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Macroeconomics. Classical theory. The monetary system
1.
HSE/NES B.A. ProgramMacroeconomics -1
Friday, 17/9/2013
Lecture - 4
Classical Theory – II
The Monetary System
2.
Introduc)onIn the previous lecture, we have seen
-
Classical theory of distribu)on
-
How in the long-‐run real interest rates are
determined in the market for loanable
funds
-
How technological change and changes in
scal policy (taxes, govt spending) a ect
the long-‐run investment
3.
Introduc)on (cont.)Yet we made several assump)ons:
1) Did not men)on money at all although money is
instrumental for all the market transac)ons
2) We focused on a closed economy, i.e., assumed
away interna)onal trade and capital ows
3) Exogenous capital stock, labor supply and
technology (to be relaxed when we do growth)
4) Perfectly exible prices (due to our focus on the
long-‐run). To be relaxed next semester to analyze
the causes of short-‐run uctua)ons in income
and employment.
4.
OverviewOur end goal: Analyzing the role of money
(changes in money supply) when prices are
exible. But before that...
We need to understand
-
The de ni)on, func)ons, and types of
money
-
How banks “create” money
-
What a central bank is and how it controls
the money supply
5.
De ni&on:
–
Money
Money is the stock of assets that can be readily used to
make transac)ons.
Func&ons:
–
medium of exchange: we use it to buy stu . Money
solves the problem of double coincidence of wants
–
store of value: transfers purchasing power from the
present to the future
–
unit of account: the common unit by which everyone
measures prices and values
6.
MoneyTypes of money:
Fiat money: has no intrinsic value
1.
example: the paper currency we use
Monopoly over the rights to print money
Trust is needed to support it
Commodity money: has intrinsic value
2.
examples: silver and gold coins, cigareXes in P.O.W.
Camps
Transi)on from commodity to yat money
7.
Which of these are money?a) Currency
b) Checks
c) Deposits in checking accounts (“demand
deposits”)
d) Credit cards
e) Cer) cates of deposit (“)me deposits”)
8.
The money supply andmonetary policy de ni&ons
• The money supply is the quan)ty of money
available in the economy.
• Monetary policy is the control over the
money supply.
• Monetary policy is conducted by a country’s
central bank.
• To control the money supply, central banks
use open market opera&ons, the purchase
and sale of government bonds.
9.
Money supply de ni)onsCentral Bank of Russia, 1/8/2013
Name
Assets included
Amount (RUB, billions)
M0
(Cash or C)
Currency: Total cash in circula6on
(outside banks)
6,480.1
M1
M0 + Balances in the domes6c
currency on current and other
demand accounts of non nancial
organiza6ons, nancial
ins6tu6ons (except for credit
ones) and households
14,017.0
M2
M1 + Balances in the domes6c
currency on 6me deposits of
non nancial organiza6ons,
nancial ins6tu6ons (except for
credit ones) and households.
28,734.3
10.
Money supply de ni)onsFED, April 2012
Name
C
Assets included
Amount ($, billions)
Currency
1,035
M1
C + demand deposits,
travelers’ checks,
other checkable deposits
2,248
M2
M1 + small )me deposits,
savings deposits,
money market mutual funds,
money market deposit accounts
9,842
11.
Banks’ role in the monetarysystem
The money supply equals currency plus
demand (checking account) deposits:
M = C + D
Since the money supply includes demand
deposits, the banking system plays an
important role.
12.
A few preliminariesReserves (R ): the por)on of deposits that
banks have not lent.
A bank’s liabili)es include deposits; its assets
include reserves and outstanding loans.
100-‐percent-‐reserve banking: a system in
which banks hold all deposits as reserves.
Frac&onal-‐reserve banking: a system in which
banks hold a frac)on of their deposits as
reserves.
13.
Banks’ role in the monetary system• To understand the role of banks, we will consider
three scenarios:
1) No banks
2) 100-‐percent-‐reserve banking (banks hold all
deposits as reserves)
3) Frac)onal-‐reserve banking (banks hold a
frac)on of deposits as reserves, use the rest to
make loans)
• In each scenario, we assume C = $1,000.
