Chapter 4 · 12 4.2 Key Definitions Ch 4–Supply of money • Base money - This consists of notes...

Chapter 4

The Supply of Money

2

Learning Outcomes

➢ The role of financial intermediaries

➢ Key definitions & identities

➢ Base Money

➢ Currency deposit ratio

➢ Reserve deposit ratio

➢ Money multiplier

➢ Simple model of banking system

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4.1 The role of financial intermediaries

Ch 4– Supply of money

Banks

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4.1 Video - Banking Explained


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The warrior monks who invented banking

▪ pilgrims needed to somehow fund months of food and transport and accommodation,yet avoid carrying huge sums of cash around, because that would have made them atarget for robbers.

▪ A pilgrim could leave his cash at Temple Church in London, and withdraw it inJerusalem. Instead of carrying money, he would carry a letter of credit. The KnightsTemplar were the Western Union of the crusades.

Read More - BBC

http://www.bbc.com/news/business-38499883

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• Economies of scale in transactions and information - If a large number

of agents deposited small quantities of savings at a bank, the bank could

then lend a large amount to a single borrower.

• Insurance - banks provide insurance services by guaranteeing a rate of

return to depositors even if loans made to borrowers turn bad.

• Maturity transformation - Arguably the most important service provided

by banks is that of issuing one form of debt that is illiquid (of long maturity),

while taking on another which is of short maturity.

7Ch 2– Nature of Money

4,1 Role of Financial Intermediaries

It’s not only Central Banks that issue currency

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Some traditional Systems still remainInformal money exchange & Hundi system

▪ Hundis are used as a form of remittance instrument to transfer money from place toplace, as a form of credit instrument or IOU to borrow money and as a bill of exchangein trade transaction

▪ an unconditional order in writing made by a person directing another to pay a certainsum of money to a person named in the order.


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4.1 New Developments

Finance Companies


10Ch 4– Supply of money

4.3 Video Review - Bitcoin

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4.2 Key definitions

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4.2 Key Definitions


• Base money - This consists of notes and coins, and the

deposits and reserves of banks with the Central Bank.

• Currency deposit ratio(C/D) – The proportion of cash that

individuals hold relative to their deposits

• Reserve deposit ratio (R/D) – The fraction of the banks

deposits that banks retain as reserves

If these ratios are stable through time then by controlling

the base money, the monetary authorities can control the

total money supply in the economy.

Definitions of Money

Money Supply =>

Base Money =>

Where the bracketed term is the money multiplier

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4.2 Key identities


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Currency


Annual report 2015 , Table 114


16

Statutory Reserve ratio


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Reserves


Annual report 2015 , Table 120

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Gross loans/ deposits ratio

86%

95%91%

108%

93%

122%

89%

105% 103%

84%

0%

20%

40%

60%

80%

100%

120%

140%

160%

COMB HNB SAMP NDB NTB DFCC SEYB PABC UB BOC

2Q16 3Q16 4Q16 1Q17 2Q17

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

COMB HNB SAMP

Tier 2

2Q16 3Q16 4Q16

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

COMB HNB SAMP

Tier 1

2Q16 3Q16 4Q16

Capital Adequacy BASEL III – Banks with assets of Rs. 500 bn and above (D-SIB’s)

Jul 1st ’17 - 7.75%

Jan 1st ‘18 -8.875%

Jan 1st ‘19 –10.00%

Jul 1st ‘17- 11.75%

Jan 1st ‘18 -12.875%

Jan 1st ‘19 –14.00%

Gross loans/ deposits ratio


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4.3 Model of the banking sector

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4.3 A Simple model of the banking sector


Banks Balance Sheet

Central banks Balance Sheet

Assets Liabilities

Loans (L) Deposits (D)

Reserves

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4.3 A simple model of the banking sector


Modelling deposits & lending

• If iD was large relative to i, that would encourage individuals to deposit

more funds with the bank.

• Equivalently, the demand for loans is a negative function of the interest rate

charged on loans.

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4.3 Banking system & regulation


Scenario 1 -Competitive equilibrium conditions

Equilibrium conditions =>

Outcome = >

.

L = D

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4.3 Banking system & regulation


Scenario 1 -Competitive equilibrium conditions

• In equilibrium, the interest rate paid on deposits equals the interest rate

charged on loans, which equals the market interest rate, i.

• The level of deposits, which in this model is equal to the level of the money

stock, equals the amount of loans.

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4.3 Banking Sector & regulation


Scenario 2 –Government regulation on deposit rate

• Since deposits must equal loans in order for the bank's balance sheet to

balance, the lower level of deposits means a lower level of loans,

• This is associated with a higher interest rate charged, iL > i.

