Econ0002 - Unit 10 Notes PDF

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Econ0002 – Unit 10 NotesBanks, Money, and the Credit Market10 Money and Wealth Money: o Money is a medium of exchange consisting of bank notes and deposits or anything else that can be used to purchase goods and services o For money to function there must be mutual trust that others will accept you...

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Econ0002 – Unit 10 Notes Banks, Money, and the Credit Market 10.1 Money and Wealth 

Money: o Money is a medium of exchange consisting of bank notes and deposits or anything else that can be used to purchase goods and services o For money to function there must be mutual trust that others will accept your money as payment o Governments and banks usually provide this trust, but even without them there could be enough trust between households and businesses o Money function:  Allows purchasing power to be transferred among people so they can exchange goods and services, even when the payment takes place at a later date (e.g. credit card)

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Wealth: o Wealth is the largest amount you can consume without borrowing after paying off debts and money owed to you e.g. if you sold all belongings  Accumulation of past and current saving  It can also include your human capital e.g. health, skills, ability to earn income (not here - use material wealth)  Wealth is a stock variable, meaning it has no time dimension  The value of wealth tends to decline, this is called depreciation – the loss in value of a form of wealth that occurs through use (wear and tear) or the passage of time (obsolescence)

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Income: o Income is the amount of money you receive over a time period, whether from market earnings (wages and salaries), investments or from the government  Income is a flow income, a quantity measured over a period of time  Gross income – an individual’s income before taxes or other deductions  Net income – is the maximum amount you could consume and leave your wealth unchanged, also flow income less depreciation

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Expenditure: o (Consumption) Expenditure is an outflow  If consumption is less than net income then wealth will increase, which means one is saving  Saving can be e.g. buying financial assets like bonds, shares  These can also be seen as investments – expenditure on capital goods

10.2 Borrowing: Bringing Consumption Forward in Time 

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Feasible Sets and Indifference Curves: o In this unit we will use both feasible sets and indifference curves analysis to determine the choice one makes between having something now, and having something later  In this case, giving up more goods now will allow one to have more goods later  The opportunity cost of having more goods now is having fewer goods later

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Borrowing and Lending: o These allow to rearrange our capacity to buy goods and services across time  Borrowing allows us to buy more now, but constrains us to buy less later o Example: Julia – needs to consume now but has no money today  Assume she spends everything that she has, so each point on the figure gives her consumption now (x-axis) and later (y-axis)

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o o o

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o o o o o

Julia has nothing now but she knows in the next period she will have $100 At first the IR is 10%, so if she borrows 91, she will pay back the $100 that she will have later  Or she could borrow $70 and pay back £77, meaning she can spend $23 next year  These points join up to show her feasible frontier and showing her feasible set for that set interest rate  Julia will choose any combination on her feasible frontier  A higher interest rate of 78%, means she can only borrow a maximum of $56, so her feasible frontier is now steeper and the feasible set smaller Initially Julia is at the point labelled ‘Julia’s endowment’ – what one can consume now Principal – how much one borrows Repayment = principal + interest  In this case:  = 91 + 91r  = 91(1+r) = $100 If ‘later’ means one year from now, then the annual interest rate, r, is:  Interest rate = repayment/principal – 1  = 100/91 – 1  = 0.1 = 10%  One can think of the interest rate as the price of bringing some buying forward in time Opportunity Cost = interest rate + 1 Marginal Rate of Transformation = Opportunity cost = 1 + r To work out maximum buy now on x-axis do $100(money available to pay back later)/1+r The lender will benefit from a higher interest rate, as long as the loan is repaid, so there is a conflict of interest as it reduces the borrowers capacity to consume in the present To have one unit of the good now, you need to give up 1+r goods in the future

10.3 Impatience and the Diminishing Marginal Returns to Consumption  2

Impatience: o Decides how much consumption one will bring forward, for two main reasons:

One prefers to smooth out consumption instead of consuming everything later and nothing now  One may just be impatient Smoothing: o This occurs as one gets to enjoy an additional unit of something more when they have not already consumed a lot of it (to avoid diminishing marginal utility)  Diminishing marginal returns to consumption (DMR): the value to an individual of an additional unit of consumption in a given period declines the more it is consumed o Example: Julia with indifference curves: 

