Chapter 11

Money,
Banking, and
Finance
©SUKHPREET KAUR@ASSISTANT PROFESSOR PML SD BUSINESS SCHOOL,CHANDIGARH
Learning Goals

 After today‘s lecture, you will be able to:

– Describe the consequences of inflation and deflation.
– Describe the functions and types of money.
– Describe the measures of the money supply
– Explain how banks create money.
– Describe the categories and functions of nonbank financial institutions.
– Explain the concept of “speculative bubble” and illustrate it with
concrete examples.

Chapter 11 2
Chapter Outline

1. Why Money?
2. What is Money?
3. The Banking System
4. Money and Finance

Chapter 11 3
Why Money?
Why Money: Making Transactions Easier

 Imagine there was no money:

– You would need to barter
– If you want to get a certain good which you don‘t have and
want to exchange something else, you need to find
someone who wants just the opposite exchange
– Sometimes, goods are not easily divisible (imagine you want
to get some eggs, but only have a cow)

Chapter 11 5
Money and Aggregate Demand

 Imagine you want to buy a house or make an

investment, but do not have the means to do so
 You go to a bank and ask for a loan
 If the bank gives you a loan, you will buy the house
 If the bank does not give you a loan or conditions are
too harsh, you will walk away not buying the house
 Hence, if the government can influence credit
conditions, it can influence aggregate demand!

Chapter 11 6
Some More Basic Thoughts About Money:

 This, however, is only true if inflation is low to

moderate
 In some cases, inflation becomes so high that money
is not generally accepted anymore
 In these cases, people might resort to barter as
money would lose value to quickly
 barter: exchange of goods, services, or assets directly
for other goods, services, or assets, without the use of
money.

Chapter 11 7
Where Do Hyperinflations Come From?

 Hyperinflation usually happens if the government starts

using the printing press to pay for its expenditure
(because it does not manage to collect sufficient
revenue)
 If the economy is large and growing and there are not
too many newly printed bills, the money usually is just
absorbed
 However, if the governments prints too much money,
there will be hyperinflation
– Germany 1920s

– Zimbabwe in 2007
Chapter 11 8
What is the Danger of a Hyperinflation in Europe
Today?
 No real danger
 Governments are not allowed to use the printing
press to pay for their deficit (EU treaty)
 Even (recently agreed) purchases of government
bonds by the ECB are limited
 Money in modern, developed economies comes into
existence by other means (via the banking system)

Chapter 11 9
Why is Inflation Disliked Even if it is Lower?

 It redistributes from creditors to debtors

 It might wipe out savings
 It makes planning difficult
 It hurts those with nominally fixed incomes (people
on unemployment assistant, pensioners etc.)
 It creates “menu” costs

Chapter 11 10
What About Falling Prices – Do They Bring Problems as
Well?
 Deflation: when the aggregate price level falls
 Wealth is redistributed from debtors to creditors
 Debtors tend to be those who spend more – firms are
usually debtors
 This might lead to bankruptcies and problems in the
banking sector
 People might postpone spending
 There might thus be problems for aggregate demand

Chapter 11 11
What is Money?
What is Money?

 We usually define money by its functions:

– Medium of Exchange—promotes economic efficiency by minimizing time
spent in exchanging goods
and services
• Must be widely accepted
• Must be divisible
• Must be easy to carry
• Must not deteriorate quickly

– Store of Value — used to save purchasing power; most liquid of all assets
but loses value during inflation
– Unit of Account — used to measure value in
the economy
Chapter 11 13
What is NOT Money?

 A lot of things you might in everyday life call “money”

is NOT money in the eyes of economists
– Income: If someone has a high income (“he earns a lot of
money”), you would call this income, not money
– Wealth: If someone has a lot of stocks or bonds, he does
not have money in the economic meaning of the term

Chapter 11 14
Types of Money

 Commodity money: something that contains intrinsic

value and is used in exchange
– Coins made of gold or silver; sometimes cigarettes
developed into a medium of exchange in hard times
– To be used as money, a commodity must be generally
acceptable, standardized, durable, portable, scarce, and,
preferably, easily divisible

