banks, money and the money creation process

‹#› Het begint met een idee

BANKS, MONEY AND THE MONEY CREATIONPROCESS

Vrije Universiteit Amsterdam

Macroeconomics IWim BoonstraFebruary 11, 2019

Banks, Money and Money Creation

‹#› Het begint met een idee3 Het begint met een idee

About myself

• Wim Boonstra

• Professor (part-time)in Economic and

Monetary Policy

• Working at VU University since 2000

• Working with Rabobank Economic research

since 1991 (chief economist 2000 – 2016)

• Fields of research:

• Money and banking

• International economics

• Balance of payments theory

• European integration


• A primer on banking: Functions of banks and banking risks• Definition of money• The importance of money• The value of money • The creation of money• Money multiplier

• Literature: Mankiw & Taylor (MT), chapter 4

• Note: MT is not a monetary handbook. They deal with some essentials in quite a simplistic way. This course (Macroeconomics 1.4) offers you just a brief introduction on the esential.

• If you’re really interested in monetary issues follow Monetary Economics in the second year!

Topics and learning goals


“A bank is an institution where you can borrow money only if youcan prove that you don’t need it”

(Bob Hope, 1930s)

“Banks are institutions that accept deposits and make loans” (Mishkin; 2016)

Banks fulfill more functions:> They operate the payment system essential, without this an economy can’t

function> They give loans to consumers (mortgage loans) and businesses> They manage financial risks for their clients> They buy and sell currencies, securities and derivatives> They play a crucial role in the money creation process

Definition of a bank

5


Reserves Balance with the CB Short-term goverment bonds Other highly liquid securities

Loans- to other banks- to the the private sector- to the government

Derivatives

Investments in tradeable securities

Investment in other companies

Illiquid assets (buildings)

A very simple bank balance

Demand deposits

Savings deposits)

Loans from other banks

Derivatives

Provisions

Issued debt securities

Subordinated debt and ‘bail in capital’

Equity

Assets Liabilities

“Trusted funds”


Liquidity Liquid assets (as % of balance sheet total or against short-term debts Liquid assets are reserves at the CB or securities that can be sold at short

notice without loss (i.e. short-term government bonds).

Solvency Equity (retained profits, issued shares) as % of balance sheet total Other loss absorbing capital (subordinated debt, bail-in capital)

Profitability Profit as a % of equity or balance sheet

Some essential definitions(you should know them by heart….)

Weighted Assets(Supervisory regimes, BIS 1 and onwards….)

Bank assets vary widely in risk Cash and reserves with the central bank bring no credit risk at all Government securities have limited credit risk, especially in well-run

industrial countries Mortgage loans are collaterized and therefore carry relatively little credit

risks, although there are differences between countries, due to legal environment (compare US with the Netherlands)

Loans to businesses carry full credit risk Securities (except government securities) carry full credit risk Private equity is very risky

Risk weighting gives the right incentives• RWA give incentives to undertake less risky business• This makes them superior to the so-called leverage ratio

10

A simple risk weighted balance sheet

11


Banks produce secondary utility, but not primary utility> People like the house they can buy with a mortgage loan, but

they hate their mortgage in itself)> People are at best neutral vis-a-vis a banking product. Basically

we are talking about dissatisfiers> Even the most satisfied client would have been happier if he

didn’t need a bank!

Banks create value at both sides of the balance sheet> Assets: loans (financing function)> Liabilities: payments function, savings function (liquidity

function)

Some observations


• Maturity• Short term funding long term lending

• Size• Small savings depossits large loans

• Risk • Credit risk, liquidity risk, market risk

• Location• Surplus areas deficit areas

The transformation functions


Liquidity risk originates in maturity transformation

Credit risk originates in risk transformation

Market risk/price risk originates in tradeable addst

Interest rate risk originates in funding and maturity transformation

Operational risk originates in all activities, above all important in payment services, risk management

Systemic Risk originates in interconnectedness (systemic failure)

Specific risks> Concentration risk ,country risk, currency risk

Banks are by definition full of risks


“Money is the stock of assets that can be readily used to make transactions” (MT, p. 98)

A broader, more complete definition:

“Money is generally accepted within a certain society as medium of exchange, unit of account and store of value”

You should remember this one!!

