ECONOMICS4

1. Money and Interest Rates

2. Money supply and the economy • In this lecture and the next, we are going to look at the special role that money plays in the economy. • Changes in the amount of money can have a powerful effect on all the major macroeconomic indicators, such as inflation, unemployment, economic growth, interest rates, exchange rates and the balance of payments. •But before we answer why changes in the money supply affect the economy? •Let’s quickly examine the meaning and functions of money

3. The meaning of Money  When we say that a person, say Jo-Nuellah has a lot of money, we usually mean that she is wealthy, has a high income, and is so rich that he can buy almost anything she wants.  However, money is not income, and money is not wealth  Economists use the word in a more specific sense:  Money is the set of assets in the economy that people regularly use to buy goods and services from other people.  It is ANYTHING that is GENERALLY ACCEPTED as a medium of exchange, that is, anything that will be accepted in exchange for goods and services.

4. The functions of money  Medium of exchange  Refers to anything that is acceptable in exchange for goods and services.  Where money does not exist, goods must be exchanged through the barter, the direct exchange of one good for another  Under the monetary system, double coincidence of wants is neatly eliminated, as money is exchanged for goods and services when people buy things; goods or services are exchanged for money when people sell things.  To serve as an efficient medium of exchange, money must have the following characteristics.  generally readily acceptable, scarce, legal tender (backed by law), portable, durable, divisible, easily recognizable, homogeneous (uniform) and not easily counterfeited.

5. The functions of money........Cont’d  means of storing wealth  A store of value is an item that people can use to transfer purchasing power from the present to the future  Money allows us to store purchasing power;  you can sell your goods today and store the money, giving you a claim to goods and services that you can exercise in the future.  To be a fully satisfactory store of future purchasing power, money must have a stable value in terms of the things that it can buy  However, this function of money is hampered when there is high inflation in the economy as inflation erodes the real value of money

6.  A means of evaluation or a unit of account o It provides a consistent way (yardstick) of quoting prices and measuring economic act o Money also allows dissimilar things (food, chocolate, needle, pencil, cars, housing units etc) to be added up and their values compared  A means of establishing value of future claims and payments o It serves as a means or standard for differed payment o That is why people can buy now on credit and pay in future and lecturers are willing to teach today and expect to be paid sometime in the future The functions of money........Cont’d

7. What should count as money?  Narrow definitions of money  include only items that can be spent directly, such as cash (notes and coins) and current accounts deposits in banks (since they can be spent directly by using cheques or debit cards)  NOTE!! Cheques, debit cards and credit cards, although they are used to pay for goods directly, do not themselves count as money  Rather it is the balance in the account on which they are drawn that counts as money  broad definitions of money  also include various items such as deposit and savings accounts in banks that cannot be spent directly, but which can nevertheless be readily converted into cash (medium of exchange)  Liquidity is used to describe the ease with which an asset can be converted into the economy’s medium of exchange

8. The ideal attributes of money  Durability  Divisibility  Transportability  Non-counterfeitability

9. The evolution of money  All sorts of commodities have been used as money at one time or another — candy bars, cigarettes, huge wheels of carved stone, cowry shells, silver and gold bars, and small scraps of paper.  These various kinds of money are generally divided into two groups, commodity monies and fiat money  Commodity monies are those items used as money that also have an intrinsic value in some other use.  The term intrinsic value means that the item would have value even if it were not used as money E.g. Gold  Fiat money, sometimes called token money, is money that is intrinsically worthless.  The public accepts paper money as a means of payment and a store of value because the government declares it a legal tender and has taken steps to ensure that its money is accepted  Printed on every Bank of Ghana note is “THIS IS ISSUED ON STATUTORY AUTHORITY AND IS LEGAL TENDER FOR THE PAYMENT OF ANY AMOUNT.”

