Money and Banking

Question 1

Orthodox view of money

Answer 1

Money as an «object» that circulates in the “Market” with the purpose of reducing transaction costs to the advantage of traders and the State.

Question 2

Heterodox view of money

Answer 2

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).

Question 3

The three types of transaction costs

Answer 3

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).

Question 4

Features of a market economy

Answer 4

Well defined property rights, division and commodification of labour, private companies, decentralized exchange and free transfer of resources.

Question 5

The three ways of exchange

Answer 5

• 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).

Question 6

Search models

Answer 6

Models that look under what conditions the third type of mechanism prevails over the other.

Question 7

Cartalists

Answer 7

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.

Question 8

Taxes

Answer 8

A payable form of money that the state issues.

Question 9

HICP

Answer 9

Harmonised indices of consumer prices that are comparable measures of changes in consumer prices.

Question 10

Unit of account

Answer 10

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.

Question 11

Old meaning of payment

Answer 11

Used to make peace and extinguish hatred; it was also used for compensating an offense.

Question 12

The central authority and its relationship to payment in society

Answer 12

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).

Question 13

Store of value

Answer 13

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).

Question 14

Liquidity

Answer 14

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.

Question 15

Other functions of money

Answer 15

Money as a weapon(against other countries)
Money as a symbol of national sovereignty
Money as an instrument of propaganda
Money, power and politics!

Question 16

Commodity money

Answer 16

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)

Question 17

Orthodox view of commodity money

Answer 17

•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.

Question 18

Minting

Answer 18

Used by the government as a guarantee against forgery and counterfeiting, but not necessarily against debasement engineered by the government itself (exploitation of seignorage).

Question 19

Seignorage

Answer 19

Profit made by a government by issuing currency, especially the difference between the face value of coins and their production costs.

Question 20

History of coins

Answer 20

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.

Question 21

Old vs New coins

Answer 21

Intrinsic value in old coins and modern coins have a number face value
Same shape
They have symbols
Copper, silver and gold colour/look.

Question 22

Fiat currency

Answer 22

“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).

Question 23

Managed money

Answer 23

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.

Question 24

Relation between commodity and managed money

Answer 24

Commodity Money and Managed Money are alike in that they are related to an objective standard of value.

Question 25

Relation between managed money and fiat money

Answer 25

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)

Question 26

History of managed money

Answer 26

• 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

Question 27

Bank money

Answer 27

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.

Question 28

Base money

Answer 28

Base money = Currency + Bank reserves (state money).

Question 29

Bank deposits

Answer 29

• 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

Question 30

Money supply

Answer 30

• 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

Question 31

Monetary aggregates

Answer 31

Empirical counterparts of Money supply

Quantitative definition of Money

Question 32

Narrow money (M1)

Answer 32

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.

Question 33

Intermediate money (M2)

Answer 33

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.

Question 34

Broad Money (M3)

Answer 34

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.

Question 35

Monetary aggregates

Answer 35

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.

Question 36

Stock data

Answer 36

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.

Question 37

Growth rate for an index

Answer 37

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.

Question 38

Base money

Answer 38

Base money = Currency + Bank reserves

Question 39

Currency

Answer 39

Currency = Coins + Banknotes

Question 40

Bank reserves

Answer 40

Bank Reserves = Req. Res. + Vol. Reserves

Question 41

CBDC Central Bank digital currency

Answer 41

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.

Question 42

Arguments against cash

Answer 42

• 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.

Question 43

Arguments for cash

Answer 43

• 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).

Question 44

The currency demand apporoach (CDA).

Answer 44

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.

Question 45

CDA Formula

Answer 45

Agg. Cash = a0 +a1(Wcash/GDP) + a2(i dep) + a3(GDP/POP) + a4(TAX)

Where a1 > 0, a2<0, a3>0, a4>0

Question 46

Demand for cash in shadow economy formula

Answer 46

CASHshadow = a0 + a4(*TAX)

Question 47

India cash crisis

Answer 47

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.

Question 48

Economic function of credit

Answer 48

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.

Question 49

Credit for companies

Answer 49

Credit enables companies to bridge the temporal gap between costs and revenues and to accumulate capital.