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Dashed line: combination of consumption now and later Indifference curve: shape due to diminishing marginal returns to consumption in each period – the more she has in the present, the less she values an additional one unit now relative to more in the future Slope of Indifference curve: MRS between consumption now and later Slope of indifference curve is steep at C (high) = little consumption now and a lot later, one would want to move more consumption to the present because of DMR (vice versa at E), when more is consumed DMRC is lower MRS falls as we move along the indifference curve from C to E: the slope is steeper at C than E One will choose a point between C and E Between CE, Julia would choose point F; it is on the highest attainable indifference curve – she prefers smooth consumption between now and later F is not necessarily equal to consumption, it will depend on the IR (1+r) (slope of feasible frontier) and the share of the indifference curve

Pure Impatience, or How impatient you are as a person: o Pure impatience:  When one values a good now more highly than later, when their initial endowment is having the same amount in both periods (the amount of consumption now and later) o 2 main reasons for pure impatience:  Myopia (short sightedness): people experience the present satisfaction of hunger/a desire more strongly than they imagine the same satisfaction at a future date  Prudence: people know they may not be around in the future so choosing present consumption is a good idea o Shown diagrammatically:

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The curve depicts that, if she lost $1 dollar now, she would need $1.5 to be compensated, and be equally happy She has pure impatience as rather than smoothing her consumption, she places more value on an additional unit of consumption today than in future The slope of indifference curve at point e.g. A (1.5) means that one values an extra unit of consumption now 1.5 times more than an extra unit later As she moves right along the IC curve, she becomes less impatient (MRS less than 1)

10.4 Borrowing allows Smoothing by bringing consumption to the present 

A Person’s Discount Rate (p): o P – is a measure of a person’s impatience: how much one values an extra unit of consumption now relative to later  This is the slope of indifference curve between consumption now and later, minus 1  = 1 + p – 1 = p, so p = discount rate o Depends on 2 factors:  One’s desire to smooth consumption: affected by situation one is in e.g. current distribution of consumption now and later  Pure impatience as a person: aka subjective discount rate (based on one’s psychology)

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One’s Optimal choice: o To find this out one must combine the Feasible Frontier with one’s impatience indifference curves o To maximise this, one will choose the highest possible indifference curve limited by the feasible set o MRS = MRT  MRS = 1 + ρ, MRT = 1 + r  MRT = MRS = 1 + ρ = 1 + r  so ρ = r  Discount rate = rate of interest  Her discount rate depends on both her desire to smooth her consumption and on her degree of pure impatience o Her optimum choice is shown below:

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At first with IR = 10%, her best option is at point E, where the IC is tangent to the feasible frontier MRS = MRT At point F, ρ > r, so one would want to bring consumption forward, leading to E An increased IR -> feasible set becomes smaller -> borrow less (G)

10.5 Lending and storing: Smoothing and moving consumption to the future 

Reservation Indifference between lenders and Borrowers: o In this example, we are presented with Marco who has $100 and Julia who has $0  Marcos wealth is $100 and Julia’s is zero currently o Julia’s indifference curve:  Julia’s IC is very steep, as she is currently holding nothing and has a strong preference for increasing consumption now  This is her reservation indifference curve: all points where one is just as well off as at their reservation position (one’s endowments with no borrowing/lending)  Julia’s endowment now = 0 now, 100 later

 o Marco’s indifference curve:  Endowment = 100 now, nothing later  Looking to transfer some of his consumption to the future o Marco’s choice  Marco, like Julia has Diminishing marginal returns to consumption, hence he would rather not consume all he had now, and save some for later  In order to smooth, he needs to move some goods to the future  One could store the good, but this results in depreciation – a reduction in wealth o Marco’s best option: 5