Note that the definition does not include ‘intrinsic value’

Definition of money


medium of exchangewe use it to buy stuff

store of valuetransfers purchasing power from the present to the future(or, in case of borrowing, from the future to the epresent)

unit of accountthe common unit by which everyone measures prices and values

Money: Functions


Solves problem of ‘coincidence of wants and needs’ required in barter exchange.

Lower number of relative prices (money is numeraire)

Lower transaction costs (fewer transactions, less search time)

Store of value function makes it possible to smoothen spendingover time

Without money, an advanced economic with a high degree of specialization is not posible

Why money?


“MONEY is not, properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another. It is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy.”

David Hume, “Essays, Moral, Political, and Literary. Of Money”1752

18David Hume


0

2000

4000

6000

8000

10000

12000

1980 1985 1990 1995 2000 2005 2010 2015

Monetaire aggregaten van eng naar ruim

M1, chartaal M1, giraal M2 M3

mrd €

Monetary aggregates eurozone(source: ECB)

Note:

Chartaal = cash (notes and coins)

Giraal = bank deposits


In an economy with n tradeable goods and servies, there are (n(n-1))/2 prices possible

If a single good is being used as unit of account (‘money’), this number declines to (n-1)

N = 10 45 prices without money. Using money this declines to 9

N = 1000 499.500 declines to 999 prices.

Barter trade


Illustration: barter economy versus money


22

• The use of money is an essential precondition foreconomic freedom

• An advanced economy in combination with economicfreedom is not possible without money

• A barter economy• Is very primitive, or• Has very little economic freedom (i.e. Inca’s), or• Has both characteristics

• Don’t trust people who favour a barter economy….


Money?


Money!

Tobacco standard(Virginia; 1607 – ca. 1800)

Cowry Shells(many,many centuries…)

Gold standard (1870 – 1914)


1. fiat money has no intrinsic value examples:

> the paper currency we use> demand deposits (bank accounts)

2. commodity money has (some or full) intrinsic value examples:

gold or silver coinscoins, cigarettes in P.O.W. camps

Money: Types


Intrinsic value: Economic value, other than for transactions. (usevalue; material value, production costs)

‘commodity money’: intrinsic value determines economic valueFiduciary money: economic value is larger than intrinsic value(banknotes, coins)Fiat money: intrinsic value = zero

Money does not need intrinsic value:

Its value depends on everyone agreeing that everyone agrees(that everyone agrees…) that it has value.

Confidence = key!

Intrinsic value


Intrinsic value is only relevant when comparing relative values: • A 10 gram golden coins has twice the value of a 5 gram coin. But only when used in

the same context• A metal-based money standard is ideal for international transactions• Only when a system collapses it helps that the money has intrinsic value ==> grian,

or red wine standard?

In the end the only source of value of any sort of money is thegeneral acceptance by ‘the public’

Intrinsic value is not relevant, anything can be used as ‘money’

The economic value of money depends on the ratio between theamount of money in circulation and the amount of tradeables

The value of money


Basically there are two important distinctions, viz. Money in circulation (meaning: not owned by banks or

government but by private sector agents) Central bank money (owned by banks (reserves) and

governments

Money in circulation: M = C + D C = notes and coins D = bank deposits

Actual measurement is more difficult, due to the high degree of substitution between overnight money andsavings accounts (“near money”)

Money supply (definition)


M0 (monetary base, ‘high powered money’, central bank money) are the direct liabilities of the central bank

In therefore consists of Total amount of banknotes and coins Reserves of the banking system at the central bank (and central bank digital currency, but this is out of the scope of this introduction)

In formula: M0 = C+ R C = banknotes and coins R = reserves of the banks at the central bank

The monetary base (M0, central bank money)


M0 (monetary base, ‘high powered money’, central bank money) Total amount of banknotes and coins Reserves of the banking system at the central bank

M1 (narrow money) Banknotes and coins in circulation

Bank deposits on checking accounts (‘overnight deposits’)

M2 (broad money) M1 the sum of M1, deposits with an agreed maturity of up to two years and deposits

redeemable at notice of up to three months;

M3 (broad money) M2 plus money market instruments (repurchase agreements, money market fund

shares/units and debt securities with a maturity of up to two years).

