Unit 10

BANKS, MONEY, AND THE CREDIT MARKET

OUTLINE
Introduction
Income, borrowing and saving
Balance sheet
Banks and money
Credit rationing
Introduction
 The Context for This Unit
Markets for goods and services allow parties to interact in mutually beneficial
ways.

In most markets, money is the medium of exchange.

• How do banks create money?
• How do banking systems affect individual consumption choices and
economic outcomes?
• What are the limitations of the banking system?
 This Unit
• Model how individuals borrow, save, and invest

• Understand the role of commercial banks and the central bank in the
economy

• Explain how banks make money and the risks they face and pose
Income, borrowing and saving
 Money
Money = A medium of exchange used to purchase goods or services
• bank notes, bank deposits, cheques, …

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.
 Definition of Money:

M0 (high powered money): Coins, bills + bank reserves

(Broad money Base money + Bank money)

M1 (supply of money): Coins, bills + deposit accounts

M2: M1 + less liquid forms

M3: M1 + M2 + even less liquid forms
 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).
• from market earnings, investments, government.
 Other Key Concepts
Depreciation = Reduction in the value of a stock of wealth over time.
Net income = The maximum amount that one could consume without running down
wealth.
Net income = gross income – depreciation
Earnings = Wages, salaries, and other income from labour.
Savings = Income that is not consumed.
Investment = Expenditure on newly produced capital goods.
 Consumption over time
There is a trade-off between consuming now and later.

The opportunity cost of having more goods now is having fewer goods later.

Borrowing and lending allow us to rearrange our capacity to buy goods and services
across time
 Consumption over time: The two-period model

We can show the saving behavior in a two-period model.

Important: We will see that the interest rate will play the same role as the relative price
between two goods. The interest here becomes the "relative price" between time
period 0 (now) and 1 (later).

Preferences of the household; U = f(c0, c1)

The budget constraint: Assume we start and end with zero assets (no inheritance)

𝑩𝟏 = 𝑰𝟎 − 𝒄𝟎 𝟏 + 𝒓𝟏 + 𝑰𝟏 − 𝒄𝟏

Where B = assets, r = interest, I = income, c = consumption

 We add the No Ponzi condition:

𝐵1 = 𝐼0 − 𝑐0 1 + 𝑟1 + 𝐼1 − 𝑐1 = 0

If c0 = 0 𝐼0 1 + 𝑟1 + 𝐼1 = 𝑐1

If c1 = 0 𝐼0 1 + 𝑟1 − 𝑐0 1 + 𝑟1 + 𝐼1 = 0

−𝑐0 1 + 𝑟1 = −𝐼0 1 + 𝑟1 − 𝐼1

𝐼1
𝑐0 = 𝐼0 +
1 + 𝑟1

We only have interest in one time period, and we can thus skip the time notation of the
interest. The budget line and the indifference curves together:
 The two-period model:

C1

I0(1+r)+I1
Optimal solution where the
slope of the budget line is equal
B to the slope of the indifference
curve in point B
c1 = I1 A

c0= I0 I0+(I1/1+r) C0
 Consumption over time: The two-period model

The indifference curve is tangent to the budget line, i.e. the slopes are equal.
The indiff curve tells us how much we want to give up of cones now to get more in the
next period (MRS) and the budget line tells us what we have to give up. At optimum we
agree with the market..
Optimization gives point B

NOTE: Remember that point A is always possible: I0 = c0 and I1 = c1.

Regardless of interest rates etc., we can always choose to neither borrow nor save. If we
want…a magic point…
 Condition for optimum:

The slope of the budget line:

𝐼0 1 + 𝑟 − 𝑐0 1 + 𝑟 + 𝐼1 − 𝑐1 = 0

We like c1 alone. Move around… 𝐼0 1 + 𝑟 − 𝑐0 1 + 𝑟 + 𝐼1 = 𝑐1

Or 𝑐1 = 𝐼0 1 + 𝑟 − 𝑐0 1 + 𝑟 + 𝐼1

𝑑𝑐1
= −(𝟏 + 𝒓)
𝑑𝑐0
 Condition for optimum:

The slope of the budget line; = −(𝟏 + 𝒓)

If the interest rate rises, the budget line becomes steeper. Lower interest – flatter
budget line.

