Money and Banking Flashcards
Orthodox view of money
Money as an «object» that circulates in the “Market” with the purpose of reducing transaction costs to the advantage of traders and the State.
Heterodox view of money
Money as a “standard of value” created by the “State” with the purpose of regulating economic activity and economic relations between the public and the private sector (Heterodox view).
The three types of transaction costs
Search and information cost (Trading place, counterparty, market rules, market conditions)
Bargaining and decision costs (Quality assessment, price fixing, contract drafting, clearing, settlement, contract registration)
Policing and enforcement costs (Compliance, littigation in case of breach of contract, fraud).
Features of a market economy
Well defined property rights, division and commodification of labour, private companies, decentralized exchange and free transfer of resources.
The three ways of exchange
- Goods today against goods today (barter, bilateral or multilateral)
- Goods today against goods in the future (credit arrangement)
- Goods today against money today which buys goods in the future (monetary exchange).
Search models
Models that look under what conditions the third type of mechanism prevails over the other.
Cartalists
A group that believes that the value and acceptability of money depends on the power of the issuing authority that imposes its use as legal tender and prior to that as unit of account.
Taxes
A payable form of money that the state issues.
HICP
Harmonised indices of consumer prices that are comparable measures of changes in consumer prices.
Unit of account
It is a number used to measure a value that doesn’t need to have a physical dimension and which is usually established by an authority.
Old meaning of payment
Used to make peace and extinguish hatred; it was also used for compensating an offense.
The central authority and its relationship to payment in society
Being able to define unit of account and means of payment enables the authority to regulate debt-credit relations within the community over which it presides.
The social convention that underlies money, always and everywhere, depends on a balance between the State and Society (including the society of merchants, i.e. the Market).
Store of value
Some of the features that characterise money as a medium of exchange also characterise it as a store of value - i.e. Store of General Purchasing power over time (Money = Frozen desires).
Whereas the unit of account and means of payment money has no rivals, as a store of value it competes with financial assets (e.g. bonds, equity, investment, fund shares) and real assets (gold ingots, jewels artwork, real estate).
Liquidity
The state of being liquid
The quality of being readily convertible into case: an investment with high liquidity
Available cash or the capacity to obtain it on demand: a bank that is increasing its liquidity by shortening the average term of its loans.
The term also means how easy it is to perform a transaction in a particular security or instrument.
Other functions of money
Money as a weapon(against other countries)
Money as a symbol of national sovereignty
Money as an instrument of propaganda
Money, power and politics!
Commodity money
Commodity money “is composed of actual units of a particular freely-obtainable, non-monopolised commodity (or of warehouse certificates for actually existing units of the commodity) which happens to have been chosen for the familiar purposes of money, but the supply of which is governed – like that of any other commodity – by scarcity and cost of production.” (Keynes 1930, p. 7)
Orthodox view of commodity money
•Commodity money consists of items that may be in common everyday use, endowed with intrinsic (use) value and used primarily as medium of exchange in the context of rural subsistence economies.
Minting
Used by the government as a guarantee against forgery and counterfeiting, but not necessarily against debasement engineered by the government itself (exploitation of seignorage).
Seignorage
Profit made by a government by issuing currency, especially the difference between the face value of coins and their production costs.
History of coins
Earliest coins 7th century b.c., made of electron and used to pay soldiers
Greek coins (Silver drachma) and Roman coins (Juno Moneta) stable for the first 150 years of the Empire (especially the gold coins) then debasement begins
Early Middle Ages the market almost vanishes and coins with it. Charlemagne’s monetary reform and the reintroduction of standardised silver pennies with limited circulation (livres and sous where mere unit of account).
Feudal economies were largely autarkic and therefore did not need money.
Old vs New coins
Intrinsic value in old coins and modern coins have a number face value
Same shape
They have symbols
Copper, silver and gold colour/look.
Fiat currency
“Fiat currency is a representative (or token) Money (i.e. something the intrinsic value of the material substance of which is divorced from its monetary face vale) – now generally made of paper except in the case of small denominations – which is created and issued by the State, but is not convertible by law into anything other than itself, and has no fixed value in terms of an objective standard” (Keynes 1930, p. 7).
