Chapter 20

. ~~w·

MONEY AND MONETARY

INSTITUTIONS

What role does money play in the economy and how did it evolve? How does money get into the
economy and how is the total amount of money determined? What role do banks play in the creation of
money? Why was there a major banking crisis in 2007-8 and why did this lead to recession in many
countries? These are some of the questions that we address in this chapter. In the following chapter we
add a monetary sector to our macro model and analyse how monetary policy works. In this chapter you
will learn that:

• Money acts as a medium of exchange, unit of account, and store of value.

• The existence of money facilitates a wider range of transactions than would otherwise be feasible.
• Money was originally composed of commodities such as gold and silver.
• Paper currency was originally convertible into gold or silver, but now has nothing backing it except its
acceptability in payment.
• The money multiplier is the ratio of broad money to high-powered money.
• Bank deposits are now the biggest part of the total amount of money in the economy, so the
behaviour of the banking system is central to determining that total.
• The financial crisis of 2007-8 was the result of several factors including a Jong period of cheap and
abundant credit in the world financial system, financial innovations that were not fully understood
even by senior bank management, lax regulation, and a perverse incentive system that encouraged
reckless behaviour among bankers and other investment firms.

Many people believe that money is one of the more and real activity has been a source of considerable debate.
important things in life, and that there is never enough of We discuss this in more detail in the following chapter.
it. However, increasing the amount of money in any one However, we do discuss in this chapter the serious financial
country or the world would not make the average person crisis of 2007-8 and how the effects of that crisis spread to
better off. Although money allows those who have it to the real economy. Box 20.1 gives a news report of the run on
buy someone else's output, the total amount of goods and Northern Rock that was the first inkling that many people
services available for everyone to buy depends on the total had of the financial crisis ahead. We discuss financial crises
output produced, not on the total amount of money that in the last section of this chapter and give more detail on
people possess. In the terminology of Chapter 19, an in- UK events during this crisis in the two case studies below.
crease in the total quantity of money will not increase Y", We start by discussing what money is, its historical origins,
the level of potential GDP. However, the link between money and the links between money and the banking system.
448 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

Box 20.1 If in doubt take it out

The first hint of financial problems in the United Kingdom in 2007 Waiting in the queue outside the Leeds city centre branch with
came when it was announced by a BBC reporter that Northern Rock, his wife was Terrance McDonald, 71, an ex-miner from Rothwell.
a UK bank, had sought an emergency loan from the Bank of He said: 'We think it's best if we take it all out; then we've got peace
England. Many of those with their savings in this bank decided to of mind."
take their money out as soon as they could and queues built up Maureen Marfi~ 67, and husband Jack, 72, from New Farland,
outside branches. The following news story explains what hap- said: "To be honest, we've got most of our life savings here and we're
pened and the first case study at the end of the chapter discusses not happy that we might lose everything. We've never had a day
the background to these events in more detail. when we haven't worked ... but people are living longer so the
money's got to last."
Northern Rock customers in run on the bank Barry Clayton, 68, a part-time decorator from Lofthouse, was
planning to withdraw all his money.
Panicked Northern Rock customers have been queuing up to remove
"I just want to close my account. Give me my money and let's
their money after the company was forced to get emergency funding
go ... get it paid straight into my bank account:"
from the Bank of England.
Northern, the UK's fifth biggest mortgage lender, went to the
In classic "run on the bank" scenes, some wereseeking reassurance
Bank of England as it warned profits would be up to £747m lower
but most were looking to remove their money.
than expected because of the soaring cost of borrowing.
Scenes across Yorkshire in which queues stretched along high
Its shares have today slumped more than 30 per cent."
streets have been replicated outside Northern Rock branches
(Source: www.yorkshirepostco.uk, 14 September 2007.)
throughout the UK despite financial experts issuing statements
advising them not to panic. The run on Northern Rock stopped the following week when
The company's website has also been hit by the volume of internet the UK government felt obliged to give 100% guarantees on all
bankers going online to transfer funds. Lengthy access delays and their deposits, in order to prevent the run spreading to other banks.
growing frustration among customers forced Northern to issue re- The government ended up nationalizing this bank {in early 2008)
assurance advising customers the website was working, but slowly. and it was still in UK government hands in December 2010:

The nature of money

There is probably more widespread misunderstanding of Money acts as a medium of exchange and can also serve as a
money and the monetary system than of any other aspect store of value and a unit of account.
of the economy. In this section we describe the functions
of money and briefly outline its history. A mediumof exchange
Before we proceed it is important to note that the As we saw in Chapter 1, if there were no money, goods
amount of money in an economy is a stock (in the UK it is would have to be exchanged by barter (one good being
so many billions of pounds), not a flow of so many pounds swapped directly for another). The major difficulty with
per month or per year. Previously, we have been talking barter is that each transaction requires a double coinci-
about flows of output or spending per period. It is also dence of wants: I can only buy from someone who wan ts
important to notice that the money supply is a nominal what I can offer in exchange. Anyone who specialized in
variable measured in money units, whereas the other vari- producing one commodity would have to spend a great
ables in our macro model are real variables measured in deal of time searching for suitable trading partners. Thus,
purchasing power units, or holding prices constant. a thirsty economics lecturer would have to find a brewer
who wanted to learn economics before he could swap a
lesson in economics for a pint of beer.
What is money?
The use of money as a medium of exchange alleviates
Money is defined as any generally accepted medium of this problem. People can sell their output or services for
exchange. A medium of exchange is anything that will be money and subsequently use the money to buy what they
widely accepted in a society in exchange for goods and want from others. So a monetary economy typically
services. Although being a medium of exchange is usually involves exchanges of goods and services for money and
regarded as money's defining function, money can also of money for goods and services, but not of goods and
serve other roles: services for other goods and services.
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 449
The double coincidence of wants, which is required for barter, is saved for future periods. In other words, money may be
unnecessary when a medium of exchange is used. accumulated as savings to help individuals buy future
goods, but it is the future real capital stock and labour
By facilitating transactions, money makes possible the
resources that will determine future real output. Money
benefits of specialization and the division of labour,
and real wealth should not be confused.
which in turn contribute to the efficiency of the economic
system. It is not without justification that money has been Money is a store of value for individuals but not for society as
called one of the great inventions contributing to human a whole.
freedom and well-being.
To serve as an efficient medium of exchange, money A unit of account
must have a number of characteristics. It must be readily Money also may be used purely for accounting purposes,
acceptable and therefore of known value. It must have a without having a physical existence of its own. For
high value relative to its weight (otherwise it would be a instance, a government store in an imaginary centrally
nuisance to carry around). It must be divisible, because planned society might say that everyone had so many
money that comes only in large denominations is useless 'pounds' to spend or save each month. Goods could then
for transactions having only a small value. Finally, it must be assigned prices and each consumer's purchases recorded,
be difficult, if not impossible, to counterfeit. the consumer being allowed to buy until his or her allo-
cated supply of pounds was exhausted. These pounds
A store of value need have no existence other than as entries in the store's
Money is a convenient way to store purchasing power; books, yet they would serve as a perfectly satisfactory unit
goods may be sold today, and the money taken in exchange of account. Whether they could also serve as a medium of
for them may be stored until it is needed. To be a satisfac- exchange between individuals depends on whether the
tory store of value, however, money must have a relatively store would agree to transfer credits from one customer
stable value. A rise in the price level leads to a decrease in to another at the customer's request. Banks will transfer
the purchasing power of money, because more money is pounds credited to current account deposits in this way,
required to buy a typical basket of goods. When the price and so a bank deposit serves as both a unit of account and
level is stable, the purchasing power of a given sum of a medium of exchange.
money is also stable; when the price level is highly vari- In the (UK) horseracing world, guineas are still used as
able, this is not so, and the usefulness of money as a store a unit of account even though there is no currency in that
of value is undermined. form. The 2000 Guineas is a famous horse race at New-
Although in a non-inflationary environment money market and the average price reported for sales of one-
can serve as a satisfactory store of accumulated purchasing year-old racehorses in 2009 was nearly 40,000 guineas.
power for a single individual, even in those circumstances Payments will not actually be made in guineas, but rather
it cannot do so for society as a whole. A single individual in pounds. By convention a guinea is worth £1.05.
can accumulate money and, when the time comes to A related function of money is that it can be used as a
spend it, can command the current output of some other standard of deferred payment. Payments that are to be
individual. However, if all individuals in a society were to made in the future, for repayment of debts for example,
save their money and then retire simultaneously to live are specified in money. Money's ability to serve as a unit
on their savings, there would be no current production to of account over time in this manner can be harmed if
purchase and consume. Society's ability to satisfy wants there is significant inflation. Serbia had a major inflation
depends on goods and services being available. lf some of in 1993 (see Box 24.1 on page 564) and thereafter a
this want-satisfying capacity is to be stored up for society foreign currency, the euro, was used to denominate loan
as a whole, some goods that are produced today must be contracts, such as mortgages.

