Economics of Money and Banking Lecture 1 Notes PDF

Preview

Summary

Download Economics of Money and Banking Lecture 1 Notes PDF

Description

Money – The circulating medium of exchange as defined by a government NOTE – It can either have intrinsic value (like gold) or it can be in the form of notes and coins distributed by a central bank (notes still technically have intrinsic value, but they have much lower intrinsic value than items such as gold). Money enables people to specialise in one job and use their earnings to purchase goods and services elsewhere. For example, this revision guide can be sold for money, and that money can then be used to pay for a video game, if desired. This type of transaction would be impossible, or much more difficult, in a barter system Barter System – A system that relies on the exchange of goods and services for other goods and services, without the use of money e.g. a potato farmer trading a sack of potatoes for a cut of beef NOTE – This isn’t ideal as it requires both parties having a double coincidence of wants. Would the owner of a sports shop be willing to exchange some trainers in exchange for some bags of bananas? Probably not (depends on the person, but you get my point). This is one of the main problems with a barter system, and is why most societies use money nowadays Double Coincidence of Wants – An economic phenomenon where two parties each hold an item the other wants Functions of Money (MUDS):   



Medium of Exchange – Money should be accepted universally (by buyers and sellers) for the payment of goods, services and debt Unit of Account – It allows the value of goods, services and other assets, to be compared, so that the prices of products and assets reflect the value that society places on them Standard of Deferred Payment – Money can be used to pay back debt e.g. a firm may want to borrow money to buy stock of a good, which they can then sell and use to pay back the debt (e.g. borrowing £100 to buy a TV at wholesale price, selling it for £250, and then using £100 of the £250 to pay back the debt). Money makes this easier Store of Value – It must be possible to use for future transactions and so it must be nondiminishable e.g. saving money in the bank NOTE – Technically speaking, inflation can actually reduce the value of money over time

Money (Benefits):   

Allows for trade / exchange to happen that would not happen in the absence of double coincidence of wants Better allocation of resources to those that value them most Facilitates specialisation and associated efficiency gains

Economy (Stages of Value Transfer):

A. Economy with exchange / barter only

B. Economy with money (cash-in-hand) (money without tim e dimension or intermediaries)

C. Economy with credit (wider financial system) (money with time dim ension and intermediaries) Credit – A contractual agreement in which a borrower receives something of value now and agrees to repay the lender at a later date (generally with interest) NOTE – This requires a double coincidence of wants of some given time period (and trust) Credit (Role):  

Economic decisions have a time decision Money is not always available when you need it for consumption or investment

Credit (Benefits):   

Maximises utility over time subject to a life-time budget constraint Maximise profits / minimise costs over time Increased efficiency of transaction in an economy

Direct Finance – A method of financing where borrowers borrow funds directly from the financial market without the use of a third-party service (e.g. financial intermediary) e.g. selling a bond, selling a share in a company etc.. Indirect Finance – A method of financing where borrowers borrow funds indirectly via the use of a third-party service (e.g. financial intermediary) e.g. borrowing from a bank Direct Financing (Costs):    

Most households and small business lack experience of selling shares / issuing bonds High transaction costs (especially with few transactions) Need knowledge / expertise to assess potential returns NOTE – This type of financing is mostly associated with big corporations, specialist brokers etc…

Indirect Financing (Benefits):



Allows contracts to be enforced between borrowers and lenders that don’t have or can’t identify double coincidence of wants and/or don’t have trust

Incomplete Contracts – An economic contract that does not explicitly mention the terms and conditions under which future issues between the contracting parties may be decided Endogenous Growth Theory – A theory claiming that economic growth is primarily the result of endogenous and not external forces NOTE – This theory holds that investment in human capital, innovation, and knowledge are significant contributors to economic growth. According to this new theory, financial systems can complete contracts and rectify incomplete markets. Investment in productivity can then enhance activities that wouldn’t otherwise have happened without the mobilising of saving, thus allocating resources and diversifying risk Correlation Between Economic Growth and Financial System (Studies): 





King and Levine (1993):  Found that financial development improves growth in real GDP per capita, rate of physical accumulation and improvement in efficiency at which economies employ physical capital Aghion (2010):  Found that financial systems alleviate liquidity constraints, thereby facilitating longterm investment and reducing volatility of investment and growth IMF (2012):  Found that financial systems alleviate liquidity constraints, thereby facilitating longterm investment and reducing volatility of investment and growth

Correlation Between Economic Growth and Financial System (Mixed Studies Over Different Countries): 







Reinhart and Rogoff (2009):  Found examples of countries with subdued financial systems where some had hampered economic growth and others had historically rapid growth Cecchetti and Kharroubi (2012):  Found that financial systems alleviate liquidity constraints, thereby facilitating longterm investment and reducing volatility of investment and growth Capelle-Blanchard and Labonne (2011):  Looked at the impact of scale of employment in financial sector on growth and found no clear and positive relationship Hassan, Sanchez and Yu (2011):  Found that a well-functioning financial system is a necessary but not sufficient condition for steady growth in developing countries

NOTE – We don’t know whether or not big economies cause big financial systems (or vice versa)

  

Allows for trade / exchange to happen that would not happen in the absence of double coincidence of wants Better allocation of resources to those that value them most Facilitates specialisation and associated efficiency gains

World Growth Facts:         

