Intro to Finance - Chapter 7 PDF

# Introduction to Finance - Chapter 7 ## Introduction to Monetary Policy ### Definition of banks - Banks collect the savings of individuals as well as businesses and then lend those pooled savings to other individuals and businesses. - Banks pursue business activities at their own risk, just like...

# Introduction to Finance - Chapter 7 ## Introduction to Monetary Policy ### Definition of banks - Banks collect the savings of individuals as well as businesses and then lend those pooled savings to other individuals and businesses. - Banks pursue business activities at their own risk, just like any other business. - They make money by charging a rate of interest to borrowers that exceeds the rate they pay to savers. ### Fundamental concepts of banking #### Bank - Provides the full range of financial services - **Gathering deposits and providing loans** - While gathering deposits, the economic actors are putting their money into the bank (later with the interest the economic actors can claim this money.) - While providing loans banks disburse money to economic actors (later with the interest, the economic actors must pay back this money.) ### Financial intermediation through banks A diagram is shown describing financial intermediation through banks. **Left side:** - Actors with money surplus (savers, make deposits) **Middle:** - Money flowing to the deposit. - Deposits accepted by the bank. - Loan/credit given by the bank. - Money flowing from the loan. - Banks own equity. **Right side:** - Actors with money deficit (borrowers, apply for loan) ### A few examples | Institution Name | Description | Total Deposits ($ in thousands) | |---|---|---| | Bank of America Corporation (BAC) | As of December 31, 2008, the company operated approximately 6,100 retail banking offices and 18,700 automated teller machines. Bank of America was founded in 1874 and is headquartered in Charlotte, North Carolina. | $1,002,708,983 | | JPMorgan Chase & Co. (JPM) | This financial holding company provides a range of financial services worldwide through six segments: Investment Banking, Retail Financial Services, Card Services, Commercial Banking, Treasury and Securities Services, and Asset Management. The company was founded in 1823 and is headquartered in New York, New York. | $ 962,505,000 | | Citigroup, Inc. (C) | As of December 31, 2008, Citigroup operated through a network of 7,730 branches. The company was founded in 1812 and is based in New York, New York. | $ 785,801,000 | | Wells Fargo Bank (WFC) | Wells Fargo & Company was founded in 1852 and is headquartered in San Francisco, California. The bank acquired Wachovia Corporation in 2008, resulting in 11,000 branches and 12,160 automated teller machines. | $ 438,737,000 | Source: http://www.ibanknet.com/scripts/callreports/fiList.aspx?type=031 ## I. One-tier banking system ### One-tier banking system - In a country, there is only one monetary institution that operates as a bank. - Economic actors can turn to this institution regarding banking services. - The bank incorporates the functions of central and commercial banks. ### Types of one tier system - **Monobank:** - One institution manages all bank services. - No separation of functions and customers. - **Functional separation:** - Within the framework of an institution, there is a separation depending on the clientele. - Type of service. ### Advantages and drawbacks | Advantage | Drawback | |---|---| | Easier to control | Not flexible | | Serves the economic policy goals of governments | Serves the economic policy goals of governments | | | Monopoly, lack of competition | | | Inefficient prices | ## II. Two-tier Banking System ### Central and commercial banks #### Central bank - Pivotal and central role in the bank system. - Issuing cash. - Lender of Last Resort: - Gives loans to commercial banks and accepts their deposits. - Creates cash and credit money. #### Commercial banks - Accept deposits and provide loans. - Creates only credit money ### Role of central banks - Price stability - control of inflation - Control of money supply through managing the credit supply. - As a secondary function, the support of the governments economic policy goals. ### Tools of monetary policy - Open market operations. - Reserve requirement. - Interest rate. ### Open market operations - buying securities - Open market operations are when central banks buy or sell securities. #### Buying securities - When the central bank buys securities, it adds cash to the banks' reserves. (Gives cash, receives security) - That gives them more money to lend. - A central bank buys securities when it wants expansionary monetary policy, in other words, it wants to increase money supply. ### Open market operations - selling securities #### Selling securities - When the central bank sells the securities, it places them on the banks' balance sheets and reduces its cash holdings. - The bank now has less to lend. - A central sells securities when it executes contractionary monetary policy. (Wants to reduce money supply) ### Reserve requirement - The reserve requirement refers to the money banks must keep on hand overnight. - They can either keep the reserve in their vaults or at the central bank. A low reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit. - A high reserve requirement is contractionary. It gives banks less money to loan. ### Effects of reserve requirement | Low reserve rate | High reserve rate | |---|---| | A low reserve requirement allows banks to lend more of their deposits. | A high reserve allows banks to lend less of their deposits. | | Increases the supply of money. | Decreases the supply of money. | | It's expansionary because it creates credit. | It's contractionary because it decreases credit. | ### Base rate - Interest rate paid after the commercial bank deposits placed at the central bank. - **Transmission effect:** Market interest rates are connected to the base rate, therefore the changes in the base rate affect: - The cost of loans. - Return of deposits. - And the money supply. ## Thank you for your attention!