The origins of money

The origins of money go back at least 4000 years and Metallic money
probably earlier. Examples of Roman coins circulating in
Britain around 2000 years ago can be seen in the British All sorts of commodities have been used as money at one
Museum and other regional museums. time or another, but gold and silver proved to have great
advantages. They were precious because their supplies
450 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

were relatively limited, and they were inconstant demand The result of debasement was inflation. The subjects
by the wealthy for ornament and decoration. Thus, these had the same number of coins as before, and hence could
metals tended to have a high and stable price. Further, demand the same quantity of goods. When rulers paid
they were easily recognized, they were divisible into their bills, however, the recipients of the extra coins could
extremely small units, and they did not easily wear out. be expected to spend them. This caused an increase in
Before the invention of coins, it would have been neces- demand, which in turn bid up prices.
sary to carry the metal itself. When a purchase was made,
Debasing the coinage was a common cause of increases in
the requisite quantity of the metal was carefully weighed
prices.
on a scale. The invention of coinage eliminated the need
to weigh the metal at each transaction, but it created an It was the experience of such inflations that led early
Important role for an authority, usually a monarch, who economists to stress the link between the quantity of
made the coins by mixing gold or silver with base metals money and the price level. The relationship, known as the
to create convenient size and durability, and affixed his or 'quantity theory of money', will be discussed in Chapter
her seal, guaranteeing the amount of precious metal that 21. A famous law in economics that owes its origins to the
the coin contained. This was clearly a great convenience, era of metallic money is set out in Box 20.2.
as long as traders knew that they could accept the coin at To this day the revenue generated from the power to
its 'face value'. The face value was nothing more than a create currency is known as seigniorage. Today, the possi-
statement that each coin contained a certain weight of bility of debasement does not enter. The term applies to
gold or silver. 1 the revenue that accrues from the powers to print bank-
However, coins often could not be taken at their face notes (which have very low production costs relative
value. A form of counterfeiting-clipping a thin slice off to their face value) and to require private banks to place
the edge of the coin and keeping the valuable metal- non-interest-bearing deposits at the central bank.
becarne common. This, of course, served to undermine The benefits of seigniorage could arise simply because
the acceptability of coins-even if they were stamped. To the monetary authorities print money and spend it, so its
get around this problem, the idea arose of minting the value would be equal to the increase in note issue each
coins with a rough edge; the absence of the rough edge period. In practice, the relevant monetary authority is the
would immediately indicate that the coin had been central bank, which is a government-owned institution
clipped. This practice, called milling, survives on some that is the sole money-issuing authority and acts as banker
coins (such as the current UK Sp, lOp, £1, and £2 coins) to the commercial banking system.3 The UK central bank
as an interesting anachronism to remind us that there is the Bank of England, for the United States it is the
were days when the market value of the metal in the coin Federal Reserve System, and for the euro area it is the
was equal to the face value of the coin.2 European Central Bank (ECB).
Not to be outdone by the cunning of their subjects, When the central bank provides banknotes to the
some rulers were quick to seize the chance of getting private sector it typically buys interest-bearing bonds with
something for nothing. The power to mint coins placed each new issue of notes. The seigniorage from the notes
rulers in a position to work a really profitable fraud. They in circulation is thus equal to the interest per period on
often used some suitable occasion-a marriage, an anni- those bonds. So, for example, if the note issue was £100
versary, an alliance-to re-mint the coinage. Subjects and the central bank had bought £100 worth of bonds
would be ordered to bring their coins into the mint to be in issuing those notes, and the yield on the bonds was
melted down and coined afresh with a new stamp. 5 per cent, then seigniorage would be £5 per year. Some
Between the melting down and the recoining, however, seigniorage also arises from the policy of many central
the rulers had only to toss some further inexpensive banks in forcing commercial banks to place non-interest-
base metal in with the molten coins. This debasing of the bearing deposits, which the central bank can also use to
coinage allowed the ruler to earn a handsome profit by purchase interest-bearing securities. In the United King-
minting more new coins than the number of old ones dom the Bank of England returns all of the revenue from
collected, and putting the extras in the royal vault. seigniorage to HM Treasury.'

I
This is why the unit for weight, a pound, Is also the unit for
money. 3
'Commercial banks' are the private-sector banks that provide
2 The tradition of using precious metals is also reflected In current
deposit and loans services to personal and corporate customers, such
UK coinage. The small change, Ip and 2p coins look like copper, the as Barclays, NatWest, and HSBC.
Sp and I Op coins look like silver and the £1 coin looks like gold, while • The Bank of England's 2009 Annual Report shows that It paid
the £2 coin is part gold and part silver. However, they are all made of about £2.2 bllJion to HM Treasury from this source lo the year to end
much cheaper materials. February 2009.
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 451

Goldsmiths would give their depositors receipts promis-

~' Box 20.2 Gresham's Law ing to hand over the gold on demand. When any depositor
wished to make a large purchase, she could go to her
The early experience of currency debasement led to the obser- goldsmith, reclaim some of her gold, and hand it over to
vation known as Gresham's Law, after Sir Thomas Gresham, an the seller of the goods. If the seller had no immediate need
adviser to the Elizabethan court, who stated that 'bad money for the gold, he would carry it back to the goldsmith for
drives out good'. safekeeping on his behalf.
When Queen Elizabeth I came to the throne of England in If people knew the goldsmith to be reliable, there was
the middle of the sixteenth century, the coinage had been no need to go through the cumbersome and risky business
severely debased. Seeking to help trade, Elizabeth minted new
of physically transferring the gold. The buyer needed only
coins that contained their full face value in gold. However, as fast
to transfer the goldsmith's receipt to the seller, who would
as she fed these new coins into circulation, they disappeared.
Why?
accept it as long as he was confident that the goldsmith
Suppose that you possessed one new and one old coin, each would pay over the gold whenever it was needed. If the
with the same face value, and had a bill to pay. What would seller wished to buy something from a third party who
you do? Clearly, you would use the debased coin to pay the also knew the goldsmith to be reliable, passing the gold-
bill and keep the undebased one. (You part with less gold smith's receipt from the buyer to the seller too could effect
that way.) Again suppose that you wanted to obtain a certain this transaction. The deposit receipt was 'as good as gold'.
amount of gold bullion by melting down the gold coins (as was The convenience of using pieces of paper instead of gold
frequently done). Which coins would you use? Clearly, you is obvious.
wou Id use new, u ndebased coins because you would part When it came into being in this way, paper money
with less 'face value' that way. For these reasons, the debased
represented a promise to pay so much gold on demand.
coins would remain in circulation, and the undebased coins
In this case the promise was made first by goldsmiths and
would disappear.
Gresham's insights have proven helpful in explaining the later by banks." Such paper money, which became bank-
experience of a number of modern high-inflation economies. notes, was backed by precious metal and was convertible
For example, in the 1970s, inflation in Chile raised the value of on demand into this metal.6
the metallic content in coins above their face value. Coins
quickly disappeared from circulation as private citizens sold Fractionallybacked paper money
them to entrepreneurs who melted them down for their Early on many goldsmiths and banks discovered that it
metal. Only paper currency remained in circulation and was was not necessary to keep a full ounce of gold in the vaults
used even for tiny transactions such as purchasing a box of for every claim to an ounce circulating as paper money.
matches. Gresham's Law is one reason why modern coins, At any one time, some of the bank's customers would
unlike their historical counterparts, are merely tokens that
be withdrawing gold, others would be depositing it,
contain a metallic value that is only a minute fraction of their
and most would be trading in the bank's paper notes
face value.
Gresham's Law has had another modern interpretation, in
without indicating any need or desire to convert them
regimes of pegged exchange rates, where the values of two into gold.
currencies are pegged together artificially. If one currency is As a result, the bank was able to issue more money
overvalued and widely expected to have to be devalued, this (initially notes, but later deposits) redeemable in gold
causes people to spend it fast, while building up their holdings than the amount of gold that it held in its vaults. This was
of the undervalued currency. The combination of hoarding one good business, because the money could be invested prof-
currency and running down balances of the other often brings itably in interest-earning loans (often called advances) to
about the devaluation that was feared-as when the pound individuals and firms. The demand for loans arose, as it
sterling was forced to leave the European Exchange Rate
Mechanism (ERM) in September 1992 and when Argentina
was forced to break the link of its currency to the US dollar
in 2001. 5
Banks grew out of at least two other trades in addition to that of
the goldsmiths. There were scriveners, who had writing skills and sold
their services managing other people's financial affairs; there were
also merchant bankers, who started trading in commodities but ended
up specializing l.n trade finance-Barlngs and Rothschilds started this
Paper money way, and are still referred to as 'merchant banks' today. (In US termin-
ology they are called 'investment banks")
The next important step in the history of money was the 6 One of the earliest issuers of formal banknotes was the Riksbank

evolution of paper currency, one source of which was of Sweden, established in 1668. It is thus twenty-six years older than
the Bank of England, which was established in 1694. The Riksbank,
goldsmiths. Since goldsmiths had secure safes, the public which is now the central bank of Sweden, Instituted the Nobel Prize
began to deposit their gold with them for safekeeping. for economics In 1968 to commemorate its tercentenary.
452 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