  Marco has $100 wealth today  The darker feasible set shows storage (20% loss of depreciation) and feasible set  His reservation IC go through his endowment  His decision to store wold be at H  The higher line shows his decision to lend at 10%  He is now able to reach a higher indifference curve o If Marco lends with IR of 10%, and finds a trustworthy borrower, he could have feasible consumption of 100 x (1 + r) later  This would expand his feasible set o IRL: term deposits, bonds, investment etc. can be used to shift consumption to the future and expand the feasible set o The situation differs because of situation not preferences: both (M & J) have similar pure impatience (to smooth consumption)

10.6 Investing: Another way to move consumption to the future 

Investment: o If Marco invested all of his grain, he could make $150

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The return of investment: The slope of the red line is -1.5 (1 + rate of return on investment)

 Profit rate = profits/investment required  Marco’s optimal choice: Marco chooses to consume $60 now and $60 later, point K  MRS = MRT o Marco gets a loan of 10%:  Would be better off; invest everything but also borrow to be able to consume more now and in the future: ‘invest-it-all’ plan

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Getting a 10% loan, expands feasible set Ends up at L, with higher utility, as he can now consume $80 now and $62 later If the borrowing rate increases, the new feasible frontier is more steep, as cost increases but investment level stays the same o The table below summarises the options and outcomes: Plan (points in Figures 10.6 and 10.8) Storage (H) Lending only (J) Investment only (K) Investment and borrowing (L)

Rate of return or interest −20% (loss)

Consumption now, consumption later $68, $26

Investment n/a

Ranking by utility (or combined consumption) Worst ($94)

10%

$65, $39

n/a

Third best ($104)

50% 50% (investment), −10% (lending)

$60, $60

$40

Second best ($120)

$80, $62

$100

Best ($142)

o The feasible sets combined are shown as:

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Differences between Lenders (Marco) and Borrowers (Julia): o Three differences explain the differences in their outcomes:  Marco has assets whilst Julia has nothing now (prospects of assets later): they are on opposite sides of the credit market  Marco has productive investment opportunities  Marco and Julia may face different interest rates: as preferential rates are typically given to those with assets  Ironic as lenders can borrow at a low interest rate as they do not need to borrow, but borrowers face higher IR o Borrowing, lending, storing, and investing are ways of bringing consumption forwards or back in time o Why people engage in these activities:  They can increase their utility by smoothing consumption: or moving consumption to present if they are impatient  They can increase their consumption in both periods: by lending or investing o People differ in which activities they engage in because:  They have different current situations e.g. income now vs later will affect opportunities for investment or not  Differ in level of pure impatience

10.7 Assets, Liabilities, and Net Worth 

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Balance Sheets: o Balance Sheets are a record of the assets, liabilities, and net worth of an economic actor such as a household, bank, firm, or government  What a household or firm owns and what is owes to others  It helps understand how wealth changes when an individual/firm borrows and lends o Assets: what you own and are owed by others o Liabilities: what you owe to others (loan you have to pay back later) o Net worth = assets - liabilities  assets ≡ liabilities + net worth  Net worth: what a household owns or is owed - what a household owes to others  Wealth = accumulated savings = net worth

o For households, income increases bank deposits, while consumption is paid with bank deposits  Bank deposits are an asset for owners so affect the asset side of a household’s balance sheet o Wealth or net worth does not change when you lend or borrow  Because a loan creates an asset (money you receive) and a liability (debt) on your balance sheet o Example: Julia  Julia = net worth of 0 with no liabilities and assets  She could borrow 58 at IR of 10% based on future income  At this time asset = 58 = liability = loan she has to pay later (will rise to 64 later with interest)  Initially before consumption, liability = assets so net worth is unchanged at 0  When she consumes the 58, she still has 58 liability but her new worth now falls to -58  She receives income of 100, and the value of her loan has risen to 64 due to accumulated interest  Net worth is now 100 - 64 = 36

10.8 Banks, Money, and the Central Bank 

Profitability: o This depends on:  The cost of borrowing  The default rate on the loans they extended to farmers  The interest rate they set

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Bank: o A Bank is a firm that makes profits through lending and borrowing activities  The terms on which they borrow to households and firms is higher than their borrowing terms, allowing them to make profit  The interest they pay on deposits is lower than the interest they charge when making loans, for profit