6.7 billion people live under ranging economic circumstances In developing countries, many children and adults die every day from hunger and preventable diseases In industrialised countries, diseases caused by too much food have replaced those caused by too little as a major health problem 20% of the world living in the richest countries receive 58% of the world’s income 1 billion people live on incomes less than $1 per day 2.6 billion live on less than $2 per day Life expectancy and average height in wealthy countries (today) is significantly higher than in the past Relatively poor countries today enjoy life expectancy higher than the British nobility at the beginning of the 1900s Some countries like Argentina are failing to keep up and a small number of African countries actually have negative growth

Gross Domestic Product (GDP) – A measure of the value of all the goods and services produced in a country over a year Purchasing Power Parity (PPP) Theory – A theory suggesting that, in the long run, an exchange rate will always equalise the purchasing power of two currencies NOTE – PPP theory is very limited in the classical sense, but PPP as a concept is still very crucial for making comparisons between the GDPs of countries (Just think of it as a special form of exchange rate that adjusts for different price levels between country)

World Income (Percentile Graph):

Rule of 72 (Doubling Time) – A means of estimating the number of years it takes for an investment or amount of money to double NOTE – In this context the “money” we are interested in is GDP (i.e. how long it takes for a country’s time to double) Rule of 72 (Doubling Time) Formula:

72 g

NOTE – The amount of time it takes for a countries

income to double at a given growth rate. Also note that this is an approximation (not a hard rule) US GDP per Capita (1870 – 2005):



US GDP per capita in 2005 was 12.5 times as large as that in 1870

Growth Rate (Mathematics):



The growth rate,

g , of a given economic variable, Growth Rate Formula:



By rearranging we get

g=

X , is:

X t +1− X t Xt

X t +1= X t ×(1+g) . Rewriting for years t+1 and t+2 (and

X t +1 from the above equation we get 2 X t +2= X t +1 × (1+g ) =[ X t ×(1+g) ] × ( 1+g ) = X t × ( 1+ g ) From this we can show that if something grows at rate g for n years then n X t +n= X t × ( 1+g) . As such, if we rearrange: subbing in



(Geometric) Average Growth Rate (Over n Years):

g=

( )

X t +n 1n −1 Xt

Linear Scale – A graph that has equal spaces on the vertical axis correspond to equal differences in the variable being graphed Ratio Scale – A graph whose equal spaces on the vertical axis correspond to equal proportional differences in the variable being graphed NOTE – For example, the vertical gap between X =1 and X =10 is the same as the vertical gap between X =10 and X =100

Linear Scale vs Ratio Scale (Graph):

US GDP Per Capita (1870 – 2005):

GDP Per Capita in US, UK and Japan (1870 – 2003):

    

Between 1870 – 2000, the average growth rate of the UK was 1.4% per year vs 1.9% in the US NOTE – Small differences in growth rates can have massive effects over time In 1870, the UK was 33% richer than the US, but by 2003 it was 27% poorer In 1885, Japan’s income was about ¼ of US income Between 1950 and 1990, the average growth rate was 5.9% in Japan vs 2.1% in the US By 1990, Japanese income was 85% of the US level

Distribution of Growth Rates (1970 – 2005):

 

  

Average growth rate in the world is 3.3%  Average growth rate of the US was 1.9% In 1960, South Korea and the Philippines had roughly equal levels of income per capita ($1,598 and $2,153)  South Korea (over the four next decades) had an average growth rate of 6.1% per year and the Philippines 1.3% per year (by 2000, $16,970 in South Korea and $3,661 in the Philippines) The uneven distribution of growth among countries has widened the income gap between rich and poor countries Between country inequality is now more important than within country inequality as a contributor to overall world inequality An important implication of the gap between rich and poor countries is that it suggests a potential for alleviating poverty

Factors of Production – The available resource inputs used in the production process of goods and services Factors of Production (CELL): Capital + Entrepreneurship + Labour + Land Factors of Production: 

Capital – Man-made aids for production; goods used to make other goods e.g. MERC – Machines + Equipment + Robots + Computers



 

Entrepreneurship – The willingness of an entrepreneur to take risks and organise production NOTE – An entrepreneur is someone who bears the risks of a business and organises production Labour – The human resource that is available in an economy; the quantity and quality of human resources Land – The natural resource that is available in an economy; the quantity and quality of natural resources e.g. oil, coal, rives, the land itself etc… NOTE – Some are renewable (e.g. trees, wind power etc…) and some non-renewable (e.g. coal, oil etc…)

Investment – Goods and services devoted to the production of new capital rather than consumed Productivity – Output of a good or service, per factor of production, per period of time NOTE – This consists of technology and efficiency Technology – The available knowledge about how inputs can be combined to product output Efficiency – The extent to which the available technology and inputs are being used optimally Economic Fundamentals – Basic economic measures e.g. interest rates, government income and spending, exports and imports, inflation, confidence, employment, home prices, stock prices etc… How to Compare Two Countries:      

GDP GDP per capita Factors of Production Investment (Savings)  This affects the amount of capital available Productivity Fundamentals

Production Function – A mathematical description of how the inputs used are transformed into its output Production Function:



Below is a set of diagrams showing the possible causes in differences in output per worker:



Differences in factor accumulation cause movements along the production function, whilst changes in productivity (improved technology or efficiency) cause shifts / pivots

Relationship between Latitude and Income per Capita:

Relationship between Income per Capita and Population Growth:

:...