10.  To see how bank deposit money evolved, let’s consider the origins of the modern banking system.  In the 15th and 16th centuries, citizens of many lands used gold as money, particularly for large transactions (i.e. gold standard).  Because gold is both inconvenient to carry around and susceptible to theft, people began to place their gold with goldsmiths for safekeeping.  On receiving the gold, a goldsmith would issue a receipt to the depositor, charging him a small fee for looking after his gold.  After a time, these receipts themselves, rather than the gold that they represented, began to be traded for goods. That is, these receipts became a medium of exchange.  The receipts became a form of paper money, making it unnecessary to go to the goldsmith to withdraw gold for transactions.  Thus as the receipts became acceptable for settling market transactions, they became money. The evolution of bank deposit money

11. The Financial System •The financial sector of any country consists of banks and other financial institutions known as financial intermediaries • They all have the common function of providing a link between those who wish to lend and those who wish to borrow. • They act as the mechanism whereby the supply of funds is matched to the demand for funds. •In this process, they provide four important services.

12. The role of the financial sector  expert advice  They advise their customers on financial matters: on the best way of investing their funds and on alternative ways of obtaining finance  expertise in channelling funds  They have the specialist knowledge to be able to channel funds to those areas that yield the highest return  They help to ensure that projects that are potentially profitable will be able to obtain finance and thus, they help to increase allocative efficiency.  maturity transformation  This is process whereby financial intermediaries lend for longer periods of time than they borrow  They are able to do this because with a large number of depositors it is highly unlikely that they would all want to withdraw their deposits at the same time  risk transformation  This is the process whereby banks can spread the risks of lending by having a large number of borrowers.  They have the expertise to be able to assess just how risky a loan is.

13. The banking system  Types of bank  Banks can be divided into two main groups: retail banks and wholesale banks  retail banks:  They specialize in providing branch banking facilities to members of the general public, but they also lend to business, albeit often on a short-term basis. E.g. Barclays, HFC, Stanbic etc  Their business is in retail deposits and loans (i.e. deposits and loans made through their branch network at published rates of interest).  wholesale banks  These are banks specializing in large-scale deposits and loans and dealing mainly with companies e.g. Investment Banks and finance houses  They often act as ‘brokers’, arranging loans for companies from a number of different sources

14. The banking system  Wholesale banks deal in wholesale deposits and loans  Large-scale deposits and loans made by and to firms at negotiated interest rates.  building societies  These institutions specialize in granting loans (mortgages) for house purchase  In the past, there was a clear distinction between banks and building societies  However they are similar today due to financial deregulation  That is, the removal of or reduction in legal rules and regulations governing the activities of financial institution

15. Deposit taking and lending  Banks are in the business of deposit taking and lending. To understand this, we must distinguish between banks’ liabilities and assets.  Liabilities are customers’ deposits in banks.  There are four major types of deposits  sight deposits, i.e any deposits that can be withdrawn on demand by the depositor without penalty E.g Current accounts  time deposits deposits require notice of withdrawal and a penalty is charged for withdrawals on demand.  However, they normally pay a higher rate of interest than sight accounts.  certificates of deposit are certificates issued by banks for fixed- term interest-bearing deposits. They can be resold by the owner to another party.  repos (sale and repurchase agreements)  This is an agreement between two financial institutions whereby one in effect borrows from another by selling its assets, agreeing to buy them back (repurchase them) at a fixed price and on a fixed date

16. Deposit taking and lending.....cont’d  Assets  these are a bank’s possessions or its claims on others  There are three main categories of assets.  cash and operational balances in the central bank  Cash balance is a certain amount of their assets they hold in cash and is largely used to meet the day-to-day demands of customers  ‘Operational balances’ are kept with the central bank for settling the day-today payments between banks and can be withdrawn on demand  short-term loans  These are in the form of market loans, and bills of exchange  The market for short-term loans and deposits is known as the money market  longer-term loans  These consist primarily of loans to customers, both personal customers and businesses  It also include investment in various subsidiary financial institutions and in building societies and long-term government bonds

17. Which of the following arranges a person’s assets in descending order of liquidity (most liquid first)? Q A. bonds; cash; shares; land B. a house; cash; shares; savings account deposits C. shares; land; savings account deposits; bonds D. current account deposits; savings account deposits; shares; a house E. cash; savings account deposits; current account deposits; bonds A. B. C. D. E. 20% 20% 20%20%20%

