stable prices” is an explicit monetary policy objective
- Central Banks are not allowed to print money to buy G&S or provide transfers
to people

Money Aggregates
1. M1
- Currency in circulation (excluding cash in bank vaults & ATMs),
checking deposits
- Check deposits = deposits that are used for transactions e.g: writing checks,
NETS etc
- Items in M1 have the greatest liquidity of all assets
 ➔ The more quickly an asset can be sold for currency, with as little impact on
its selling price, the more liquid the asset is
2. M2
- M1 + very liquid assets
- For USA, “very liquid assets” include savings deposits, small time (fixed) deposits,
negotiable certificates of deposits, shares in “money market” funds, overnight
repos, overnight Eurodollar deposits
3. M3
- M2 + liquid assets
- For USA, “liquid assets” include large time deposits, term repos, term
Eurodollar deposits

2. Banking and the Financial System

I. Components of the Financial System

1. The Central Bank
- Other than monetary policy, central banks are also tasked with the
following functions:
1. Ensure financial stability
- Oversee the payment system
- Oversee and regulate the financial system
- Coping with financial crisis
2. Some central banks manage the exchange rate
- E.g: US Federal Reserve System, European Central Bank, MAS

2. Financial Intermediaries
- Saver -> financial intermediaries (e.g: banks) -> borrowers
- Financial intermediaries includes: commercial banks, insurance companies,
pension funds, mutual funds, hedge funds
- They earn profit mainly by charging a spread between the interest they pay
savers and the interest they charge borrowers
- Why use financial intermediaries?

Saver -> Borrower Saver -> Bank -> Borrower

Expertise at evaluating Weak expertise Strong expertise

and monitoring borrowers Typical saver isn’t an expert Due to specialization
at lending

Ability to finance large Difficult to finance Easy to finance

projects Borrower must engage Borrower deals with bank.
many savers Bank pools funds from many
savers
 Risk to saver High risk Low risk
All depends on the fortunes Diversified across many
of one borrower borrowers

Liquidity for saver Loan: illiquid asset Deposit: Liquid asset

Bound by contract - cannot Can be converted into cash
be converted into cash readily; checking deposits
readily are part of M1

3. Financial Markets
- Where lending and borrowing of funds are conducted
➔ Include the market for bank loans, and markets where securities
(tradable financial instruments) are traded
➔ E.g. of securities:
● Stock: a tradable share of the ownership rights to a company;
traded on a stock exchange
● Bond: a tradable debt security representing a promise to pay
borrowed funds; traded on bond market
- Presence of securities markets reduce some of the advantages of using
financial intermediaries

II. Bank Balance Sheets

Bank’s balance sheet includes:
- Assets: property, buildings, securities, loans, reserves (cash in vaults and
ATMs, deposits at the Central Bank - not included in M1)
- Liabilities: checking deposits (included in M1), other deposits, other borrowing
- Equity is also known as net worth, net assets, bank capital (for banks)

III. The Payment System

reserves
A bank’s reserve ratio = checking deposits

- Banks can choose to hold excess reserves

- If banks are short of reserves, they can (1) attract deposits, (2) recall loans or
liquidate other assets, (3) borrow reserves from other banks, (4) borrow
reserves from Central Bank
3. Banks & Money Creation

I. Banks participate in Money Creation

- Central Bank creates money
- See lecture notes for whole process of money creation

1
Money multiplier = RRR

- In practice, money multiplier can be smaller because:

1. Banks may hold excess reserves
2. People may hold part of their money as cash

II. How central banks influence money creation

1. Required reserve ratio
- Changing RRR can affect the size of the money multiplier
- Raise RRR -> loans decrease & deposits decrease -> less money created
- Decrease RRR -> loans increase & deposits increase -> more money created
★ Changing RRR does not change reserves
★ Changing RRR will not work if banks are holding excess reserves

2. Open Market Operations

- Central Bank changes the qty of reserves by purchasing or selling
(usually short-term) government securities
- Open market sale: accepts payment by deducting reserves -> reserves falls
-> loans decrease & deposits decrease -> less money created
- Open market purchases: pay by creating reserves in banks -> reserves rise -
> loans increase & deposits increase -> more money created

3. Discount loans and the Discount Rate (the rate charged to banks seeking
to increase their reserves when they borrow directly from Fed)
- Banks that are short of reserves can take a discount loan from the
Central Bank; Discount rate = interest rate on discount loan
- Raise discount rate -> fewer discount loans -> reserves fall -> loans
decrease & deposits decrease
- Reduce discount rate -> more discount loans -> reserves rise ->
loans increase & deposits increase

4. Changing the interest rate paid on reserves

- Some central banks pay interest on bank reserves. Changing the interest
rate on reserves (IOR) changes bank’s willingness to make loans
- Increase IOR -> encourages banks to make fewer loans -> loans decrease
& deposits decrease
 -Decrease IOR -> encourages banks to more loans -> loans increase
& deposits increase
★ Changing IOR can be used when even banks have excess reserves

4. Banks & Financial Stability

I. Banks are inherently fragile

- Banks are highly leveraged -> amplifies gains, but also amplifies losses
- Borrow short term and lend long term
Leverage Ratio = assets / equity
Capital Ratio = equity / assets

Bank Runs
- Depositors suspect bank to be insolvent -> rush to withdraw their deposits ->
deposits are short term liabilities that can be withdrawn any time -> banks usually
don’t have enough reserves to handle massive withdrawals -> as loans are
long term assets that cannot be recalled quickly
- Will affect money supply and the money multiplier
- Bank runs are contagious, can cause banking panics
- Banking panics can cause tremendous damage to an economy:
➔ Payment system disrupted
➔ Wealth is destroyed
➔ Lack of bank lending

II. Policies for Financial Stability

Regulations in place
- Reserve requirements (RRR)
- Capital requirements (minimum capital ratio) to reduce leverage
- Restricting bank’s activities, regular monitoring by Central Bank etc

Deposit Insurance
- Provided by the govt.
- Banks pay compulsory insurance premiums to govt
- If there is a bank run and the bank cannot pay depositors, govt will pay on its behalf
- Deposit insurance removes the sense of urgency to withdraw deposits, and
thus helps to prevent bank runs from happening
Lender of Last Resort, Owner of Last Resort
- To stop a banking panic, the Central bank acts as a lender of last resort - lend
to troubled banks when no one else will
- Central bank and/or govt may also need to inject capital into banks,
effectively becoming owner of last resort

Refer to Macro 5 to see how US Federal Reserve confronted a financial crisis that greatly
resembled a banking panic