Chapter 11 15
The System of Gold-Backed Currencies

 Gold and silver coins inconvenient to carry around in large

quantities
 Paper monies were issued representing claims on actual
commodities
 Starting in the late 1830s, most European countries had
their national currencies by law backed by gold
 Exchange rate between different currencies was computed
from their respective value relative to gold, and
international transactions were finally settled in gold
reserves
 System of gold-backed currencies broke down with the
start of World War I
Chapter 11 16
What is the Basis of Value of the Coins and Euro
Banknotes we use Today?
 The basis of value is—precisely and no more than—
the expectation that the euro bill will be acceptable in
exchange.
 Fiat money
– A euro bill is money because the government declares it to
be money
– Fiat money possesses exchange value
– The value of the goods or services that such money can pay
for in the market
Chapter 11 17
Nowadays, You Are Likely to Make Many of Your
Transactions by Other Means
 Type of money which is purely based on a promise to
pay by someone other than the central bank, is called
credit money
– Your deposit in a checking account

Chapter 11 18
Figure 11.1 The Liquidity Continuum
 Items more to the left are more liquid or, in other words, more easily used to
purchase something of value. The farther to the right on this continuum, the less
liquid the item is. Currency is as liquid as it gets, and real estate is usually about the
most difficult asset to convert to money (seldom taking less than a few months).

Liquidity Continuum
More Less
Liquid Liquid

Currency Share of Stock Real Estate

Checking Account Precious Metal

Chapter 11 19
Do You Use Money if You Use a Credit Card to Make a
Purchase?
No!

 one is taking out a temporary loan from the credit

card company
 only one day a month, when you send a check or
electronic transfer to your credit card company from
your checking account, you make a “money”
transaction

Chapter 11 20
Bank Deposits and Money

 Dank deposits fulfill the criteria for money

– Store of value
– Widely accepted in payment
– Unit of account
 But: deposits have a different degree of liquidity; not
all can be used for payment
 What do we count as money?
– Pragmatic solution: different monetary aggregates which
include bank deposits with different kinds of maturities
Chapter 11 21
Monetary Aggregates: The Example of the euro area,
in Billion €
Mid 2009 March 2013
Cash in Circulation 733.6 866.7
+ Overnight Deposits 3606.7 4336.0
= M1 4340.3 5202.7

+ Deposits with agreed maturity up to 2 years 2134.9 1784.9

+ Deposits redeemable at a period of notice up to 1722.9 2102.2
3 month
= M2 8198.2 9089.7

+ Repurchase agreements 331.0 122.3

+ Money market fund (MMF) shares/units 745.0 457.8
+ Debt securities up to 2 years 171.8 140.0
= M3 9445.9 9809.9
Chapter 11 22
The Banking System
Table 11.1 A Simplified Balance Sheet of a Commercial Bank

Assets Liabilities

Reserves €10 million Deposits €100 million

Government bonds €20 million

Loans €70 million

bank reserves: funds not loaned out by a private bank, but kept
as vault cash or as deposit at the central bank
In most countries, banks are required to keep some share of
their deposits as reserves – this is called required reserves

Chapter 11 24
How Commercial Banks Earn Profits

 Government bonds
– Earn interest by lending money to national governments
– Relatively safe and liquid
 Portfolio of loans
– Funds that are owed to the bank by businesses, households,
nonprofits, or nonfederal levels of government
– Less liquid than government bonds
– Major asset and major way to make earnings

Chapter 11 25
Table 11.2 Bank Types

Chief Functions
Retail banks Safekeeping of money, checking accounts, loans
Savings banks Similar to retail bank but specializing in loans, particularly
mortgages and loans to small and medium sized businesses
Cooperative banks Same as a retail bank, but cooperatively owned by customers
Private banks Caters almost exclusively to high net worth individuals; functions
extend beyond traditional banking into variety of financial
services
Investment banks No traditional banking functions; involved in underwriting and
issuing securities, assistance with company mergers and
acquisitions, market making, and general advice to corporations
Universal banks Covering both investment and retail banking services
Central banks Overseeing the monetary stability of the national economy by
setting interest rates and providing liquidity to commercial banks

Chapter 11 26
Banks and Their Activities Have Been and Still Are
Heavily Regulated
 Rules about
– minimum reserves, capital requirement, qualification of the
management
 After WWII, binding ceilings for interest rates on
deposits and loans
 USA: Banking Act (Glass-Steagall Act) of 1933:
separation of commercial and investment banking
 Wave of deregulation in the 1990s
 Re-regulations after the financial and economic crisis
2008-09
Chapter 11 27
How Commercial Banks Create Money

 When a commercial bank decides to make a loan, it

credits the amount to the checking account
– With the stroke of a key, deposit money is created!
– This increases M1
 Hence, commercial banks can create money!