• Banks now make a positive level of profits

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Scenario 2 –Government regulation on deposit rate

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4.3 Banking sector & regulation


Scenario 3 – Mandatory Reserve ratio

• The interest rate charged on loans is now higher than the interest rate paid

on deposits.

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Scenario 3 – Mandatory reserve Ratio

• The impact of a change in the reserve ratio on deposits depends on the relative

elasticity of lending

• Inelastic => Total revenue increases => Higher id => Increase in deposits

• Elastic => Total revenue decreases => Lower id => Decrease in deposits

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Scenario 4 – Controlling the monetary base

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Scenario 4 – Controlling the monetary base



33

4.4 Changing Views on Money Supply

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Sept ‘17 - Sri Lanka not ready to allow free export ofrupee notes: CB

▪ Sri Lanka is not ready to allow large scale exports of rupee notes to other countries asit may complicate monetary policy, Central Bank officials said.

▪ Central Bank Governor Indrajit Coomaraswamy told reporters the practice wascurrently illegal when asked whether it could be liberalized, or even traded abroad.

▪ "Why many countries do not like to allow their local money to be transacted orcirculated abroad is because of monetary policy implications," Deputy Central BankGovernor Nandalal Weerasinghe said.

▪ "If you want monetary policy effectively implemented it has to be territory where youhave control. That is why US monetary policy has effects all over the world.

▪ "Effectiveness of monetary policy is eroded if we allow the rupee to be traded offshore.“

Read More: EconomyNext


http://www.economynext.com/Sri_Lanka_not_ready_to_allow_free_export_of_rupee_notes__CB-3-8806-1.html

35

Aug ‘18 - CB Chief calls on financial sector IT experts to collaborate to achieve ‘less cash’ economy

▪ “As a country, digital transformation allows us to increase our economic outputthrough, optimisation of time and opportunities provided by the ever advancingtechnologies. Efficiency gains have increased productivity, thereby creating theenabling conditions for higher profitability and enhanced incomes. The adaptation todigital transformation by financial sector Institutions has grown rapidly and is now anintegral part of operational strategies,”

▪ “The Central Bank is fully supportive of digitalisation and the use of new technologiesto promote a less cash society in Sri Lanka through the use of new cashless paymentmechanisms such as digital banking accounts, smart mobile apps, mobile wallets, QRcode payments, nickname-based payments, initiatives on e-commerce payments andcross border payments,”

▪ Dr.Coomaraswamy said the Central Bank is confronted with the complex challenge ofaiding the adoption of technology, while taking precautions to minimise risksassociated with technological innovations to achieve the appropriate mix of innovationand stability.

Read More: Daily FT


http://www.ft.lk/financial-services/CB-Chief-calls-on-financial-sector-IT-experts-to-collaborate-to-achieve--less-cash--economy/42-661580

36

Feb ‘18 - Why Governments Might Join the Cryptocurrency Craze

▪ Russia’s central bank plans to talk to countries including Brazil, China, India and thefive former Soviet republics about creating a supra-cryptocurrency that could covercountries with 40 percent of the world’s population.

▪ In theory, a government could have greater control of a virtual currency than a paperone because it would be able to keep tabs on all transactions recorded on theblockchain ledger.

▪ Regulating the money supply through changes in interest rates -- i.e. monetary policy -- would be much more direct, which could mean it’smore effective and cost-efficient.

▪ The blockchain technology would supplant the clearing process now handled bycommercial banks, undermining an important revenue stream.

Read More: Bloomberg


https://www.bloomberg.com/news/articles/2018-02-12/why-governments-might-join-the-cryptocurrency-craze-quicktake

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Recap & Learning outcomes


38

End of Chapter Questions


39

Further Reading

▪ Nial Fergusson – The Ascent of Money - Video


https://www.youtube.com/watch?v=JAbVltqySrA

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Supplementary Slides

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Private money & bank Vulnerabilities

▪ A merchant from Lyon who wanted to buy - say - Florentine wool could go to thisbanker and borrow something called a bill of exchange. This was a credit note, an IOU,but it was not denominated in the French livre or Florentine lira.

▪ Its value was expressed in the ecu de marc, a private currency used by thisinternational network of bankers.

▪ And if the Lyonnaise merchant or his agents travelled to Florence, the bill of exchangefrom the banker in Lyon would be recognised by bankers in Florence, who would gladlyexchange it for local currency.

▪ That description rings true even today. International banks are locked together in aweb of mutual obligations that defies easy understanding or simple control.

▪ And, since their debts to each other are a very real kind of private money, when thebanks are fragile, the entire monetary system of the world also becomes vulnerable.

Read More - BBC


http://www.bbc.com/news/business-38499883

42



Maturity Transformation

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Chapter 4 · 12 4.2 Key Definitions Ch 4–Supply of money • Base money - This consists of notes...

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