does today, because some customers wanted credit to in the form of 'gold certificates' that asserted that the gold
help them over hard times or to buy equipment for their was available on demand. The gold supply thus set some
businesses. To this day banks have many more claims out- upper limit on the amount of currency. However, central
standing against them than they actually have in reserves banks, like private banks before them, could issue more
available to pay those claims. We say that the currency currency than they had in gold, because in normal times
issued in such a situation is fractionally backed by the only a small fraction of the currency was presented for
reserves. payment at any one time. Thus, even though the need to
The major problem with a fractionaUy backed, convert- maintain convertibility under a gold standard put an
ible currency was maintaining its convertibility into the upper limit on note issue, central banks had substantial
precious metal by which it was backed. The imprudent discretionary control over the quantity of currency
bank that issued too much paper money would find itself outstanding.
unable to redeem its currency in gold when the demand During the first half of the twentieth century almost
for gold was even slightly higher than usual. It would then all of the countries of the world abandoned the gold stan-
have to suspend payments, and all holders of its notes dard; their currencies were thus no longer convertible into
would suddenly find that the notes were worthless. How- gold. Money that is not convertible by law into anything
ever, the prudent bank that kept a reasonable relationship else derives its value from its acceptability in exchange.
between its note issue and its gold reserve would find that Fiat money is widely acceptable because government order,
it could meet a normal range of demand for gold without or fiat," declares it to be legal tender. Legal tender is any-
any trouble. thing that by law must be accepted when offered either
If the public lost confidence and demanded redemption for the purchase of goods or services or to discharge a debt.
of its currency en masse, however, the banks would be Bank of England notes have been legal tender in England
unable to honour their pledges. The history of nineteenth- and Wales since 1833.
and early-twentieth-century banking around the world is
Today almost all currency is fiat money.
fuJl of examples of banks that were ruined by 'panics', or
sudden runs on their gold reserves. When this happened, Bank of England notes still say on them 'I promise to
the banks' depositors and the holders of their notes would pay the bearer on demand the sum of x pounds', and they
find themselves with worthless pieces of paper.7 are signed by the chief cashier. Until 1931 (apart from
occasional temporary suspensions of convertibility) you
Fiat money could take these notes into the Bank of England and
As time went on, note issue by private banks became demand gold of equivalent value in return for your notes.
less common, and central banks, which are (usually) Today, however, the promise is a quaint tradition rather
state-owned institutions, took control of the currency. than a real contract. The pound sterling, like all major
Over time central banks have assumed a monopoly in currencies, is a fiat currency that is not backed by gold or
the provision of money to the economy.8 As a result they any other commodity (though some people still argue for
have the job of controlling monetary conditions and are the return to a gold standard).
ultimately responsible for determining the value of a
Fiat money is valuable because it is accepted by convention and
nation's (or group of nations') currency.
in law in payment for the purchase of goods or services and for
Originally central banks issued paper currency that was
the discharge of debts.
fully convertible into gold. In those days gold would be
brought to the central bank, which would issue currency Many people are disturbed to learn that present-day
paper money is neither backed by, nor convertible into,
anything more valuable-that it consists of nothing but
pieces of paper whose value derives from general accep-
7
In the early 1930s about 10,000 banks, or a third of the total, went tance. Many people believe that their money should be
bust in the United States. The personal and corporate losses involved more substantial than this.
were a major contributor to the Great Depression.
8 In England and Wales no new banks have been permitted to If fiat money is always acceptable in payment, it is a
issuenotessince the 1844 Bank Charter Act, though in Scotland banks medium of exchange, and, if its purchasing power remains
such as the Bank of Scotland, the Royal Bank of Scotland, and the stable, it is a satisfactory store of value. If both of these
Clydesdale Bank still issue the main notes in circulation. (Since 1845,
however, the Scottish note issue has had 100 per cent backing with things are true, it will also serve as a satisfactory unit of
Bank of England liabilities, and hence has been fully under Bank of account.
England direction.) ln 2002 euro notes were issued by the European
Central Bank to replace the previous currencies of the 11 member
states of the eurozone (see pages 490-1 below). ln 2010 the eurozone
had 16 members. • Fiat means 'let there be' in Latin, and hence 'by decree'.
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 453

How does money get into the economy?

When gold was the basis of money, it was not too difficult anyone in the private sector that holds it, but to the
to see how more gold got into circulation. It was either central bank it is a liability.
produced from gold mines, converted from non-monetary
The central bank gets high-powered money into the economy
uses (such as jewellery), or imported from other countries.
simply by buying securities (usually government debt instru-
In effect, it was received in payment for some transaction
ments). It pays for these purchases with newly issued high-
from the owners of gold mines, or from the previous
powered money.
owner of the gold, wherever in the world they happened
to be. However, it is not so obvious how fiat money gets Hence, in creating new high-powered money, the
into the economic system. In fact, as suggested above, central bank is expanding both sides of its own balance
it comes from the central bank-in the UK the Bank of sheet. At the same time as it increases its liabilities, it pur-
England, in the USA the Federal Reserve, in the euro area chases assets of equal value. Of the two components of
the European Central Bank (ECB). high-powered money, in the UK case bankers' deposits are
The central bank does not just drop money from the the liability of the Banking Department of the Bank of
sky, or even just give it to the government to spend. What England and currency is the liability of the Issue Depart-
the central bank has direct control over is referred to as ment. The balance sheets of these two departments are
high-powered money, the cash base, or the monetary shown in Table 20.1. The data here and the following
base. This consists of currency (banknotes and coin) held discussion are deliberately chosen to reflect normal times
by the public and the banks, and of deposits held by the prior to the financial crisis that started in 2007. We look
banks with the central bank.'? The monetary base is at the Bank of England's response to this crisis and the
referred to as high-powered money because it is the basis effect on its balance sheet more closely (especially on
upon which a much bigger stock of monetary assets is page 493) below.
built (including the biggest component of the money It is simplest to think of the process of high-powered
stock, bank deposits). High-powered money ls an asset to money creation in two steps. First, we will discuss, using

Table20.1 Bank of England balance sheet, February 22nd 2006

Assets (Em) Liabilities (Em)

(i) Balance sheet of issue department

Government securities 13,370 Notes in circulation 36,834
Other securities 23,470 Notes in Banking Dept. __6
Total assets 36,840 Total liabilities 36,840
(ii) Balance sheet of banking department
Government securities 2,173 Public deposits 788
Advances 15.406 Bankers' deposits 2,884
Premises, equipment and other securities 7,485 Reserves and other acs. 21,383
Notes and coin __ 6 Balancing item __ 15
Total assets 25,070 25,070

The Bank of England is divided into the Issue Department and the Banking Department. The table shows the balance sheets of these two depart·
ments at 22 February 2006. The only function of the issue department is to issue currency (banknotes). It does this in exchange for purchases of
securities, normally through a transaction with the banking department. The Banking Department acts as banker to the government and also holds
deposits from the banks.
Source: Bank of England, Monetaryand Financial Statistics.

•0 The monetary base includes bankers working balances at the latter are a form of tax on the banks that finance the Bank of England,
Bank of England but it excludes compulsory cash ratio deposits. The making it not reliant on government funding.
454 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

the UK example, how the purchase of securities by the cash from the Banking Department. The Banking Depart-
Bank of England creates bankers' deposits. Then, we will ment, in turn, would replenish its own stock of cash by
selling securities to the Issue Department. The Issue
see how currency gets into circulation.
Department prints the new currency. Currency is made
available on demand to the economy in this way and is
Bankers' deposits not restricted in supply by the Bank of England.
Consider a situation in which there are initially no net The stock of currency in circulation is determined entirely by the
transactions between the Bank of England and the rest of demands of the economy and is not set by any policymakers.
the economy. The Bank now buys£ lm worth of securities
from an agent in the private sector. The seller receives a
cheque for £1m from the Bank of England that is paid Modern money
into the recipient's bank account at, say, Barclays Bank. The total amount of money in the economy is called the
Barclays' deposits rise by £1m, but at the same time money supply or the money stock." The creation of
Barclays receives an increase of £1m in its deposits at the high-powered money is only part of the story of how the
Bank of England. The balance in Barclays' account at the money supply is created, because most measures of the
Bank of England is an example of what are called bankers' money supply include a wider range of assets than just
deposits. This increase in its bankers' deposits at the Bank the monetary base. In particular, money is usually defined
of England arises when Barclays clears the cheque drawn to include bank deposits.
on the Bank of England. (A cheque deposited in Barclays
drawn on HSBC Bank would simply transfer bankers' Depositmoney
deposits from HSBC to Barclays, but a cheque drawn on Today's bank customers frequently deposit coins and
the Bank of England creates new bankers' deposits at the paper money with the banks for safekeeping, just as in
central bank.) former times they deposited gold. Such a deposit is
This is not be the end of the story so far as Barclays is recorded as a credit to the customer's account. A customer
concerned, because as we shall see bankers' deposits who wishes to pay a debt may come to the bank, claim the
constitute reserves against which the commercial banks money in currency, and then pay the money to someone
can create new deposits. We will soon explain how this else, who may themselves redeposit the money in a bank.
is done. In the meantime, this is most of what we need As with gold transfers, this is a tedious procedure. It is
to know about how the Bank of England expands the more convenient to have the bank transfer claims to
monetary base, though we will look more closely in money on deposit. As soon as cheques, which are written
Chapter 21 at how the Bank of England uses its money instructions to the bank to make a transfer, became widely
market operations to set interest rates in normal times and accepted in payment for commodities and debts, bank
we will also explain the special monetary measures, deposits became a form of money called 'deposit money'.
known as quantitative easing, that were introduced in Deposit money is defined as money held by the public
2009. Contraction of the monetary base simply reverses in the form of deposits in commercial banks that can be
the process-the Bank sells securities. A member of the withdrawn on demand. Cheques, unlike banknotes, do
public then writes a cheque drawn on, say, NatWest Bank, not circulate freely from hand to hand; thus cheques
payable to the Bank of England, and NatWest transfers themselves are not currency. However, a balance in a
bankers' deposits to the Bank of an equivalent amount. current account deposit is money; the cheque simply
The monetary base falls. transfers that money from one person to another. Because
cheques are easily drawn and deposited, and because they
are relatively safe from theft, they have been widely used.
Currency
New technology has recently replaced many cheque
The above discussion explains how central banks, such as transactions by computer transfer. Plastic cards, such as
the Bank of England, create or destroy high-powered Visa, Mastercard, and Maestro, enable holders of bank
money. The division of high-powered money between
bankers' deposits and currency is determined by the
demand for currency on the part of the general public. . .
If private individuals (or firms) choose to increase their .... ~; Those who have studied microeconomics should note that the
currency holdings, relative to bank deposits, they simply concept of a money supply is different from the concept of the su~ply
of some commodity. In microeconomics, supply refers to a desued
go to their bank and withdraw deposits in cash. The bank quantity: how much a producer would like to make and sell per period.
(if it did not have enough cash in its tills) would go to the In macroeconomics, the money supply is the actual amount of money
Bank of England and withdraw some bankers' deposits in that is in existence at a point in time.
 CHAPTER 20 MONEY AND MONETARYINSTITUTIONS 45 5
accounts to transfer money to another person's account Bank deposits are money. Today, just as in the past, banks can
in new ways.12 The principle is the same, however: the create money by issuing more promises to pay (deposits) than
balance in the bank account is the money that is to be they have cash reserves available to pay out.
transferred between customers, not the cheque or the
plastic card. The main reason that we are interested in the money
When commercial banks lost the right to issue notes of stock is that if the amount of money is increased too
their own, the form of bank money changed, but the sub- quickly inflation will result. Here, 'too fast' roughly means
stance did not. Today banks have money in their vaults faster than real GDP is growing. For this purpose, it is the
(or on deposit with the central bank) just as they always broad measure of the money stock that includes bank
did. Once it was gold; today it is the legal tender of the deposits that is most relevant, as bank deposits can be
times-fiat money. It is true today, just as in the past, that used in payment for goods and it is often said that 'too
most of the banks' customers are content to pay their bills much money chasing too few goods' is the source of
by passing among themselves the banks' promises to pay inflation. Which specific measure of broad money we
money on demand. Only a small proportion of the value choose to use is of second-order importance.
of the transactions made by the banks' customers involves Box 20.3 shows the various measures of the money
the use of cash. stock that were in use in the United Kingdom in 2010. The