14.
SCENARIO 1: No banks• With no banks,
D = 0 and M = C = $1,000
15.
SCENARIO 2: 100-‐percent-‐reserve banking• Ini)ally C = $1000, D = $0, M = $1,000.
• Now suppose households deposit the $1,000 at
“Firstbank.”
• Aler the deposit:
Firstbank’s
B
alance
S
heet
C = $0,
D = $1,000,
Assets
Liabili)es
M = $1,000
• LESSON: 100%-‐reserve
banking has no impact
Reserves = $1,000 Deposits = $1,000
on size of money
supply.
16.
SCENARIO 3: Frac&onal-‐reserve banking• Suppose banks hold 20% of deposits in reserve,
making loans with the rest.
• Firstbank will make $800 in loans.
Firstbank’s Balance Sheet
Assets
Liabili)es
Reserves = $200
Deposits = $1,000
Loans = $800
The money supply now
equals $1,800:
• Depositor has $1,000
in demand deposits.
• Borrower holds $800
in currency.
17.
SCENARIO 3: Frac&onal-‐reserve banking (cont.)• Suppose the borrower deposits the $800 in
“Secondbank”.
• Ini)ally, Secondbank’s balance sheet is:
Secondbank’s Balance Sheet
Assets
Liabili)es
Reserves = $160
Deposits = $800
Loans = $640
• Secondbank will loan
80% of this deposit.
18.
SCENARIO 3: Frac&onal-‐reserve banking (cont.)• If this $640 is eventually deposited in Thirdbank,
• then Thirdbank will keep 20% of it in reserve and
loan the rest out:
Thirdbank’s Balance Sheet
Assets
Liabili)es
Reserves = $128
Deposits = $640
Loans = $512
19.
Finding the total amount of money:Original deposit = $1000
+ Firstbank lending = $ 800
+ Secondbank lending = $ 640
+ Thirdbank lending = $ 512
+ other lending…
Total money supply = (1/rr ) x $1,000
where rr = ra)o of reserves to deposits
In our example, rr = 0.2, so M = $5,000
20.
Money crea&on in the bankingsystem
A frac)onal-‐reserve banking system creates
money, but…
it doesn’t create wealth:
–
Bank loans give borrowers some new money and
an equal amount of new debt.
21.
Bank capital, leverage, and capitalrequirements
• Bank capital: the resources a bank’s owners
have put into the bank
• A more realis)c balance sheet:
Assets
Liabili&es and
Owners’ Equity
Reserves $200
Deposits $750
Loans $500
Debt $200
Securi)es $300
Capital (owners’ equity) $50
22.
Bank capital, leverage, and capitalrequirements (cont.)
• Leverage: the use of borrowed money to supplement
exis)ng funds for purposes of investment
• Leverage ra6o = assets/capital = $(200 + 500 + 300)/$50
= 20
Assets
Liabili&es and
Owners’ Equity
Reserves $200
Deposits $750
Loans $500
Debt $200
Securi)es $300
Capital (owners’ equity) $50
23.
Bank capital, leverage, and capitalrequirements (cont.)
• Being highly leveraged makes banks vulnerable.
• Example: Suppose a recession causes our bank’s
assets to fall by 5%, to $950.
• Then, capital = assets – liabili)es = 950 – 950 = 0
Assets
Liabili&es and
Owners’ Equity
Reserves $200
Deposits $750
Loans $500
Debt $200
Securi)es $300
Capital (owners’ equity) $50
24.
Bank capital, leverage, and capitalrequirements (cont.)
Capital requirement:
minimum amount of capital mandated by regulators
intended to ensure banks will be able to pay o depositors
higher for banks that hold more risky assets
2008-‐2009 nancial crisis:
Losses on mortgages shrank bank capital, slowed lending,
exacerbated the recession.
Govt injected $ billions of capital into banks to ease the crisis
and encourage more lending.
25.
A model of the money supplyExogenous variables:
Monetary base, B = C + R
controlled by the central bank
Reserve-‐deposit ra&o, rr = R/D
depends on regula6ons & bank policies
Currency-‐deposit ra&o, cr = C/D
depends on households’ preferences