Topic 9: The Monetary System - Lecture Notes

TOPIC 9 The monetary system Fundamentos de Economía 1 Topic 9. The monetary system Concept and functions of money. Financial institutions. 1. Money market. Fundamentos de Economía 2 Activity  Create a Bill note of your own creation.  Name it and e...

TOPIC 9 The monetary system Fundamentos de Economía 1 Topic 9. The monetary system Concept and functions of money. Financial institutions. 1. Money market. Fundamentos de Economía 2 Activity  Create a Bill note of your own creation.  Name it and explain its denominations  What do you “think” or imagine you can buy with “your” money? Write an example Fundamentos de Economía 3 Introductory video https://www.youtube.com/watch? v=YCN2aTlocOw Fundamentos de Economía 4 1. Concept and functions of money Let's start by clarifying some basic definitions In everyday language, the expression "money" is often used as a synonym for "wealth".  However, the economic definition of money does not include all forms of wealth (it does not include cars, houses, or stocks, for example). Money is defined in terms of what it does: Money is any asset that can be easily used to buy goods and services. It consists, then, of cash - liquid by definition - and other assets that have high liquidity. An asset is liquid if it can be quickly converted into cash without significant loss of value. Fundamentos de Economía 5 1. Concept and functions of money We continue to clarify concepts  Cash in the hands of the public is banknotes and coins in the hands of citizens. And demand deposits are also considered money, as most merchants accept checks or payment by cards linked to those accounts. Notice that money increases well-being, even if it does not produce anything directly. If it did not exist, individuals could only exchange the goods and services they want through barter. A cardiovascular surgeon could only buy a refrigerator if the owner of the appliance store needed a heart operation... Fundamentos de Economía 6 1. Concept and functions of money Money plays three roles It is a means of payment It is an asset that individuals use to exchange for goods and services. Under normal circumstances, a country's official currency is the means of payment used almost always, but in difficult circumstances, other goods or assets may perform that function: It may be another country's currency that inspires more confidence.  Or cigarettes in prison camps during World War II... Fundamentos de Economía 7 1. Concepto y funciones del dinero  Money also performs these other two functions. It is a store of value It is a means of storing purchasing power over time. ¿Example s? The function of store of value is a necessary characteristic, but it is not a distinguishing feature of money, since many other assets that maintain their purchasing power over time also play that role. It is a unit of account It is the commonly accepted measure used by individuals to set prices and to make economic calculations.Fundamentos de Economía 8 1. Concept and functions of money  What types of money are there? The commodity-money It is a good that is used as a means of payment and that has intrinsic value for other uses. For example, gold or silver. It therefore has a value independent of its function as a means of payment. Money backed by commodities It is a means of payment without intrinsic value, whose value lies in the promise that it will be exchanged for a valuable good when requested.  Banknotes that, unlike today's banknotes, were issued by private banks that promised to exchange them for gold or silver when asked. Fundamentos de Economía 9 1. Concept and functions of money What types of money are there? Fiat money It is the money whose acceptance as a means of payment derives exclusively from its legal status, that is, from its official status as a means of payment. It has advantages over the types of money described above: It does not use any real resources (except paper). - The money supply can be adjusted according to the needs of the economy, rather than depending on the pace of discovery of precious metals. It also poses risks: Possible fakes (forgery). - The temptation of some Fundamentos governments de Economía 10 to issue 1. Concept and functions of money How is the money supply measured?  