18. A bank’s balance sheet  A bank’s balance sheet  It’s a financial statement that shows the total liabilities and assets of the bank over a period of one year.  Let’s quickly see how it looks like for a typical bank

19. Sterling liabilities £bn % Sterling assets £bn % Sight deposits (31.0) Notes and coin 9.2 (0.3) UK banks, etc. 103.1 Balances with Bank of England (1.4) UK public sector 8.9 Reserve balances 40.8 UK private sector 749.7 Cash ratio deposits 2.0 Non-residents 128.4 Market loans (15.2) Time deposits (36.0) UK banks, etc. 179.2 UK banks, etc. 82.3 CDs, etc. 54.0 UK public sector 51.2 Non-residents 243.3 UK private sector 645.8 Bills of exchange 52.6 (1.7) Non-residents 373.5 Reverse repos 272.7 (8.7) Certificates of deposit (CDs) 240.3 (7.5) Investments 333.2 (10.6) Repos 383.8 (12.0) Advances 1816.3 (58.1) Sterling capital & other funds 310.0 (9.7) Other 121.1 (3.8) Miscellaneous 124.8 (4.0) Total sterling liabilities 3198.2 (100.0) Total sterling assets 3127.9 (100.0) Liabilities in other currencies 4645.7 Assets in other currencies 4715.9 Total liabilities 7843.9 Total assets 7843.9 Source: based on data in Table B1.2 of Bankstats (Bank of England) Balance sheet of UK banks: November 2008

35. Source: based on data in Table B1.2 of Bankstats (Bank of England) Sterling liabilities £bn % Sterling assets £bn % Sight deposits (31.0) Notes and coin 9.2 (0.3) UK banks, etc. 103.1 Balances with Bank of England (1.4) UK public sector 8.9 Reserve balances 40.8 UK private sector 749.7 Cash ratio deposits 2.0 Non-residents 128.4 Market loans (15.2) Time deposits (36.0) UK banks, etc. 179.2 UK banks, etc. 82.3 CDs, etc. 54.0 UK public sector 51.2 Non-residents 243.3 UK private sector 645.8 Bills of exchange 52.6 (1.7) Non-residents 373.5 Reverse repos 272.7 (8.7) Certificates of deposit (CDs) 240.3 (7.5) Investments 333.2 (10.6) Repos 383.8 (12.0) Advances 1816.3 (58.1) Sterling capital & other funds 310.0 (9.7) Other 121.1 (3.8) Miscellaneous 124.8 (4.0) Total sterling liabilities 3198.2 (100.0) Total sterling assets 3127.9 (100.0) Liabilities in other currencies 4645.7 Assets in other currencies 4715.9 Total liabilities 7843.9 Total assets 7843.9 Balance sheet of UK banks: November 2008

36. Which of the following would be classified as a liability of a bank? Q A. B. C. D. E. 20% 20% 20%20%20%A. Holdings of ‘toxic’ debt B. Current account deposits C. Reserves in the central bank D. Loans to other banks E. Customers’ overdrafts

37. Which of the following describes a ‘repo’?Q A. B. C. D. 25% 25%25%25% A. Where a bank agrees to buy certain assets from an institution for cash in return for being able to borrow from that institution in the future. B. Where a bank sells some assets (e.g. bonds) and agrees to buy them back at a particular price after a set period of time. C. Where bank X lends to bank Y provided that bank Y is prepared to lend to bank X in the future. D. Where a bank sells assets to person or institution X in return for buying assets from person or institution Y.

