BANKS, MONEY AND THE MONEY CREATION PROCESS
Transcript of BANKS, MONEY AND THE MONEY CREATION PROCESS
‹#› Het begint met een idee
BANKS, MONEY AND THE MONEY CREATIONPROCESS
Vrije Universiteit Amsterdam
Macroeconomics IWim BoonstraFebruary 11, 2019
Banks, Money and Money Creation
‹#› Het begint met een idee3 Het begint met een idee
About myself
• Wim Boonstra
• Professor (part-time)in Economic and
Monetary Policy
• Working at VU University since 2000
• Working with Rabobank Economic research
since 1991 (chief economist 2000 – 2016)
• Fields of research:
• Money and banking
• International economics
• Balance of payments theory
• European integration
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• A primer on banking: Functions of banks and banking risks• Definition of money• The importance of money• The value of money • The creation of money• Money multiplier
• Literature: Mankiw & Taylor (MT), chapter 4
• Note: MT is not a monetary handbook. They deal with some essentials in quite a simplistic way. This course (Macroeconomics 1.4) offers you just a brief introduction on the esential.
• If you’re really interested in monetary issues follow Monetary Economics in the second year!
Topics and learning goals
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“A bank is an institution where you can borrow money only if youcan prove that you don’t need it”
(Bob Hope, 1930s)
“Banks are institutions that accept deposits and make loans” (Mishkin; 2016)
Banks fulfill more functions:> They operate the payment system essential, without this an economy can’t
function> They give loans to consumers (mortgage loans) and businesses> They manage financial risks for their clients> They buy and sell currencies, securities and derivatives> They play a crucial role in the money creation process
Definition of a bank
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Reserves Balance with the CB Short-term goverment bonds Other highly liquid securities
Loans- to other banks- to the the private sector- to the government
Derivatives
Investments in tradeable securities
Investment in other companies
Illiquid assets (buildings)
A very simple bank balance
Demand deposits
Savings deposits)
Loans from other banks
Derivatives
Provisions
Issued debt securities
Subordinated debt and ‘bail in capital’
Equity
Assets Liabilities
“Trusted funds”
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Liquidity Liquid assets (as % of balance sheet total or against short-term debts Liquid assets are reserves at the CB or securities that can be sold at short
notice without loss (i.e. short-term government bonds).
Solvency Equity (retained profits, issued shares) as % of balance sheet total Other loss absorbing capital (subordinated debt, bail-in capital)
Profitability Profit as a % of equity or balance sheet
Some essential definitions(you should know them by heart….)
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Weighted Assets(Supervisory regimes, BIS 1 and onwards….)
Bank assets vary widely in risk Cash and reserves with the central bank bring no credit risk at all Government securities have limited credit risk, especially in well-run
industrial countries Mortgage loans are collaterized and therefore carry relatively little credit
risks, although there are differences between countries, due to legal environment (compare US with the Netherlands)
Loans to businesses carry full credit risk Securities (except government securities) carry full credit risk Private equity is very risky
Risk weighting gives the right incentives• RWA give incentives to undertake less risky business• This makes them superior to the so-called leverage ratio
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A simple risk weighted balance sheet
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Banks produce secondary utility, but not primary utility> People like the house they can buy with a mortgage loan, but
they hate their mortgage in itself)> People are at best neutral vis-a-vis a banking product. Basically
we are talking about dissatisfiers> Even the most satisfied client would have been happier if he
didn’t need a bank!
Banks create value at both sides of the balance sheet> Assets: loans (financing function)> Liabilities: payments function, savings function (liquidity
function)
Some observations
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• Maturity• Short term funding long term lending
• Size• Small savings depossits large loans
• Risk • Credit risk, liquidity risk, market risk
• Location• Surplus areas deficit areas
The transformation functions
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Liquidity risk originates in maturity transformation
Credit risk originates in risk transformation
Market risk/price risk originates in tradeable addst
Interest rate risk originates in funding and maturity transformation
Operational risk originates in all activities, above all important in payment services, risk management
Systemic Risk originates in interconnectedness (systemic failure)
Specific risks> Concentration risk ,country risk, currency risk
Banks are by definition full of risks
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“Money is the stock of assets that can be readily used to make transactions” (MT, p. 98)
A broader, more complete definition:
“Money is generally accepted within a certain society as medium of exchange, unit of account and store of value”
You should remember this one!!