Box 20.3 Definitions of UK monetary aggregates

The way in which 'money' is defined has changed a great deal over • Retail M4. This encompasses UK non-bank and non-building·
time and is likely to change again in the future. In 1750 money would society holdings of notes and coins, plus sterling retail deposits with
almost certainly have been defined as the stock of gold in circula- UK banks and building societies.
tion (specie). By 1850 it would probably have been defined as gold • M4. M4 is retail M4 plus all other private sector sterling interest-
in the hands of the non-bank public plus banknotes in circulation.
bearing deposits at banks and building societies, plus sterling cer-
In 1950 the most likely definition would have been currency held tificates of deposit (and other paper issued by banks and building
by the public plus current account bank deposits. In 1998 money societies of not more than five years' original maturity).
was usually defined to include currency held by the public plus all
deposits (current and savings) in banks and building societies. By • M3. This is a harmonized measure created to have standard
2050, who knows? Perhaps money on the internet will be included. money definitions throughout the EU. It is equal to M4 plus resi-
There have been many changes in the definition of money even dents' foreign currency deposits in UK banks and building societies
in the last few years. Many of these are the result of the financial plus public corporations' sterling and foreign currency deposits in
innovations of the 1980s. We should not expect this to be the end UK banks and building societies.
of the story. UK money measures such as Ml and £M3 (sterling
M3), which were at the centre of monetary policy debates into the The accompanying table presents data for these monetary
first half of the 1980s, have disappeared. These had to be dropped aggregates for January 2010.
after 1989, when the Abbey National Building Society converted UK money supply, January 2010
into a bank (and other conversions followed later). Thereafter, any (E million, SA)
monetary aggregate that contained bank deposits but not building
society deposits became distorted. MO, which includes notes and Notes and coin in circulation 47,031
coin in circulation and bankers' working deposits at the Bank of Retail M4 1,134,180
England used to be used as a narrow money measure, but this has
Wholesale M4 1,027,586
been dropped since changes in the rules affecting banks' reserves
M4 2,208,704
were changed in 2006. Banks' reserve holdings have been even
more distorted by quantitative easing in 2009-10. M3 2,374,815
The money measures current in 2010 were as follows:
Note: Data for components of M4 do not add up the whole owing to
• Notes and coin. This measure refers to all the currency in separate seasonal adjustments.
circulation outside the Bank of England. Source: Bank of England, Monetaryond Financial Statistics.

12
With credit cards such as Visa or Mastercard, if you buy, say, petrol point of sale) cards like Maestro,however, the funds are transferred direc-
today, the petrol companywill receive a credit In its bank account after tly from your account to the account of the petrol company very quickly.
a few days and you will have to settle with the credit card company The technology is likely to keep changing, but it does not fundament-
once a month. With so-called EFTPOS (electronic funds transfer at the ally alter the nature of the bank account transfer that is involved.
456 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

main aggregate is M4, a broad measure that includes all slightly larger than M4 because it adds residents' foreign
retail and wholesale bank and building society deposits. currency deposits (and some public sector deposits) to M4.
Notes and coin in circulation is also available, as is retail We now turn to a discussion of the role of banks in
M4.13 Notice also that there is also an EU harmonized determining the broad money supply and in transmitting
measure of broad money known in the UK as M3. This is policy-determined interest-rate changes to the economy.

Two models of banking

We now present two models of the creation of deposit deposit of £100 in cash. Each bank now has on its books
money. The first shows how banks can create a large vol- the new entries shown in Table 20.2. The banks are on a
ume of deposit money on the basis of a given amount of fractional reserve system, and we assume for purposes of
reserves. It is called the ratios approach to the creation of this illustration that they wish to hold 10 per cent cash
money and is best suited for showing the relation between reserves against all deposits. The new deposits put the
reserves and deposit money. The second shows how banks banks into disequilibrium, since they each have 100 per
work in a competitive environment to attract the reserves cent reserves against these new deposits.
they need in order to create deposit money. This model is First, suppose that only one of the ten banks begins to
better suited to understanding both the forces of competi- expand deposits by making new Joans (advances). When
tion between banks themselves and the competition a bank makes a loan to a customer, it simply writes a larger
between banks and other channels of financial interme- balance into the customer's account, thereby increasing
diation (such as securities markets). the size of its deposits. Now, when cheques are written on
these deposits, the majority will be deposited in other
The ratios approachto the creation of banks. If, for example, this one bank has only 10 per cent
of the total deposits held by the community, then, on
deposit money average, 90 per cent of any new deposits it creates for its
If you deposit cash with a bank, that deposit is an asset to customers-and thus much of its £100 in cash-wiJI drain
you and a liability to the bank-because the bank owes away to other banks. On this basis the bank will make
that amount to you. Because the bank has the cash as an loans of £90, expecting that it will suffer a cash drain of
asset, its assets equal its liabilities. If a bank gives you a £81 on account of these Joans, leaving it with a £19 cash
loan, it writes an extra balance into your account. This reserve (£100 new deposit minus the £81 cash drain). This
creates a deposit for you, but it is also a loan that you have is the position shown in Table 20.3.
to repay. So the process of overdraft or loan creation cre-
One bank in a multi-bank system cannot produce a large
ates both deposits and loans simultaneously. In general,
multiple expansion of deposits based on an original accretion
banks' deposits are their liabilities, and whatever loans
of cash when other banks do not also expand their deposits.
they make or securities they purchase constitute their
assets. We will see below how banks can create deposits Now assume, however, that all ten banks begin to
(and loans) that are some multiple of their cash reserves. expand their deposits based on the £100 of new reserves
This fractional reserve ban.king is analogous to the frac- that each received. On the one hand, since each bank does
tional backing of the note issue discussed above. Notice one-tenth of the total banking business, 90 per cent of the
two slightly different meanings of the term cash. 'Cash'
held by the banks can be currency in their tills or deposits
at the central bank; 'cash' for the public means currency.
Suppose that, in a system with many banks, each bank Table 20.2 A new cash deposit
obtains new deposits in cash. Say, for example, that there liabilities (f) Assets {£)
are ten banks of equal size and that each receives a new
Deposit 100 Cash 100

13
A new cash deposit has 100 per cent backing. The balance sheet
Notes and coin plus bankersdeposits at the Bank of England used
shows the changes in assets and liabilities resulting from a new cash
to be known as MO, but big changes in the Bank's reserve operations
and quantitative easing have cause major distortions lo MO so this is deposit. Both cash assets and deposit liabilities rise by the same
no longer used as a monetary aggregate. Retail M4 used to be known amount.
asM2.
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 457

Table 20.3 Deposit expansion in expectation of a cash drain Table 20.4 Restoration of a 10 per cent reserve ratio

Liabilities (£) A5sets (£) Liabilities (£) Assets (£)

Deposit 190 Cash 100 Deposit 1,000 Cash 100

Loans ..2Q Loans 900
190 190 1,000 1,000

If a bank expands deposits in the expectation of a cash drain, it will With no cash drain, a new cash deposit will support a multiple
end up with excess reserves. The table shows the position if a bank expansion of deposit liabilities. The table shows the changes in
expands deposits on the basis of receiving £ l 00 in new cash deposits assets and liabilities when all banks engage in deposit expansion after
and in the expectation that 90 per cent of any new deposits will drain each has received a new cash deposit of £ l00. New assets are £900
out of the bank in a cash flow. The bank obtains new assets of loans and new deposits are E900. The accretion of £100 in cash now sup-
and bonds of £90 by creating new deposits of that amount It expects ports £1,000 in deposits, thus restoring the 10 per cent reserve ratio.
£81 of these to be withdrawn in cash, leaving it with £ 19 to provide a A multi-bank system creates a multiple increase in deposit money
10 per cent reserve against £190 of deposits. when all banks with excess reserves expand their deposits in step
with each other.

