Ch 29. The Monetary System

.title[
# Ch 29. The Monetary System
]
.subtitle[
## Macroeconomics for Students of Accounting, Finance and Digital Applications
]
.author[
### Lyuben Ivanov, PhD; Georgy Ganev, PhD
]
.institute[
### Sofia University St Kliment Ohridski
]
.date[
### Apr 25, 2024
]

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.pull-right[
_Everybody knows what money is, and even economists can define it in a page or two..._
<hr style="background-color: black; margin: 0em 0em 0em 0em;">
<span style="float: right; font-variant: small-caps; ">anonymous author &nbsp;</span>
]

---

<hr>

---

# Definition of Money

<br>
<table class="none">
  <tr>
    <td style="text-align: center; vertical-align: middle;"><b>money</b></td>
    <td> </td>
    <td> </td>
    <td>Money is everything which is generally accepted by
economic agents as a means for payment or for settling
debts.</td>
  </tr>
</table>

<br>

Essential characteristics of money:

- They service the process of exchange – money exists only
where value is transferred;

- They are accepted by economic agents in exchange for
goods and services.

---

# Functions of Money

**Medium of exchange**<br>
this function allows economic agents to expand
considerably the space of possible exchange and avoid the
limitations of barter.

**Unit of account**<br> money becomes the unit in which all
prices are expressed. This makes them much easier to
compart and also makes them calculable, which is a
crucial requirement for economic decision-making.

**Store of value**<br> a means for transferring value through
time. Here money have a competition due to other
possibilities available to economic agents – physical
inventories, real estate, valuables, precious metals…

---

# Properties of Money

<br>

General acceptance.

Easily establishable value.

Durability.

Divisibility.

Transferability.

---

.pull-right[
_If you let me talk about the history of money you will wake up after 3 weeks... and I will be just getting started..._
<hr style="background-color: black; margin: 0em 0em 0em 0em;">
<span style="float: right; font-variant: small-caps; ">Georgy Ganev &nbsp;</span>
]

---

# Historical Development of Money

<br>

**Full-value money**

- Commodity money (stones, cattle, shells, polished stones, precious stones,
metals, precious metals);

- Gradually some quantities of metal are processed so that metal pieces
serve exclusively as money and gradually acquire the attributes of coins –
with their value (weight) specifically marked.

---

# Historical Development of Money

<br>

<table class="none">
  <tr>
    <td style="text-align: center; vertical-align: middle;"><b>fiat money</b></td>
    <td> </td>
    <td> </td>
    <td>Money by decree, whose production costs are much
lower than the value marked on them, which they represent.</td>
  </tr>
</table>

Initially this happens through debasement of coins, later through simple
printing on less valuable material such as paper – banknotes.

Gradually payments start happening without a physical (material) carrier of
value – non-cash payments, which involve a complicated system of
registers and guarantees that value is indeed transferred, i.e. that it belongs
to the receiver of the payment (bank transfers; electronic money).

---

# Money Supply in Bulgaria (2022)

---

<hr>

---

# Why Do Banks Exist?

Banks exist because they specialize (and are more
productive than other economic agents) in:

- Providing liquidity;

- Managing risk;

- Gathering, processing and transmitting information.

---

# Assets and Liabilities of Banks
<br>

**Liabilities**<br> 
the promises given by banks to savers,
involving obligations by banks to provide some
benefits in the future.

**Own capital**<br> a specific type of liability, namely
towards the owners of the bank.

**Assets**<br>
the obligations of others (mostly borrowers)
towards the bank for some future benefit, or for
observance of the banks’ property rights.

