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Money
Itwouldbealmostimpossibleforanindividualtosupplyofhisown
needs,i.e.beselfsufficient.Exchangeandtradeisanimportantconcept
ineconomics.PeoplespecialisebyprovidingafactorofproducAonin
returnforpayment(income).Thispaymentisalmostalwaysmoney.They
canthenswapthismoneyinreturnforthegoodsandservicesthatthey
require.Theexistanceofmoneyiscrucialtoallowforworkersto
specialiseinproducingwhattheyaregoodatandthenexchangemoney
thattheygetfromtheirworkinreturnforotherthingsthattheywishto
have.Remember,specialisaAonmakesworkersmoreproducAve,i.e.it
allowsworkerstoproducemore.ItisthequanAtyofgoodsandservices
producedthatdefinesthewealthofanaAon.Theexistanceofmoney
allowsforworkerstospecialisewhich,intheory,makessocietyricher.
Money,intheshortrunatleast,caneffectthelevelofproducAonandas
suchthelevelofoutputintheeconomy.Therefore,iftheamountof
moneyavailableinaneconomycancausemoretobeproduced,itcan
alsoeffectthestandardoflivinginacountry.Moneycaneffectmany
thingsofMacroeconomicinterest.E.g.
1) ProducAonandGrowth
2) InterestRates
3) InflaAon
4) ExchangeRates
Wewillseelaterinthischapterandlaterones,howmoneyeffectsthese
variables,butbeforethatwewilllookatwhatmoneyis.
Money:isanythingthatisgenerallyacceptedbythemajorityofpeople
inexchangeforgoodsandservices
TheFunc,onsofMoney
1) MediumofExchange:Moneyallowspeopletobuygoodsandservices
orallowsexchangebetweenbuyersandsellers.Alsomoneyallowsthe
buyingandsellingofgoodsandservicestobebrokenintotwodisAnct
acAviAes.Thismeansthatnobarterisrequired.
2) MeasureofValue:Moneyenablesapricetobeputongoods&
services.
3) StoreofWealth:Moneyallowspeopletosaveforthefutureinorder
tomakepurchasesinthefuture.
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4) StandardforDeferredPayment:Moneyiscapableofmeasuringvalue
forafuturedate.Moneymakescredittrading(i.e.buying&selling)
possible.
TheCharacteris,csofGoodMoney
1) Recognisable:Moneyshouldbeeasilyrecognisableasgenuineandbe
difficulttocounterfeit.Ifsomepeoplehavedoubtsaboutthe
authenAcityoftheitembeingusedasmoney,theywillnotacceptit.
Onceitisnotgenerallyaccepted,itisnolongermoney.
2) Portable:Whateverisbeingusedasmoneymusteasilybecarriedin
largequanAAes.
3) Durable:Euronotesandcoinscansurvivewearandtear.E.g.being
washedinthewashingmachine.ThisisapracAcalaspectofmodern
moneyinordertocutdownonthecostofreplacingit.
4) Divisible:Aeurocoincanbebrokendowninto50c,20c,10c,5c,2c1c
pieces.Thisistofacilitategivingchange.
5) Scarce:MoneymustbescarceinrelaAontothedemandforit.Thisis
toensurethatmoneymaintainsitsvalue.Anincreaseinthemoney
supplycausesinflaAonwhichisareducAoninthevalueofmoney.
Barter
Beforemoneywasinvented,peopleexchangedthegoodsandservices
thattheyhadforgoodsandservicesthattheywanted.Thissystemof
exchanginggoodsandserviceswithouttheuseofmoneyisknownas
barter.
Barter:Thedirecttradeofgoodsorservicesforothergoodsorservices
E.g.Swappingabo[leofwaterforapacketofAc-tacs.
DisadvantagesofBarter
1) DoubleCoincidenceofWants:ThepersonwhowantstheAc-tacs
mustfindanotherpersonwhonotonlyhasAc-tacsforexchangebut
alsowantsabo[leofwater.
2) TheProblemofDivisibility:Letssaythatafarmerhasacowtotrade
andhewantssometoothpaste.HefindsadenAstthatwantsthecow
whoiswillingtoswaptoothpasteforit.Howdotheybothdecidehow
muchbeefatubeoftoothpasteisworth.Whatdoesthefarmerdo?
KillthecowandgivetheagreedamounttothedenAst?Ifyes,thenhe
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quicklyhastofindpeoplelookingforbeefthathavethingsthathe
wantsbeforethebeefrots.
3) Specialisa,onisDiscouraged:Asaresultoftheaboveissues,people
a[empttosupplyalloftheirownneedsinordertoavoidbarter.The
benefitsofspecialisaAonarethenlosttotheeconomy.
ABriefHistoryofMoney
Originally,coinswerecutoutofgoldandotherpreciousmetalswhich
hadintrinsicvalue.Thismeansthatthevalueofthecoinwasequaltothe
amountofgoldusedtomakethatcoin.
Moneythathasintrinsicvalueiscalledcommoditymoney.
CommodityMoney:ismoneythatismadefrommaterialswiththeir
ownvalue.
CounterfeiterssoongotwisetothepracAceofclipping(clippingsmall
amountsofmetalfromaroundthesidesofthecoin)andsweaAng
(puangcoinsintoaheavybagandshakingthemtoknocksmallparAcles
ofmetaloffthecoinsandcollecAngthemattheend).
Thisleadtotheexistenceofgoodmoney(moneywiththecorrectof
preciousmetalinthem)andbadmoney(coinsthatwereclippedor
sweated)
ThisledtoGreshamsLawwhichstatesthatbadmoneydrivesgood
moneyoutofcirculaAon.
Eventually,standardcoinscontainingnopreciousmetalswereintroduced
whichwereacceptedpurelyfortheirexchangevalueliketheonestoday.
Thesecoinswereanexampleoftokenmoney.
TokenMoney:ismoneythatitsfacevalue(exchangevalue)isgreater
thanitsintrinsicvalue.
E.g.TheEuro
Themodernbankingsystemaswenowknowitstartedinthe17thand
18thcenturywhenrichmembersofBriAshsocietywhohadaccumulated
largeamountsofgoldandotherpreciousmetals,placedtheminthe
vaultsofgoldsmiths,whowouldinturnwritethemareceipt.
Ifthedepositor(thepersonwhoputthegoldinthegoldsmith’svault)
neededtopayadebt,hewouldbringthereceiptbacktothegoldsmith,
getsomeorallofhisgoldandusethesenewlymadegoldcoinstopayhis
debtors.
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Gradually,peoplerealisedthattheycouldgivethegoldsmith’sreceiptas
paymentofadebtinsteadofofconstantlygoingtothegoldsmith.
Goldsmithsmadethisjobeasierbyissuingmorereceiptswithsmaller
value.E.g.100£1receiptsinreturnfor£100ofgold.
Asthegoldsmithsweretrusted,theirreceiptsweregraduallypassed
fromonepersontoanotherandveryfewwereactuallypresentedfor
paymentofgold.Thesereceiptswerethebeginningofourmodernbank
notesandwerefullyredeemableforgold.Thiswasthebeginningofwhat
iscalledthegoldstandard.
TheGoldStandard:iswhenallnotesandcoinsofacurrencyarefully
redeemableforgold.
ThispracAceofacountry’scurrencybeingfullyredeemableforgold
conAnuedintothe20thcentury.
TheUnitedStatescamecompletelyoffthegoldstandardin1971under
PresidentRichardNixon.Eventhoughthesepiecesofpaperwere
intrinsicallyworthlessandnownotredeemableforgold,peopleweresAll
preparedtoacceptthesedollarsinreturnforgoodsandservicesasthey
werelegaltender.
LegalTender:ismoneythatmustbeacceptedifofferedaspaymentfor
purchaseofgoodsandservicesorinse[lementofadebt.
Goldsmithssoonrealisedthatfewofthereceiptsthattheyissuedwere
everactuallyredeemedforgold.Oncetheyrealisedthis,goldsmiths
begantoissuereceiptsfarinexcessofthevalueofgoldthattheyhadin
theirvaults.OncetheydidthistheystartedacAnglikemodernbanks.
ThisbeganthemodernsystemofcreditcreaAonwhichwewilllookat
later.
SomeGoldsmithsgotgreedyandissuedtoomanyreceiptsinexcessof
thegoldthattheyhadintheirvaults.Theydidnothaveenoughgoldto
saAsfytheamountofpeoplethatwereredeemingtheirreceiptsforgold.
Oncewordspreadthatthegoldsmithwasrunningoutofgold,peopleran
tothegoldsmithtotrytotakeoutthegoldtheyhadplacedinthevaults
beforethegoldsmithhadgivenallthegoldawayinordertotrytosaAsfy
itscustomers.Thisbroughtaboutabankrun
ABankRun:iswheredepositorsbelievethattheirbankisgoingtogo
bankruptandtherefore“run”tothebanktowithdrawtheirdeposits
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TheEconomicEffectsoftheEuroonIreland
TheEurocameintophysicalexistenceon1stofJanuary2002.Ithashada
massiveeffectonIrelandandwewillnowtakealookatthedifferent
secAonsoftheIrishsocietythathasbeeneffected.