38. Liquidity and profitability  Banks have the two conflicting aims of liquidity and profitability.  The liquidity of an asset is the ease with which it can be converted into cash without loss.  Cash itself, by definition, is perfectly liquid  Other assets like personal & business loans, mortgages & T-bills are less liquid  In general, the more liquid an asset, the less profitable it is, and vice versa  For reasons of profitability, the banks will want to ‘borrow short’ and ‘lend long’  they want to hold illiquid assets in order to make a profit  after all, the less liquid the asset (i.e long-term loans), the greater the interest the bank is likely to be able to charge

39. Source: based on data in Table B1.2 of Bankstats (Bank of England) Sterling liabilities £bn % Sterling assets £bn % Sight deposits (31.0) Notes and coin 9.2 (0.3) UK banks, etc. 103.1 Balances with Bank of England (1.4) UK public sector 8.9 Reserve balances 40.8 UK private sector 749.7 Cash ratio deposits 2.0 Non-residents 128.4 Market loans (15.2) Time deposits (36.0) UK banks, etc. 179.2 UK banks, etc. 82.3 CDs, etc. 54.0 UK public sector 51.2 Non-residents 243.3 UK private sector 645.8 Bills of exchange 52.6 (1.7) Non-residents 373.5 Reverse repos 272.7 (8.7) Certificates of deposit (CDs) 240.3 (7.5) Investments 333.2 (10.6) Repos 383.8 (12.0) Advances 1816.3 (58.1) Sterling capital & other funds 310.0 (9.7) Other 121.1 (3.8) Miscellaneous 124.8 (4.0) Total sterling liabilities 3198.2 (100.0) Total sterling assets 3127.9 (100.0) Liabilities in other currencies 4645.7 Assets in other currencies 4715.9 Total liabilities 7843.9 Total assets 7843.9 Balance sheet of UK banks: November 2008

40. Which of the following would be classified as liquid asset of a bank? Q A. B. C. D. E. 20% 20% 20%20%20% A. Sight deposits B. Time deposits C. Personal loans D. Certificates of deposit in other banks E. Repos with the central bank

41. The balance between profitability and liquidity • Profitability is the major aim of banks and most other financial institutions. • However, the aims of profitability and liquidity tend to conflict  Cash is totally liquid, but earns no profit  But they must hold sufficient liquid assets to be able to meet any demands from their customers and avoid a crisis of confidence. • The only way of reconciling the two conflicting aims is to hold a mixture of liquid and illiquid assets •The ratio of an institution’s liquid assets to total assets is known as its liquidity ratio. •If the liquidity ratio is too high, they will make too little profit. •If the ratio is too low, there will be the risk that customers’ demands may not be able to be met: •This would cause a crisis of confidence and possible closure.

42. The central bank  The Bank of Ghana is Ghana’s central bank  All countries have a central bank and they fulfil two vital roles in the economy  to oversee the whole monetary system and ensure that banks and other financial institutions operate as stably and as efficiently as possible.  to act as the government’s agent, both as its banker and in carrying out monetary policy  Aside its two broad roles, it has a number of different functions

43. Other functions of the Central Bank  It issues notes  It acts as a bank to the gov’t and commercial banks  It manages the government’s borrowing  (i.e. national debt)  It provides adequate liquidity to banks  oversees the activities of banks and other financial institutions  operates monetary policy  operates exchange rate policy and manages reserves

44. The financial system  The money market is the market in short-term deposits and loans. It consists of the discount and repo markets and the parallel money markets  through which a central bank exercises control  The London money market  the discount and repo markets  the importance of inter-bank lending  the parallel money markets

45. Money and Interest Rates The Supply of Money

46. The supply of money  Definitions of the money supply  monetary base  broad money  Definitions in the UK  cash in circulation  M4  Definitions in the eurozone  M1  M2  M3

47. UK monetary aggregates: (end July 2008) £ million Cash in circulation (i.e. outside the Bank of England) 44 384 – Cash in banks and cash held outside the country –1 422 + Private-sector retail bank and building society deposits 1 074 841 = Retail deposits and cash in M4 1 117 803 + Private-sector wholesale bank and building society deposits + CDs 664 358 = M4 1 782 161

50. UK monetary supply using ECB measures: (end July 2008) Currency in circulation + Overnight deposits = M1 + Deposits with agreed maturity up to 2 years + Deposits redeemable up to 3 months' notice = M2 + Repos + Money market funds and paper = M3 43 667 948 374 992 041 172 050 513 839 1 677 930 196 217 87 241 1 961 388 £ million

