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03.13 - Money and Banking

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University of British Columbia
ECON 102
Lanny Zrill

Money and Banking 03-18-2013 Side note: In-Class Documentary Original proposal: Buy all the toxic assets (at the taxpayers expense) to remove responsibility from the banks. What actually happened: Capital injection Why bail out all major banks and not just the ones that are suffering?  If you only bail out the ones that are in trouble, the public will know which ones they have to take out their money of. If this happens, the suffering banks will fail anyway and due to the interconnectedness of all these big banks, the whole system is at risk to fail.  Mortgage backed security? The Canadian Banking System Two main players:  Central Bank  Financial Intermediaries – ex. commercial banks, credit unions, insurance companies, etc. o Firms that take deposits from people and then lend it to people who need money Bank of Canada  Central bank  Owned by the government – only shareholder o Federal Reserve System of the US is privately owned by the private banks  Operated by an appointed Governor (Mark Carney) o Deputy of Finance Minister is only involved in bigger decisions o Mark Carney’s agenda: stable inflation of 2%  Semi-independent from government: day-to-day autonomy o They don’t have to answer to the government with what decisions they make ex. when they decide to change the interest rate o BUT the gov’t does have the power to appoint and dismiss who the governor is – must dismiss the governor before they can intervene on any decisions Functions of BOC 1. Banker to Commercial Banks a. Accepts deposits from commercial banks b. “Lender of last resort” 2. Banker to the Federal Government a. Buys government securities ex. bonds (“IOU”) 3. Regulator of the Money Supply a. Chapter 29 4. Regulator and Supporter of Financial Markets a. To prevent potentially catastrophic banking system failure b. Financial stability Balance Sheet of BOC  Main asset: Government of Canada bonds (securities)  Liabilities: o Notes in circulation – involves currency - guarantee that your money is worth something o Government of Canada deposits o “Other liabilities and capital”  Capital – what the business is worth after paying off all the liabilities Example: Euro debt crisis – one central bank that makes monetary policy for all countries  Greece wasn’t able to pay back their bonds – value of these assets fell  liabilities > assets  Why would you buy a bond from the government? They “don’t” go bankrupt (pre-2008).  Greece in trouble  European central bank in trouble  every other country in Europe in trouble Commercial Banks  Privately owned, profit-seeking institution  Main function: accepts deposits and makes loans  Solves major information friction in savings/investment markets o Acts as an intermediary between those who have funds and those who need funds o Credit is required for:  Large household purchases ex. homes  Investment by firms Reserves  Banks must have money on hand in case depositors want to make a withdrawal  How much do they need? Only a fraction.  What if they don’t have enough? o Lender of last resort (borrow from BOC) o CDIC – Canadian Deposit Insurance Corporation – if your bank fails, they will compensate for up to $100,000 Fractional Reserve System Target and Excess Reserves  Reserve ratio – fraction of its deposits that a commercial bank holds as reserves o Reserves are held in the form of cash or deposits with the central bank  Target reserve ratio – fraction of its deposits that a bank wants to hold as reserves  Excess reserves – deposits in excess of the target reserve rati Commercial Banks’ Collective Balance Sheet Assets:  Reserves (including deposits with BOC)  Government securities  Loans  Canadian securities (corporate and provincial and municipal governments)  No stocks – regulation that BOC has: not allowed to invest in other companies because they’re only allowed to invest in safe assets (low risk)  Foreign currency assets Liabilities:  Deposits  Shareholders’ equity Money Supply and Money Demand 03-20-2013 What is Money? Three Principle Functions:  Medium of Exchange (most important) o Solves “Double Coincidence of Wants” Problem o Eliminates inconvenience/inefficiency of barter trade (searching for a trading partner)  Store of Value o Spend some of it today for the things I want today, and spend some of next month on things I want next month. o Create value in the present and store it for the future for when you actually want to spend it.  