Condition for optimum:

MRS = −(𝟏 + 𝒓)

Remember the magic point: I0 = c0 and I1 = c1. Means that the budget line rotates at this
point when interest rates change!
 Condition for optimum:

Income changes:

Since the incomes of both periods are in both intercepts, a change in income in period
0, period 1 or in both at the same time means that the dynamic budget line shifts:

Increased income - The budget line shifts parallel outwards

Decreased income - The budget line shifts parallel inwards

 Case 1: We save. Means that we consume less than the income in period 0

C1
Assume: We raise the interest rate
I0(1+r)+I1

C Because we save, we will benefit from an

incresase in the interest rate, and we reach
B
a higher level of utility in point C. Depending
c1 = I1 on our preferences, it can lead to us saving
more, the same amount or less. Depends on
how we do the drawing…

c0= I0 I0+(I1/1+r) C0
 Case 2: We borrow. Means that we consume more than the income in period 0

C1
Assume: We raise the interest rate
I0(1+r)+I1
Because we are lending, we will lose
from an incresase in the interest
rate, and we reach a lower level of
c1 = I1 utility in point C. Depending on our
preferences, it can lead to, us saving
more, the same amount or less.
B Depend on our drawing…
C

c0= I0 I0+(I1/1+r) C0
 Case 1: We save. Means that we consume less than the income in period 0

C1
Income and substitution effect:
I0(1+r)+I1
Substitution effect: B – D. We substitute away
C
D consumption in period 0 because it has become
B more favorable to save
c1 = I1 Income effect: D – C. The higher interest rate
has given us a positive income effect and we
can save more/consume more (in one or both
periods)

c0= I0 I0+(I1/1+r) C0
 The set up in the book. Only income in period one (later)

𝐵1 = 𝐼0 − 𝑐0 1 + 𝑟 + 𝐼1 − 𝑐1 = 0

Since 𝐼0 = 0

𝐵1 = −𝑐0 1 + 𝑟 + 𝐼1 − 𝑐1 = 0

If c0 = 0 𝑐1 = 𝐼1

If c1 = 0 −𝑐0 1 + 𝑟 + 𝐼1 = 0

−𝑐0 1 + 𝑟 = −𝐼1

𝐼1
𝑐0 =
1+𝑟
 The set up in the book. Only income in period one (later)

Borrowing allows us to buy more now, at the

cost of buying less later.

Interest rate (r) = The price of bringing some

buying power forward in time.

With 10% interest rate: 100/1.1 = 91

(1+r) = Tradeoff between current and future

consumption (MRT)
 Consumption smoothing
An individual smoothes their
consumption to avoid consuming a lot in
one period and little in the other.
 Pure impatience

Classroom experiment:

Assume you are supposed to receive 1000 SEK today. However, suddenly
it is decided you will have your money one year later.

How much would you like to be compensated with to be equally happy as

if you got the money today?...............
 Optimal decision-making
Discount rate (ρ) = a measure of a
person's impatience.
• Consumption smoothing
• Pure impatience

Individual borrows at the point where

discount rate = interest rate

MRS = MRT
1+ρ = 1+r
 Saving and lending
A saver smoothes his consumption by
postponing it into the future.

Lending money at interest expands the

saver’s feasible set, compared to simply
storing it.

Note: We assume income now

Balance sheet
 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
Banks and money
 Banks

A bank is a firm that makes profits by lending and borrowing.

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.
 Central bank
Base money/high-powered money = notes and coins. Money as legal tender.

Legal tender has to be accepted as payment by law.

The central bank is the only bank that can create legal tender.
• the central bank is usually owned by the government.
• acts as the banker for the commercial banks, who have accounts at the central
bank that hold legal tender.
• by crediting these accounts, the central bank can create money.
 Bank money
Commercial banks create money by making loans
• this is called bank money ≠ legal tender
• it is a liability to the bank, not an asset
• banks earn profits by charging interest on bank money

Bonus Bank gives Gino a loan of $100

Bonus Bank’s assets Bonus Bank’s liabilities

$20 base money

$120 payable on
$100 bank loan demand to Gino
Total: $120

MO: Broad money = base money + bank money

 Default risk and liquidity risk
Banks provide the service of maturity transformation:
• deposits can be withdrawn at any time
• but loans only need to be repaid after a specified time

This is also liquidity transformation:

• deposits are liquid
• loans to borrowers are frozen (illiquid)

This exposes the bank to risks:

1. Default risk
2. Liquidity risk
 Banking crisis
Banks make money by lending much more than they hold in legal tender.

Bank run = situation when all depositors demand their money at once; may result in
bank failure.

