ECO1011S

Banks, Money and the Credit Market

Money and Wealth

Money
Money:
 Medium of exchange used to purchase goods & services
 Bank notes, bank deposits, cheques, etc…
 Allows purchasing power to be transferred among people, everyone else must trust
that others will accept your money as payment

Function of Money:
 Store value
 Unit of account & medium of exchange

Types of Money:
 Commodity money
 Fiat money
 Fiduciary money
 Bank money

Income and Wealth

Wealth:
 Stock of things owned or value of that stock
 Buildings, land, machinery, capital goods - debts owed + debts owed to you

Income:
 The amount of money one receives over some period of time (flow)
 Market earnings, investments, government, etc…

Other Key Concepts

 Depreciation: Reduction in the value of a stock of wealth over time
 Net income: Maximum amount that one could consume without running down wealth
 Net income = gross income - depreciation
 Earnings: Wages, salaries & other income from labour
 Savings: Income that is not consumed
 Investment: Expenditure on newly produced capital goods

Borrowing: Bringing Consumption Forward in Time

Consumption Over Time and Borrowing:
 Trade off between consuming goods now and later
 Opportunity cost of having more goods now is having fewer later
  Borrowing: allows to buy more now, at the cost of buying less later & rearrange our
capacity to buy goods & services across time
 Interest rate (r): the price of bringing some buying power forward in time
 The (1 + r): Trade-off between current & future consumption
 FV = PV(1 + i): FV = future value & PV = present value

Stream of Payments:
 Dealing with payments per period, flow measures, rather than a present or future
value, which are stock measures
 Suppose you agree to pay $10/ye to repay a debt with an interest rate of 10%/pa: your
present value = $10/1.1 + $10/1.12 + $10/1.13 = $24.87

Impatience and the Diminishing Marginal Returns to Consumption

Preferences for Consumption:
 Borrowing allows us to bring consumption forward depending on consumption
smoothing (diminishing marginal returns on consumption) & pure impatience ([myopia:
experience present satisfaction] & [prudence: knowing one may not be around in the
future])

Consumption Smoothing:
 Consumer has a fixed amount of money
 Spend all of it on two normal goods
 Prices of both the commodities are constant
 Principle of more is better applies
 Diminishing marginal returns to consumption
 An individual smooths their consumption to avoid having a lot in one period & little in
another

Assets, Liabilities and Net Worth

Balance Sheet:
 Summarizes what is owned &owed
 Assets: anything of value that is owned
 Liabilities: anything of value that is owed
 Net worth: Assets - Liabilities
 Wealth or net worth does not change when you lend or borrow
 A loan adds both assets & liabilities to the balance sheet (borrowed money is an asset;
debt owed is a liability)

Banks, Money and the Central Bank

Banks:
 A firm that makes profit by lending & borrowing
 Borrow from households (deposits), other banks & the central bank
  The interest they pay on deposits is lower than the interest they charge on loans, which
is how banks make money

Central Bank:
 Base money/high-powered money: money as notes & coins (money as legal tender)
 Legal tender: has to be accepted as payment by law
 Central bank is the only bank that can create legal tender
 Usually government owned
 Acts as banker for commercial banks who have accounts that hold legal tender with
them
 By crediting these accounts it can create money

Bank Money:
 Commercial banks create money by making loans
 This is called bank money (not the same as legal tender)
 Liability to the bank, not an asset
 Profits made through charging interest on bank money
 Broad money = base money + bank money

Default Risk and Liquidity Risk

 Banks exposed to 1. Default risk & 2. Liquidity risk

Maturity Transformation:
 Deposits can be withdrawn at any time
 Loans only need to be repaid over a specific time period

Liquidity Transformation:
 Deposits are liquid, no penalties for withdrawals
 Loans to borrowers are frozen (illiquid), penalty for withdrawals

Banking Crisis:
 Banks make money by lending more than they have in legal tender
 Bank run: all depositors request their money at once; may result in bank failure
 Banks can also fail through bad investments, loans not being repaid, etc…
 Government may intervene as a banking crisis can bring down the financial system

The Money Market:

 Banks need enough base money to cover their net transactions
 Borrow base money on the money market at short-term interest rate
 Demand for base money depends on commercial bank transactions
 Supply of base money is decided by the central bank
 The Central Bank, The Money Market and Interest Rates

The financial system:

 Policy interest rate: rate on base money set by central bank
 Bank lending rate: average rate charged by commercial banks

The Business of Banking and Bank Balance Sheets

The Business of banking

 Expected return: return on loans accounting for default risk
Bank’s costs:
 Operational: salaries/rent
 Interest costs: interests on liabilities (borrowing/deposits)

Bank’s revenue:
 Interest & repayment of loans

Bank’s balance sheet

 Assets: bank lending
 Liabilities: bank borrowing (deposits, etc…)

Bank’s Net Worth

 Assets - liabilities
 What is owed to shareholders/owners (equity)
 If negative, the bank is insolvent
 Leverage describes the reliance on debt
 Leverage = (total assets)/(net worth)

Spending Effect of Central Bank’s Policy Rate

 Households and firms borrow to spend
 Higher interest cause lower spending