Chapter 11 28
The Central Bank and Commercial Banks‘ Money Creation

 In the euro area (and other jurisdictions), commercial

banks are required to hold a certain share of their
deposits as reserves
 Banks need to borrow these reserves
– From other banks

– From the ECB

 These reserves do not need to be available at the time
when a deposit or a loan is made, but have to be put in
the account within a certain time
 If commercial banks need cash, they have to borrow it
from the ECB
Chapter 11 29
 Central Bank

Borrower

Commercial Commercial
Bank A Bank B
Bank makes loan
Increase Money Supply M1

Chapter 11 30
reserves do
not need to
be available Central Bank
at the time
when a
deposit or a
loan is made! or Bank A/B borrows from
Commercial Central Bank against collateral
Bank hold and interest rate
certain share
of deposits at
Central Bank
Reserve Requirement
Borrower

Commercial Commercial
Bank A Bank B
Bank makes loan

Bank A/B borrows reserves from Bank B/A

Chapter 11 31
 Central Bank

CB provides
cash

Commercial
Bank
provides Borrower
collateral and
pays interest

Commercial Commercial
Bank A Bank B

ATM

Commercial Bank provides Cash NO increase in M1

Chapter 11 32
Money and Finance
Functions of Finance

 Provision of money to support investment in real

capital
 Portfolio investment, i.e. investing funds in securities
such as stocks or bonds
 another form of saving, a means of postponing
consumption

Chapter 11 34
Speculation as Investment

 Exploit changes in prices to achieve short-term profit

 Economic impact of risking their own funds is limited
 Speculators may borrow money in order to exploit
what they see as market opportunities based on
short-term price movements
 Leverage—investments based on borrowed funds

Chapter 11 35
Nonbank Financial Institutions

a financial institution that performs a number of services

similar to those offered by banks but that is not a
licensed bank and is not subject to banking regulations

 An industry that has been growing in size and importance

relative to banking
 Activities do not directly affect the money supply

 Loans from these entities, unlike transactions using bank

accounts, are not liquid  “nonmoney assets”

Chapter 11 36
Nonbank Financial Institutions

 Collective investment vehicle or pooled fund

– an investment vehicle that pools investments from many different
sources, making investment decisions for them all as a group
 Index fund
– a type of pooled fund that tries to replicate a common stock or bond
market index. As this fund does not require active management by a
manager, fees are usually lower than in other types of pooled funds
 Hedge fund
– a type of pooled fund that often engages in highly speculative
investments and to which access is generally restricted to wealthy clients

Chapter 11 37
Nonbank Financial Institutions

 Pension fund
– a fund with the exclusive purpose of paying retirement benefits
 Insurance company
– a company that pays to cover all or part of the cost of specific
risks against which individuals and companies chose to insure
themselves
 Reinsurer
– a company that sells insurance to insurance companies to share
the risk in case of large damages caused e.g. through natural
disasters.
Chapter 11 38
Nonbank Financial Institutions

 Securities broker
– an agent responsible for finding a buyer for sellers of different
securities, thereby offering enhanced liquidity to the seller
 Building society
– a financial institution which collects savings from its customers and
offers them at preferential rates to other customers so that they
can buy or build a residence
 Shadow bank
– credit intermediation that involves entities and activities outside
the regular banking system
Chapter 11 39
Modern Economies Are Much More Dependent Than
Ever on Finance
 In the euro area, total financial assets banking sector
roughly doubled from 2003 to 2013 to a total of €57
trillion (almost six times euro area annual GDP)
 In the UK and US, financial assets have surpassed the
equivalent of ten times the respective national GDP
 Financial transactions is even larger. For the U.S., this
value was 73 times GDP already in 2009, primarily a
result of rapid growth in high-frequency trading

Chapter 11 40
Is Too Much Finance Bad for the Economy?