Unit of Account o Way of measuring the quantity of the object we’re talking about What makes good money? A “good” medium of exchange should have the follow characteristics:  Easily recognizable and readily acceptable  High value relative to weight  Divisible  Durable  Difficult to counterfeit Some examples from the past: precious metals, shells, beads, etc. Modern Money  Modern money has no intrinsic value  Instead, its value is derived from people’s willingness to accept it as a medium of exchange  Called Fiat Money – because the money is derived by fiat Money Creation Currency is created when the Bank of Canada decides to print more bills. But deposits are also considered money. Commercial banks “create” money by lending out deposits. So how are deposits created? Assumptions for this model:  Fixed target reserve ratio  No “cash drain” – all money goes to the bank right away New Deposits A new deposit occurs for one of three reasons: (How new money comes to life)  An individual may immigrate and deposit their cash in a Canadian bank  An individual may have cash “hidden under their bed” – it wasn’t existing for a long period of time (goes back into the system/flow)  The BOC purchases government bonds from a firm or individual. Money is then deposited in a commercial bank. o When money is in the Bank of Canada, we assume that it is out of circulation. When BOC takes money out of their vaults, it goes back into circulation and will therefore be considered a “new deposit”. If someone makes a deposit of x, how much new money will actually be made? More or less? The same? Money Creation  Target Reserve ratio = 20%.  What happens to the quantity of deposits if another 100$ is deposited into this new bank?  Deposit of $100 increases deposits and reserves  reserve ratio is now 27%  Bank loans out excess reserves  restores reserve ratio to target  New loan is deposited at another bank  new process starts  Deposit and Loan cycle goes on indefinitely  Amount of initial deposit = Amount of physical currency = Addition to New Reserves Money Multiplier  The initial deposit of $100 results in a total increase in deposits of $500 o It is as if money was created out of thin air  Define the reserve ratio: o v = Reserves/Deposits  We have a simple formula: Money Multiplier o Δ Deposits = (1/v) x Initial Deposits  Note: the money creation process is partially determined by the behavior of banks and so is not under the complete control of the BOC o BOC no longer mandates the reserve ratio o Commercial banks can choose what their target reserve ratio is Cash Drain  Cash drain – situation where households choose to deposit only a fraction of their money and hold on to the rest in the form of cash o Less money is circulated through the banks  Dampens the money creation process o Define the currency-deposit ratio:  c = Currency/Deposits o New formula:  Δ Deposits = (1/c+v) x Initial Deposits  Would be smaller because cash drains minimize the money creation process Money Supply (Chapter 27!)  Money Supply = Currency in Circulation + Deposits Money Demand  We would like to model the market for money in a supply and demand framework. But what is the “price” of money?  Assumption: All individual (disposable) income is used to purchase either money (non-interest bearing assets) or bonds (interest bearing assets). o Buy bonds when they want to save money  Hence, the opportunity cost of holding money is the return (interest) from holding bonds. o Price of money = interest rate = rate of return on bonds Present Value  Question: Would you prefer $100 today or $100 in one year’s time?  Principle: People prefer money today over the same amount in the future.  Why? Money received today can be saved and earn interest. o Put in savings account and acquire interest  $100 + interest o Inflation will erode purchasing power of that $100 o $100 in the future will be able to buy less goods and services  How much do we value money received in the future relative to the present?  Example: If the annual interest rate is 8%, how much money will you have if you deposit $100 for 1 year? o Answer: $108 o This is more than you would have if you received the $100 in one year’s time instead. o Hence, money promised in the future is worth less than money received immediately. o How much less?  Question: How much would you be willing to accept today in lieu of receiving $100 in one year? o Obviously, this should be less than $100 (because you can earn interest) o Tells us how much the future payment is worth today o This is called the present value and it depends on the interest rate (or opportunity cost)  Consider an asset that pays $X in one year’s time. If the interest rate is i% per year, the PV of the asset is  In general, an asset that pays $X in t years time has a present value of: o Incorporating OC of several years on interest o How much will you be willing to trade in the present to forgo possible interest?  Can also be extended to assets with multiple payments (as is common with bonds): o Stream of payments o Figure out what it’s worth today using this formula  Note: PV is negatively correlated with the interest rate Bonds Consider a bond with a face value of $1000 and a coupon rate of 10% that expires after 3 years. If the market interest rate is 8%, what is the present value of the bond?  Bonds – you know exactly how much you’ll be receiving and when (fixed income)  Face value – lump some payment that occurs when the bond expires – receive $1000 at the end of 3 years  Coupon rate – annual rate – paid according to percentage of the face value o At end of year 1, 2 and 3, you’ll receive a payment worth 10% of face value How much would we expect this bond to sell for? What is the rate of return or yield at this price?  Context: look at it as a much simpler bond  Consider a bond with a face value of $1000 and no coupon that expires after 3 years. If the market interest rate is 11%, what is the present value of the
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