Question 50

Credit availability on GDP

Answer 50

Credit availability influences aggregate demand, GDP and employment, often in a procyclical way.

Question 51

Credit impact on agg supply

Answer 51

•Credit impacts on aggregate supply through its influence on investment, infrastructure and innovation.

Question 52

Link between money and credit

Answer 52

• 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

Question 53

Time element in credit

Answer 53

• 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).

Question 54

Lender and borrower

Answer 54

• 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.

Question 55

Relationship between lender and borrower

Answer 55

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.

Question 56

Elements of a Debt contract

Answer 56

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).

Question 57

Two types of debt contracts

Answer 57

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.

Question 58

Features of marketable debt contract

Answer 58

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).

Question 59

Interest

Answer 59

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!

Question 60

Maturity and payback

Answer 60

• 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).

Question 61

When does payback not occur?

Answer 61

• Renegotiation (extended maturity, interest reduction)
• Debt forgiveness / redemption
• Debt insolvency (Default partial or total)

Question 62

Credit risk

Answer 62

•Credit risk = Lender’s risk + borrower’s risk

Question 63

Information asymmetries (market failure)

Answer 63

Because of information asymmetries (market failure), credit markets cannot function as anonymous price-taking markets in the neoclassical sense.

Question 64

Ways to make it more likely for the borrow to payback the loan.

Answer 64

• Screening (ex ante) / monitoring (ex post)
• Guarantees
• Shorten maturity
• Reduce exposure
• Long-term customer relation
• Credit rationing

Question 65

Default/Insolvency

Answer 65

Default occurs when repayment is not made on time.

Question 66

Why do defaults occur?

Answer 66

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).

Question 67

Functions of credit institutions

Answer 67

• Risk consolidation or transformation (law of large numbers)
• Delegated monitoring and provision of liquidity services.

Question 68

Intrest rate in nominal terms

Answer 68

• 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).

Question 69

The discount rate

Answer 69

• 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.

Question 70

Fall in nominal terms

Answer 70

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».

Question 71

Rise in nominal terms

Answer 71

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».

Question 72

Determinants of the rate of interest in nominal terms

Answer 72

•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.

Question 73

The risk structure of interest rates

Answer 73

• 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.

Question 74

Price levels

Answer 74

• 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

Question 75

Gross interest rate in real terms

Answer 75

(1+r)=(1+i)/(1+π)

•Ex. i = 0,05 (5%), π = 0,02 (2%), (1+r) = 1,05/1,02 = 1,0294

Question 76

Net real interest rate

Answer 76

r = i – π /(1+π)

Question 77

Higher inflation

Answer 77

•Higher than expected inflation is bad for creditors and good for debtors (including the State)

Question 78

Lower inflation

Answer 78

•Lower than expected inflation is good for creditors and bad for debtors (including the State).

Question 79

Coupon bonds

Answer 79

• 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)

Question 80

Bonds and par value

Answer 80

• 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.

Question 81

Perpetual bonds

Answer 81

• 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).

Question 82

Zero coupon bonds

Answer 82

• 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.

Question 83

Instantaneous return

Answer 83

•Instantaneous return of the bond I (inst) = C / PBOND

Question 84

Yield to maturity

Answer 84

•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

Question 85

Period bond return

Answer 85

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).

Question 86

Effect of interest rate on bonds

Answer 86

• 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.

Question 87

Duration of a bond

Answer 87

•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

Question 88

Different FED securities

Answer 88

• 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

Question 89

Term structure

Answer 89

•Term structure considers the three interest rates together and the relationship between them [ibill, inote , ibond]

Question 90

The yield curve

Answer 90

• 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.

Question 91

The Pure expectation theory

Answer 91

Long-term interest rates reflect market expectations about short-term interest rates in the future.

Question 92

Underlying assumption theory

Answer 92

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).

Question 93

Segmented market theory

Answer 93

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.

Question 94

Negative interest rates

Answer 94

•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).

Question 95

Financial repression

Answer 95

When the government imposes specific portfolio restrictions and regulations on investors and banks.

Question 96

Example of financial repressions

Answer 96

• 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.

Question 97

Negative interest rate lending

Answer 97

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.