value of any newly created deposits will find its way into
other banks as customers make payments by cheque to
various members of the community. This represents a Table 20,5 Deposit creation with a cash drain to the public
cash drain to these other banks. On the other hand, 10 per
Liabilities (£) Assets (£)
cent of the new deposits created by each other bank
should find its way into this bank. Thus, if all banks receive Deposit 500 Cash 50
new cash, and all start creating deposits simultaneously, Loans 450
no bank should suffer a significant cash drain to any other 500 500
bank. Instead of finding itself with its surplus cash drained
away, a bank with the balance sheet shown in Table 20.3 A cash drain to the public greatly reduces the amount of new depos-
its that can be created on the basis of a given amount of cash. The
would have cash reserves of close to 53 per cent (£100 table shows the balance sheet of the banking system on the assump-
reserves against £190 deposits) rather than only 10 per cent tion thatthere is £100 of cash in the system butthe public desires cash
as desired. holdings equal to 10 per cent of their bank deposits. The outcome that
When all banks can go on expanding deposits without satisfies both banks' desired reserve ratio and the public's cash to
losing cash to each other, they need only worry about deposit ratio is such that the banks hold £50 in reserves and issue
£450 worth of loans. Total deposits are £500, and £50 is held in cash
keeping enough cash to satisfy those depositors who
by the public. The total money stock is £550 (deposits plus cash held
occasionally require cash. Thus, the expansion can go on, by the public). An example in which the banks' reserve ratio differs
with each bank watching its own ratio of cash reserves to from the public's cash to deposits ratio is given in Table 20.6.
deposits, expanding its deposits as long as the ratio exceeds
1:10 and ceasing to do so when it reaches that figure.
Assuming no cash drain to the public, the process will not
come to a halt until each bank has created £900 in addi-
tional deposits, so that, for each initial £100 cash deposit, new deposit money, the system will suffer a cash drain as
there is now £1,000 in deposits backed by £100 in cash. the public withdraws enough cash from the banks to
Now each of the banks will have new entries in its books maintain its desired ratio of cash to deposits.
similar to those shown in Table 20.4. An example
A multi-bank system creates a multiple increase in deposit Assume that the public wishes to hold a proportion of
money when all banks with excess reserves expand their depos- cash equal to 10 per cent of the size of its bank deposits.
its in step with each other. This means that for a given stock of cash in the system,
the amount that will be held in bank reserves is reduced,
A complication: cash drainto the public so the maximum amount of deposit creation is also
So far we have ignored the fact that the public actually reduced. Tn this special case in which banks have a reserve
divides its money holdings in a fairly stable proportion ratio of 10 per cent and the public holds cash to the value
between cash and deposits. This means that when the of 10 per cent of the size of its bank deposrts, the outcome
banking system as a whole creates significant amounts of will be as in Table 20.5. Half of the cash in existence
458 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

(assumed to be £100 in total) will be held in banks' We can arrive at an expression that links M and H by
reserves, and the public will hold the other hall. On the substituting eqn (20.2) into eqn (20.S) for C and then eqn
basis of their £50 reserves, banks will extend £450 of (20.4) into eqn (20.5) for D. This gives
loans, so total deposits will be £500. This is only half
of the value of deposits that were created when the M= (b+ 1) H. (20.6)
(b+x)
entire £100 of cash was held in bank reserves (as shown
in Table 20.3). Expression (20.6) is known as the money multiplier,
because it tells us how much bigger is the money supply
A cash drain to the public reduces the expansion of deposit
than the cash base of the system. In the UK banking sys-
money that can be supported by the banking system.
tem, prior to the recent financial crisis, reserve ratios and
The general case of deposit creation cash ratios were small and the money multiplier was of
The two ratios that we have discussed (the banks' reserve the order of 30, since M4 was 30 times greater than notes
ratio and public's ratio of cash to deposits) can now be and coin in circulation plus bankers' deposits at the Bank
used to determine the total level of deposit creation in of England. 14 However, as a result of the special monetary
a formal way. Let R be the cash held in bank reserves, operations called quantitative easing in 2009-10, bankers'
C be the cash held by the non-bank public, H (for high- deposits at the Bank of England rose enormously and the
powered money) be the total cash in the economy, and D money multiplier shrank to about 10. We discuss quanti-
be the size of bank deposits. Thus tative easing in more detail. in Chapter 21.
The money multiplier should not be confused with the
C+R=H. (20.1) multiplier that links changes in exogenous spending with
This says that the total cash in the economy is held either changes in GDP. The same term is used for two different
by the banks or by the public. Let the desired reserve ratio concepts.
of banks be x. This allows us to write The size of the money multiplier is greater, the smaller is the
R=xD. (20.2) banks' desired reserve ratio x and the smaller is the public's
desired cash ratio b.
Finally, let the public hold a fraction, b, of its bank depos-
A diagrammatic exposition of the above algebra is given
its in cash:
in Figure 20.1. It shows that the two ratios, combined with
C=bD. (20.3) a given cash base, can be used to determine the level of
deposits that result and also the money supply. A numer-
Substituting the second and third equations into the
ical example of the same ideas is given in Table 20.6.
first gives

bD+xD=H,
A competitivebankingsystem
and solving for D yields
The ratios approach to bank behaviour gives us important
insights into how deposit money is created as some
D=_!!_. (20.4)
(b+x) multiple of high-powered money, but it does not provide
an accurate picture of how modern banks work. They do
Equation (20.4) shows that if the public's desired cash ratio not just sit around waiting for cash deposits to be made
is zero, deposits rise by the reciprocal of the cash reserve and then lend some multiple of the deposit (though it is
ratio. (If the banks' reserve ratio were 0.1 (10 per cent), then certainly true that their deposits are some multiple of
deposits would be ten times the cash in the economy.) their reserves, and since eqn (20.6) above is an identity it
A positive value of b, however, means that the resulting cannot be 'wrong'). Instead, modern banks usually start
cash drain lowers the increase in deposits since it raises from the other end. They wait until they have found a
the value of the denominator in eqn (20.4). profitable lending opportunity, and they then take steps
The money multiplier to make sure that funds are available to make the loan.
The total money supply in an economy with a banking This they can do either by offering higher interest on
system is defined as D + C. (It does not include R because deposits, or by borrowing from other banks.
In the ratios world, banks passively receive deposits
the deposit that created the original bank reserves is
and then use these to make loans. In the modern world,
already counted in with deposits, D, and should not be
however, banks are trading in highly competitive markets
counted twice.) Hence the money supply, M, is

M=C+D. (20.5) 14
This was the figure in 2006, for example.
 CHAPTER 20 MONEY ANO MONETARY INSTITUTIONS 459
make loans. They borrow from one set of people or firms
and lend to another.
The supply curve of deposits is positively sloped because
for given interest rates elsewhere in the economy, banks

Total cash
in economy
(monetary
l cash held
by banks
cash held
D
can attract more deposits by offering higher interest rates.
(Not all deposits in banks pay interest, but the deposits
that banks can increase by offering high interest rates-
their marginal deposits-do.) To make the explanation
base) by public easier, we assume that the spread is a constant absolute
Deposits size, so that the supply curve of loans is drawn parallel to
the supply curve of deposits, but above it by the constant
Figure 20.1 The ratios approach to the determination amount of the spread.15
of the money supply
The public's demand curve for loans is negatively sloped
The money supply is determined by the stock of high-powered because the higher the interest rate being charged the less
money (monetary base), the reserve ratio of the banks, and the
cash-deposit ratio of the non-bank public. The diagram illustrates will customers wish to borrow. Equilibrium in the market
the size of deposit creation, given the banks' reserve ratio x (= AC! for bank loans occurs where the demand and supply curves
CB), the public's cash-deposit ratio b (= EC/CF), and the total cash intersect, the amount customers wish to borrow is equal
in the economy AC. Deposits plus cash held by the public make up to the amount banks wish to lend.
the total money supply. The total stock of high-powered money, or
cash, in the economy has to be held by either the banks or the public. Money supply and competitive banking
At point A the public holds all the cash available so there are no bank
deposits, and the total money supply is just AC, which is all cash. The ratios approach to money supply creation and the
At point C the banks hold all the cash and on that reserve base they competitive model of banking present two rather different
create deposits of CB. The line AB thus plots the level of deposit ways of looking at the banking system, but they are com-
creation resulting from each level of cash reserves (where point
patible. Indeed, each helps us understand the other better,
A represents the point where banks have no cash or deposits and
point C represents the point where all the cash in the economy is held and both are necessary for a complete understanding of
in bank reserves and CB is the value of bank deposits created on that modern monetary control techniques.
reserve base). The banks' reserve ratio AC/CB is thus equal to (minus) The ratios approach tells us that the total money supply
the slope of AB. is related to the stock of high-powered money, this rela-
The line CD represents the cash-deposit ratio for the non-bank
tionship being determined by the reserve ratio of banks
public. Its slope, measured by EC/CF, is equal to that cash-deposit
ratio. For a given base of high-powered money(cash), deposit creation and the cash-deposits ratio of the public. For given reserve
will be determined at the point where these two ratios are both satis- ratios the total money supply would be determined if the
fied. This will be where CD and AB intersect. So the actual outcome authorities fixed the supply of high-powered money.
is at point C, where banks have AE cash in reserves and create CF of However, the UK monetary authorities (and most other
deposits. The public holds EC of cash and CF of deposits. The total
central banks, including the ECB) do not normally operate
money supply at G is given by CF plus EC.
this way. Rather, they aim to control total deposits via the
demand for bank loans. If they wish to lower deposits (and
for both deposits and loans. In a competitive market there loans), they force up short-term interest rates, as shown in
will be a market-clearing interest rate for both deposit Figure 20.2. In other words the authorities use the know-
money and loans. Banks cannot expand their activity in ledge of the market demand curve for loans in order to
either of these markets without taking into account the influence the total stock of deposits and, therefore, also
supply curve of deposits and the demand curve for loans the money supply. Box 20.4 discusses whether the evolu-
that they face. tion of electronic money, sometimes called e-rnoney, will
The market for bank loans is illustrated in Figure 20.2. have an impact on the way the monetary system works.
This shows a positively sloped supply curve for the loans Having chosen what they think is the correct interest
that banks are willing to make to the public and a nega- rate to generate the desired demand for loans, the UK
tively sloped demand curve for the loans that the public monetary authorities supply whatever high-powered
is willing to take out. The supply curve of loans is deter- money is demanded at that going interest rate. So, the
mined by two factors: the supply curve of deposits, and
the spread. The spread is the difference between what rs Although, the spread may vary from loan to loan depending,
the banks have to pay to borrow money and what they among other things, on the size or the loan and the credit worthiness
get by lending it (which has to provide a margin to cover of the customer, on average the spread over all loans is driven down
by competition among banks to an amount that will [ust cover costs
staff costs, return on capital employed, and default risk). with no pure profits. I Ienco, Its average value can be reasonably
Remember that banks have to take in deposits in order to assumed to be a constant.
460 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