53. The supply of money  The creation of credit  simple illustration

54. Liabilities £bn Assets £bn Deposits (old) Total 100 ___ 100 Balances with B of E (old) Advances (old) Total 10 90 ___ 100 Credit creation: Banks' original balance sheet

55. Credit creation: Effect of a new deposit of £10bn Liabilities £bn Assets £bn Deposits (old) Deposits (new) Total 100 10 ___ 110 Balances with B of E (old) Balances with B of E (new) Advances Total 10 10 90 ___ 110

56. Liabilities £bn Assets £bn Deposits (old) Deposits (new: initial) (new: subsequent) Total 100 10 90 ___ 200 Balances with B of E (old) Balances with B of E (new) Advances (old) Advances (new) Total 10 10 90 90 ___ 200 Credit creation: Full effect of a new deposit of £10bn

57. The supply of money  The creation of credit  simple illustration  bank deposits multiplier: 1/L

58. If an extra £100m is deposited in the banking system and the bank deposits multiplier is 5, by how much can credit expand? Q A. B. C. D. 25% 25%25%25% A. £80m B. £180m C. £400m D. £500m

59. In an economy where all commercial banks keep ten per cent of their deposits in liquid assets, total bank assets would be increased by £100 million if bank holdings of cash increased by: Q A. B. C. D. E. 20% 20% 20%20%20% A. £10,000 million B. £1000 million C. £100 million D. £10 million E. £1 million

60. The supply of money  The creation of credit  simple illustration  bank multiplier: 1/L  money multiplier: m = MS/MB = (D +C) / (R +C)

61. The supply of money  The creation of credit in the real world  banks’ liquidity ratio may vary  banks may hold a higher level of liquid assets when they perceive increased risk  customers may not take up all the credit on offer  banks may not operate a simple liquidity ratio  how much of the extra cash will be withdrawn by the public?

62. The supply of money  Causes of increases in money supply  banks reduce liquidity ratio  households and firms choose to hold less cash  currency flow surplus on the balance of payments  public-sector deficit

63. Which of the following methods of financing an increase in the public-sector net cash requirement will lead to an increase in the money supply? Q A. B. C. D. E. 20% 20% 20%20%20%A. Sales of securities to overseas purchasers B. Sales of bonds to the non- bank private sector C. Sales of Treasury bills to the non-bank private sector D. Sales of Treasury bills to the banking sector E. Sales of bonds to the banking sector

64. The supply of money  Flow-of-funds equation  M4 = (a) PSNCR – (b) sale of public-sector debt to non-bank private sector + (c) banks’ lending to UK private sector + (d) external effect

65. M4 equals PSNCR (Item 1) minus Sales of public-sector debt to (or plus purchases of public-sector debt from) the non-bank private sector (Item 2) plus Banks’ and building societies’ sterling lending to UK private sector (Item 3) plus External effect (Item 4) Counterparts to changes in M4 (£m) PSBR (+) PSDR (-) (1) Sales of (-) / purchases of (+) public-sector debt to/from non-bank private sector (2) Banks’ and building societies’ lending to UK private sector (3) External effect: inflows (+) outflows (-) (4) Total M4 2000 –37 525 +13 536 +80 279 +10 689 = +66 979 2004 +41 150 –26 298 +86 000 –4 249 = +96 603 2007 +32 343 –2 673 +233 549 –80 528 = +182 691 Flow of funds equation and counterparts to changes in M4

73. The supply of money  Flow-of-funds equation  M4 = (a) PSNCR – (b) sale of public-sector debt to non-bank private sector + (c) banks’ lending to UK private sector + (d) external effect  Exogenous or endogenous money supply?