Banks can also fail by making bad investments, such as by giving loans that do not get
paid back.

The government may intervene, because unlike the failure of a firm, a banking crisis
can bring down the financial system.
 The money market
Banks need enough base money to cover their net transactions.

They borrow base money on the money market at the short-term interest rate.

• The demand for base money depends on how many transactions commercial
banks have to make.
• The supply of base money is a decision by the central bank.
 The Supply of Money

MO: Broad money = base money + bank money

• The central bank can change M0 by reducing or increasing bank money

i.e. the reserves in the bank system. The goal is then to change M1

M1: Money supply = base money + bank deposits

• Let’s see what happens with a simple/silly example:

 The Supply of Money
Central bank increases MO by increasing bank money with 50 000 SEK

• The banks now have 50 000 more and decide to keep 5000 for reserves and lend 45000 to a
person that is buying a used car.
• The car seller puts the money on hens saving account i.e. in the bank.
• The bank then decides to keep 4500 for reserves and lend (45000-4500); 40 500 to another
costumer that is planning a nice vacation.
• The travel agency puts the money for the travel sale (40 500) on their bank account and the
bank decide to keep 4050 for reserves and lend (40500-4050); 36450…

Remember M1: Money supply = base money + bank deposit

It is clear that M1 will increase much more than the initial change in bank money by the money
multiplicator. The effect on M1 is always uncertain and the Central bank need to constantly
monitor M0 to reach the decided M1.
 The Supply of Money

Question:

What would happen if a rumor suddenly spread that a bank

was going bankrupt?
 The Supply of Money
Interest
MS

Money; M1
 The Demand for Money
We have previously shown what happens when the Central bank increases the supply
of money via increased reserves to the banks that lend these to households and firms.
By the Credit Multiplier we get a total increase in the money supply.
Important Assumption:
Households have (only) two options to hold wealth/income:

• As notes, coins, or in the bank deposit/account. Assumed to give zero interest.

• As an interest-bearing asset such as treasury bills or bonds.
 The Demand for Money
Interest

MD(GDP)

Money; M1
 Equilibrium on the Money Market
Interest
MS

4%

MD(GDP)

Money; M1
The financial system
Policy interest rate = The interest rate on
base money set by the central bank.

Bank lending rate = The average interest

rate charged by commercial banks to firms
and households.
 The business of banking
Bank’s costs: Bank’s revenue:
• operational: the salaries of bank • interest and repayment of loans
officers, branch rents
• interest costs: paying interest on their
liabilities (deposits and other borrowing)

Expected return = The return on the loans, taking into account the default risk.
 Bank’s balance sheet

Assets: bank lending

Liabilities: bank borrowing (deposits and other)
 Bank’s net worth
Net worth = assets – liabilities

The net worth of a bank is what is owed to the shareholders/ owners. It is also
called equity.

Negative net worth means the bank is insolvent.

Leverage describes the reliance of a company on debt.

 Policy rate and the economy
The central bank’s policy rate affects
the level of spending in the economy,
because households and firms
borrow to spend.

higher interest rate → low spending today

Credit rationing
 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.

E.g. Financing a project

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.
 Equity and collateral

To resolve the conflict of interest between the principal (lender) and the agent
(borrower):

• Equity: the lender may require the borrower to put some of her wealth into the
project

• Collateral: the borrower has to set aside property that will be transferred to the
lender if the loan is not repaid
 Credit rationing

Those with less wealth find it more difficult to provide equity or collateral.

Credit rationing = when those with less wealth

• borrow on unfavourable terms compared with those with more wealth (credit-
constrained)
• or are refused loans entirely (credit-excluded)
 Lending and inequality
Inequality may increase when some people are
in a position to profit by lending money to
others.

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.
 Summary
1. Ways to move consumption forward/into the future
• Borrowing, saving, investing
• Options available depend on individual’s endowment
• Optimal choice depends on individual’s discount rate

2. Outline of the banking system

• Banks create money (lend) to make profits
• Central bank sets the policy rate, which influences spending
• Issues: principal-agent problem, credit constraints
 In the next unit

• More about markets for financial assets: How prices change, and how price
bubbles form