TheEffectoftheEuroonIrishConsumers
1) ForeignTravel:Noforeignexchangecosts/noconversioncharges
applytothosetravellingwithineurozonecountries.
2) Infla,on:TheintroducAonoftheeuroledtoinflaAonwithinthis
countryintheimmediateamermathofitsintroducAon.
3) PriceComparisons:Cannowbemadewithinalleurozonecountries,
allowingforgreatertransparency.
4) GreaterChoiceofFinancialProducts:Irishconsumerscannow
choosewheretosave,borrow,investandseekinsurancethereby
facilitaAngincreasedcompeAAon.
5) GreaterAwareness/Compe,,on:Theeurohasresultedingreater
awarenessasregardspricesandIrishconsumerscannowseekbe[er
valuefortheireuro.
6) PrudentManagementoftheEconomy:Membershipoftheeuro
constrainsthegovernmentinrelaAontoeconomicpolicyandensures
prudentmanagementoccurs.
7) LowInterestRates:ThelowerinterestratessincetheintroducAonof
theeurohavebenefitedconsumers,resulAnginincreasedborrowings.
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TheEffectoftheEuroonIrishExportersandImporters
1) ExchangeRiskEliminated:NodevaluaAonorrevaluaAonhastaken
placeresulAnginincreasedcertaintyininternaAonaltrade.
2) EasierPaymentforTrading:Asnoconversionchargesapplytotrade
withintheeurozonethisfacilitatesspeedierpayment.
3) LowerInterestRates:Oneofthemajorbenefitsoftheeurohasbeen
accesstolowercompeAAveinterestratesforfirms.
4) CostofImportedRawMaterials/CapitalGoods:Theseshouldnow
bemorecompeAAveduetoopencompeAAon,theabsenceof
currencyfluctuaAonsandmoretransparencyininternaAonalpricing.
5) PressureforDomes,cCompe,,veness:Employeesarebecoming
increasinglyawarethatsuccessasaneconomydependsonbeing
compeAAveandthishasensuredmoderaAoninwageincreases.
6) IncreasedTradeOpportuni,es:AccesstoEUmarketsiseasierand
leadstogreateropportuniAes.
7) Fluctua,ngValueoftheEuro:CompanieswhosemainmarketisUK/
US,havebeenaffectedbythefluctuaAngvalueoftheeuroresulAngin
alossofcompeAAveness.
Aswassaidabove,theeuroislegaltenderinIreland.However,thereare
manyotheritemsthatcanbeusedasmoneyeventhoughtheyarenot
money.Cheques,creditcardsetc.Theseitemsareknownasnearmoney.
NearMoney:isthetermusedtodescribethoseassetswhichfulfill
somebutnotallofthefuncAonsofmoney.
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MeasuringtheMoneySupply
MeasuringthemoneysupplycanstartoffasquiteasimplequesAon.
HowmuchmoneyisthereinaneconomyatagivenAme?Butwhatdo
weincludeasmoney?Obviouslythenotesandcoinsinyourpocket
wouldbeincludedandacarwouldnot.Buthavinglookedattheideaof
nearmoney,thereareplentyofthingsthatmightbeincludedandhow
doweknowwhetherweshouldincludethemornot.
Inordertogetaroundthisissueofdecidingwhatshouldbeincludedand
whatshouldnotbeincludedinthemoneysupply,economistsusethree
differentmeasuresofthemoneysupply.
1) M1:TheNarrowMoneySupply
2) M2:TheIntermediateMoneySupply
3) M3:TheBroadMoneySupply
Measure of Money Supply
NarrowMoneySupply(M1)
Contents
Includescurrencyandovernight
deposits
IncludeseverythinginM1+
• Depositswithanagreed
IntermediateMoneySupply(M2)
maturityofupto2years
• DepositsredeemableatnoAce
upto3months
IncludeseverythinginM2+
• RepurchaseAgreements
BroadMoneySupply(M3)
• DebtsecuriAesupto2years
• Moneymarketfund(MMF)
shares/units
NarrowMoneySupply(M1):includescurrency,i.e.banknotesand
coins,aswellasbalanceswhichcanimmediatelybeconvertedinto
currencyorusedforcashlesspayments,i.e.overnightdeposits.
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OvernightDepositsareamountsofmoneythatarelentforaday.
Theovernightrateisgenerallytheratethatlargebanksusetoborrow
andlendfromoneanotherontheovernightmarket.
Theovernightmarketisthecomponentofthemoneymarketinvolving
theshortesttermloan.Lendersagreetolendborrowersfundsonly
"overnight"i.e.theborrowermustrepaytheborrowedfundsplus
interestatthestartofbusinessthenextday.Giventheshortperiodof
theloan,theinterestratechargedintheovernightmarket,knownasthe
overnightrateis,generallyspeaking,thelowestrateatwhichbankslend
money.
TheIntermediateMoneySupply(M2):comprisesthenarrowmoney
supply(M1)and,inaddiAon,depositswithamaturityofuptotwo
yearsanddepositsredeemableataperiodofnoAceofuptothree
months.
DepositswithanAgreedMaturityofupto2Years:aremoneythat
peoplearesavinginafinancialinsAtuAon,thattheycan’twithdrawtheir
moneyfrom,unAl2yearshavepassed.
DepositsRedeemableatNo,ceupto3Months:aremoneythatpeople
haveinafinancialinsAtuAon,thattheyhavetogivethreemonthsnoAce
beforetheycantaketheirmoneyout.
TheBroadMoneySupply(M3):comprisestheintermediatemoney
supply(M2)and,inaddiAon,repurchaseagreements,moneymarket
fundshares/unitsanddebtsecuriAes
SecuriAesaresimplyamethodoffinance.Financemeansgeangmoney
forthefirm.TherearethreedifferenttypesofsecuriAes
1)DebtSecuriAes:Thisisexactlythesameasaloan.Theborrower“sells
debtsecuriAes”tothelender.Thisjustmeanstheygetaloanofmoney
thattheyhavetopaybackwithinterestatanagreedfuturedate.
2)EquitySecuriAes:Thisisjustsellingapartofthefirmlikebuyingshares
inafirm.
3)DerivaAveSecuriAes:Thisiswherethefirmgetsthemoneyfor
somethingnowanddeliversthegoodlater.Forwards,futuresopAons
andswaps.
Infinance,aforwardorforwardcontractisacontractbetweentwo
businessestobuyorsellanassetataspecifiedfutureAmeataprice
agreedtoday.E.g.Iwillbuythatspecificcaroffyouintwomonthsfor
€1,000.
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Infinance,aforwardorforwardcontractisacontractbetweentwo
businessestobuyorsellanassetataspecifiedfutureAmeataprice
agreedtoday.E.g.Iwillbuythatspecificcaroffyouintwomonthsfor
€1,000.
Infinance,afuturescontractisacontractbetweentwobusinessesto
exchangeaspecifiedassetofstandardizedquanAtyandqualityforaprice
agreedtoday.Iwillbuy1,000bananasoffyouin6monthsfor€500.
Infinance,anopAonisasomethingthatspecifiesacontractbetween
twoparAesforafuturetransacAononanassetatareferenceprice.The
buyeroftheopAongainstheright,butnottheobligaAon,toengagein
thattransacAon,whilethesellerincursthecorrespondingobligaAonto
fulfillthetransacAon.
ABondisacerAficateofindebtedness.ItisanI.O.U.ItmeansthatIgive
moneytosomeone,theygivemeabondwhichsaysthattheywillpayme
backthemoneyatanagreeddateusuallywithinterest.
AShare,ispartownershipofthecompany.Ifyoubuysharesyoubecome
partownerofacompany.
Swapsiswheretwopeoplebothownafinancialinstrumentlikeabond
orashare,andtheyagreetoswopthebenefitsfromthoseshares.So,if
oneguyownsariskysharethatyieldsgooddividends,hemightbe
willingtoswapthedividendsforthedividendsofanothershare,owned
bysomeoneelse,thatislessriskyandviceversa.
Arepurchaseagreement,alsoknownasarepo,RP,orsaleand
repurchaseagreement,isthesaleofsecuriAestogetherwithan
agreementforthesellertobuybackthesecuriAesatalaterdate.
ToputtheaboveinEnglish,allthathappensinaSaleandRepurchase
Agreementisthatafirmsellssomethingandagreestobuyitbackata
futuredate.
Therepurchasepriceshouldbegreaterthantheoriginalsaleprice,the
differenceeffecAvelyrepresenAnginterest,someAmescalledtherepo
rate.
Amoneymarketfund(alsoknownasmoneymarketmutualfund)isan
open-endedmutualfundthatinvestsinshort-termdebtsecuriAes.
