ECON6049 ECONOMIC ANALYSIS, S1 2021

Week 7: Unit 10 – Banks, Money and the Credit Market

OUTLINE
A. Functions of Money
B. Banks Create Money
C. Functions & Risks for Banks
D. Credit Rationing
 A. FUNCTIONS OF MONEY
• Barter: requires a double-coincidence of wants. Money resolves the problem of barter.
• Functions of Money:
• Medium of exchange – used to purchase goods and services. Money allows
purchasing power to be transferred among people. For money to do its work,
everyone else must trust that others will accept your money as payment.
• Unit of account , i.e. provides units of measurement that allows the price of goods
and services to be compared.
• Store of value: Economic agents can store wealth in a variety of ways and money is
one way of storing wealth. If an economic agent holds shares in a firm and forms
the expectation that their value will decline, then selling them for money enables
the agent to preserve the value of their wealth.
• Money is not always the same as legal tender. Legal tender is issued by central banks
i.e. notes and coins. Legal tender has to be accepted as payment by law.
 TYPES OF MONEY
• Money can take the form of bank notes, bank deposits, or whatever else one purchases
things with.
• Base money: Cash held by households, firms, and banks, and the balances held by
commercial banks in their accounts at the central bank, known as reserves. Base
money is the liability of the central bank.
• Bank money: Money in the form of bank deposits created by commercial banks when
they extend credit to firms and households. Bank money is the liability of commercial
banks.
• Broad money: The amount of broad money in the economy is measured by the stock
of money in circulation. This is defined as the sum of bank money and the base money
that is in the hands of the non-bank public (i.e., cash held by households and firms)
B. BANKS CREATE MONEY
 WHAT IS A BANK?
 A bank is a firm
• makes profits by lending and borrowing.
• It can also create money in the form of bank deposits in the process of
supplying credit.

 Banks borrow from households (deposits), other banks and the central bank.

 The interest they pay on deposits is lower than the interest they charge on loans,
which is how banks make profits.
 BALANCE SHEET
A balance sheet summarises what the
household or firm owns and what it owes
to others.
Assets = Anything of value that is owned.
Liabilities = Anything of value that is
owed.
Net worth = assets - liabilities
 BANK BALANCE SHEETS
• Let’s say Marco deposits $100 cash in Abacus Bank

• Marco purchases $20 of goods from Gino and uses his debit card to transfer the
funds to Bonus Bank. The bank must transfer base money.
 BANKS CREATE MONEY
• Suppose that Gino borrows $100 from Bonus Bank which is credited to his account.
Now Gino is owed $120. But he owes a debt of $100 to the bank.

• Bonus Bank has now expanded the money supply: Gino can make payments up to
$120, so in this sense the money supply has grown by $100—even though base money
has not grown. The money created by his bank is called bank money.
• Base money remains essential, however, partly because customers sometimes take out
cash, but also because when Gino wants to spend his loan, his bank has to transfer
base money.
 BANKS CREATE MONEY
• Suppose Gino employs Marco to work in his shop, and pays him $10. Then Bonus Bank
has to transfer $10 of base money from Gino’s bank account to Marco’s bank account in
Abacus Bank.

• What would happen if Gino wanted to pay Marco say $30 (rather than $10)?
His bank does not have enough base money to make the transfer! What can Bonus
Bank do?
 BANKS CREATE MONEY
• The loan has increased the amount of money in the system.

• How much of the $200 is legal tender (or available as cash)?

• Not only do some banks not have enough reserves to pay out all their deposits at
any time, but the banking system as a whole does not have enough reserves to pay
their account holders should they want their money back at a point in time.
MONEY IN AUSTRALIA
C. FUNCTIONS & RISKS FOR BANKS
 FUNCTIONS OF BANKS

• Match lenders with borrowers

• Loans
 Increases the capacity of firms to invest, purchase goods & services.
 Allows consumers (households) to invest & purchase more goods &
services.
 MATURITY AND/OR LIQUIDITY TRANSFORMATION
Banks by taking deposits & making loans engage in:
(i) maturity transformation – borrowing short-term but making loans over a
longer timeframe
• deposits can be withdrawn at any time (bank borrowing)
• but loans only need to be repaid after a specified time
(ii) liquidity transformation – the funding of illiquid assets such as long-
term loans with liquid liabilities such as deposits
• deposits are liquid
• loans to borrowers are frozen (illiquid)
 DEFAULT RISK AND LIQUIDITY RISK