Managed money
Managed money is similar to Fiat Money, except that the State undertakes to manage the conditions of its issue in such a way that, by convertibility or otherwise, it shall have a determinate value in terms of an objective standard.
Relation between commodity and managed money
Commodity Money and Managed Money are alike in that they are related to an objective standard of value.
Relation between managed money and fiat money
Managed Money and Fiat Money are alike in that they are representative or paper money, having relatively little or no intrinsic value apart from the law or practice of the state.” (Keynes 1930, p.8)
History of managed money
- 1717 Isaac Newton (Master of the English mint) unintentionally overvalued gold, pushing silver out of circulation and putting England on a gold standard (formalized in 1816)
- XIX century the age of metallic standards: gold, silver, bi-metallic
- 1880-1914 Heyday of the international gold standard
- 1914-1944 attempts to reestablish the Gold Standard, Gold Exchange standard, suspension of convertibility and monetary disorder
- 1944 – 1971 The Bretton woods regime
- 1971 End of dollar convertibility into gold
Bank money
Co-exists with state money
Belonged to the state
Banks that create money - one special bank but private banks also produce.
The Bank of England (oldest central bank in the world) used to be private and used to pay dividends to its shareholders and it was publicized by the labour party in the year 1946.
Base money
Base money = Currency + Bank reserves (state money).
Bank deposits
- Bank Deposits = Current Accounts + TS Deposits
- Current account deposits a.k.a. Sight deposits, Demand deposits
- Held by the public and companies to settle all types of payments
- Time / saving deposits (Less liquid that CAD)
- Held as a saving instrument
Money supply
- Money Supply = Currency + Bank Deposits
* Part of the money supply comes directly from the State (via the central bank), part comes from the banking system
Monetary aggregates
Empirical counterparts of Money supply
Quantitative definition of Money
Narrow money (M1)
Includes currency, i.e. banknotes and coins, as well as balances which can immediately be converted into currency or used for cashless payments, i.e. overnight deposits.
Intermediate money (M2)
comprises narrow money (M1) and, in addition, deposits with a maturity of up to two years and deposits redeemable at a period of notice of up to three months. Depending on their degree of moneyness, such deposits can be converted into components of narrow money, but in some cases there may be restrictions involved, such as the need for advance notification, delays, penalties or fees. The definition of M2 reflects the particular interest in analysing and monitoring a monetary aggregate that, in addition to currency, consists of deposits which are liquid.
Broad Money (M3)
Comprises M2 and marketable instruments issued by the MFI sector (e.g Money Market Fund shares/units). As a result of their inclusion, M3 is less affected by substitution between various liquid asset categories than narrower definitions of money, and is therefore more stable.
Monetary aggregates
The ECB calculates the growth rates of monetary aggregates and of the components and the counterparts to monetary aggregates on the basis of adjusted flows rather than the simple comparison of end-of-period levels.
Stock data
refer to the last day of the period (month or quarter), which can either be the last working day or the last calendar day, depending on national practice.
Growth rate for an index
The growth rate over the n months ending in month t is calculated by dividing the index for month t by the index for month t-n.
Base money
Base money = Currency + Bank reserves
Currency
Currency = Coins + Banknotes
Bank reserves
Bank Reserves = Req. Res. + Vol. Reserves
CBDC Central Bank digital currency
CBDC is potentially a new form of digital central bank money that can be distinguished from reserves or settlement balances held by commercial banks at central banks.
Arguments against cash
- Physically handling cash is costly;
- Cash supports shady activities and reduces tax revenues (large denomination banknotes in particular);
- Holding cash is risky (especially if you are hoarding it);
- Cash (both banknotes and coins) is easily forged;
- The cost of producing low value coins sometimes exceed their face value.
Arguments for cash
- Conservatism
- Demographics (old people, people who live at the margins);
- Seignorage (central banks make money by issuing money);
- Privacy (Cash is anonymous);
- Security (Cash works even if electricity is not there).
The currency demand apporoach (CDA).
It is the most popular method to estimate the shadow economy among the so-called indirect macroeconomic approaches.