 When economies grow on the basis of mass

investment in assets with questionable foundations,
yet rise in price, the growth is unstable and destined
to be of short duration
 Such irrational speculative price rises are called
bubbles

Chapter 11 41
The Dutch Tulip Frenzy (Tulip Mania)
1636-37
 Different tulip types had different values
 Mass speculation
– first: only wealthy Dutch were buying them

– eventually, everyone was buying tulips

 Rapid increase in prices
– peak: March 1637

– some select bulbs sold for several times the yearly

income of a skilled craftsman
– shortly thereafter, confidence in their value vanished
 Almost overnight, the tulip market crashed, and many speculators
were ruined.
Chapter 11 42
Stock Market Bubble 1929

 “new reality”
– establishment of the Federal Reserve in 1913
– government policies to extend free trade, fight inflation,
relaxation of antitrust laws
 1920s: everyone is buying shares
– consumer debt was taken on to buy stock shares (instead of
consumer goods)
 October 1929: the stock market crash
 The Great Depression
Chapter 11 43
Dow-Jones Industrial Stock Price Index for USA, 1914-
1942

400

350

300

250
Dollars per Share

200

150

100

50

0
0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1
2- 2- 2- 2- 2- 2- 2- 2- 2- 2- 2- 2- 2- 2-
4 -1 6 -1 8 -1 0 -1 2 -1 4 -1 6 -1 8 -1 0 -1 2 -1 4 -1 6 -1 8 -1 0 -1
1 91 1 91 1 91 1 92 1 92 1 92 1 92 1 92 1 93 1 93 1 93 1 93 1 93 1 94

Source: National Bureau of Economic Analysis

Chapter 11 44
Since the 1970s, Many Other Bubbles Developed…

 East Asia 1997

 “Dot-com” stock market bubble 1999/2000
 Housing bubbles in the US, UK, Ireland, Spain and
other European countries late 2000s

 Bubbles are characterized by a rapid increase in prices

that are not generally accompanied by an equally
rapid improvement in economic conditions
- buying begets more buying
- appreciation in the asset values is fleeting
Chapter 11 45
Why Do We Fail to Learn From Past Mistakes?

Speculative bubbles form for psychological and

economic reasons
 Psychological reasons

– faith or “blind optimism”

– herd behaviour
 Economic reasons
– easy credit
– borrowing for purchases of stocks or real estate
– inflation of a financial bubble
Chapter 11 46
How Exactly Are All These Possibilities of Bank-Based
and Non-Bank-Based Finance Linked to the
Macroeconomy?
Finance is crucial to realize investment plans of firms
 no savings have to be collected prior to the
investment undertaking
 banks can create deposit money by extending loans
with “the stroke of a pen”
 investment plans depend on banks and non-banks
willingness and ability to provide funds to firms and
households

Chapter 11 47
Figure 11.2 Credit and Aggregate Demand
 A larger amount of credit disbursed tends to lead to more aggregate demand:
Money is usually borrowed by households and firms to finance spending on
consumer goods, residential properties or new equipment.
More
financialized  However, the more
economy finalized an economy,
the more of the credit
goes into non-
productive activities
without an impact on
aggregate demand. For
Credit Volume

a financialized
economy, therefore,
Less the Credit-AE-curve is
financialized further to the left.
economy

Aggregate Expenditure Chapter 11 48

The International Aspect of Finance: Cross-Border
Trading of Financial Assets
 Some invest in foreign assets because of good
performance of – for example – a Japanese car
company
 Others invest abroad to speculate on changes in the
exchange rate
 Trading financial assets across borders means that one
country borrows and another country acquires claims

Chapter 11 49
What to Take Home (I)

 Hyperinflation comes from running the printing press

 Deflation is a fall in aggregate price levels
 Money is a store of value, a medium of exchange, and
a unit of account
 Economists differentiate between commodity money
and fiat money
 Commercial banks make profits through collecting
deposits and investing in a portfolio of loans as well as
miscellaneous securities
 Deposit money is created when banks make loans
Chapter 11 50
What to Take Home (II)

 Nonbank financial institutions are not subject to

banking regulation
 Economies became financialized
 Irrational speculative real estate or asset price rises
are called bubbles
 Finance is crucial to realize investment plans of firms

Chapter 11 51