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HowisitPossibleforBankstoCreateCredit
BeforeyoustarttoreadthisexplanaAon,itisveryimportanttorealise
thatthisisjustanexplanaAontohelpyouunderstandhowbankscan
createcreditwhich,ineffect,isthesameasprinAngmoney.Youdonot
needtolearnthisoffinanywayshapeorform,butIwouldadviseyouto
readitatleastoncesothatyoucangainagreaterunderstanding.Howto
answerthisquesAonwhenitcomesupintheexamfollowsthisvery
lengthyexplanaAon.
Rememberthattheamountofmoneyyouhaveincludescurrency(the
notesandcoinsinyourwallet)anddemanddeposits(themoneyyou
haveinyourcurrentaccount).Asdemanddepositsareheldinbanks,the
behaviourofbankscaninfluencethequanAtyofdemanddepositsinthe
economyandtherefore,themoneysupply.
Wewillnowlookathowbankseffectthemoneysupplyandhowthey
complicatetheECB’sroleoftryingtocontrolthemoneysupply.
TheCaseof100%ReserveBanking
Toseehowbanksinfluencethemoneysupply,itisusefultofirstimagine
aworldwithoutanybanksatall.Currencyistheonlyformofmoneyand
thetotalquanAtyofcurrencyintheeconomyis€100.Therefore,the
moneysupplyis€100.
Nowsupposethatsomeoneopensabankcalled“FirstNaAonalBank”.
FirstNaAonalBankisonlyadepositoryinsAtuAon,itacceptsdepositsbut
doesnotmakeloans.Thepurposeofthebankistogivedepositorsasafe
placefortheirmoney.
Wheneverapersondepositssomemoney,thebankkeepsthemoneyin
itsvaultunAlthedepositorcomestowithdrawitorthedepositorwrites
achequeagainsttheirbalance.Depositsthatbankshavereceivedbut
havenotloanedoutarecalledreserves.
Reserves:aredepositsthatthebankhasreceivedbuthasnotloaned
out.
Inthisimaginaryeconomy,alldepositsareheldasreserves,sothis
systemiscalled100%ReserveBanking.
WecanwritethisinformaAoninaT-Accountformatwhichisa
simplifiedaccounAngstatementthatshowschangesinabanksassets
andliabiliAes.HereistheT-AccountforFirstNaAonalBankifthe
economy’senAre€100isdepositedinthebank.
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FirstNaAonalBank
Assets
LiabiliAes
Reserves€100 Deposits€100
OnthelemhandsideoftheT-Accountarethebank’sassetsof€100(the
reservesthatthebankholdsinitsvault).Ontherighthandsidearethe
banksliabiliAesof€100(theamountitowesitsdepositors).NoAcethat
theassetsandliabiliAesofFirstNaAonalBankexactlybalance.
Nowconsiderthemoneysupplyinthisimaginaryeconomy.BeforeFirst
NaAonalBankopened,themoneysupplyisthe€100ofcurrencythatthe
peopleareholding.Amerthebankopensandpeopledeposittheir
currency,themoneysupplyisthe€100ofdemanddeposits.(Thereisno
longeranycurrencyasitisallinthebank).Eachdepositinthebank
reducescurrencyandrisesdemanddepositsbyexactlythesame
amount,leavingthemoneysupplyunchanged.
Therefore,ifbanksholdalltheirdepositsinreserve,banksdonot
influencethemoneysupply.
MoneyCrea,onwithFrac,onalReserveBanking
However,intherealworld,weknowthat100%reservebankingdoesnot
occur.Weknowthatbanksdonotholdalltheirmoneyintheirvaultsbut
lendsomeofthatmoneyoutinloans.Wewillnowreturntoour
imaginaryeconomytoseehowthisoccurs.
Eventually,thebankersatFirstNaAonalBankmaystarttoreconsider
theirpolicyof100%reservebanking.Leavingallthatmoneyintheir
vaultssiangidleseemstobeunnecessary.Whynotusesomeofitto
makeloans.Familiesbuyinghouses,firmsbuildingfactoriesandstudents
tryingtopayforcollegewouldhappytopayali[leinteresttoborrow
someofthismoneyforawhile.Ofcourse,FirstNaAonalBankhastokeep
somemoneyinreserveinordertomakesurethatithasenoughcashto
givetoconsumerswhentheyusetheirATM’sandsoon,butiftheflowof
newdepositsisroughlythesameastheflowofwithdrawls,FirstNaAonal
BankneedsonlytokeepafracAonofitsdepositsinreserve.Fromthis
logic,FirstNaAonalBankadoptsasystemcalledfrac:onalreserve
banking.
Frac,onalReserveBanking:isabankingsysteminwhichbankshold
onlyafracAonofdepositsasreserves
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ThefracAonoftotaldepositsthatthebankholdsinreservesincalledthe
reservedepositra:o.
TheReserveDepositRa,o:thefracAonofdepositsthatbanksholdas
reserves
ThisraAoisdeterminedbyacombinaAonofgovernmentregulaAonand
bankpolicy.Aswewilldiscusslater,theEuropeanCentralBank(ECB)
placesaminimumontheamountofreservesthatabankcanhold.Thisis
calledthereservedepositra:o.
InaddiAon,banksmayholdreservesinexcessofthelegalminimum,
calledexcessreserves,sotheycanbemoreconfidentthattheywon’trun
shortofcash.Forourpurposes,wewilltakethereserveraAoasagiven
andexaminewhatfracAonalreservebankingmeansforthemoney
supply.
LetssupposethatFirstNaAonalBankhasareserveraAoof10%.This
meansthatitkeeps10%ofitsdepositsinreserve,andloansouttherest.
WewillnowtakealookatthenewT-Account.
FirstNaAonalBank
Assets
LiabiliAes
Reserves€10 Deposits€100
Loans€90
FirstNaAonalBanksAllhas€100inliabiliAes,becausemakingloansdid
notaltertheamountofmoneythatthebankowestoitsdepositors.But
nowthebankhas2kindsofassets.
1)Ithasthe€10ofreservesinthevault
2)Ithastheloansof€90.
TheseloansareliabiliAesofthepeopletakingoutthemoneybutthey
areassetsofthebankmakingthem,becausetheborrowerswillrepay
thebanklater.
Intotal,wecanseethatthetotalassetsofFirstNaAonalBankaresAll
equaltotheirliabiliAes.
Onceagain,wetakealookatthemoneysupplyintheeconomy.Before
FirstNaAonalBankmakesanyloans,themoneysupplyis€100of
depositsinthebank.Yet,amerFirstNaAonalBankmakestheseloans,the
moneysupplyincreases.ThedepositorssAllhavedemanddeposits
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totaling€100,butnow,theborrowersholdanother€90incurrency.The
moneysupply,whichequalscurrencyplusdemanddeposits,equals
€190.
Therefore,whenbanksholdonlyafrac:onofdepositsinreserve,banks
createmoney.
Atfirstglance,thiscreaAonofmoneybyfracAonalreservebankingmay
seemtoogoodtobetruebecauseitseemsthatthebankhascreated
moneyoutofthinair.TomakethiscreaAonofmoneyseemless
miraculous,notethatwhenFirstNaAonalBankloansoutsomeofits
reservesandcreatesmoney,itdoesnotcreateanywealth.Loansfrom
FirstNaAonalBankgivetheborrowerssomecurrencyandthustheability
tobuysomegoodsandservices.Yettheborrowersarealsotakingon
debts,sotheloansdonotmakethemanyricher.Inotherwords,asa
bankcreatestheassetofmoney,italsocreatesacorrespondingliability
foritsborrowers.AttheendofthisprocessofmoneycreaAon,the
economyismoreliquidasthereismoremediumofexchange,butthe
economyisnoricherastherehasbeennothingelseproduced.
TheMoneyMul,plier
ThecreaAonofmoney,doesnotstopwiththeFirstnaAonalBank.
SupposetheborrowerfromtheFirstNaAonalBankusesthemoneyto
buysomethingoffsomeonewhothenlodgesthemoneyintheSecond
NaAonalBank.HereistheT-AccountfortheSecondNaAonalBank.
SecondNaAonalBank
Assets
LiabiliAes
Reserves€9 Deposits€90
Loans€81
Amerthedeposit,thebankhasliabiliAesof€90.IftheSecondNaAonal
BankhasareserveraAoof10%,itkeepsassetsof€9inreserveand
makes€81inloans.Inthisway,SecondNaAonalBankcreatesan
addiAonal€81ofmoney(credit).Ifthis€81iseventuallydepositedin
ThirdNaAonalBank,whichalsohasareserveraAoof10%,thisbank
keeps€8.10inreserveandloansout€72.90.HereistheT-Accountfor
ThirdNaAonalBank.
ThirdNaAonalBank
Assets
LiabiliAes
Reserves€8.10 Deposits€81
Loans€72.90
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Thisprocessgoesonandon.EachAmethatmoneyisdepositedanda
bankloanismade,moremoneyiscreated.Howmuchmoneyis
eventuallycreatedintheeconomy?Letsadditup.