Measures the size of the shadow economy in two stages:
•1) the econometric estimation of an aggregate money demand equation, with a specific component related to cash transactions in the underground sector;
•2) the computation of the value of these shadow transactions via the quantity theory of money. Quantity Theory of money MV = PY.
CDA Formula
Agg. Cash = a0 +a1(Wcash/GDP) + a2(i dep) + a3(GDP/POP) + a4(TAX)
Where a1 > 0, a2<0, a3>0, a4>0
Demand for cash in shadow economy formula
CASHshadow = a0 + a4(*TAX)
India cash crisis
In an unscheduled televised address on 8 November 2016 Prime Minister Narendra Modi gave the nation just four hours notice that 500 ($7.30; £6) and 1,000 rupee notes would no longer be legal tender.
This was to crack down on corruption and illegal cash holdings aka “black money”.
Some 300 million Indians don’t have gov issued IDs and most use cash as their man form of transaction.
Indian banks had received three trillion rupees ($44.4bn) in cash in the first four days after the ban.
Economic function of credit
Credit enables consumers to reconcile their desired intertemporal spending path with their income path (intertemporal choice):
•Borrowing makes it possible to consume in excess of present income.
•Saving makes it possible to consume in excess of future income.
•Nexus between finance and growth can be studied from a cyclical and/or structural perspective.
Credit for companies
Credit enables companies to bridge the temporal gap between costs and revenues and to accumulate capital.
Credit availability on GDP
Credit availability influences aggregate demand, GDP and employment, often in a procyclical way.
Credit impact on agg supply
•Credit impacts on aggregate supply through its influence on investment, infrastructure and innovation.
Link between money and credit
- Most credit operations entail the transfer of sums of money over time.
- Debts are denominated in terms of money (unit of account).
- Debts are paid using money (legal tender).
- Money is «created» via credit operations.
- Banks create bank money (deposits) by making loans to firms and households
- The central bank creates money (base money) by making loans to banks
Time element in credit
- Time 0 (the beginning): negotiation, contract drafting.
- Time 1 (maturity or the end = fin = finance) the credit matures and paid (recall connection between credit and the means of payment function of money).
Lender and borrower
- Lender (creditor) = L; Borrower (Debtor) = B
- Lender owns something valuable (money, financial assets, goods) that he is willing to part with between Time 0 and Time 1.
- Borrower needs what L owns and is willing to pay a premium (interest + guarantees) in order to have it.
- Once L and B have reached an agreement, B receives the valuables from L and signs a debt contract whereby he assumes the obligation to pay back her/his debt in accordance with mutually agreed terms.
Relationship between lender and borrower
The relationship between L and B as a power relation.
•Asymmetric and complex power relations
•Urgency, alternative sources of credit, market power exerted by L and B.
Elements of a Debt contract
Elements of the contract:
•Identification of lender and borrower
•Description of what is being transferred
•Loan duration (maturity)
•Payback conditions
•Periodic payments – normal case in case of long-term loans; no intermediate payment = zero coupon bond.
•Interest may be forbidden as is the Middle Ages or in the case of Islamic finance)
•Additional clauses (e.g. marketability, guarantees).
Two types of debt contracts
The debt contract can be marketable (e.g. government and corporate bonds) i.e. liquid or non-marketable (e.g. bank loan, consumer credit) i.e. illiquid.
•Primary and secondary debt markets (financial markets)
•Primary markets connect ultimate lenders and borrowers.
•Secondary markets enhance liquidity.
•Non-marketable debt contracts can be turned into marketable securities through securitization.
Features of marketable debt contract
Marketability (Liquidity) mitigates the importance of the personal element and the need for guarantees from B to L.
•Marketability (Liquidity) requires standardization, low carrying costs, wide acceptance …
•Marketability (Liquidity) as an antidote to credit risk (see below). If L looses confidence in B, he can always sell the contract to some one else (possibly at a discount) as long as the debt contract is liquid enough (if at all).
Interest
Interest is the extra that the borrower agrees to pay to lender in return for the possibility of using lender’s resources.
Interest can be zero; it can also be negative!
