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Chapter 10 (2) - Banks, money, and the credit market - Coggle Diagram
Chapter 10 (2) - Banks, money, and the credit market
Unit 8
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Bonus Bank has now expanded the money supply: Gino can make payments up to $120, so in this sense the money supply has grown by $100—even though base money has not grown. The money created by his bank is called bank money.
Suppose that Gino borrows $100 from Bonus Bank. Bonus Bank lends him the money by crediting his bank account with $100, so he is now owed $120. But he owes a debt of $100 to the bank. So Bonus Bank’s balance sheet has expanded. Its assets have grown by the $100 it is owed by Gino, and its liabilities have grown by the $100 it has credited to his bank account, shown in Figure 15
Suppose Gino employs Marco to work in his shop, and pays him $10. Then Bonus Bank has to transfer $10 of base money from Gino’s bank account to Marco’s bank account in Abacus Bank. This transaction is shown in Figure 16
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Marco wants to pay $20 to his local grocer, Gino, in return for groceries, so he instructs Abacus Bank to transfer the money to Gino’s account in Bonus Bank (he could do this by paying Gino using a debit card). This is shown on the balance sheets of the two banks in Figure 14
If Marco and Gino were customers of the same bank, there will be no loss of base money.
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Because of the loan, the total ‘money’ in the banking system has grown, as Figure 17 shows.
let us suppose in this case that Marco has $100 in cash and he puts it in a bank account in Abacus Bank. Abacus Bank will put the cash in a vault, or it will deposit the cash in its account at the central bank. Abacus Bank’s balance sheet gains $100 of base money as an asset, and a liability of $100 that is payable on demand to Marco, as shown in Figure 13.
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Reserves are equivalent to cash because a commercial bank can always take out reserves as cash from the central bank, and the central bank can always print any cash it needs to provide.
Base money (excluding legal tender held by banks) plus bank money is called broad money. Broad money is money in the hands of the non-bank public.
The interest they pay on deposits is lower than the interest they charge when they make loans, and this allows banks to make profits.
By taking deposits and making loans, banks provide the economy with the service of maturity transformation
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The profitability of their lending business depends on:
- the cost of their borrowing
- the default rate on the loans they extended to farmers
- the interest rate they set
Like any other firm in a capitalist system, banks can also fail by making bad investments, such as by giving loans that do not get paid back.
Unit 10
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On the liability side of the bank balance sheet, there are three forms of bank borrowing shown in figure 20.
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The asset side of the bank balance sheet:
- Cash and central bank reserves
- Bank's own financial assets
- Loans to other banks
- Loans to households and firms
- Bank assets
Figure 21 shows the simplified balance sheet of Barclays Bank (just before the financial crisis) and Figure 22 shows the simplified balance sheet of a company from the non-financial sector, Honda.
If the value of the bank’s assets is less than the value of what the bank owes others, then its net worth is negative, and the bank is insolvent
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If the risk of making loans (the default rate) is higher, then there will be a larger gap (or spread or markup) between the interest rate banks charge on the loans they make and the cost of their borrowing.
Here, we calculate the leverage for Barclays and Honda using the definition used for banks: total assets divided by net worth.
A bank’s costs and revenues:
- The bank’s operational costs: These include the administration costs of making loans.
- The bank’s interest costs: Banks must pay interest on their liabilities, including deposits and other borrowing.
- The bank’s revenue: This is the interest on and repayment of the loans it has extended to its customers.
- The bank’s expected return: This is the return on the loans it provides, taking into account the fact that not all customers will repay their loans.
Unit 11
To see the effect of a lower interest rate on consumption spending, we return to Julia, who has no wealth, but expects to receive $100 one year from now.
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Households and firms borrow to spend: the more it costs to borrow (equivalently, the higher the interest rate), the less they spend now.
Unit 13
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Thus if i = 0.10 and Π = 0.15 then the lenders’ share of total income is 2/3 and the borrowers’ is 1/3.
Imagine that 40 of the prospective borrowers are excluded (and since they cannot borrow, they receive no income at all) and that nothing else in the situation changes (i and Π remain unchanged).
The lender receives a share of i/Π of total output, and the borrower receives a share of 1 − (i/Π).
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An economy is composed of 90 farmers who borrow from 10 lenders, and use the funds to finance the planting and tending of their crops. The harvest (on average) is sold for an amount greater than the farmer’s loan, so that for every euro borrowed and invested the farmer gains income of 1 + Π, where Π is called the rate of profit. Following the harvest, the farmers repay the loans with interest, at rate i.
The new Gini coefficient is 0.70, showing an increase in inequality as the result of the credit market exclusion of the poor.
We can analyse inequalities between borrowers and lenders using the same Lorenz curve and Gini coefficient model
Unit 12
One response of the lender to this conflict of interest is to require the borrower to put some of her wealth into the project (this is called equity.
Equity or collateral reduces the conflict of interest between the borrower and the lender. The reason is that when the borrower has some of her money (either equity or collateral) at stake:
- She has a greater interest in working hard: She will try harder to make prudent business decisions to ensure the project’s success.
- It is a signal to the lender: It signals that the borrower thinks that the project is of sufficient quality to succeed.
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Typically the reason why the borrower needs a loan is that she is not wealthy. As a result, she may be unable to provide enough equity or collateral to sufficiently reduce the conflict of interest and hence the risk faced by the lender, and the lender refuses to offer a loan. This is called credit rationing
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Borrowers whose limited wealth makes it impossible to get a loan at any interest rate are termed credit-excluded
it is often not possible for the lender (the principal) to write a contract that ensures a loan will be repaid by the borrower (the agent). The reason is that it is impossible for the lender to ensure by contract that the borrower will use the funds in a prudent way that will allow repayment according to the terms of the loan.
Those who borrow, but only on unfavourable terms, are termed credit-constrained
The relationship between the lender and the borrower is a principal–agent problem. The lender is the ‘principal’ and the borrower is the ‘agent’.
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But lenders face two further problems. When loans are taken out for investment projects, the lender cannot be sure that a borrower will exert enough effort to make the project succeed.
Unit 9
What determines the price of borrowing in the money market (the interest rate)? We can think in terms of supply and demand:
- The demand for base money depends on how many transactions commercial banks have to make
- The supply of base money is simply a decision by the central bank
Banks in the money market will respect that price: no bank will borrow at a higher rate or lend at a lower rate, since they can borrow at rate i from the central bank. This i is also called the base rate, official rate or policy rate
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The average interest rate charged by commercial banks to firms and households is called the bank lending rate. This rate will typically be above the policy interest rate, to ensure that banks make profits
Suppose in the above example that Gino wants to pay $50 to Marco (and there are no other transactions that day). Gino’s bank, Bonus Bank, doesn’t have enough base money to make the transfer to Abacus Bank, as we can see from its balance sheet in Figure 18. So Bonus Bank has to borrow $30 of base money to make the payment.
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Unit 14
In modern economies, the creation of money is inextricably tied up with the creation of credit, or the process of lending by commercial banks whose actions are regulated by government and managed by the central bank.
Borrowing and lending allows people to smooth consumption when they have irregular incomes, to satisfy their impatience, or to finance investment that can increase their future consumption possibilities.
Substantial mutual gains are made possible when a group of people develop sufficient trust in each other and in a particular medium of exchange.