OriginalDeposit=€100
FirstNaAonalLending=€90
SecondNaAonalLending=€81
ThirdNaAonalLending=€72.90
TotalMoneyCreated=€1,000
ItturnsoutthateventhoughthisprocessofmoneycreaAoncanconAnue
itdoesnotcreateaninfiniteamountofmoney.IfyouweretoconAnueto
addtheinfinitesequenceofnumbersinthepreviously,youwouldfind
thatreservesof€100generate€1,000ofmoney.Theamountofmoney
thatthebankingsystemgenerateswitheach€1ofreservesisknownas
themoneymul:plier.
TheMoneyMul,plier:istheamountofmoneythatthebankingsystem
generateswitheacheuroofreserves
Inthisimaginaryeconomy,wherewherethe€100ofreservesgenerates
€1,000ofmoney,themoneymulAplieris10.
WhatdeterminesthesizeofthemoneymulAplier?Itturnsoutthatthe
answerissimple.
Themoneymul:plieristhereciprocalofthereservera:o.
IfRisthereserveraAoforallbanksintheeconomyandtheneachdollar
ofreservesgenerates1÷Reurosofmoney.InourexampleRwas10%or
0.1,thereforethemoneymulAplieris
1
R
=
1
0.1
=
10
ThemoneymulAplieris10
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Thisformulashowshowthattheamountofmoneybankscreatedepends
onthereserveraAo.IfthereserveraAowereonly5%(0.05)thenthe
moneymulAplierwouldbe
1
1
0.05
R
=
20
Thatmeansthateacheuroofreserveswouldgenerate€20ofmoney.
Similarly,ifthereserveraAowas20%(0.2),themoneymulAplierwould
be
1
1
=
=
5
0.2
R
AmoneymulAplierof5meansthateach€1ofreserveswouldgenerate
€5ofmoney.
Therefore,thehigherthereservera:o,thelessofeachdepositbanks
loanout,andthesmallerthemoneymul:plier.
Inthespecialcaseof100%reservebanking,thereserveraAois1,and
banksdonotmakeloansorcreateanymoney.
HowisitPossibleforBankstoCreateCredit
1) CommercialBanksacceptcashdepositsfromtheirconsumersforsafe
keeping,e.g.€100.
2) Thesebanksknowfromexperiencethattheircustomerswillonly
demandasmallamountofthesedepositsincash,say10%,because
becauseoftheiruseofcheques,creditordebitcardsasanacceptable
methodofpayment.
3) Sotheynowhaveasurplusofcashtogiveloans,€90.
4) Theamountofaloanthatthebankgiveisrelatedto,butinexcessof
theircashdepositsandisbasedontheirreserveraAo.
Theamountofcreditthatabankcancreateisasfollows
IncreaseinCredit=
IncreaseinCashDeposits
1
X
1
BanksReserveRaAo
JonathanTraynor15
LCEconomicswww.thebusinessguys.ie©
ExplainhowanIncreaseintheUseof“Plas,cMoney”(creditcards,
etc)byCustomersaffectstheAbilityoftheBankstoCreateCredit
1) Bankswillbeabletoincreasetheamountofcredittheycancreate.
2) Therefore,banksnowhavetheuseofanincreasedamountoftheir
=
depositorscashwithwhichtoextendtheamountofcreditcreated.
Or
IfconsumersusemoreplasAcmoney,thebankscannowdecreasetheir
banksreserveraAoandhenceincreasetheamountofcreditcreated.
IncreaseinCredit=
IncreaseinCashDeposits
1
X
1
BanksReserveRaAo
Limita,onsofBanksAbilitytoCreateCredit
1) DesiretoReduceBadDebts:Reducingbaddebtswouldreducethe
banks’abilitytocreatecreditastheywouldbecomemorecauAous
aboutlendingandwouldthereforebeholdingmorecash.Ifbanksare
notissuingloansthismeanslesscreditisbeingcreated.
2) AvailabilityofCreditworthyCustomers:Loanscanonlybegivento
thosepeoplewhoareinaposiAontorepaythem.
3) AvailabilityofCashDeposits:Abankcanonlygiveloansprovidedit
cana[ractcashdepositors.
4) CustomersDemandforCash:Thebankmustkeepsufficientcashto
beabletomeetthedemandsofitscustomersforcash.
5) EuropeanCentralBankGuidelines:Commercialbanksmustnotethe
guidelinesoftheCentralBank.
6) DemandforLoansbyCustomers:Abankislimitedintheamountof
loansitcreatesbythedemandforloans.Inarecessionaryperiod,the
demandforloanswillfall.
JonathanTraynor16
LCEconomicswww.thebusinessguys.ie©
HowdoesaBankReconcileitsTwinObjec,vesofLiquidityand
Profitability(Intro)
Banksareprivateenterprisesandlikeallprivateenterprisestheywishto
makeasmuchmoneyaspossible.Banksmaketheirmoneybymaking
loanstopeopleandgeangtheloanandtheinterestpaidback.Themore
loansthatabankmakes,themoreprofitthattheyearn.
However,banksneedtomakesurethattheyhaveenoughcashtogive
outtotheirdepositorswhentheywantsomeoftheirmoney,e.g.going
totheATM.Themoremoneyabankholdsincash,themoreliquidthe
bankis.
But,themoreliquidabankis,themorecashithasavailabletosaAsfyits
customersneedforcash,thelessmoneythattheycanlendoutandas
such,thelessprofitabletheybecome.
Liquidity:referstotheneedbyabanktohaveliquidassetsinorderto
meetthedemandforcashbyitscustomers.Themoreliquidtheassetis
thelessprofitableitis.
Profitability:referstotheneedforabanktomakeasmuchprofitsas
possiblefromitsassetstosaAsfyitsshareholders.Themoreprofitable
theassetisthelessliquiditis.
HowdoesaBankReconcileitsTwinObjec,vesofLiquidityand
Profitability(Answer)
1) BanksmustsaAsfytheircustomersneedforcashi.e.theymusthave
enoughliquidity,theycoulddothisbyholdingall,theirassetsincash.
2) Butcashdoesn'tearninterestandbanksalsowishtobeprofitable.
3) Bankshavelearnedfromexperiencethatthecompromiseinhaving
sufficientliquidityandyetearningprofitsistoholdtheirassetsalong
thefollowingpor|olio:
• ItwillkeepthemajorityofitsassetsintheformofLoansand
Overdrams.Theseassetsearnprofitsbutarenotveryliquid.
• Itwillrequiresufficientassetsincashandliquidformtomeetthecash
requirementsoftheircustomers.Theseassetsareliquidbutearnli[le
profit.
Seediagramonnextpage.
JonathanTraynor17
x Banks must strike a balance between the twin requirements of profitability and liquidity. As a
result LCEconomicswww.thebusinessguys.ie©
banks structure their holding of assets along the following lines:
Term loans and overdrafts
50%
Earning
Assets
Government stock / gilt edged securities
Exchequer Bills / Bills of Exchange
20%
12%
Money at call
Liquid
Assets
30%
8%
Liquidity Increases
Profitability Increases
70%
Cash Deposits
10%
Theaboveissufficientforananswerbuttheitemsthatfollowarejustto
helpyouunderstandwhateachofthesetermsmean.Youdon’tneedto
x By focusing on profitability (extending credit) at the expense of liquidity a bank may give loans
learnorevenreadanyofthedefiniAonsbelow.
to high risk ventures e.g. commercial property development loans. Property loans are highly
illiquidTermLoan:Aloanfromabankforaspecificamountthathasaspecified
but can be very profitable. A bank may run the risk of increasing bad debts, falling share
prices,repaymentscheduleandafloaAnginterestrate.Termloansalmost
a lack of capital and possible bank failure.
alwaysmaturebetweenoneand10years.
x By ignoring liquidity requirements, banks may not have enough cash to meet the demand of
Forexamplemanybankshaveterm-loanprogramsthatcanoffersmall
their depositors
and this could result in a ‘run’ on the banks and result in bank failure.
businessesthecashtheyneedtooperatefrommonthtomonth.Omena
smallbusinesswillusethecashfromatermloantopurchasefixedassets
25 marks graded
suchasequipmentusedinitsproducAonprocess.
Overdra`:Anoverdramoccurswhenmoneyiswithdrawnfromabank
accountandtheavailablebalancegoesbelowzero.
Thisiswhereadepositortakesmoremoneyoutoftheiraccountthen
theyhadinit.Interestischargedonthisoverdramwhichisusuallyvery
high.Itisaformofabankloan.
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GovernmentStock:Oneofthebondssoldbyagovernmenttofinance
itsbudgetdeficit(thedifferencebetweenwhatitgetsintaxesandwhat
itspends).Governmentbondsareusuallyconsideredtobeaverysafe
formofinvestment.
Verysimply,thisisthemoneythatthebanklenttothegovernment,and
thegovernmenttopaythisbackwithinterest,usuallyitwillbepaidback
inalumpsumwiththeinterestincluded.
GiltEdgedSecuri,es:GiltsarebondsissuedbycertainnaAonal
governments.
Theyarepre[ymuchexactlythesameasgovernmentstock
ExchequerBills:Interest-bearingExchequerBillswereintroducedin
Englandin1696asaformofpublicborrowing:theywereissuedin
returnformoneylenttothegovernment.