Table 20.6 High-powered money, deposits, and the money supply

Banks Non-bank public High-powered Money supply

money (H=C+ R) (M=C+D)
Reserves (R} Deposits (D) Cash (C) Deposits (0)
(Rx 20) (1,000-R) (Cx 10)
(1) (2) (3) (4) (5) (6)

1,000 20,000 0 0 1,000

600 12,000 400 4,000 1,000
400 8,000 600 6,000 1,000
333.3 6,666.6 666.6 6,666.6 1,000 7,333.3
200 4,000 800 8,000 1,000
100 2,000 900 9,000 1,000
0 0 1,000 10,000 1,000

For a given stock of high-powered money, the amount of bank deposits created will be the amount that is consistent with the banks' reserve
ratio and the non-bank public's cash-deposit ratio. The table sets out a range of desired positions for banks and the non-bank public independently.
Only one of these positions satisfies the desired positions for both the banks and the public, such that the deposits the banks wish to create are the
same as the deposits the public wishes to hold.
The example assumes that high-powered money (the cash base or monetary base) is fixed at El,000. This can be held in some proportion between
the banks and the public, but it cannot be changed other than by the monetary authorities. Banks are assumed to have a reserve ratio of 5 per cent,
and the non-bank public is assumed to wish to hold cash at a level 10 per cent of their holding of bank deposits. Column ( 1) shows a range of
possible levels of reserve holding for the banks, ranging from all of the £1,000 to none of it. Column (2) shows the level of deposits they would like
to create (by making loans) in order to satisfy their desired reserve ratio for each level of reserve holding in column (1 ). Column (3) shows the cash
holding by the public that is implied for each level of banks' reserves in column (1 ), so it is equal to E 1,000 minus the number in column (1 ). Column
(4) shows the level of deposits that the public would like to hold given their cash holdings in column (3). Column (5) reminds us that the stock of
high-powered money is fixed at El ,000 throughout. Column (6) shows the value of the money supply for the unique position that satisfies the desires
of both the banks and the public.
The actual outcome is the single position where the deposits that the banks wish to create are exactly equal to the deposits the public wishes to
hold. This is where the level of deposits is £6,666.6. At this point the banks hold £333.3 in reserves and the public holds £666.6 in cash. The money
supply is £7,333.3 (deposits plus cash held by the public) and the money multiplier is 7.333 (MfH). We could also calculate this from equation (6) on
p. 454: (b + 1 )/(b +x) is 1.1/0.15 (where b=O. l and x=0.05); this is 7.333.

Figure 20.2 Competitive banking: supply of and demand

Supply of loans
for loans
Supply of
deposits The volume of bank loans is determined by the intersection of the supply
curve of loans and the demand curve for loans. The diagram shows the posi-
tively sloped supply curve of loans and the negatively sloped demand curve for
loans. The supply curve of loans is determined by the supply curve of deposits
and the spread, or the interest margin that banks require to cover costs and risk.
For given interest rates elsewhere in the economy, the supply curve of deposits
is positively sloped because higher interest will attract more savings. The demand
'' curve for loans is negatively sloped-high interest rates discourage borrowing
'' and low rates encourage borrowing. Competition in banking drives the margin
' between deposit and loan rates to a level like l, - id, where the spread is just
'' enough to allow banks to cover costs and make a normal return on capital. With
', Demand for
the demand and supply curves shown there will be OA deposits and loans, and
loans
depositors will receive an interest rate of id while borrowers pay the loan rate i1•
0 A
Volume of loans and deposits
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 461

Box 20.4 The implications of electronic moneyfor the monetary system

Some people have argued that electronic money will fundamentally Secondly, there are some forms of money that are transferred via
change the nature of the monetary system and perhaps even the internet. Here the answer depends on the nature of the transac-
eliminate the power of central banks to either control the stock of tion involved. If all you are doing is using an internet message to
high-powered money or set the short-term interest rate in money transfer funds from your bank account to someone else's, then
markets. Is this likely? again this is just a new way of writing a cheque and no new
Our answer is that this is possible but very unlikely. There are two principles are involved. If, however, new types of institution get to
main forms of electronic money. be able to issue tokens that become widely accepted in payment,
First, what is sometimes called an 'electronic purse', involves then this would be a new departure and these new forms of money
loading some prepaid credits onto a plastic card (that either has a could provide a substitute for existing moneys. However, if such new
magnetic strip or a computer chip recording information). The car- moneys did emerge it is most likely that governments would
rier of the card can then use this to make retail payments in various regulate them. The money issuers would be regulated like banks,
shops where some of the balance on the card can be transferred to and as banks they would have to hold deposits with the central bank.
the retailer. Such cards are just a more general form of pre-paid In which case, again, no new principles would be involved. Indeed,
telephone cards that carry some credit paid for in advance. They are most large payments, both in the domestic economy and in the inter-
certainly feasible methods of facilitating some payments. But national economy, have been made electronically for many years.
whether they catch on remains to be seen. The key thing to note is This trend started with the invention of the telegraph in the 1830s
that they offer no difference in principle from earlier payment and continued with the opening of the trans-Atlantic telegraph
methods. In effect, they are just a new way of transferring owner- cable in the 1880s. The internet is a new technology for authorizing
ship of bank deposits from one person to another. They may lead to payments but the monetary principles involved are not new.
the general public needing to hold less cash, but they do not change This all suggests that e-money is not going to break the monop-
the reality that bank deposits are the main component of money. oly of central banks to issue high-powered money and so it is not
The amount of cash loaded onto one of these cards is in effect a going to weaken their ability to set interest rates in wholesale
bank deposit and this is transferred to the retailer when a purchase money markets. Neither is e-rnoney going to affect the ability of
is made. This is just a new way of ordering your bank to transfer central banks to control inflation, as that depends on the impact of
money from your account to that of someone from whom you interest rates on spending decisions and this is not affected in any
buy goods. obvious way by the nature of the payments technology.

authorities do not fix the supply of high-powered money; able to them to more profitable uses. Thus, in the absence
rather, this is demand-determined at the interest rate that of high legal reserve requirements (and aside from the
policymakers have set. The competitive model of banking crisis conditions of recent years), banks' chosen reserve
helps us to see how this can be done by moving up or ratios tend to be very small, especially when, as in normal
down the market demand curve for bank loans. We will market conditions, they can access liquid funds very
return to this issue in more detail below. quickly by borrowing in the interbank market.
Before moving on, however, there are two other Imper- Secondly, the competitive model helps us to understand
tant insights provided by the competitive model of bank- that the banking system as a whole is in competition with
ing. Flrst, in the absence of reserve requirements imposed other financial channels in the economy for the available
on the banking system by the monetary authorities, 16 we amount of borrowing and lending (intermediation)
can see that the reserve ratio that banks will choose will business at any point in time. The real size of the banking
be the outcome of an internal optimization process. Banks sector, relative to other channels of finance (and, indeed,
will try to keep the level of reserves as low as possible, other industries), is determined by how efficient it is in
subject to the need to supply cash on demand when cus- channelling funds from savers to borrowers in the econ-
tomers wish to withdraw deposits. This is because reserves omy. Issues relating to the nominal size of bank deposits
earn a relatively low interest rate and so banks would like and the money supply should be kept separate from the
to devote as much as possible of the funds that are avail- question of the real relative size of the banking system as
compared to other channels of borrowing and lending
flows (such as through securities markets).
In the next chapter we look at how money fits in to our
16
In the United Kingdom in March 2010 reserves (known as the short-term model of the macro economy. Before conclud-
cash-ratio deposit, or CRD) held with the flank of England were
required to be 0.11 per cent of deposits for institutions with deposits ing this chapter we turn to the issue of financial crises and
above £500 million and zero for smaller deposit-taking institutions. how they affect the rest of the economy.
462 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