---

# Bank Assets and Liabilities in Bulgaria

<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" width="250px" colspan="2">ASSETS </td>
<td style="text-align: center; border-bottom: solid;" width="250px" colspan="2">LIABILITIES </td>
</tr>
<tr>
<td > Bank reserves </td> <td style="text-align: right; border-right: solid; padding-right: 15px;"> 32,428</td> <td> Deposits </td> <td style="text-align: right;"> 134,079</td>
</tr>
<tr>
<td> Securities </td> <td style="text-align: right; border-right: solid;"> 24,452</td> <td> </td> <td> </td>
</tr>
<tr>
<td> Credits </td> <td style="text-align: right; border-right: solid;"> 92,666</td> <td> Other </td> <td style="text-align: right;"> 4,045 </td>
</tr>
<tr>
<td> Other </td> <td style="text-align: right; border-right: solid;"> 5,859</td> <td> Capital </td> <td style="text-align: right;"> 17,281 </td>
</tr>
<tr >
<td> </td> <td style="text-align: right; border-right: solid;"> </td> <td> </td> <td>
</tr>
<tr>
<td> Total </td> <td style="text-align: right; border-right: solid;"> 155,406</td> <td> Total </td> <td style="text-align: right;"> 155,406 </td>
</table>

<span style="float: right;">**Source**: Bulgarian National Bank, end of 2022, thousands of BGN.</span>

---

<hr>

---

# Non-own Liabilities

<br>
**Deposits**
- promises to accept free funds, to pay interest on their
balances and to provide full access to these funds to the
saver
- can have immediate access and delayed access
- the saver can always fully withdraw, even if the deposit
has delayed access, delayed access deposits may involve a
slight penalty

<br>
**Attracted funds**
- loans from other agents, most often other banks, in
various forms
- most common forms: interbank deposits and repo
transactions

---

# Own Capital
<br>
Own capital are the funds provided to the bank by its owners. It consists of 
two main components: shareholding capital and retained earnings.

**Shareholding capital**

The sum actually paid-in by
shareholders after primary purchase of stock.

**Retained earnings**

Profit from previous periods not
distributed to the owners as dividend, which remains
with the bank, also belongs to the owners.

---

<hr>

---

# Reserves

The bank reserves are the sum of highly liquid assets of the bank, with which the
bank can execute payments when necessary.

Reserves consist of two components: cash in the bank
vaults and deposits with the central bank.

**Minimal required reserves**

The funds, calculated as a
percent of all attracted deposits, which the bank is obliged
under law to keep at all times as reserves.

**Excess reserves**

The funds which the bank chooses to keep
as reserves in excess of the minimal requirement.

---

# Credits

**Business loans**

Given to firms to service their activities and
implement projects. Can be related to servicing the firm’s
payments, or to finance investment projects.

**Mortgage loans**

Given to firms or households to acquire real
estate, with the real estate serving as collateral for the loan.

**Consumer loans**

Given to households to enable them to meet
consumer expenditures, which then are gradually paid off from
the future incomes of the household.

---

# .font90[Claims on Other Financial Intermediaries]

<br>

Mostly these are funds lent on the interbank market.

They can be also due to the purchase by the bank of a specific
product or service of another bank.

Although not as liquid, they can be turned into reserves very quickly
and cheaply.

---

# Tradable Securities and Other Assets

**Tradable Securities**

They are a part of the investment portfolio of the bank.

In Bulgaria this is most often a portfolio of government securities.

**Other Assets**

Mostly long-term material assets, or receivables in
process, or collateral property acquired on non-performing loans.
---

# Bank Net Value of Assets = Own Capital

<br>

`$$\sf \text{Net Value} = \text{Assets} - \text{Non-own Liabilities}$$`

A change in the market value of assets (and sometimes of some
liabilities), when accounted for, turns into profit or loss.

Profit is paid as dividend or increases own capital; loss
decreases own capital.

If a bank permits the market value of its assets to fall below the
market value of its non-own liabilities, it is **economically
insolvent**.

When market realities get reflected in the accounting balance
of the bank, it becomes **accountingly insolvent**, and may have
to disappear in legal and economic terms.