Again,itsjustanotherwayofthebanklendingthegovernmentmoney.
MoneyAtCall:Ashort-termloanthatdoesnothaveasetrepayment
schedule,butispayableimmediatelyandinfullupondemand.
Thisisjustwhenonebankloansmoneytoanotherbank
Money-at-callloansgivebanksawaytoearninterestwhileretaining
liquidity.Theinterestrateonsuchloansiscalledthecall-loanrate.
CashDeposits:Thisisthecashthatthebankreceivesfromdepositors
anditholdsinordertosaAsfyitsreserverequirements.
JonathanTraynor19
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Banksmayfailbyoverextendingtheirloanbook’.Explainthisstatement
withinthecontextofabank’stwinrequirementsofliquidityand
profitability
Abankhastwinrequirements,ProfitabilityandLiquidity
Question
4 Money & Banking, Capital
(a)
8Banks
may fail by overextending their loan book’.
Profitability:referstotheneedforabanktomakeasmuchprofitsas
Explain this statement within the context of a bank’s twin requirements of liquidity and profitability.
possiblefromitsassetstosaAsfyitsshareholders.Themoreprofitable
A bank has
twin requirements:
theassetisthelessliquiditis.
x Profitability: refers to the need for a bank to make as much profits as possible from its assets
toLiquidity:referstotheneedbyabanktohaveliquidassetsinorderto
satisfy its shareholders. The more profitable the asset is the less liquid it is.
meetthedemandforcashbyitscustomers.Themoreliquidtheassetis
x Liquidity: refers to the need by a bank to have liquid assets in order to meet the demand for
thelessprofitableitis.
cash
by its customers. The more liquid the asset is the less profitable it is.
Banksmuststrikeabalancebetweenthetwinrequirementsof
x Banks must strike a balance between the twin requirements of profitability and liquidity. As a
profitabilityandliquidity.Asaresultbanksstructuretheirholdingof
result
banks structure their holding of assets along the following lines:
assetsalongthefollowinglines:
Term loans and overdrafts
50%
Earning
Assets
Government stock / gilt edged securities
Exchequer Bills / Bills of Exchange
20%
Liquidity Increases
Profitability Increases
70%
12%
Money at call
Liquid
Assets
30%
8%
Cash Deposits
10%
Byfocusingonprofitability(extendingcredit)attheexpenseofliquiditya
bankmaygiveloanstohighriskventurese.g.commercialproperty
developmentloans.
x By
focusing on profitability (extending credit) at the expense of liquidity a bank may give loans
to high risk ventures e.g. commercial property development loans. Property loans are highly
Propertyloansarehighlyilliquidbutcanbeveryprofitable.Abankmay
illiquid but can be very profitable. A bank may run the risk of increasing bad debts, falling share
runtheriskofincreasingbaddebts,fallingshareprices,alackofcapital
prices, a lack of capital and possible bank failure.
andpossiblebankfailure.
x By ignoring liquidity requirements, banks may not have enough cash to meet the demand of
Byignoringliquidityrequirements,banksmaynothaveenoughcashto
their depositors and this could result in a ‘run’ on the banks and result in bank failure.
meetthedemandoftheirdepositorsandthiscouldresultina‘run’on
thebanksandresultinbankfailure.
25 marks graded
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BankRegula,on
Sincetherecentfinancialcrisis,manypeoplebelievethatifbankswere
properlyregulated(iftherewererulesaboutwhatreserveraAobanks
hadtokeepandthenumberofbondstheycouldissueinordertofund
theirlendingpracAces),thenthiscriseswouldnotoccur.
However,othersbelievethatbankregulaAonwouldremovethebanks
abilitytofundinvestmentprojectsandassuchmeanalowerstandardof
livingforeveryoneintheeconomy.
BelowaretheargumentsforregulaAon.
1) ProtectConsumers:RegulaAonwillensurethattheinterestsofthe
banks’consumersareprotectedandthatsavers’depositsaresecure.
2) ProperLendingPolicies:RegulaAonwillensurethatthebanksfollow
correctlendingproceduresandthatexcessive/recklesslendingis
avoided.
3) BankingSystemStability:RegulaAonwillensurethatthebanking
systemshouldremainstable.
4) EconomicStabilityorConfidence:ProperregulaAonmayensurethat
thebanksoperateefficientlyresulAnginpublicconfidenceinthe
bankingsystem/allowfortheflowofcreditandforeconomicgrowth
oftheeconomy.
5) LessNeedforGovernmentInterven,on:Ifthebanksareproperly
regulatedthentherewillbelessneedforthegovernmenttobecome
involvedasithashadtodowiththeguaranteesforsaversdeposits;
naAonalisaAonofAngloIrishBank;andtheseangupofNAMA.
6) LessNeedforEU/IMFfunds:Ifbanksareproperlyregulatedit
shouldresultinthegovernmentnothavingtoresorttofundsfrom
theEU/IMFtocapitalisethebanks.
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BankNa,onalisa,on
Ameralltheeconomichardshipfollowingthefinancialcrisisandthebank
guaranteescheme,manypeoplebelievethatbanksarefartoimportant
tobeinprivatehandsandthatthegovernmentshouldtakeownershipof
thebanks.Whenthegovernmenttakesownershipofwhatwasformerly
aprivateenterprise,thisisknownasnaAonalisaAon.
Na,onalisa,on:Takinganindustryorassetsintopublicownershipbya
government.
BelowaretheargumentsinfavourofandagainstthenaAonalisaAonof
CommercialBanks.
CommercialBanks:InsAtuAonswhichprovidedeposit/lendingservices
topersonalconsumers/business.
ArgumentsinFavourofNa,onalisa,onofBanks
1) StabilitytoEconomy/InvestorConfidence:ItmaysignaltodomesAc
andinternaAonalinvestorsthatthestateseekstoprotectan
importantresourceandsoa[ractinvestment.
2) AvailabilityofCredit:Itmayensurethatcreditwouldflowtothose
individualsandbusinesseswhichrequireit,unlikeatpresentwhere
creditrestricAonsapply.
3) Ra,onalisa,onofBankingServices:ItmayleadtoaraAonalisaAonof
bankingserviceswithinthestate,theeliminaAonofwastefulpracAces
/costefficiencies.
4) Employment/ConsumerProtec,on:Jobscurrentlyunderthreatmay
beprotectedbystateintervenAon.Consumersmaybeofferedbe[er
protecAonbystatebanks.
5) DevelopmentofEthicalBankingPrac,ces:WithnaAonalisaAon
bankingpracAcesmaybelessmoAvatedbythegeneraAonofprofit
andmoretowardstheprovisionofthoseservicesrequiredby
consumers.
6) Con,nuedProvisionofBankingServicestotheCommunity/Prevent
ForeignOwnership:ThenaAonalisedbankmayconAnuetoprovide
retailservicestothosecommuniAeswhichinthepastwereonly
providedifthebranchwasprofitable/socialobjecAve
JonathanTraynor22
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ArgumentsAgainstNa,onalisa,onofBanks
1) UnnecessaryStateInterference:Toomuchstateinvolvementin
commercialbusinessesmaydiscouragedomesAc/internaAonal
investors.
2) ShareholdersPenalised:Theymaybeforcedtoselltheirsharesata
pricedeemedunfair.
3) IncreasedTaxa,on:Taxesmayhavetobeincreasedtofundthe
purchaseandrunningofthenaAonalisedbanks.
4) OpportunityCosts:ThemoneyusedforthenaAonalisaAoncouldhave
beenputtoalternaAveusesbythestatee.g.provisionofimproved
healthservicesetc.
5) ProfitMo,veDiminished:Shouldthisoccurthenthepressureto
improveservices;achieveefficienciesandmaximiseprofitsmaybebe
diminished.
6) FinancialCost:Largeamountoffundsneededtoensuretheirfuture
andtheycouldconAnuetobeloss-makingintotheforeseeablefuture.
AnIntroduc,ontoTheEuropeanCentralBank(ECB)
Onthe1stofJanuary1999elevenmemberstatesoftheEuropeanUnion
adoptedacommoncurrencycalledtheeuro.Thesecountrieswere
Austria,Belgium,Finland,France,Germany,Ireland,Italy,Luxembourg,
theNetherlands,PortugalandSpain.GreecejoinedinJanuary2001but
theUnitedKingdom,SwedenandDenmarkdecidedtooptoutofthe
euroandretaintheirnaAonalcurrencies.
Together,thecountriesusingtheeuroastheircurrencyareformthe
Eurosystemortheeuroarea.Ineffect,theparAcipaAngcountriesagreed
toeliminatetheircurrencies(francs,punts,liraetc)andreplacethem
withthenewcommoncurrency(theEuro).AtthesameAmecontrolof
MonetaryPolicyineachcountrypassedfromtheirnaAonalCentralBanks
tothenewlyestablishedEuropeanCentralBank(ECB)basedinFrankfurt.
MonetaryPolicy:ThoseacAonsbytheECB,whichinfluencesthemoney
supply,interestratesandtheavailabilityofcredit.
