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Money Lecture 1 2020
Money Lecture 1 2020
Alessandro Missale
Money is any financial asset that can be readly used to pay for
transactions; to buy goods and services directly.
Functions of money:
Medium of exchange (it facilitates transactions)
Store of value (it allows to transfer purchasing power to future
periods of time)
Unit of account (prices are expressed in Euro)
The main function of money is to facilitate transactions that money
accomplishes because of its liquidity (spendibility).
Liquidity is the property of a financial asset to be transformed into
a medium of exchange with the least loss of value.
Monetary aggregates (in the US and EU)
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There are various monetary aggregates that can play the role of money in
various degrees depending on their liquidity.
Currency = coins and banknotes (cash) held by the nonbank public
M0 = Monetary Base = Currency + Reserves (held by banking syst.)
M1 = Currency + Demand Deposits (sight/checkable deposits)
M2 (US) = M1 + Saving accounts + Small Time Deposits + Balances in
retail money market mutual funds.
M2 (EU) = M1 + Deposits with an agreed maturity up to 2 years +
Deposits redeemable at a period of notice up to 3 months.
M3 (EU) = M2 + Repurchase agreements + Money market fund shares +
Debt securities with initial maturity of up to 2 years (issued by MFIs)
Conventionally: Money = M1; i.e. the sum of currency and demand (sight)
deposits at banks that can be spent with debit cards.
Portfolio Choice, Money Demand
10
Note also that, if the money market is in equilibrium, then the bond
market is also in equilibrium, and vice-versa:
and thus
It is a particular case of Walras’ Law
Focusing on just one market allows to derive equilibrium conditions for
both markets.
Choosing between money and bonds
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NB: OMOs lead to equal changes in the assets and liabilites of the
Central Bank’s balance sheet:
The bond market and the effect of OMO
20
Note that the total amount of bonds is equal to the sum of bonds on the
market, say , and those held by the CB, say,
Central Bank Balance Sheet
Assets Liabilities
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OMOs change the relative supply of money and bonds on the market
and lead to an excess demand for bonds:
the price of bonds increases and the interest rate falls
The price of bonds and the interest rate
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The higher is the current price, the lower the interest rate
Open market operation (revisited)
22
Banks keep part of the funds they receive as reserves in the form of cash
or highly liquid funds held at the CB in order to meet cash/liquidity
needs that may arise from imbalances between withdrawals and
deposits, transfers made and received.
Besides liquidity needs, banks are subject to minimum reserve
requirements that require banks to hold a minimum amount of reserves
in some proportion of their short-term liabilities
In Switzerland the required reserve coefficient (or ratio) is 2.5%;
In Europe the req. reserve ratio is 1% since 2012 (down from 2%);
In the US it depends on the amount of net transaction accounts (ie checking
deposits); the ratio goes from 0% to 3% up to 10%.
The CB balance sheet revisited and
the Balance Sheet of Banks (Banking Sector)
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The CB issues the Monetary Base, M0, outside money (or high
powered money):
Assets Liabilities
M0 = Reserves + Currency
It is the fraction of deposits that banks want to hold liquid for, say,
precautionary reasons or future opportunities.
As the reserve ratio increases, inside money decreases because
banks do not invest deposits buying bonds or giving loans:
Inside money:
M1 – M0 = Deposits – Reserves
M1 – M0 = Reserves
it uses to buy the bond are credited on the bank account of the
counterpart (a firm or an individual).
Then, the recipient bank keeps as reserves part of the deposits and
(may use the remaining part to) buy a bond or make a loan. In turn,
the proceeds from the sale of the bond are deposited in a third
bank that, etc. etc…
This way deposits are multiplied and money is created
Equilibrium in the Money Market
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Supply = Demand
Equilibrium on the interbank market for reserves: supply = demand.
The interest rate that the CB controls is the interest rate that clears the
market for banks’ reserves.
The Federal Funds Rate and the EONIA
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Reserves = Deposits
The equilibrium interest rate
(when the CB controls reserves)
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Supply of CB
Reserves The equilibrium interest rate
makes the demand for
reserves equal to its supply;
i.e. it makes banks willing to
hold reserves
Demand for CB
Reserves
Note that an increase in the
reserve ratio, , shifts the
demand to the right and leads
to a higher interest rate
CB Reserves
The Central Bank decides the interest rate
35
Discount Loans
Borrowed and nonborrowed reserves
38