---

<hr>

---

# Main Participants and Assumptions

<br>

**Main Participants**

&nbsp; Central bank<br>
&nbsp; System of commercial banks<br>
&nbsp; Depositors<br>
&nbsp; Bank credit borrowers

**Assumptions of the Model**

&nbsp; Required reserves: 10% of deposits<br>
&nbsp; No excess reserves<br>
&nbsp; No cash

---

# Central Bank Buys Securities

<centering>
<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" colspan="4">Central Bank </td>
</tr>
<tr>
<td > Securities </td> <td style="text-align: right; border-right: solid; padding-right: 15px;"> +100.00 </td> <td> Reserves </td> <td style="text-align: right;"> +100.00</td>
</tr>
<tr >
<td> </td> <td style="text-align: right; border-right: solid;"> </td> <td> </td> <td>
</tr>
</table>
</centering>
<br>

<centering>
<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" colspan="4">Commercial Banks </td>
</tr>
<tr>
<td width="25%"> Securities </td> <td style="text-align: right; border-right: solid; padding-right: 15px;" width="25%"> -100.00 </td> <td> </td> <td style="text-align: right;"> </td>
</tr>
<tr >
<td> Excess reserves</td> <td style="text-align: right; border-right: solid;"><br>+100.00 </td> <td> </td> <td>
</tr>
</table>
</centering>

---

# .font90[Commercial Banks Lend Excess Reserves]

<centering>
<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" colspan="4">Commercial Banks </td>
</tr>
<tr >
<td> Excess reserves</td> <td style="text-align: right; border-right: solid;"><br>-100.00 </td> <td> </td> <td>
</tr>
<tr>
<td width="25%"> Loans </td> <td style="text-align: right; border-right: solid; padding-right: 15px;" width="25%"> +100.00 </td> <td> </td> <td style="text-align: right;"> </td>
</tr>
</table>
</centering>

---

# Borrowers Deposit the Money in Banks

<centering>
<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" colspan="4">Commercial Banks </td>
</tr>
<tr >
<td> Required reserves</td> <td style="text-align: right; border-right: solid;"><br>+10.00 </td> <td> <br> Deposits </td> <td> <br> +100.00 </td>
</tr>
<tr>
<td width="25%"> Excess reserves </td> <td style="text-align: right; border-right: solid; padding-right: 15px;" width="25%"> <br> +90.00 </td> <td> </td> <td style="text-align: right;"> </td>
</tr>
</table>
</centering>

---

# Banks Lend the Excess Reserves

<centering>
<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" colspan="4">Commercial Banks </td>
</tr>
<tr >
<td> Excess reserves</td> <td style="text-align: right; border-right: solid;"><br>-90.00 </td> <td> </td> <td>
</tr>
<tr>
<td width="25%"> Loans </td> <td style="text-align: right; border-right: solid; padding-right: 15px;" width="25%"> +90.00 </td> <td> </td> <td style="text-align: right;"> </td>
</tr>
</table>
</centering>

---

# Borrowers Deposit the Money in Banks

<centering>
<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" colspan="4">Commercial Banks </td>
</tr>
<tr >
<td> Required reserves</td> <td style="text-align: right; border-right: solid;"><br>+9.00 </td> <td> <br> Deposits </td> <td> <br> +90.00 </td>
</tr>
<tr>
<td width="25%"> Excess reserves </td> <td style="text-align: right; border-right: solid; padding-right: 15px;" width="25%"> <br> +81.00 </td> <td> </td> <td style="text-align: right;"> </td>
</tr>
</table>
</centering>

---

# Banks Lend the Excess Reserves

<centering>
<br>
<table class="none">
<tr> 
<td style="text-align: center; border-bottom: solid;" colspan="4">Commercial Banks </td>
</tr>
<tr >
<td> Excess reserves</td> <td style="text-align: right; border-right: solid;"><br>-81.00 </td> <td> </td> <td>
</tr>
<tr>
<td width="25%"> Loans </td> <td style="text-align: right; border-right: solid; padding-right: 15px;" width="25%"> +81.00 </td> <td> </td> <td style="text-align: right;"> </td>
</tr>
</table>
</centering>

<br>

And so forth...

---

# Total Deposits (Money Supply) Created

<br>

`$$\begin{aligned}
\sf \Delta D  & \sf = 100 + 90 + 81 + \ldots  \\ \\
 & \sf = 100 \times \frac{1}{1-0.9} \\ \\
 & \sf = 1,000 \\ \\
 & \sf = \Delta R \times \frac{1}{rr} \\ \\
  & \sf = \Delta R \times m \\ \\
  \end{aligned}$$`

---

# Money Supply and Monetary Base

<br>

The monetary base (MB) in an economy is the sum of the
currency in circulation (C) and the reserves (R) of the
banking system.