TheECBisatthecentreofanewbankingsystemknownastheEuropean
SystemofCentralBanks(ESCB),whichconsistsoftheECBandthe
naAonalCentralBanks(NCBs)ofallEUmemberstatesincludingthoseof
non-parAcipaAngcountries.However,whilenon-parAcipaAngCentral
Banks,suchastheBankofEngland,arepartoftheESCB,theyplayno
roleinitsdecisionmakingprocess.TodisAnguishbetweenthosemember
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stateswhichusetheeuroastheircommoncurrencyandthosewhohave
retainedtheirnaAonalcurrencies,theECBusesthetermEurosystemto
refertothosecountriesthatusetheeuro.
Eurosystem:thoseEUmemberstateswhichusetheeuroastheir
currencyandforwhomtheECBistheirCentralBank.
EuropeanSystemofCentralBanks(ESCB):theECBandthenaAonal
CentralBanksofallmemberstatesincludingthosewhodonotusethe
euroastheircurrency.
EuropeanCentralBank(ECB):theCentralBankoftheEurosystem
whichcomprisesallcountriesusingtheeuroastheircurrency.
Func,onsoftheEuropeanCentralBank(ECB)
1) PrintsLegalTender:TheCentralBankhasthesoleauthoritytoprint
andminteurocurrencyinIreland.Itdistributestheeurothroughthe
financialinsAtuAonswithinIreland.ItsmintislocatedinSandyfordin
Dublin.
2) GovernmentsBank:Allmoniesreceivedbygovernmentarepaidinto
theGovernment’saccountintheCentralBankandallmoniespaidout
byGovernmentaredrawnfromitsaccountwiththeCentralBank.
3) Bankers'Bank/RegulatorofFinancialsector/Issueslicencesto
FinancialIns,tu,ons:ItactsasaClearingHouseforthecommercial
bankswhomaintainaccountshere.Itregulatesthefinancialsectorin
Irelandincludingcreditunions,buildingsocieAes,theIFSCoperaAons,
etc.TheCentralBankactsaslenderoflastresort.
4) OfficialExternalReserves:Thesearethiscountry’sofficialholdingsof
gold,foreigncurrenciesandotherreservesheldassecurityagainst
theissueoftheeuro.TheCentralBankmanagesthesereserveson
behalfofthecountry.
5) MaintainsPriceStability:ThekeyroletheCentralBankplaysisto
maintainpricestabilitythroughitsmonetarypolicyoperaAonssoasto
ensurecompeAAvenesswithintheEU.Thisitdoesthroughvarious
measures:MainrefinancingoperaAons,StandingFaciliAesand
MinimumReserveRequirements.
6) ProvidesConsumerInforma,on/EconomicResearch–CentralBank
Reports:TheCentralBankregularlyprovidesinformaAononall
aspectsoftheeconomythroughitsCentralBankreportsandprovision
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ofstaAsAcsrelaAngtotheIrisheconomy.Italsoconductsresearchon
variousma[ersconcerningtheeconomy.
RoleoftheECBasLenderofLastResort
ThecentralbankofferscredittofinancialinsAtuAonsexperiencing
financialdifficulAes/liquidityproblemsandareunabletoobtain
necessaryfundselsewhere.
InstrumentsofMonetaryPolicy
Aswehavesaidpreviously,theECBisresponsibleforcontrollingthe
moneysupplyidtheeuroarea.WeareawarethatprinAngmoneycan
causeinflaAon,andthemaingoalorjoboftheECBisPriceStability
(keepingthepricelevelwhereitisandnotallowittogoupordown).All
CentralBanksareresponsibleforformulaAngMonetarypolicy.
MonetaryPolicy:ThoseacAonsbytheECB,whichinfluencesthemoney
supply,interestratesandtheavailabilityofcredit.
Broadlyspeaking,theECBhasthreemantoolsthatitcanusetoinfluence
themoneysupplyand(aswewillseelater),theinterestrate.
1) OpenMarketOperaAons
2) MainRefinancingOperaAons
3) ReserveRequirements
OpenMarketOpera,ons
ThiswheretheECBwilleitherbuyorsellgovernmentbondstoorfrom
thepublic.IftheECBwantstoincreasethemoneysupply,itwillbuy
governmentbondsfromthepublic.ThisisknownasanOpenMarket
Purchase.Assumingthatthepublicisholdingallthemoneyitwantsin
currency,theywilllodgethisextramoneyinthebank.Thebankwilllend
outthisiniAaldepositAmesthemoneymulApliertothepubliccausing
themoneysupplytoincrease.
OpenMarketPurchase:Thepurchaseofgovernmentbondsfromthe
publicbytheECBforthepurposeofincreasingthesupplyofbank
reservesandthemoneysupply
Inordertoreducebankreservesandhencethemoneysupply,thebank
reversestheprocedure.Thegovernmentsellsbondstothepublicwhich
paysforthesebondswithcash(inthepostoffice)orwithacheque.This
reducestheamountofmoneyincirculaAonandassuchthemoney
supply.ThisisknownasanOpenMarketSale.
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OpenMarketSale:ThesalebytheECBofgovernmentbondstothe
publicforthepurposeofreducingbankreservesandthemoneysupply
ThesellingandbuyingofgovernmentbondsbytheECBisanindirectway
ofeffecAngthemoneysupply.
MainRefinancingOpera,ons
MainrefinancingoperaAonsareatypeofopenmarketoperaAonthat
effectsthemoneysupplydirectly.Eachweek,theECBannouncesa
tender.AtenderisanamountofmoneythattheECBiswillingtolendto
commercialbankseachweek.Notonlydoestheamountofmoneythat
theECBlendoutchange,butsodoesthecostofborrowingthemoney
(theinterestrate).
Theinterestratethatcommercialbankshavetopaywhenborrowing
fromtheECBiscalledthe“mainrefinancingrate”.
MainRefinancingRate:theinterestratewhichcommercialbanks
borrowreservesfromtheEuropeanCentralBank(ECB).
Commercialbanksbidagainsteachothertogainaccesstothetender
everyweekandassuchcanbidupthemainrefinancingrate.Thegreater
thesizeofthetender,thelowerthemainrefinancingrate,thegreater
thequanAtyofcashborrowed,causingthemoneysupplytoincrease.
Thesmallerthesizeofthetender,thehigherthemainrefinancingrate,
thesmallerthequanAtyofcashborrowed,howeversAllcausingthe
moneysupplytoincreasebutataslowerrate.
ReserveRequirements
IftheECBinsiststhatcommercialbanksholdagreaterquanAtyofcash(a
higherReserve-DepositRaAo),thenthisreducestheamountofcredit
thatcommercialbankscancreate.Thisreducesthemoneysupplyinthe
future.TheECBcancheckthatcommercialbanksarecomplyingwiththis
increaseinthereserve-depositraAobymakingcommercialbankslodge
greaterquanAAesofcashwiththeirNaAonalCentralBanks,whichispart
oftheEuropeanSystemofCentralBanks.
IftheECBallowscommercialbankstoholdasmallerquanAtyofcash
(reducingthereserve-depositraAo)thenthisincreasestheamountof
creditthatcommercialbankscancreate.Thisincreasesthemoneysupply
inthefuture.
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Explainthelikelyeconomiceffectsifthesupplyofmoneygrowsata
fasterratethanacountry’sproduc,onofgoodsandservices 1) Infla,on:pricesmayrisebecauseofinsufficientsupply/excess
demand.
2) Imports:demandmaybemetbyincreasedimports.
3) Savings:theinsufficientsupplyofgoodsmayforcepeopletosave.
4) Currency:thevalueofcurrencyinanon-eurozonecountrymayfall
becauseofexcesssupply.
5) RateofInterest:underKeynes’LiquidityPreferenceifthesupplyof
moneygrowstheninterestrateswillfall.
Explainthelikelyeconomiceffectsifthesupplyofmoneygrowsata
slowerratethanacountry’sproduc,onofgoodsandservices
1) Defla,on/Modera,oninPriceLevels:pricesmayfallbecauseof
excesssupply.
2) FallingDemand:decliningeconomicgrowthmeansproducersmay
raAonalize,leadingtorisingunemployment.
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InterestRateDetermina,on
TherearetwotheoriesonhowinterestratesaredeterminedontheL.C.
Economicscourse.Bothmustbeknownandunderstoodastheycanbe
askedseparately.
TheLoanableFundsTheory(InterestRatesintheLongRun)
Thisisthenamegiventothetheoryofinterestratesputforwardbythe
19thcenturyClassicalEconomists.LoanableFundsreferredtothemoney
thatwasavailableforlendingonfinancialmarkets.
TheSupplyCurveofsuchfundswasseenasbeingupwardsloping,
indicaAngthatthehighertherateofinterest(i.e.thehigherthereturnto
savers),thegreaterthesupplyofsuchfunds.TheDemandCurvefor
loanablefundswasseenasdownwardsloping,indicaAngthatthehigher
therateofinterest(i.e.thehigherthepriceinvestorsmustpay),the
lowertheamountofsuchfundsthatwouldbedemanded.