Maturity and Liquidity Transformation expose the bank to 2 basic risks:

(i) Default risk – risk that loans won’t be repaid.
(ii) Liquidity risk – risk that the bank can’t meet short-term
financial demands (say for deposits). When the bank can’t
transform an asset into cash without incurring a financial loss
on the asset.
 BANKING CRISIS
• Bank run = situation when all depositors demand their money at once; may result in
bank failure.
• Bank run scene in It’s a Wonderful Life
https://www.youtube.com/watch?v=lbwjS9iJ2Sw
• Bank run scene in Mary Poppins
https://www.youtube.com/watch?v=GW-22ZtfhBU
• Banks can also fail by making bad investments, such as by giving loans that do not
get paid back. E.g., Northern Rock’s bank run in 2007.
• The central bank can intervene, because unlike the failure of a firm, a banking crisis,
like the 2008-09 global financial crisis, can bring down the financial system
 SOURCES OF FUNDS
• Internal: shareholders equity
• External:
• Deposits: Term deposits, on demand and short-term deposits, non-
interest bearing deposits; Certificate of Deposits.
• Borrowings from other banks and non-bank institutions in the
interbank market, or money markets (short-term) and in bond
markets (long-term)
• Others: Securitization, Wealth Management products.
 INTEREST RATES
• Policy interest rate (i) (aka base rate, official rate. In Australia, it is called
the cash rate) = The interest rate on base money set by the central bank;
applies to banks that borrow base money from each other, and from the
central bank.
• Bank lending rate = The average interest rate charged by commercial
banks to firms and households.
• The difference between the bank lending rate and the policy or base rate
is the mark-up or spread on commercial lending. In Australia, for example,
the policy (cash) rate set by the RBA is currently at 0.1%, but few banks
would lend at less than 3%.
• The central bank does not control this mark-up, but generally the bank
lending rate goes up and down with the base rate.
 BASE MONEY & BANK TRANSACTIONS
 Banks need base money for transactions, and they can borrow base money from other
banks or the central bank, normally, at the policy interest rate.
• The demand for base money depends on how many transactions commercial
banks have to make, and they borrow from each other in the overnight interbank
market. No bank will borrow at a higher rate or lend at a lower rate, since they
can borrow at rate i from the central bank.
• The supply of base money is a decision by the central bank.
• The central bank intervenes in the money market by lending whatever quantity of
base money is demanded at the policy rate.
 The technicalities of how the central bank implements its chosen policy interest rate
vary among central banks around the world. The details can be found on each central
bank’s website.
THE FINANCIAL SYSTEM
D. CREDIT RATIONING
 PRINCIPAL-AGENT PROBLEM
• Lenders face the risk that money borrowed will not be repaid, but lack
information about the project’s success or borrower’s effort so cannot
ensure that the project succeeds. A Principal-agent problem.
 Principal-agent problem = a conflict of interest between principal and
agent, about some hidden action or attribute of the agent that cannot
be enforced or guaranteed in a binding contract.
• It is often NOT possible for the lender (the principal) to write a contract
that ensures a loan will be repaid by the borrower (the agent). The
reason is that it is impossible for the lender to ensure by contract that
the borrower will use the funds in a prudent way that will allow
repayment according to the terms of the loan.
 EQUITY AND COLLATERAL
To resolve the conflict of interest between the principal (lender) and the
agent (borrower):
• The lender may require the borrower to put some of her wealth into
the project. This is called Equity.
• The borrower has to set aside property that will be transferred to
the lender if the loan is not repaid. This is called Collateral.
Those with less wealth find it more difficult to provide equity or collateral,
thus won’t be able to borrow.
RELATIONSHIP BETWEEN WEALTH & CREDIT
 CREDIT RATIONING
• Credit-constrained - when those with less wealth borrow on
unfavourable terms (especially higher interest rates) compared with
those with more wealth or
• Credit-excluded - those refused loans entirely
• Credit-rationing increases inequality: people with limited wealth are not
able to profit from the investment opportunities that are open to those
with more assets.