Source: ECB

Monetary aggregates (ECB definition)(this is really important, also conceptually)


There is a relation between the monetary base and

money in circulation: the money multiplier

Monetary Base(M0)

Money in

circulation

(M1, M2, M3)

Cash in circulation is the overlapping item


Monetary base: created by central banks(with the minor exception of coins ==> National Mint)

Money in circulation: created by commercial banks(with the relative minor exception of banknotes and coins)

Who creates money?

32


Monetary policy is conducted by a country’s central bank.

• In the U.S., the central bank is the Federal Reserve(“the Fed”). Based in Washington D.C.

• The most important Federal reseve Bank is the New York Fed

• In the Eurozone, monetary policy is conduscted by the so-called Eurosystem.

• The Eurosystem consists of the ECB in Frankfurt, plus the National Central Banks of the member countries of the Eurozone

The central bank

The Federal Reserve

Building Washington,

DC

ECB

Eurosystem

(ECB plus NCBs Eurozone)

European System of Central Banks

(Eurosystem plus NCBs non-euro

member states


Central bankLoans to banks and goverments

Open market operations

Base Money (M0)

Loans to consumers, business and governments

Money in circulation(M1, M2, M3)

Government Foreign sector

Banks(k)

Money multiplierNon-financial private sector (c)


Assets Notes and coins

(not in circulation, not part of M0, M1) Securities (bonds, money market certificates) Loans to commercial banks Loans to the government Other (a.o. gold, as part of investment portfolio ) Currency reserves

Central bank balance sheet

Liabilities Notes in circulation (Part of M0, M1)

Reserves banking system (part of M0)

Government reserves at central bank(not part of M0)


Central bank transactions that result in more base money:> Printing of banknotes*> Central bank buys securities from banks (open market

operation)> Central bank buys foreign currency (open market operation)> Central bank gives loans to banks

The destruction of base money:> Central bank sells securities and/or foreign currency> Destruction of banknotes> Central bank issues its own securities

* And minting of coins (usually by the government)

The creation of base money

central bank

assets liabilities


|

(1. and 2.) | (1.)

|


|

|

|

|

|



|

| Other liabilities

| ( 5. + 3. + 6. + 7. +8. + 9. +10. + 11.)

|


(3. + 4. +6. + 8. + 9.) |

central bank

assets liabilities


|

(1. and 2.) | (1.)

|


|

|

|

|

|

|

|

|



|

| Other liabilities

| ( 5. + 3. + 6. + 7. +8. + 9. +10. + 11.)

|


(3. + 4. +6. + 8. + 9.) |

Central bank creating bank reserves


Assets1) Lending to banks (against collateral) : Loans to banks +1,000

2) Buying securities and foreign currency Securities + 1,000 Foreign currency+ 1,000

3) Lending to government Loans to government + 1,500

The creation of base money(examples)

Liabilities1)Reserves banking system + 1,000

2)Reserves banking system + 2,000

3)Government reserves + 1,500 (‘schatkistsaldo’, this is not a part of M0)

• Central banks have unlimited powers to create base money (M0)

• Seigniorage is for central bank (usually owned by the government)

The balance sheet of the Fed(billion of USD)

-

500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

4.500

5.000

The Eurosystem balance sheet (year-end,1999 – 2018)

(Assets, billion euro)

0

500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

4.500

5.000

1999 2002 2005 2008 2011 2014 2017

Gold and foreign exchange reserves Lending to credit institutions

Securities held for monetary policy purposes Other assets

Normal situation

Conventional

policy in

unconventional

amounts

Unconventional

monetary policy

The Eurosystem balance sheet (year-end,1999 – 2018)

(Liabilities, billion euro)

Conventional

policy in

unconventional

amounts

Unconventional

monetary policyNormal situation


Why legal tender?