TherateofinterestwouldadjustunAlthedemandforloanablefunds
equaledthesupplyofloanablefunds.Seethegraphbelow.
SLF
Rateof
Interest
RoIHIGH
RoIEq
RoILOW
DLF
Q1
QEQ
Q2
QuanAtyof
LoanableFunds
JonathanTraynor28
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TheDemandforLoanableFundscomesfrominvestors,whiletheSupply
forLoanableFundscomesfromsavers.IftherateofinterestwasRoILOW,
thenthedemandforfundsexceedssupply.Thereisupwardpressureon
theinterestratecausingittorise.IftherateofinterestwasRoIHIGH,the
supplyofloanablefundsexceedsthedemand.Thereisdownward
pressureontheinterestratecausingittofall.AtRoIEq,thedemandfor
LoanableequalsthesupplyofLoanablefunds.Thisishowthemarketfor
LoanableFundsreachestheequilibriuminterestrate.
Unfortunately,thistheoryisseenasbeingtoosimpleanexplanaAonon
howinterestratesaredeterminedintheshortrun.Intheshortrun,the
interestrateisnotthemostimportantthingaffecAngthedemandfor
fundsbyinvestors.Therateofreturnexpectedbytheinvestorismore
importantthantheinterestrate.Also,therateofinterestisnotthemost
importantthingthataffectsthelevelofsavingintheeconomy(i.e.the
SupplyofLoanableFunds),thelevelofincomeismoreimportant.
ThetheoryofLoanableFundsisseenasthecorrectmodelforinterest
ratedetermina:oninthelongrun,butnotintheshortrun.
TheTheoryofLiquidityPreference(InterestRatesintheShortRun)
ItwasthegreateconomistJohnMaynardKeynesthatcameupwiththe
ideaofthetheoryofLiquidityPreference.Hesaidthatinterestrates
wherenotdeterminedbythesupplyanddemandofloanablefunds,but
interestratesaredeterminedbypeoplesdemandforcashandthe
amountofcashthatthecentralbankdecidestoprint.
Itisimportanttobespecifichere.Cashisthephysicalnotesandcoins
thatpeoplecanusetopayforthings.
Again,thisisjustanotherlengthyexplanaAontohelpyouunderstandthe
ideaofthetheoryofliquiditypreference.ReadthissecAononceand
thenlearnofftheLeavingCertanswerthatfollows.
TheSupplyofMoneyinLiquidityPreference
Remember,inthetheoryofLoanablefundsthesupplyofloanablefunds
wasprovidedbysavers.However,nowwearetalkingaboutliquidmoney
notjustloanablefunds.Well,moneyisprintedinthemint,atanyone
Amethereisafixedsupplyofitavailable.Thisfixedamountisdecided
uponbytheEuropeanCentralbankandasmembersoftheEurosystem;
itistheCentralBankofIrelandthatisresponsibleforcontrollingand
sAckingtotheMoneySupplysetoutbytheEuropeanCentralBank.
JonathanTraynor29
LCEconomicswww.thebusinessguys.ie©
Aswehavealreadysaid,thesupplyofmoneyisfixedatanyoneAmeand
assuchthesupplycurveformoneyisaverAcalstraightline,indicaAng
thatthesupplyofmoneydoesnotdependontherateofinterest.
SupplyofMoney
Rateof
Interest
(%)
SM
QM
QuanAtyofMoney
TheDemandforMoneyinLiquidityPreference
Whenwetalkaboutthedemandandsupplyofmoneywhatdowe
mean?Everybodydemandsmoreofitandnobodygivesitawayso
demandishighandsupplyislow.ABSOLUTELYNOT!!!!!!!!!!!!!!!!When
wetalkaboutthedemandformoneywemeanthedesirebyapersonto
holdtheirwealthinliquidorcashform(notes,coinsetc)andnotleaveit
inthebank.Whenwetalkaboutthesupplyofmoneywemeanthetotal
amountofnotesandcoinsintheeconomy.
Aswehavesaidearlier,thedemandformoneyreferstothedesirefor
peopletokeeptheirwealthinliquidform.Thatisnotes,coinsorcurrent
accountbalances.Keynessaidthattherewerethreereasonswhypeople
wouldwishtoholdtheirmoneyinliquidform.Hecalledthesereasons
moAves.
JonathanTraynor30
LCEconomicswww.thebusinessguys.ie©
FIRSTMOTIVE:TheTransac,onsMo,ve(DT)
AllisimpliedinthismoAveisthatpeopleneedcashfordaytoday
expenses.Theamountpeopleneedforthispurposedependsonhow
muchtheyspendwhichinturndependsontheirincome.Thehigherthe
levelofincome,thegreaterthetransacAonsdemandformoney.The
lowerthelevelofincome,thelowerthetransacAonsdemandformoney.
TherateofinteresthasnoeffectonthetransacAonsdemandformoney
sothetransacAonsdemandcurveformoneyisaverAcalstraightline.
Rateof
Interest
(%)
DT
QMD
QuanAtyofMoney
Remember,thetransacAondemandformoneydependsonthelevelof
incomeonly.Itdoesnotdependontheinterestrate.Ifincomerises,DT
rises.Ifincomefalls,DTfalls.
JonathanTraynor31
LCEconomicswww.thebusinessguys.ie©
SECONDMOTIVE:ThePrecau,onaryMo,ve(DP)
TheprecauAonarydemandformoneyreferstothemoneyheldbypeople
inordertopayforunforeseenexpenseslikedoctorbillswhenpeopleget
sickorhouseholdrepairsetc.Suchexpensesinevitablyarisebutpeople
donotknowhoworwhentheywillarise.
AgaintheprecauAonarydemandformoneydependsonthelevelof
income.Thehigherthelevelofincome,thegreatertheprecauAonary
demandformoney,(themoremoneypeopleputawayforarainyday).
However,italsodependsontheinterestratetoalesserextent.The
highertherateofinterest,thelowertheprecauAonarydemandfor
moneywillbe.Thisisbecausethereisanopportunitycostofholding
moneyincashform.Theopportunitycostofholdingmoneyincashform
istheinterestthatitcouldbeearningifitweretobeplacedinasavings
account.
Imightbewillingtokeep€5,000incashincaseofemergenciesiftherate
ofinterestwas3%,butIwouldnotkeepthesameamountincashifthe
interestratewas50%asIwouldbegivingup€2,500ininterestifIwere
todoso.Theopportunitycostofkeeping€5,000incashwhenthe
interestrateis50%isthe€2,500inforgoneinterest.Thegraphbelow
showstheprecauAonarydemandcurveformoney.
Rateof
Interest
(%)
DP
QuanAtyofMoney
Remember,theprecauAonarydemandformoneydependsmainlyonthe
levelofincome,butisslightlyaffectedbytheinterestrate.Thatiswhy
weseethisveryinelasAcdemandcurveformoney.IfincomerisesDP
rises,ifincomefalls,DPfalls.Also,iftherateofinterestrises,DPfallsand
iftherateofinterestfalls,DPrises.
JonathanTraynor32
LCEconomicswww.thebusinessguys.ie©
THIRDMOTIVE:TheSpecula,veMo,ve(DS)
ThespeculaAvemoAvereferstomoneyheldbyindividualsinorderto
takeadvantageofprofitmakingopportuniAesthatmayarise.Peoplewill
wanttohaveaccesstocashinordertohavetheopportunitytopurchase
anassetthatisexpectedtoriseinvalue.Thisassetmaybestocks,shares,
apieceofcapital,agovernmentbondetc.
ThereisaninverserelaAonshipbetweentherateofinterestandthe
speculaAvedemandformoney.Whentherateofinterestrises,the
speculaAvedemandformoneyfalls.Whentherateofinterestfallsthe
speculaAvedemandformoneyrises.
Rateof
Interest
(%)
DS
QuanAtyofMoney
Wheninterestratesarehigh(e.g.20%),thespeculaAvedemandfor
moneywillbelow.Peoplewillprefertoputtheirmoneyintofixedinterestearningaccountswherethereisnorisk.Assuch,themoneythat
theyholdascashforprofitmakingopportuniAeswillbesmall,asvery
fewprofitmakingopportuniAescanguaranteeareturnof20%.
Conversely,wheninterestratesarelow(e.g.2.5%),thespeculaAve
demandformoneywillbehigh.Peoplewillprefertoholdontotheir
wealthintheformofcashinthehopeofavailingofaprofitmaking
opportunitythatwouldyieldareturngreaterthan2.5%.
Thetotaloraggregatedemandformoney(DM)issimplytheaddiAonof
thetransacAons,precauAonaryandspeculaAvedemandsformoney.
JonathanTraynor33
LCEconomicswww.thebusinessguys.ie©
Rateof
Interest
(%)
SM
ROIeq
DM
QuanAtyofMoney
Aswecanseefromthegraphoverleaf,therateofinterest,accordingto
Keynes,wasdeterminedbytheintersecAonoftheverAcalmoneysupply
curve(SM)andthedownwardslopingaggregatedemandformoneycurve
(DM).Whenthesecurvesshim,achangeintheinterestrateistheresult.