Note that the definition does not include ‘intrinsic value’
Definition of money
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medium of exchangewe use it to buy stuff
store of valuetransfers purchasing power from the present to the future(or, in case of borrowing, from the future to the epresent)
unit of accountthe common unit by which everyone measures prices and values
Money: Functions
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Solves problem of ‘coincidence of wants and needs’ required in barter exchange.
Lower number of relative prices (money is numeraire)
Lower transaction costs (fewer transactions, less search time)
Store of value function makes it possible to smoothen spendingover time
Without money, an advanced economic with a high degree of specialization is not posible
Why money?
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“MONEY is not, properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another. It is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy.”
David Hume, “Essays, Moral, Political, and Literary. Of Money”1752
18David Hume
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0
2000
4000
6000
8000
10000
12000
1980 1985 1990 1995 2000 2005 2010 2015
Monetaire aggregaten van eng naar ruim
M1, chartaal M1, giraal M2 M3
mrd €
Monetary aggregates eurozone(source: ECB)
Note:
Chartaal = cash (notes and coins)
Giraal = bank deposits
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In an economy with n tradeable goods and servies, there are (n(n-1))/2 prices possible
If a single good is being used as unit of account (‘money’), this number declines to (n-1)
N = 10 45 prices without money. Using money this declines to 9
N = 1000 499.500 declines to 999 prices.
Barter trade
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Illustration: barter economy versus money
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• The use of money is an essential precondition foreconomic freedom
• An advanced economy in combination with economicfreedom is not possible without money
• A barter economy• Is very primitive, or• Has very little economic freedom (i.e. Inca’s), or• Has both characteristics
• Don’t trust people who favour a barter economy….
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Money?
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Money!
Tobacco standard(Virginia; 1607 – ca. 1800)
Cowry Shells(many,many centuries…)
Gold standard (1870 – 1914)
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1. fiat money has no intrinsic value examples:
> the paper currency we use> demand deposits (bank accounts)
2. commodity money has (some or full) intrinsic value examples:
gold or silver coinscoins, cigarettes in P.O.W. camps
Money: Types
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Intrinsic value: Economic value, other than for transactions. (usevalue; material value, production costs)
‘commodity money’: intrinsic value determines economic valueFiduciary money: economic value is larger than intrinsic value(banknotes, coins)Fiat money: intrinsic value = zero
Money does not need intrinsic value:
Its value depends on everyone agreeing that everyone agrees(that everyone agrees…) that it has value.
Confidence = key!
Intrinsic value
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Intrinsic value is only relevant when comparing relative values: • A 10 gram golden coins has twice the value of a 5 gram coin. But only when used in
the same context• A metal-based money standard is ideal for international transactions• Only when a system collapses it helps that the money has intrinsic value ==> grian,
or red wine standard?
In the end the only source of value of any sort of money is thegeneral acceptance by ‘the public’
Intrinsic value is not relevant, anything can be used as ‘money’
The economic value of money depends on the ratio between theamount of money in circulation and the amount of tradeables
The value of money
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Basically there are two important distinctions, viz. Money in circulation (meaning: not owned by banks or
government but by private sector agents) Central bank money (owned by banks (reserves) and
governments
Money in circulation: M = C + D C = notes and coins D = bank deposits
Actual measurement is more difficult, due to the high degree of substitution between overnight money andsavings accounts (“near money”)
Money supply (definition)
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M0 (monetary base, ‘high powered money’, central bank money) are the direct liabilities of the central bank
In therefore consists of Total amount of banknotes and coins Reserves of the banking system at the central bank (and central bank digital currency, but this is out of the scope of this introduction)
In formula: M0 = C+ R C = banknotes and coins R = reserves of the banks at the central bank
The monetary base (M0, central bank money)
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M0 (monetary base, ‘high powered money’, central bank money) Total amount of banknotes and coins Reserves of the banking system at the central bank
M1 (narrow money) Banknotes and coins in circulation
Bank deposits on checking accounts (‘overnight deposits’)
M2 (broad money) M1 the sum of M1, deposits with an agreed maturity of up to two years and deposits
redeemable at notice of up to three months;
M3 (broad money) M2 plus money market instruments (repurchase agreements, money market fund
shares/units and debt securities with a maturity of up to two years).