Financial crises

So far in this chapter we have been explaining how banks

and the monetary system work in normal times. From Box 20.5 Neither a borrower
time to time, however, things go badly wrong and banks nor a lender be!
collapse. When many financial institutions are in trouble
at the same time, this is associated with a financial crisis. There were a number of specific factors that contributed to
This section discusses the general characteristics of most the instability in US and UK financial institutions and led to
financial crises. Box 20.5 discusses some specific factors the 2007-8 financial crisis. Many of these are discussed in the
behind the global banking crisis of 2007-8 and the case text but some other important underlying influences are set
studies below cover other important aspects of this crisis. out here.
A global financial crisis erupted in Europe and North At one time investment banks and many other financial
America in 2007-8 and its aftereffects will still be felt well firms were partnerships and their managers were also owners
who cared about the long-term profits and survival of the
into the middle of the following decade. Certainly they
business. When these firms became limited liability companies
were still influencing major economies and government
in the 1980s and 1990s (the timing varied between countries)
policies in 2010 when this book was being written. We the managers were no longer also owners and they were then
will look more closely at the recent financial crisis in the playing with other people's money. Their perspective then
case study below and in several of the following chapters. became that of maximizing current returns on which their
However, here we set out some patterns that are common salaries and bonuses depended. Many of them were paid
to many financial crises. The underlying forces that we bonuses based on how much new business they had set up for
will set out are the same forces that are associated with their bank within a specific year, so they had an incentive to set
business cycles (see Box 16.1 on page 361). Financial crises up as many deals as possible even if some of these deals were
are not the outcome in every cycle but they are associated increasingly risky (such as the securitization of mortgages as
discussed in the second case study below). These deals looked
with the most severe downturns.
profitable when first set up but banks as a whole made huge
losses when the underlying value of these assets collapsed
Optimismin the upturn (and many banks found themselves holding large amounts of
mortgage-backed securities, or were liable for those that they
Most financial crises have their roots in a sustained period had created).
of economic growth and rising optimism. This may have Financial innovations, such as the growth of derivatives
started as the slow recovery after a previous slowdown and securitization (see below) allowed them to bundle loans
or recession. As activity increases consumer confidence together and sell them on in such a way as to confuse inventors.
rises and demand in the economy expands. Firms invest For example, by bundling very bad loans with a few quite good
to provide more capacity with which to supply their prod- ones they could make the average look not too bad and so
unload the real turkeys.
ucts and this enhances job prospects, which further
The rating agencies also had a role to play in the explosion
enhances consumer confidence.
of the mortgage-backed securities market. They were paid by
In the financial sector, banks see firms and consumers the banks to rate the securities they were issuing, and were thus
with growing incomes and they feel confident about Lend- caught in a classic conflict of interest situation. The ratings
ing to finance further expansion or property purchases. agencies gave AAA ratings to securities that turned out to be
Asset prices, such as house prices and company shares, rise very risky and so were really B or C (or worse). Investors bought
in value and this makes lenders even more confident as these as they were rated as low risk and banks could use the
they see the collateral of borrowers increasing in value. funds raised to buy even more risky mortgages and resell
Worries about risks of default tend to shrink as economic those too.
prospects generally improve and the longer a sustained Since agents selling the mortgages and the firms granting
them got paid commissions and bonuses based on current
period of growth appears to be continuing. This makes
sales and since securitization allowed them to offload these
finance even cheaper for those who wish to borrow to
high risk assets before the risks were obvious, the incentives
finance investment or asset acquisition.
were all in the wrong direction.
As asset prices rise, speculative purchases can lead to even Thus, a central element of the recent financial crisis was the
further rises. In stock markets, investors buy in expect- incentive structure faced by bankers themselves. How these
ation of being able to sell at higher prices later. In housing incentive problems can be avoided in future remains a topic of
markets, potential buyers worry about missing out on active debate.
owning a house. They see prices rising and rush to buy in
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 463
case prices rise even higher in future. Those with spare Many factors could trigger the end of the boom, but once
cash feel that property would be a good investment so buy households and firms switch to being pessimistic about
in order to let rather than occupy. All of these forces lead their prospects then the forces of contraction can set in
to prices continuing to rise for some time and many feel quite quickly. The first visible sign of the downturn is
encouraged to borrow as much as they can in order to buy often a sharp fall in the stock market. This leads those who
assets with rising values. Consumers feel confident in have been speculating on higher share prices to want to
borrowing to finance further spending as their incomes sell as quickly as possible. Selling pressure can lead to very
are rising and their jobs seem secure. large percentage falls in values. Losses in wealth lead
The build-up phase prior to a financial crisis has the same households to cut back spending and firms to become
cautious about investment. Some firms that have been rely-
pattern as a boom in the business cycle. Rising demand and
ing on assets as collateral. against loans may go bust while
employment lead to greater optimism and this in turn leads to
higher asset prices, easier finance and reduced worries about others find demand for their products shrinking. Loan
risk. Higher asset prices encourage further buying by those defaults may follow and this will lead to losses for banks
seeking capital gains and many of these speculative purchases and they will become very cautious about further lending.
are funded by increasing debt. The downturn becomes a financial crisis when banks
themselves get into difficulty. Defaults on loans they
There may be some specific stories that reinforce people's have made, and insolvency of firms to which they have
optimism during the upturn. Sometimes it is a belief that lent money can lead to losses. Falls in the market value of
a new technology is underpinning a sustainable surge in banks' shares can erode their capital. Rumours of financial
growth. This happened when the introduction of railways difficulties in a specific bank can mean that depositors
was revolutionizing the UK transport system in the 1840s, seek to withdraw their funds and make other banks
it happened in the 1920s when electricity was the new unwilling to lend in the wholesale interbank market.
technology, and it happened again during the internet Bank failures can be triggered by an insolvency in which
boom of the late 1990s. At other times it may be the belief the bank's assets become worth less than its liabilities or
in the wisdom of a specific regulator or government policy by a liquidity shortage in which a bank is unable to borrow
regime that sustains optimism. This played some role in even though it may still strictly be solvent. In some cases
the run up to the recent financial crisis. Indeed, the period the bank may be dosed down, in others the authorities
from the early 1990s to 2006 was called at the time 'the may organize a takeover by a stronger bank, and in still
great moderation' owing to the apparent success of policy- others the government may step in and take over the bank
makers in keeping GDP dose to potential and inflation or inject substantial public loans.
under control. The collapse of any bank and the fear this induces in all
You may at this stage wonder how the availability of households and firms (as well as other banks) makes credit
finance keeps expanding to underpin the continued hard to find as other banks become much more cautious
expansion of spending and of asset prices. We discuss this about lending. This is what leads to such crises becoming
point in the context of the recent UK experience in the known as a 'credit crunch'. Such credit crunches reveal an
second case study later in this chapter. The international intimate relation between the real and monetary sectors
influences are also important in explaining the recent that is often not appreciated. This is that since all produc-
cycle and we discuss these on page 523. tion takes time, firms must pay out to buy or hire all of
their inputs of labour and materials long before they can
Greed turns to fear sell their products to recoup their production costs and reap
any profits. Much of this gap between payments to inputs
The boom in activity and in asset prices can go on for and sales revenue from outputs is filled by credit. So, if
many years and the forces working in the upturn tend to credit becomes hard to get, firms often are forced to cease
reinforce each other. The longer it goes on the more likely normal production activities for Jack of funds to pay for
are firms and financial institutions to have borrowed their inputs. The result is falling employment and output.
heavily to invest on the assumption of even more profits Then, as consumers cut back on spending and firms cut
to come in future. However, at some point some event back on investment, aggregate demand falls. Firms Jay off
happens that makes people revise their belief that the workers and this reduces confidence even further and asset
boom will continue forever. The trigger could be a policy prices continue to fall. What was a self-reinforcing upward
tightening such as a rise in interest rates, or it could be the spiral becomes a self-reinforcing downward slide. As asset
collapse of an over-indebted firm or financial institution, prices and demand continue to fall other firms and finan-
or it could be a sharp rise in energy prices (which would cial institutions find themselves in difficulty. Some big
suggest that the boom might be becoming unsustainable). institutions may then fail and things get even worse.
464 CHAPTER 20 MONEY ANO MONETARY INSTITUTIONS

In the 2007-8 financial crisis, for example, the first bank emerging economies. The events of 2007-8 and the
problems emerged in August 2007 while it was September subsequent impact on real activity have changed this per-
2008 when Lehman Brothers collapsed in the United ception dramatically. At the time of writing the regulatory
States and both RBS and Lloyds banks needed substantial response is still being discussed. However, it very clear
injections of government funds in the United Kingdom. that nobody is complacent any more. It is fully under-
It was 2009 when the worst effects of this financial crisis stood today that extremely costly financial crises can hap-
were felt in the real economy with a major recession in pen anywhere. But if past history is any guide, this lesson
many countries and a sharpfall in world trade. will soon be forgotten.
Prior to 2007 there was a feeling in Europe and North Some aspects of the recent crisis are examined in more
America that the financial system was working well and detail in the following two case studies and other aspects
that financial crises only happened in developing or of this crisis are examined in later chapters.