Maturity and payback
- As the loan reaches maturity, B pays back his debt (principal and interest) to L or to someone else if in the meantime L sold the contract to L’
- Payback requires a unit of account to quantify the debt and a means of payment to be discharged of the obligation (Recall Keynes’s Treatise on Money).
When does payback not occur?
- Renegotiation (extended maturity, interest reduction)
- Debt forgiveness / redemption
- Debt insolvency (Default partial or total)
Credit risk
•Credit risk = Lender’s risk + borrower’s risk
Information asymmetries (market failure)
Because of information asymmetries (market failure), credit markets cannot function as anonymous price-taking markets in the neoclassical sense.
Ways to make it more likely for the borrow to payback the loan.
- Screening (ex ante) / monitoring (ex post)
- Guarantees
- Shorten maturity
- Reduce exposure
- Long-term customer relation
- Credit rationing
Default/Insolvency
Default occurs when repayment is not made on time.
Why do defaults occur?
Default may be due to feasibility constraints, if the debtor has insufficient resources to meet the terms of the contract (even if enforcement is perfect), or incentive constraints, if the creditor cannot adequately enforce the contract (limited liability plus costly state verification).
Functions of credit institutions
- Risk consolidation or transformation (law of large numbers)
- Delegated monitoring and provision of liquidity services.
Intrest rate in nominal terms
- L lends X to B at time 0
- B pays back X* to L at time 1, one year later
- X* / X = (1+i) = gross interest rate in nominal terms
- ( i ) = Net interest rate in nominal terms
- Ex. X = 100€, X* = 105€, (1+i) = 105/100 = 1,05
- i = 0,05 = 5%
This measures the Time Value of Money i.e. the value of money today (T0) measured in terms of money tomorrow (T1).
The discount rate
- Similarly, the discount rate in nominal terms 1/(1+i) indicates the of money «tomorrow» in terms of money «today».
- In the example above, the discount rate is 1/(1+i) = 1/(1,05)=0,95. This means that one euro available in one year’s time is equivalent to 95 euro cents today.
Fall in nominal terms
If the rate of interest in nominal terms falls, the discount rate rises and the value of money available «tomorrow» increases relative to the value of money available «today».
Rise in nominal terms
If the rate of interest in nominal terms rises, the discount rate falls and the value of money «tomorrow» decreases relative to the value of money «today».
Determinants of the rate of interest in nominal terms
•Let us adopt L’s point of view …
•
•i = rEXP + πEXP + Risk + Liq
•rEXP = Expected return on the loan at constant prices net of all risks (pure remuneration for waiting)
•πEXP = Expected inflation risk premium as inflation erodes the purchasing power of money over time
•Risk = Credit risk premium depends on the borrower’s identity, on the presence of collateral and guarantees, on time to maturity, on cyclical conditions.
•Liq = Liquidity premium depends on the marketability of the debt contract, on the size of the market, on the distance between 0 and 1. Liquidity premium increases as liquidity of the credit contract declines.
The risk structure of interest rates
- Default risk, liquidity premiums and different tax treatment are the main determinants of domestic rate interest rate differentials.
- Changes in credit risk affect demand and supply of underlying assets (credit contracts) in opposite directions and interact with liquidity risk.
Price levels
- P1 > P0 → inflation, (1/P) decreases over time
- P1 < P0 → deflation, (1/P) increases over time
- P1 = P0 → stability, (1/P) remains constant over time
Gross interest rate in real terms
(1+r)=(1+i)/(1+π)
•Ex. i = 0,05 (5%), π = 0,02 (2%), (1+r) = 1,05/1,02 = 1,0294
Net real interest rate
r = i – π /(1+π)
Higher inflation
•Higher than expected inflation is bad for creditors and good for debtors (including the State)
Lower inflation
•Lower than expected inflation is good for creditors and bad for debtors (including the State).
Coupon bonds
- Coupon bonds (government bonds, corporate bonds):
- Bond with maturity N (ex. N = 10 years), Face Value (ex. FV = 1.000€) and fixed coupon rate (ic = 5% annual)
- B issues the bond at par and L underwrites it
- At time 0, L pays 1.000 € to B
- At time 1, B pays 50€ to L (Coupon = FV*ic)
- At time 2, B pays 50€ to L (Coupon = FV*ic)
- …
- At time N, B pays 1050€ to L (FV + FV*ic)
Bonds and par value
- Bonds may be issued at par, below par, above par
- If bond is issued below par, L pays less than FV and receives and extra return
- If bond is issued above par, L pays more than FV and receives.