Changes in the monetary base (MB) affect
the money supply (M) through the process of issuing of new loans and deposit (D)
multiplication.

There is a limit to the amount of money (M) which can
be created on the basis of a given monetary base (MB).

The money multiplier (m) is the inverse of the reserve ratio (rr) and represents the link between
monetary base (MB) and money supply (M).

---

# Money Supply and Monetary Base

<br>
`$$\begin{aligned}
\sf M & = \sf C + D \\ \\
\end{aligned}$$`

Therefore,

`$$\begin{aligned}
\sf \Delta M & \sf = \Delta C + \Delta D \\ \\
 & \sf = \Delta C + \frac{1}{rr} \times \Delta R \\ \\
 & \sf = \Delta C + m \times \Delta R \\ \\
\end{aligned}$$`

---

<hr>

---

# Monetary Base in USA

---

# Money Supply in USA

---

# Currency in Circulation in USA

---

# Demand Deposits in USA

---

<hr>

---

# Motivation of the Central Bank

<br>

The legislator defines a mandate for the central bank
and the motivation of the central bankers is the
realization of this mandate.

The realization of the legislative mandate is a result of
setting and acting to achieve certain goals.

The level of independence of action of the members
of the governing body of the central bank is a matter
of interesting historical development and of serious
academic disputes.

---

# Organization of BNB

<br>

Subject to its operation under a currency board regime, an
emissions department is separated to operate as the currency
board. The banking and bank supervision departments are
more traditional.

The rule for currency boards is that the monetary base cannot
be larger than the international reserves of the central bank.

The main governing body of BNB is the Governing Council,
consisting of 7 members. Four of them are the Governor of
BNB and the three deputy governors heading the three main
departments, and they are elected by Parliament. The other
three members are appointed by the President of Bulgaria.

---

<hr>

---

# Open Market Operations

Open market operations (OMO) are the most used
monetary policy instrument, because they act
immediately, transparently, can be finely tuned and swiftly
reversed to correct errors.

OMO are performed through purchasing and selling
government securities, because:

- The market for government securities is very liquid, at any
moment the necessary operations can be executed;

- Government securities are generally considered to be the lowest
risk available;

- The possibility of abuse when securities of private agents are
traded is avoided.

---

# Open Market Operations in Bulgaria

<br>

Under a currency board, OMO are banned, because
the central bank is not permitted to:

- Lend to its own government, even indirectly by buying its
securities from other agents;

- Lend to domestic economic agents by buying
securities issued by them;

- Purchase any securities denominated in the domestic
currency.

---

# Types and Mechanics of OMO

Two types of OMO:

- Dynamic – aiming at changing the monetary base;

- Defensive – aiming at neutralizing (sterilizing) changes in the monetary
base caused by sources not controlled by the CB.

Mechanics of OMO:

- A trading desk within the CB authorized to execute the operations;

- Partners for OMO, pre-selected by the central bank;

- Communication infrastructure for asking for and accepting offers and
executing the transactions.

---

# The Discount Rate

The discount rate does not give the CB complete control over changes in the
monetary base and is clumsier to use than OMO.

It is used under a set of circumstances:

- Providing liquidity to banks when they are facing liquidity difficulties – often
in this situation there is a specific, higher (penalizing) discount rate;

- The CB serving its function as lender of last resort – in periods of systemic
crisis or panic, the CB can provide practically unlimited liquidity until the
crisis or panic settles.

NB: The function of a lender of last resort creates moral hazard and can cause
banks to take on more risk during the good times. Hence, under a currency board this instrument is also not available!

---

# Reserve Requirements

This is the only instrument for the use of which the CB acts as a body
of government power and not as an equal partner in a transaction.

Problems:

- Very powerful instrument, unavailable for fine tuning;

- Its administrative nature precludes the possibility of changing it in
small steps;

- With time banks find ways to circumvent the limitations set by the
requirement.

NB: Under a currency board this is the only available instrument of
monetary policy!

---

# Questions?

<br>

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# Thank You!

<br>

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