Why have governments over time tried to create a monopoly on the creation of money?

Is the status of legal tender essential for the general acceptanceof fiduciairy or fiat money?

Legal tender


‘Paper money’ is circulated as proof that there is ‘something valuable’ in thevault of the bank”.

The money is fully covered by i.e. gold 100% (liquidity) reserve banking

Note: no net money creation and no seigniorage. Just substitution within money supply. Composition of money supply changes Coins in circulation decline, paper money increases

Paper money creation by private banks (1)(money creation by substitution)

45


The law of large numbers teaches: most gold remains in bank vault and paper money stays in circulation.

Bank can calculate the probability that clients want to have theirgold and withdraw thier deposits

Bank can start the printing press to produce more paper money in order to gain seigniorage.

This process can go on until clients go en masse to their bank towithdraw their deposits (bank run)

Paper money creation by private banks (2)

46


47

Money creation via the creation of debt (1)


Results of this transaction are:> Increase in money supply (from 10,000 tot 20,000)> Increase in debt (by 10,000)> Larger balance sheet of bank> Decline in liquidity ratio (from 100% tot 50%)

Cash reserve ratio < 100% fractional reserve banking

No seigniorage: the money created by the private bank is notowned by the bank (liability), but by the ‘public’.

Profit for the bank is the interest margin (income out of earningassets minus costs of liabilities


48


Do commercial banks create money? yes, they do

Do commercial banks create their own money? no, theydon’t

Do banks create their own funding? yes, as a system they do.

Do individual banks create their own funding? not really, as the newly created money usually starts to circulate in theeconomy

Do all commercial banks create money? no


49


0

2000

4000

6000

8000

10000

12000

1980 1985 1990 1995 2000 2005 2010 2015

Monetaire aggregaten van eng naar ruim

M1, chartaal M1, giraal M2 M3

mrd €

Monetary aggregates Eurozone(source: ECB)

Note:

Chartaal = cash (notes and coins)

Giraal = bank deposits

Created by

commercial

banks

Created

by central

banks


• Cash reserves are necesary, but not very profitable quest formore income keep reserves as low as possible

• Law of large numbers: calculate optimal cash reserve ratio (rr)

• As long as cash reserve ratio > optimum banks will offer loans(and create debt and money)

• There is a formal relation between the size of the cash reserves of the banking system (part of M0) and the banks’ propensity tolend.

• This relation is the money multiplier

Money creation by commercial banks:the money multiplier

51


2

4

6

8

10

12

2004 2006 2008 2010 2012 2014 2016

Het betreffende maatschappelijke geldbegrip (M1-2-3),als veelvoud van de monetaire basis (M0)

M1/M0 M2/M0 M3/M0

The ex-post relation between the monetary aggregates and the

monetary base (ex-post money multiplier)


Situation 1Starting position

Situation 2Multiplier collapses

Monetary base unchanged

Situation 3Smaller multiplier

Increased monetary base

Quantitative easing


“A Government can live for a long time, even the German Government or the Russian Government, by printing paper money.”

John Maynard Keynes, A Tract on Monetary reform (1923)

54

Monetary financing of government spending(both monetary base (M0) and money supply (M1) increase)

Increase in governmentspending, financed bythe central bank

Money comesdirectly in circulation andeconomic activitywill increase

Money lands in bank accounts of companies andemployee, involvedin public projects(M1 increases)

Money is spendand/or saved

Monetary base (M0) increases, bank reserves larger

Banks can lendmore money , which will resultin increase of M1


To spend more without raising taxes or selling bonds, the government can print money (monetary financing).The “revenue” raised from printing (or otherwise creating) money is called seigniorage.The inflation tax:> Printing money to raise revenue causes inflation. Inflation is like a tax on

people who hold money.> If the government holds the printing press it can buy goods and services

with freshly created money ==> a real tax> There is no such thing as an unfunded budget deficit. The public always

pays the bill. Either by taxes, or by the inflation tax (Keynes, 1923)

Seigniorage

banks, money and the money creation process

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