It is the total value of an economy's financial assets that are considered money. It can be measured with different aggregates according to whether a more or less strict liquidity criterion is applied: You can only consider cash in the hands of the public and current accounts. - Or you can add the so-called quasi-money (or near money), which are financial assets, such as savings accounts, which cannot be used directly as a means of payment, but which can be easily converted into cash or demand deposits (although Do you sometimes think that with asuch financial assets penalty...). or bonds as stocks are part of the money supply? Fundamentos de Economía 11 2. Financial institutions  The monetary multiplier: liquidity creation by banks Banks use liquid assets in the form of bank deposits to finance less liquid investments of their borrowers (they grant mortgages, loans to companies...). They create money because they do not need to hold all deposited funds in liquid assets (except in a financial panic situation, depositors will not withdraw all their funds at once). ¿Ejempl - When a bank lends the excess reserves derived o? from a new deposit, it induces the appearance of more deposits in the banking system and so on, generating a multiplier effect on the money supply. Bank reserves are made up of the cash that banks keep in their safes plus their deposits with the Fundamentos de Economía 12 Central Bank ⇨ They are not part of the cash in the 2. Financial institutions  The monetary multiplier: liquidity creation by banks https://youtu.be/ 93_Va7I7Lgg Fundamentos de Economía 13 2. Financial institutions  Below we describe how banking regulation prevents financial panic situations.  Deposit guarantee fund: in Spain, the Deposit Guarantee Fund, financed by financial institutions and the Bank of Spain, covers - up to a maximum limit - the losses of depositors, in the event of the insolvency of any entity.  Regulatory capital: reduces incentives for excessive risky behaviour by forcing banks to hold assets at a much higher level than deposits.  Statutory reserves: a minimum cash ratio is set for banks. Discount window: the central bank lends money to banks (which thus avoid having to sell their assets to cope with a sudden increase in withdrawals from their customers). Fundamentos de Economía 14 2. Financial institutions  The Central Bank The Central Bank is the institution that supervises and regulates the banking sector and controls the monetary base. Fundamentos de Economía 15 2. Financial institutions  The European Central Bank The Eurosystem consists of the European Central Bank (ECB) and the national central banks of the Member States whose currency is the euro (19 countries) Its primary objective is price stability. The European System of Central Banks (ESCB): made up of the ECB and the national central banks Euro introduced since 1999: Germany, France, Italy, Spain, Belgium, Holland, of all EU Member States. Luxembourg, Ireland, Portugal, Austria and Finland Since 2001: Greece Since 2007: Slovenia Since 2008: Cyprus and Malta Since 2009: Slovakia Since 2011: Estonia Since 2014: Latvia Since 2015: Lithuania Since 2023: Croatia Fundamentos de Economía 16 2. Financial institutions  Zona Euro Link to the Banco de España's Eurosystem website Fundamentos de Economía 17 3. Money market  The demand for money Individuals and businesses find it useful to have cash instead of other assets, as the money can be used directly to make purchases. - But then they must give up the higher profitability offered by other assets (fixed-term accounts, for example). A similar reasoning applies to the choice between a demand deposit or a time deposit that also poses a dilemma between the convenience of having the money available when it is needed and higher profitability.  Well, these decisions will be influenced by the interest rate: the higher the interest rate, the higher the opportunity cost of holding money; The lower the interest rate, the lower the opportunity cost of Fundamentos holding money. de Economía 18 3. Money market  The money demand curve will thus slope negatively: the amount of money that individuals and firms want to keep is, all else unchanged, inversely related to the interest rate. Interest A higher interest rate rate raises the opportunity cost of holding money, which then reduces the demand for money. Demand for money And a lower interest rate...? Amount of money Fundamentos de Economía 19 3. Money market  The money demand curve will shift if:  The aggregate price level changes, because if it rises, the demand for money will increase with each interest rate.  GDP changes, because the greater the amount of goods and services exchanged, the greater the amount of money that families and businesses will want to keep, with each interest rate.  Credit markets and the technology of banking are changing, as, for example, the emergence of credit cards reduced the need to hold cash. It changes banking regulation, which can, for example, raise or lower the remuneration of accounts. Fundamentos de Economía 20 3. Money market  The money supply curve is a vertical curve plotted over the level of money supply chosen by the central bank (M1). Interest An increase in As we will rate the money supply... explain in topic 11, by increasing i1... causes a the money decrease in the supply, the interest rate central i2 bank can lower the Demand for mone interest rate. M1 M2 Amount of money Fundamentos de Economía 21 Let’s wrap it up… What have we learned in this topic? Fundamentos de Economía 22 Referencia bibliográfica Krugman, P., Wells, R. y Graddy, K (2022). Fundamentos de Economía. Barcelona: Editorial Reverté. Fundamentos de Economía 23