Perpetual bonds
- PBOND = C / i (check !)
- PBOND = C1 / (1+i) + C2 / (1+i)2 + … (Cn + FV) / (1+i)n
- Both the instantaneous return and the yield to maturity vary inversely with PBOND (for a given cash flow).
Zero coupon bonds
- L lends IV (issuance value) to B at time 0 (IV < FV)
- B pays back FV (face value) at time 1
- FV / IV = (1+i) zero coupon nominal rate.
Instantaneous return
•Instantaneous return of the bond I (inst) = C / PBOND
Yield to maturity
•Yield to maturity is the nominal interest rate that equates the present value of the future payments that bondholders are entitled to receive to the market price of the PBOND
Period bond return
If an investor buys the bond at time t on the secondary market (paying PBOND,t) and sells it at time t + 1 (receiveing PBOND,t+1) and receives 1 coupon the Effective return on her investment will be
- R = (C/PBOND,t) + (PBOND,t+1 – PBOND, t )/ (PBOND,t)
- where (PBOND,t+1 – PBOND, t )/ (PBOND,t) = g
- g > 0 (capital gain)
- g < 0 (capital loss)
•Capital loss can be so large as to lead to R < 0 (Negative return).
Effect of interest rate on bonds
- Typically, a rise in interest rate is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than the holding period.
- The more distant a bond’s maturity, the greater the size of the percentage price change associated with a given interest rate change.
Duration of a bond
•Duration is a way of measuring the sensitivity of bond prices to changes in interest rates (Market risk)
- PBOND = C1 / (1+i) + C2 / (1+i)2 + … (Cn + FV) / (1+i)n
- Calculate (dPBOND/ di)(1+i/ PBOND)
- Elasticity of PBOND to changes in I = Duration
Different FED securities
- Treasury bill (maturity 3 months)
- Treasury note (maturity 5 years)
- Treasury bond (maturity 10 years)
- Each security has its advantages and disadvantages both for the government and for investors. Each of them has its own FV, IV and annualised «coupon rate»
- ibill = Short-term interest rate
- inote = Medium-term interest rate
- ibond = Long-term interest rate
Term structure
•Term structure considers the three interest rates together and the relationship between them [ibill, inote , ibond]
The yield curve
- The yield curve: A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
- The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates.
- The curve is also used to predict changes in economic output and growth and in the monetary policy stance.
The Pure expectation theory
Long-term interest rates reflect market expectations about short-term interest rates in the future.
Underlying assumption theory
Risk-neutral agents will choose either bills or bonds, perfect capital markets, rational expectations, perfect substitutability between long-term security (bonds) and short-term securities (bills).
Segmented market theory
This theory sees markets for different-maturity bonds as completely seperate and segemented.
- Bonds of different maturities are not subsitutes at all which is opposite of pure expectation theory.
- Can explain why yield curves usually tend to slope upward.
- Cannot explain why interest rates on bonds of different maturities tend to move together.
- Cannot explain why yield curves tend to slope upwards when short-term interest rates are low.
Negative interest rates
•Negative interest rates in real terms occur when inflation exceeds the rate of interest in real terms
r = i – π so if i < π then r < 0.
•Negative interest rates in real terms often occurr in connection with financial repression (e.g. Italy in the 1970s).
Financial repression
When the government imposes specific portfolio restrictions and regulations on investors and banks.
Example of financial repressions
- Caps or ceilings ceilings on interest rates, Government ownership or control of domestic banks and financial institutions
- Creation or maintenance of a captive domestic market for government debt
- Restrictions on entry to the financial industry
- Directing credit to certain industries.
Negative interest rate lending
It may be preferable to lend money to another bank or a government rather than pay to keep it at the central bank.
In addition some types of investment funds essentially have to buy government debt, so there is a certain amount of what has been called passive investment going on, despite the poor returns.