L.C.Q:Keynes’conceptof‘LiquidityPreference’isbasedonthreereasons
whypeopledesiretoholdwealthinmoneyform.Stateandexplaineach
ofthesereasons
ANSWER:
1) Transac,onaryMo,ve:Peopledesiretoholdmoneyforday-to-day
expensese.g.buyinggoods&services
2) Precau,onaryMo,ve:Peopledesiretoholdmoneyforemergencies/
rainydaye.g.illness,houserepairs.
3) Specula,veMo,ve:Peopledesiretoholdmoneyforanypossible
profitablefutureinvestmentopportuniAes.
JonathanTraynor34
LCEconomicswww.thebusinessguys.ie©
L.C.Q:Discusstheeffect,ifany,afallininterestratesisgenerally
expectedtohaveoneachofthesereasons.
ANSWER:
Motive
Effectoffallininterestrates
ThedemandformoneyfortransacAonaryreasonsis
notaffectedbythefallintherateofinterest.Why?
TransacAonary
Peopleneedtohavecashforday-to-dayspending
andthis,alliedtotheirlevelofincome,notratesof
interestdeterminesthemoAve.
ThedemandformoneyforprecauAonaryreasonsis
affectedslightly(negaAvely)bytherateofinterest.
PrecauAonary
Why?Asinterestratesfallslightlymoremoneywill
beheldforprecauAonarypurposes,duetothe
opportunitycostoflowerratesofinterest.
ThedemandformoneyforspeculaAvereasonsis
greatlyaffected(negaAvely)bytherateofinterest.
SpeculaAve
Why?Asinterestratesfallmoremoneywillbeheld
forspeculaAvepurposesaspeoplewillholdmore
wealthincashformtoprofitfromfuturehigher
ratesofinterest.
JonathanTraynor35
LCEconomicswww.thebusinessguys.ie©
L.C.Q:Discusstheeffect,ifany,ariseininterestratesisgenerally
expectedtohaveoneachofthesereasons.
ANSWER:
Motive
Effectofriseininterestrates
ThedemandformoneyfortransacAonaryreasonsis
notaffectedbytheriseintherateofinterest.Why?
TransacAonary
Peopleneedtohavecashforday-to-dayspending
andthis,alliedtotheirlevelofincome,notratesof
interestdeterminesthemoAve.
ThedemandformoneyforprecauAonaryreasonsis
affectedslightly(negaAvely)bytherateofinterest.
PrecauAonary
Why?Asinterestratesriseslightlylessmoneywill
beheldforprecauAonarypurposes,duetothe
opportunitycostofhigherratesofinterest.
ThedemandformoneyforspeculaAvereasonsis
greatlyaffected(negaAvely)bytherateofinterest.
SpeculaAve
Why?Asinterestratesrise,lessmoneywillbeheld
forspeculaAvepurposesaspeoplewillholdless
wealthincashformsoasnottoloosemoneyfrom
futurelowerratesofinterest
JonathanTraynor36
LCEconomicswww.thebusinessguys.ie©
EffectofaReduc,oninInterestRatesontheIrishEconomy
1)BorrowingisEncouraged:borrowingisnowcheaper,resulAnginlower
loanrepayments.Lowerloanrepaymentsmeanincreasedspending
power.ThisleadtogreaterspendingwhichleadstohigherinflaAon.
IncreasedinflaAonleadstohigherimports,whichleadstoahigher
standardofliving.
2)SavingisDiscouraged:Withlowerrateofreturns,peoplemayfindit
lessa[racAvetosave,whichagainleadstohigherspending.
3)ReducedMortgageRepayments:Thecostofmonthlyrepayments
decreasesresulAnginahigherstandardofliving.Thiscanalsoleadtoa
riseinhouseprices.
4)CostofServicingtheNa,onalDebt:WithlowerdomesAcinterest
rates,thecostofrepayingtheeuro-zoneporAonofthenaAonaldebt
falls.
5)ReducedCostsofProduc,on:CostsofproducAonwillfallresulAngin
lowerpricesand/oranincreaseinthenumbersemployed.
6)Incen,vetoInvest:TheMarginalEfficiencyofCapital(MEC)willrise,
leadingtohigherprofits,usuallycausinganincreaseininvestment.Thisis
because,itbecomescheaperforbusinessestoborrowandsobusinesses
mayinvest.
7)EconomicGrowthisEncouraged:Withpossiblyhigherinvestment,
futureeconomicgrowthinIrelandmaybeincreased.
8)RevenueReceivedfromDIRT:Withlesssavingsthegovernmentmay
receivelessrevenuethroughDIRT
9)Shi`inEmphasisinGovernmentPolicy:Withlowerinterestrates,the
governmentcouldshimitsemphasisfromtaxrevenuesmoretowards
borrowing,asitisnowcheaperforthegovernmenttoborrow.
JonathanTraynor37
LCEconomicswww.thebusinessguys.ie©
EffectofanIncreaseinInterestRatesontheIrishEconomy
1) BorrowingDiscouraged:BorrowingismoreexpensiveresulAngin
higherloanrepayments,whichwillreducespendingpower,resulAng
inalowerstandardofliving.
2) SavingsEncouraged:Withahigherrateofreturnpeoplemayfindit
morea[racAvetosave,andsotheywillreducetheirspending.
3) IncreasedMortgageRepayments:Thecostofmonthlyrepayments
increases,resulAnginreduceddisposableincomeandalower
standardofliving.
4) IncreasedCostofServicingtheNa,onalDebt:WithhigherdomesAc
interestratesthecostofrepayingtheinternalporAonofthenaAonal
debtrises.
5) IncreasedCostsofProduc,on/ReducedCompe,,veness:Costof
producAonwillincreaseresulAnginhigherdomesAcprices.Thiswill
reducethecompeAAvenessofIrishexportsandmayleadtoreducAon
insales.
6) Disincen,vetoInvest:TheMECwillfallresulAnginlowerprofitsand
thismaydiscourageinvestors/itbecomesmoreexpensivefor
businessestoborrowandsotheymaynotinvest.
7) EconomicGrowthisHindered:Withpossiblelowerinvestment,
futureeconomicgrowthinIrelandmaybedamaged.
8) Taxa,onRevenueEffects:WithaddiAonalsavingsthegovernment
mayreceiveaddiAonalrevenuethroughDIRT.However,withlower
spendingtherevenuefromVATandexciseduAesmayfall.If
unemploymentincreasestherewillbeareducAoninincometax
revenue.
9) IncreasesinUnemployment:Lowerconsumerspending,falling
demandforIrishexports,areducAonininvestmentandadeclinein
economicgrowthmayresultinanincreaseinthenumbers
unemployed.
JonathanTraynor38
LCEconomicswww.thebusinessguys.ie©
RoleoftheInterna,onalMonetaryFund(IMF)
1) ExpansionofWorldTrade:TheIMFencouragesexpansionintradeby
encouragingmembercountriestoadoptsoundeconomicpolicies.It
monitorseconomicandfinancialdevelopmentsinmembercountries
andgivesadvicetoitsmembers.
2) PromoteExchangeRateStability:TheIMFpromotesinternaAonal
monetaryco-operaAon.ItprovidesaforumforconsultaAonon
internaAonalmonetaryproblems.Ittriestomaintainorderly
exchangearrangementsamongcountriesandaimstoavoid
compeAAvedevaluaAons.
3) OrderlyCorrec,onofBalanceofPaymentsProblems:TheIMFlends
tomembercountrieswithBalanceofPaymentsproblemstoprovide
temporaryfinancingandtosupportreformpoliciesaimedat
correcAngtheunderlyingproblems.
4) Opera,onofaMul,lateralSystemofPayments:TheIMFoperates
thissysteminrespectofcurrenttransacAonsbetweenmembersand
aimstoeliminateforeignexchangerestricAonswhichmayhamperthe
growthofworldtrade.
5) ProvisionofTechnicalAssistanceandTraining:Whereamember
needshelptheIMFwillprovidethisassistanceandtraining.Whenthe
SovietUnioncollapsedtheIMFsteppedinandsetuptreasurysystems
fortheircentralbankstohelpthetransiAonfromcentrallyplannedto
marketbasedeconomicsystems.
RoleofTheWorldBank
1) EncourageinvestmentfundstoLDCs:Obtainsfundsfromtheworld’s
advancedcountriesandusestheseresourcestomakeloansavailable
toLDCssotheycaninvestinroads,schoolsetc.
2) Financecapitalprojectsinmembercountries:TheWorldBankgives
loanstomemberstatesandtoprivatebusinessesinthesecountries
soastoassistwithcapitalprojects.ExamplesinIrelandincludedin
thepastthebuildingoftheoriginalcommunityschoolsbytheDES.
3) DebtreliefforLDCs:TheWorldBankhelpsLDCsreducetheirdebt
burdenbyextendingthetermofloansand/orre-negoAaAnginterest
rates.
JonathanTraynor39