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Types of Money: o Base money (legal tender): cash held by households, firms, banks, and balances held by commercial banks in their accounts at the central bank, known as reserves – liability of the central bank o Bank money: money in the form of bank deposits created by commercial banks when they extend credit to firms and households – liability of commercial banks o Broad money: amount in economy is measured by the stock of money in circulation: Defined as the sum of bank money and the base money that is in the hands of the nonbank public o Legal Tender is accepted as payment by law, and so is different to other types of money e.g. bank deposits and cheques  It comprises of cash (notes/coins) and accounts held by commercial banks at the central bank, called commercial bank reserves  Reserves, are equivalent to cash, as they can be taken out as cash from central bank, and the central bank can always print cash to provide this.  Different to commercial banks; as they do not always have the cash available to satisfy all their customers’ needs

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Commercial Bank Loans: o Makes up most of what we consider as money but is not a legal tender issued by central banks:  1. Marco deposits $100 into his bank account at Abacus Bank (AB)  2. AB will deposit cash into central bank or put cash in the vault  3. AB’s balance sheet gains $100 of base money as an asset with a liability of $100 to pay to Marco on demand  4. Marco wants to pay his local grocer Gino, so instructs AB to transfer money to Gino at Bonus Bank (e.g. using a debit card)  5. AB’s assets go down by $20 but BB’s assets increase by $20 of base money, their liabilities increase by $20 payable to Gino  6. So far this is a transaction using base money/legal tender but banks create money when making loans  7. Gino borrows $100 from BB so is now owed $120 from them but also has a debt of $100 to the bank  8. BB’s balance sheet has expanded  9. Assets: base money + bank loan ($20 + $100)  10. Liabilities: now adds $100 to the amount payable on demand (now $120)  11. BB has expanded the money supply  12. Gino can now make payments up to $120 so supply has grown by $100 even though base money has not grown  13. If Gino wants to spend his loan, his bank has to transfer base money  Base money is still essential in case customers want to take out cash or if Gino wants to spend his loan then BB has to send him base money o Suppose Gino employs Marco to work in his shop and pays him $10.  14. Then BB has to transfer $10 of base money from Gino’s account at BB to Macro’s account at AB o Banks constantly make transactions to each other, which mostly cancel each other out and then the rest is settled at the end of each day o Each bank will transfer or receive the net amount of transactions they have made each day, so they do not need to have available the legal tender to cover all transactions or demands for cash o If customers were all at the same bank there would be no loss of base money; why banks fight to get larger shares of deposits o Due to the loan, it means that total ‘money’ in the banking system has grown o Money created is a liability not an asset, as it has to be paid to the borrower on demand o It is the corresponding loan that is an asset for the bank o Bank’s profit is the interest rate  e.g. 100 at interest rate of 10% means banks liabilities will fall by 10 when the interest is paid  This increases the banks accumulated profits and net worth by $10  Positive net worth o Base money (excluding legal tender held by banks) plus bank money is called broad money – money in the hands of the non-bank public o Ratio of base money to broad money:  Varies across countries  Pre 2008, base money was 3-4% of broad money in UK, 6-8% in South Africa, 8-10% in china

o Maturity Transformation is the practice of borrowing money short-term and lending it long-term  Depositors can withdraw money without notice  But banks lend with a fixed date for it to be repaid e.g. mortgage 30 year repayment  length of loan is termed its maturity  Also known as liquidity transformation where the lenders’ deposits are liquid (free to flow out of bank on demand) but bank loans to borrowers are illiquid  Maturity transformation is essential but expose bank to liquidity and default risk  Liquidity risk: the risk that an asset cannot be exchanged for cash rapidly enough to prevent a financial loss.  Default risk: the risk that credit given as loans will not be repaid o Banks make money by lending more than they hold in legal tender counting on depositors not needing all their funds at the same time e.g. 100 of base money but owed others 200  If all were to demand money the banks would not be able to repay -> a bank run  liquidity risk is a cause of bank failure  Banks can also fail through bad investments e.g. loans that are defaulted but will often be bailed out by ...