Source: ECB
Monetary aggregates (ECB definition)(this is really important, also conceptually)
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There is a relation between the monetary base and
money in circulation: the money multiplier
Monetary Base(M0)
Money in
circulation
(M1, M2, M3)
Cash in circulation is the overlapping item
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Monetary base: created by central banks(with the minor exception of coins ==> National Mint)
Money in circulation: created by commercial banks(with the relative minor exception of banknotes and coins)
Who creates money?
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Monetary policy is conducted by a country’s central bank.
• In the U.S., the central bank is the Federal Reserve(“the Fed”). Based in Washington D.C.
• The most important Federal reseve Bank is the New York Fed
• In the Eurozone, monetary policy is conduscted by the so-called Eurosystem.
• The Eurosystem consists of the ECB in Frankfurt, plus the National Central Banks of the member countries of the Eurozone
The central bank
The Federal Reserve
Building Washington,
DC
ECB
Eurosystem
(ECB plus NCBs Eurozone)
European System of Central Banks
(Eurosystem plus NCBs non-euro
member states
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Central bankLoans to banks and goverments
Open market operations
Base Money (M0)
Loans to consumers, business and governments
Money in circulation(M1, M2, M3)
Government Foreign sector
Banks(k)
Money multiplierNon-financial private sector (c)
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Assets Notes and coins
(not in circulation, not part of M0, M1) Securities (bonds, money market certificates) Loans to commercial banks Loans to the government Other (a.o. gold, as part of investment portfolio ) Currency reserves
Central bank balance sheet
Liabilities Notes in circulation (Part of M0, M1)
Reserves banking system (part of M0)
Government reserves at central bank(not part of M0)
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central bank
assets liabilities
|Gold and foreign exchange reserves | Banknotes in circulation
|
(1. and 2.) | (1.)
|
Lending to credit institutions (5.) | Liabilities to credit institutions (2.)
|
|
|
|
|
Securities held for monetary policy purposes
(7.) | Debt certificates (4.)
|
| Other liabilities
| ( 5. + 3. + 6. + 7. +8. + 9. +10. + 11.)
|
Other assets | Capital and reserves (12.)
(3. + 4. +6. + 8. + 9.) |
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Central bank transactions that result in more base money:> Printing of banknotes*> Central bank buys securities from banks (open market
operation)> Central bank buys foreign currency (open market operation)> Central bank gives loans to banks
The destruction of base money:> Central bank sells securities and/or foreign currency> Destruction of banknotes> Central bank issues its own securities
* And minting of coins (usually by the government)
The creation of base money
central bank
assets liabilities
|Gold and foreign exchange reserves | Banknotes in circulation
|
(1. and 2.) | (1.)
|
Lending to credit institutions (5.) | Liabilities to credit institutions (2.)
|
|
|
|
|
Securities held for monetary policy purposes
(7.) | Debt certificates (4.)
|
| Other liabilities
| ( 5. + 3. + 6. + 7. +8. + 9. +10. + 11.)
|
Other assets | Capital and reserves (12.)
(3. + 4. +6. + 8. + 9.) |
central bank
assets liabilities
|Gold and foreign exchange reserves | Banknotes in circulation
|
(1. and 2.) | (1.)
|
Lending to credit institutions (5.) | Liabilities to credit institutions (2.)
|
|
|
|
|
|
|
|
Securities held for monetary policy purposes
(7.) | Debt certificates (4.)
|
| Other liabilities
| ( 5. + 3. + 6. + 7. +8. + 9. +10. + 11.)
|
Other assets | Capital and reserves (12.)
(3. + 4. +6. + 8. + 9.) |
Central bank creating bank reserves
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Assets1) Lending to banks (against collateral) : Loans to banks +1,000
2) Buying securities and foreign currency Securities + 1,000 Foreign currency+ 1,000
3) Lending to government Loans to government + 1,500
The creation of base money(examples)
Liabilities1)Reserves banking system + 1,000
2)Reserves banking system + 2,000
3)Government reserves + 1,500 (‘schatkistsaldo’, this is not a part of M0)
• Central banks have unlimited powers to create base money (M0)
• Seigniorage is for central bank (usually owned by the government)
The balance sheet of the Fed(billion of USD)
-
500
1.000
1.500
2.000
2.500
3.000
3.500
4.000
4.500
5.000
The Eurosystem balance sheet (year-end,1999 – 2018)
(Assets, billion euro)
0
500
1.000
1.500
2.000
2.500
3.000
3.500
4.000
4.500
5.000
1999 2002 2005 2008 2011 2014 2017
Gold and foreign exchange reserves Lending to credit institutions
Securities held for monetary policy purposes Other assets
Normal situation
Conventional
policy in
unconventional
amounts
Unconventional
monetary policy
The Eurosystem balance sheet (year-end,1999 – 2018)
(Liabilities, billion euro)
Conventional
policy in
unconventional
amounts
Unconventional
monetary policyNormal situation
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Why legal tender?
