## Sunday, 29 May 2011

### Economics: money, money supply and money creation

Money
In ancient time, people exchange goods for goods, that’s called barter economy. However, the difficulties faced include:
1)       Difficulty to quantitize its value because the value of a good is subjective, some goods like living things are hard to be divided
2)       High transaction cost, low transacted quantity
3)       Hard to meet double-coincidence of wants, that is, trader A wants trader B’s goods while trader B wants trader A’s goods. Also heterogeneity exist among goods, it may cause disagreement of the exchange.
4)       No standard of deferred payment and low durability: goods depreciates time to time so the value of goods in future is less foreseeable.
Therefore money is invented to fulfill the following features:
1)       As a medium of exchange, money is generally accepted to be exchanged so the problem of double-coincidence of wants is solved. Also it’s usually durable to store value, like gold, silver or coins.
2)       Quantitizing and dividing value in a generally accepted way. Purchasing power of money is more foreseeable so it’s also the standard deferred payment.
Functions of money:
1)       Medium of exchange: it facilitates exchange and hence lowered the cost of exchange
2)       Unit of account: quantitizing value of goods in money terms.
3)       Store of value since money itself is an asset as well.
4)       Standard of preferred payments.
Forms of money
1)       Commodity money
In ancient time people trade with salt, shells and later precious metal like gold and silver. They are scarce and durable, and their face value is equal to their intrinsic value.
2)       Representative money
It face value is less than intrinsic value but it’s convertible to goods of equal amount of its intrinsic values(they have equal amount of backup of goods), like gold and silver certificates.
3)       Credit/inconvertible money
It’s also known as flat money. They have little face value, no back up  and they exchange value fluctuates under change of price level. Examples like legal tender.
4)       Bank deposit money
-          Demand deposit (current account): write cheques to draw on their deposits with no interest usually. It’s money since it’s generally accepted as exchange medium.
-          Saving deposit: interest is given but people can’t write cheques to draw money from it.
-          Time deposit: people can’t draw the money in a specified period, but the interest rate is higher.
-          Negotiable certificate of deposit is transferable.
5)       Electronic money
It’s money without physical form and zero face value, like money stored in octopus card (not octopus card itself)
Types of banks according to their functions
1)       Commercial banks: usually accept deposit, make loans, facilitate financial trade for public.
2)       Merchant banks are underwriter of shares, arrange large scale loans and manage the funds. Their target customers are usually companies or the government.
3)       Central banks: issuing currency; act as government banker and adviser; supervising authorized institutions; being lender of last resort (lending money to banks at discount rate to prevent bank run, interest rate of loans among banks are called HK Interbank Offered Rate), central clearing house, carrying out monetary policy (controlling MS), keep economy’s foreign exchange reserves and negotiating with foreign monetary institutions.
The banks now days may act as both commercial and merchant banks. Also, there’s no central bank in HK, but HKMA act as the central banks, like issuing $10 legal tender and coins. Types of banks according to their scale 1) Licensed banks (LB), which they can use “bank” in their names, can accept all kinds of deposits; the minimum paid-up capital is HK$300 mil, like HSBC.
2)       Restricted licensed banks (RLB) can use the word “restricted license bank” in their names, they can only accept time and certificates of deposit. The minimum amount of deposit of HK$0.5 mil. And the minimum paid-up capital is$100 mil., like China Construction Bank.
3)       Deposit-taking companies (DTC) can only accept time and certificates of deposit of at least HK$0.1 mil and have 3 month of maturity period. The minimum paid-up capital is HK$25 mil.
All banks should have liquidity ratio above 25%.
Liquidity ratio = loans repay in 1 month / deposit due in 1 month, which represents the ratio between assets and liabilities.
Money supply
M0 is defined as the monetary base = legal tender issued = Cp (currency in public circulation) + reserve in banks
M1 is defined based on the money as the medium of exchange. M1 = Cp + Dd (Demand deposit)
M2 is defined based on money as a medium of exchange and store of value, including deposit in LB only. M2 = M1 + Ds (saving deposit) + DtLB + CDLB (time deposit and certificate of deposit in license banks)
M3 includes the deposits in the whole three-tier system, and it includes long-term savings and also deposits in RLB and DTC. M3 = M2 + DtRLB + DtDTC + CDRLB + CDDTC.
Note:
1)       The next level of MS includes the last level’s MS. e.g., M2 includes M1.
2)       Except cash leakage to foreign place, M3 usually remains the same. The change in M0~M3 is given by the change in the smaller parts. For example, when a people put $50 into time deposit in license bank, ΔM1 = ΔCp = -$50, ΔM2 = ΔM1 + ΔDtRB = -$50 +$50 = $0. In HK, HKMA authorized HSBC, Standard Chartered Bank of HK and Bank of China to issue bank notes while HKMA issues$10 legal tender and all coins. In order to stabilize the exchange rate US$1 = HK$7.8, all HK currency issued, are backed up by equivalent amount of US dollar at 1:7.8. The backed up currency has made HKD into an exchange standard.
Money creation
Banks accept deposits, put some as reserve (the reserve ratio is at least the required reserve ratio (rrr) ordered by central bank or government) and loan out the rest to make profit. Loans can be risky since people may withdraw money from time to time. The rrr is set up to prevent bank run to meet customers’ withdrawal.
Assets VS liabilities
To a bank, accepting deposits are liabilities to the bank since the bank owes the customers the sum of money. Similarly, the reserves and loans are assets of bank because the lender owes the bank the sum of money.
When ones put some money into the bank, for a bank the deposit and reserves increase at the same time (of the same magnitude). We have total assets = total liabilities.
Assumption of money creation
1)       Bank only keep required reserve (deposit * rrr) and lends out the rest, i.e., they have exactly zero reserves.
2)       Only demand deposit exists.
3)       All money will be re-deposited into the banking system and no leakage of cash (i) from the bank to the public, and; (ii) in/out of the economy.
Process of money creation
When one deposited a sum $X into the banking system, the bank keeps$X(rrr) and lend out a sum of $X(1-rrr). That money is again divided into reserves and loans. The process continues until all$X becomes required reserve and the money creation process is done. It follows that the deposit increases $X/rrr (because Δdeposit * rrr = Δreserve). Thus 1/rrr is called the banking multiplier. In reality, banks may keep excess reserve; otherwise they can’t meet the req. reserve and they have to call back loans, which are called money contraction. Actual reserve ratio = actual reserve / deposit and excess reserve = reserve – req. reserve = deposit (actual reserve ratio – rrr). For example, when one deposited$80 into a bank where rrr = 50%. The bank keeps $80*50% =$40 and lends out $40. When that$40 is again put in the bank they keep $20 and loan out the rest… until$80 becomes the reserve fully. Total increase in deposit = $80 / 50% =$160.
Money multiplier = (Cp + Dd) / (Cp + reserve) = M1/M0, is the multiplier given that there’s some money in public circulation or in central bank.