CASE STUDIES

1. Holed on a rock fall and assets that were securitized on mortgages (see next case
study) started to fall in value. This asset-backed securities market
A sinking feeling started to come over the UK financial system in had become so large and so many banks were involved in both
September 2007 with the troubles at Northern Rock bank that issuing these assets and trading them that the wholesale money
were highlighted in Box 20. l on Page 448. This was the first that markets took fright. Banks became very cautious about lending to
many people knew about what was later to become a major finan- each other on an unsecured basis.17
cial crisis engulfing several large banks and other financial institu-
tions in Europe and in the United States. Northern Rock was not
the cause of the problems and it was a small player so was not in 120
itself a significantthreatto financial stability. It was rather a victim
of a sudden change in financial market conditions that left it 100 "'
e.;;·
vulnerable and unable to carry on without state assistance. "O
0
Banks are involved in maturity transformation. This means that 80 5·
:;:-
they borrow deposits that can be withdrawn on demand. and they ~
'al
make longer-term loans. Their assets are longer term than their
liabilities. This could cause problems if their depositors want their
--- 60
0
II

0
money back in a hurry, as banks cannot liquidate their loans (T

e.;;·
40
quickly. This is why, as we discussed earlier in this chapter, banks "O
0
tend to manage this problem by holding liquid reserves and they 5·
20 g
have also developed a market (the interbank market) through
which they can lend to each other when one bank is in need of
short-term funds, while others have a surplus.
Jan. Apr. July Oct. Jan. Apr.
In the two years prior to 2007, Northern Rock had embarked 2007 08
upon a strategy of expanding its loans (mainly mortgages) rapidly
and financing these loans by borrowing in the wholesale money I- Sterling - US dollar - Euro
markets (including the interbank market). Traditionally, mortgage
providers had lent only out of the deposits of their own customers. Figure 20.3 Three-month interbank rates relative to
The attraction of expanding in this new way was that Northern expected policy rates'"
Rock's management thought that both the loans were safe as the (a) Spread of three-month Libor (London interbank offered rate) to
value of collateral in the form of houses would keep on rising and official policy rates.
thatthey would always be able to borrow all the funds they needed Sources: Financial Stability Report, Bank of England, April 2008, data are
Bloomberg and Bank calculations.
in the wholesale markets. Profitability would be assured because
the interest rate they could charge on mortgages would be above
the rate they would have to pay to borrow wholesale funds.
17 Secured lend.ing involves the holding of some asset as security for
Things did not go according to plan. In the United States the the loan, whereas an unsecured loan can be worthless if a borrower
Federal Reserve had raised interest rates and the US housing defaults. Mortgages are a secured loan as the lender holds the deeds to
market had slowed after a sustained boom. House prices started to the house, while interbank lending is typically unsecured.
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 465
Chart 20.3 shows what happened to interest rates in the inter- could compete for deposits by offering higher interest rates but this
bank market in the United States, the United Kingdom and the squeezed their profit margins and did not increase deposits as
eurozone. The market froze and any trades that were done involved a whole.
a substantial risk premium. For Northern Rock the message was Securitization was a financial technique that changed the
simple. It could no longer borrow the funds it needed to finance constraints facing banks. They could make a bunch of loans, say
its loan book. Neither could it sell off its mortgages as the appetite mortgages, and sell off the income stream from those loans in the
for mortgage-backed securities had just dried up. To make matters form of a fixed-income investment instrument like a bond {which
even worse, the UK housing market also started to turn down, so the we explain in the next chapter). Potential buyers would be attracted
quality of its assets {which were secured on houses) deteriorated. by the interest stream that they could get and with apparently
Northern Rock had to turn to the British government for help. low risk. Banks could lock in some profit on the deal and could then
It initially obtained an emergency loan from the Bank of England, use the proceeds to make even more Joans .... and then perhaps
but the publicity surrounding this only served to make customers securitize those too.
think that the bank was in serious trouble and this is when queues This financial innovation meant that banks could expand their
of depositors built up outside the bank. The Chancellor of the Joans faster than the increase in their deposits. Figure 20.4 shows
Exchequer stepped in by guaranteeing all deposits in Northern how banks were able to expand their loans by over £700 billion
Rock and eventually taking Northern Rock into government more than their deposits by 2008. This is the customer funding
ownership. gap. Some of this expansion came from funds borrowed abroad
The possible alternatives to nationalization were: closing the {also shown in the figure) but much of this came from loan securi-
bank or arranging a takeover by a stronger bank. The latter option tization. One estimate is that by 2007 around 25 per cent of UK
was attempted but no willing buyer could be found at the right bank loans were securitized.
price. Closing the bank would have caused severe disruption to the Figure 20.5 shows the level of issuance in the global residential
many savers who held deposits with Northern Rock (even though mortgage-backed securities market. This figure shows the total
there was insurance on deposits up to £35,00018 at the time) and issuance of mortgage-backed securities and the proportion retained
it would have led to runs on other banks. by the issuers. This market collapsed in July 2007 and remained
There were plenty of problems still ahead for the world's banking subdued for several years after that. From October 2007 much of
system before the financial crisis was over. We discuss the role of the issuance was retained to use as security for central bank loans.
monetary policy in the next chapter. Northern Rock was caught by the collapse of the securitization
market as well as by the freezing of the interbank market, as one
2. Bankers as conjurers: securitization moves of its potential sources of funding had been mortgage-backed
the boundaries bond sales.
Many other financial institutions found themselves in trouble
Traditional commercial banking involved banks taking deposits when the mortgage-backed securities market imploded. The most
and making loans. They paid a lower interest rate on their deposits serious phase in this crisis happened in September 2008, with the
than they charged on their loans and this is how they made a profit. collapse of Leh mans and the bail out by the UK government of RBS
The profit margin had to be sufficientto covertheircosts and cover and Lloyds. We look at this phase of the crisis in more detail on
any losses that arose from loan defaults. However, the growth of the page 549 (1st case study of Chapter 23 ). We also look at the role
bank was constrained by the growth of its deposit base. Without of securitization in the global crisis on pages 523-6.
more deposits a bank could not make more loans. Individual banks In the next chapter we look at how monetary policy works and
how the policymakers have had to adopt new tools as a result of
18
This was raised to £50,000 in October 2008. the recent crisis.

soo.---~~~~~~~~~~~~~~~~~~~~~--. Figure 20.4 Major UK banks' customer

700 funding gap and foreign interbank
deposits
600
The customer funding gap refers to all of banks'
500 customers, both depositors and borrowers. The gap
c:
~ 400 is the total amount lent to those customers minus
300 the total amount of their deposits. It is thus the
amount that banks have been able to lend using
200 sources of funds other than customers' deposits.
100 1 --:7- Interbank deposits from abroad
- -- Source; FSA, Turner Review, 2009.
466 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS

Figure 20.5 Global residential

• Retained by issuer mortgage-backed securities issuance
• Publicly and privately placed Jan 2006-0ct 2008
The market for mortgage-backed securities col-
200 lapsed after July 2007, but some were created to use
as security against loans from central banks. These
are included in those 'retained by issuer'.
Source: FinancialStabilityReview,Bank of England, October
- 150 2008.
c
....
V>

g
5·
100 ~

50

Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct.
2006 07 08

Conclusion

The role of money and the monetary sector is vital in any financial crises occur, as a result of over expansion of credit
market economy as its permits the specialization of func- and asset price inflation, the ensuing collapses of banks and
tion that is fundamental to any modern economy. Banks firms can have a major impact on the real economy that
play an important role in the payments system and in can be severe and long-lasting.
providing credit for households and firms. However, when

SUMMARY

The nature of money How does money get in the economy?

• Money is a medium of exchange, a unit of account, and a store of • Central banks create the monetary base or high-powered money,
value. which is made up of notes and coins and bankers deposits at the
• Money avoids the need for a double coincidence of wants and centra I bank.
thus facilitates a wider range of transactions. • Banks create deposit money by expanding loans and deposits.

The origins of money Two models of banking

• Money has evolved from being based primarily on a precious • Banks create deposits to some multiple of their cash reserves.
metal to being mainly in the form of bank deposits.
• In a competitive market in which banks pay interest on deposits
• Early moneys were based on commodities, and especially precious and charge interest on loans, banks' behaviour is best understood
metals like gold and silver. in terms of demand and supply curves of deposits and loans.
• Paper currency started as a claim to a deposit of precious metal. Banks must pay competitive interest rates to attract deposits, and
• Bank deposits for most of modern money. they must charge competitive rates on their loans.
 CHAPTER 20 MONEY AND MONETARY INSTITUTIONS 467

Financial crises

• Financial markets sometimes get carried away with overoptimism • Failures of financial institutions can result when asset prices col-
leading to asset price booms and associated with credit lapse and defaults ensue.
expansion. • Financial crises will have real effects and are associated with a
downturn in activity.

TOPICS FOR REVIEW

• medium of exchange; • money multiplier;

• unit of account; • competitive banking systems;
• store of value; • interest rate spread;
• gold standard; • bank run;
• reserve ratio; • securitization;
• fiat money; • financial crisis.

QUESTIONS

Suppose that the monetary base is £20 billion, that the general 5 How is the broad money stock determined in a system where the
public wish to hold 20% of their money in cash and the remaining monetary base is demand-determined, the central_bank sets an
80% in bank deposits, and that banks wish to hold a 5% cash interest rate and the banking system is competitive?
reserve. What will be the size of the broad money stock? 6 Why do people hold money when there is normally a higher
2 How does the answer to Question l change for bank reserve ratios yielding asset available?
of a) 0%, b) l %, and c) 10%? 7 What role does money play in a market economy?
3 How does the answer to Question l change for general public 8 What difference would it make to the economy if there were
cash holdings of a) 0%, b) 5%. c) 100%? no money? What types of commodity might serve as money
4 How would the answers to Questions 2 and 3 change if the instead?
monetary base were £40 billion?