Why have governments over time tried to create a monopoly on the creation of money?
Is the status of legal tender essential for the general acceptanceof fiduciairy or fiat money?
Legal tender
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‘Paper money’ is circulated as proof that there is ‘something valuable’ in thevault of the bank”.
The money is fully covered by i.e. gold 100% (liquidity) reserve banking
Note: no net money creation and no seigniorage. Just substitution within money supply. Composition of money supply changes Coins in circulation decline, paper money increases
Paper money creation by private banks (1)(money creation by substitution)
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The law of large numbers teaches: most gold remains in bank vault and paper money stays in circulation.
Bank can calculate the probability that clients want to have theirgold and withdraw thier deposits
Bank can start the printing press to produce more paper money in order to gain seigniorage.
This process can go on until clients go en masse to their bank towithdraw their deposits (bank run)
Paper money creation by private banks (2)
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Money creation via the creation of debt (1)
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Results of this transaction are:> Increase in money supply (from 10,000 tot 20,000)> Increase in debt (by 10,000)> Larger balance sheet of bank> Decline in liquidity ratio (from 100% tot 50%)
Cash reserve ratio < 100% fractional reserve banking
No seigniorage: the money created by the private bank is notowned by the bank (liability), but by the ‘public’.
Profit for the bank is the interest margin (income out of earningassets minus costs of liabilities
Money creation via the creation of debt (2)
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Do commercial banks create money? yes, they do
Do commercial banks create their own money? no, theydon’t
Do banks create their own funding? yes, as a system they do.
Do individual banks create their own funding? not really, as the newly created money usually starts to circulate in theeconomy
Do all commercial banks create money? no
Money creation via the creation of debt (3)
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0
2000
4000
6000
8000
10000
12000
1980 1985 1990 1995 2000 2005 2010 2015
Monetaire aggregaten van eng naar ruim
M1, chartaal M1, giraal M2 M3
mrd €
Monetary aggregates Eurozone(source: ECB)
Note:
Chartaal = cash (notes and coins)
Giraal = bank deposits
Created by
commercial
banks
Created
by central
banks
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• Cash reserves are necesary, but not very profitable quest formore income keep reserves as low as possible
• Law of large numbers: calculate optimal cash reserve ratio (rr)
• As long as cash reserve ratio > optimum banks will offer loans(and create debt and money)
• There is a formal relation between the size of the cash reserves of the banking system (part of M0) and the banks’ propensity tolend.
• This relation is the money multiplier
Money creation by commercial banks:the money multiplier
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2
4
6
8
10
12
2004 2006 2008 2010 2012 2014 2016
Het betreffende maatschappelijke geldbegrip (M1-2-3),als veelvoud van de monetaire basis (M0)
M1/M0 M2/M0 M3/M0
The ex-post relation between the monetary aggregates and the
monetary base (ex-post money multiplier)
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Situation 1Starting position
Situation 2Multiplier collapses
Monetary base unchanged
Situation 3Smaller multiplier
Increased monetary base
Quantitative easing
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“A Government can live for a long time, even the German Government or the Russian Government, by printing paper money.”
John Maynard Keynes, A Tract on Monetary reform (1923)
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Monetary financing of government spending(both monetary base (M0) and money supply (M1) increase)
Increase in governmentspending, financed bythe central bank
Money comesdirectly in circulation andeconomic activitywill increase
Money lands in bank accounts of companies andemployee, involvedin public projects(M1 increases)
Money is spendand/or saved
Monetary base (M0) increases, bank reserves larger
Banks can lendmore money , which will resultin increase of M1
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To spend more without raising taxes or selling bonds, the government can print money (monetary financing).The “revenue” raised from printing (or otherwise creating) money is called seigniorage.The inflation tax:> Printing money to raise revenue causes inflation. Inflation is like a tax on
people who hold money.> If the government holds the printing press it can buy goods and services
with freshly created money ==> a real tax> There is no such thing as an unfunded budget deficit. The public always
pays the bill. Either by taxes, or by the inflation tax (Keynes, 1923)
Seigniorage