74. O Rateofinterest Quantity of money MS Money supply determined independently of the demand for money and interest rates The supply of money curve: (a) exogenous money supply

75. O Rateofinterest Quantity of money MS Money supply depends (in part) on the demand for money and interest rates The supply of money curve: (b) endogenous money supply

76. Which of the following would NOT cause a rise in money supply (assume ceteris paribus)? Q A. B. C. D. E. 20% 20% 20%20%20%A. An increase in government spending financed by borrowing from the banking sector. B. An increase in the proportion of the national debt financed by bills rather than by bonds. C. The central bank imposes a statutory liquidity ratio on banks (above their current ratio). D. A rise in demand for money and the central bank does not change interest rates. E. The government finances the budget deficit by selling securities to the central bank.

77. Money and Interest Rates The Demand for Money

78. What do we mean by the term the ‘demand for money’? Is it: Q A. B. C. D. E. 20% 20% 20%20%20% A. the proportion of people’s income held as wealth? B. a means of controlling the money supply? C. a term used by the Bank of England to refer to the demands placed upon it by the banking sector? D. the desire by individuals and firms to spend, given their level of income? E. the demand to hold assets in money form?

79. The demand for money  The motives for holding money (M4): liquidity preference  transactions and precautionary demand for money: L1

80. O Rateofinterest L1 Active balances The transactions-plus-precautionary demand for money: L1

81. The demand for money  The motives for holding money: liquidity preference  transactions and precautionary demand for money: L1  speculative (assets) demand for money: L2

82. O Rateofinterest L2 Idle balances The speculative demand for money: L2

83. The demand for money  The motives for holding money: liquidity preference  transactions and precautionary demand for money: L1  speculative (assets) demand for money: L2  the total demand for money: L1 + L2

84. O Rateofinterest Total money balances L ( = L1 + L2) L2 L1 The total demand-for-money curve: L (= L1 + L2)

85. Which one of the following would NOT increase the demand for money? Q A. B. C. D. E. 20% 20% 20%20%20%A. People are paid less frequently. B. People decide to holder larger precautionary balances of money. C. Property prices are expected to rise. D. Speculators believe that interest rates will rise. E. Speculators believe that the exchange rate index will rise.

86. The demand for money  The motives for holding money: liquidity preference  transactions and precautionary demand for money: L1  speculative (assets) demand for money: L2  the total demand for money: L1 + L2  Additional effects of expectations

87. Asset Period of loan Rate of interest (% per year) Call money Overnight 5.25 Gilt repos 2 weeks 5.12 Inter-bank loans 1 month 5.47 Treasury bills 3 months 5.24 Long-dated government bonds 20 years 5.03 Variable mortgage rate Variable (25 years typical) 6.92 Ordinary shares (dividend yield of FTSE 100) – 4.20 (Banks’ base rate = Bank Rate) – 5.00 Selected rates of interest: June 2008 (end)

88. Money and Interest Rates Equilibrium in the Money Market

89. Monetary equilibrium  Equilibrium in the money market  equilibrium rate of interest

90. O Rateofinterest L Money MS re Me Equilibrium in the money market

91. Which of the following will lead to an increase in interest rates? Q A. B. C. D. E. 20% 20% 20%20%20%A. A decreased holding of transactions balances B. An increase in narrow money (cash in circulation) C. A belief that bond and other security prices will fall D. Banks choose to operate with a lower liquidity ratio. E. A reduction in the PSNCR

92. Monetary equilibrium  Equilibrium in the money market  equilibrium rate of interest  effects of changes in the money supply or demand on the rate of interest

93. O Rateofinterest L Money MS re Me Equilibrium in the money market

94. Monetary equilibrium  Equilibrium in the money market  equilibrium rate of interest  effects of changes in the money supply or demand on the rate of interest  Equilibrium in foreign exchange market  equilibrium rate of exchange  effects of changes in the money supply  effect on interest rates  effect on exchange rates  effect on imports and exports

95. Assuming ceteris paribus, an increase in national income will: Q A. B. C. D. E. 20% 20% 20%20%20% A. increase the transactions demand for money and thereby push up interest rates. B. increase the supply of money and thereby push down interest rates. C. decrease the speculative demand for money and thereby push up interest rates. D. increase both the demand and supply of money and thus leave interest rates unchanged. E. decrease savings in the economy and thereby push down interest rates.

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