The Federal Reserve in the United States provides two main measures of money – M1 and M2, where M1 is the narrowest and M2 the broadest. When some prospective borrowers are excluded, the Gini coefficient increases to 0.70. The dashed line in Figure 10.21 shows the new situation. The new Gini coefficient is 0.70, showing an increase in inequality as the result of the credit market exclusion of the poor.
- Therefore, an increase in the supply of money does not necessarily lead to an increase in GDP or inflation without taking the velocity of money into consideration.
- The criteria used to classify and define monetary aggregates by individual countries are compared and summarized.
- While M0 and M1 are used to describe narrow money, M2, M3, and M4 qualify as broad money and M4 represents the largest concept of the money supply.
- So the lender receives a share of i/Π of total output, and the borrower receives a share of 1 − (i/Π).
- All deposits and CDs held with ADIs by the private non-ADI sector are included in M3.
- Months have passed since they sold the last harvest and so the only way they can buy inputs is to borrow, promising to repay at the next harvest.
11 The central bank’s policy rate can affect spending
In Figure 10.6, some part of his feasible frontier lies outside his endowment indifference curve, so he can do better by storing some grain. Now think about Marco, an individual facing a different situation from Julia who was considering a payday loan, or a farmer in Chambar seeking a loan until the harvest. While Julia is deciding how much to borrow, Marco has some goods or funds worth $100, but does not (yet) anticipate receiving any income later. Julia and Marco will both get $100 eventually, but time creates a difference. More generally, the value to the individual of an additional unit of consumption in a given period declines the more that is consumed. This is called diminishing marginal returns to consumption.
It comprises cash (notes and coins) and accounts held by commercial banks at the central bank, called commercial bank reserves. 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. As we will see, this is not the case with accounts held by households or businesses at commercial banks—commercial banks do not necessarily have the cash available to satisfy all their customers’ needs.
Conversely, in an inflationary setting, interest rates are raised and the money supply diminishes, leading to lower prices. But do banks and the financial system make some people poor and other people rich? To answer this question, compare banks to other profit-making firms.
Surveys show that the public in Germany, Spain and many other countries hold their banks in low esteem. This has particularly been the case since the financial crisis of 2008. The profitability of the business depends on the difference between the cost of borrowing and the return to lending, taking account of the default rate and the operational costs of screening the loans and running the bank. Like moneylenders, 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.
- The principal–agent problem between borrower and lender is similar to the ‘somebody else’s money’ problem discussed in Unit 6.
- Because bank deposits are an asset for their owner, these operations affect the asset side of the household’s balance sheet.
- Thus, NM1 includes currency with the public and non-interest-bearing deposits with the banking sector including that of RBI.
- The slope of the indifference curve of 1.5 (in absolute value) at point A in Figure 10.3b means that she values an extra unit of consumption now 1.5 times as much as an extra unit of consumption later.
- So what happens when the banks close their doors and everyone knows that cheques will not bounce, even if the cheque writer has no money?
- Issuers of M2+ and M2++ are, in addition to those of M1+ and M1++, central government for savings bonds, government-owned savings institutions, and life insurance companies.
V. 3. Summary of the Monetary Aggregates in Philippines
In March 2006, the Federal Reserve stopped publishing M3 statistics. 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. In the case of borrowing and lending, 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 broad money refers to allow repayment according to the terms of the loan. A loan is made now and has to be repaid in the future.
Exercise 10.5 Interest rate markups
Money holders for M1 and M2 are domestic residents other than public sector enterprises, central and local governments, and resident banks as well as savings and loan companies. Savings deposits and time deposits are classified by terms of maturities with savings redeemable at a period of notice up to 3 months and time deposits maturing up to 2 years being included in non-M1 component of M2. That is, velocity is defined by the values of the other three variables. Unlike the other terms, the velocity of money has no independent measure and can only be estimated by dividing PQ by M. Adherents of the quantity theory of money assume that the velocity of money is stable and predictable, being determined mostly by financial institutions. M0 is referred to as the “wide monetary base” or “narrow money” and M4 is referred to as “broad money” or simply “the money supply”.
Because bank deposits are an asset for their owner, these operations affect the asset side of the household’s balance sheet. M1 is the narrowest measure of the money supply, including only the most liquid forms of money such as currency in circulation and demand deposits. Money issuers are commercial banks, savings banks, and Norges Bank (the central bank of Norway) for currency, coins, and deposits. M3 money issuers are domestic banks, savings and loan companies, Bank of Mexico for notes and coins, federal government, investment companies.
The base rate applies to banks that borrow base money from each other, and from the central bank. But it matters in the rest of the economy because of its knock-on effect on other interest rates. 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 (it will also be higher for borrowers perceived as risky by the bank, as we saw earlier).
While maturity transformation is an essential service in any economy, it also exposes the bank to a new form of risk (called liquidity risk), aside from the possibility that its loans will not be repaid (called default risk). The ratio of base money to broad money varies across countries and over time. For example, before the financial crisis, base money comprised about 3–4% of broad money in the UK, 6–8% in South Africa, and 8–10% in China. 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. A balance sheet summarizes what the household or firm owns, and what it owes to others.
The feasible sets for all of Marco’s options are shown in Figure 10.10. If Marco were to invest all of his grain, he could harvest $150 worth of grain later. Marco is now able to reach a higher indifference curve. Point H on Marco’s indifference curve denotes the amount of storage that he will choose.
Therefore, it represents both the most liquid and the least liquid cash and deposit-based assets held within a nation. This includes funds in bonds or other securities as well as institutional money market accounts. While M0 and M1 are used to describe narrow money, M2, M3, and M4 qualify as broad money and M4 represents the largest concept of the money supply. Broad money may include various deposit-based accounts that would take more than 24 hours to reach maturity and be considered accessible. These are often referred to as longer-term time deposits because their activity is restricted by a specific time requirement. The narrow money supply only contains the most liquid financial assets.
Figure 10.10 Options for the individual (Marco) who starts with assets. If he could get a loan at 10%, he would be better off by investing everything he has. This expands his feasible set, as shown by the dotted red line. The dark line shows Marco’s feasible frontier using storage, and the shaded area shows his feasible set. Figure 10.5 Reservation indifference curves and endowments. If Julia knows she can have two meals tomorrow but she has none today, then we have seen that diminishing marginal returns to consumption could explain why she might prefer to have one meal today and one tomorrow instead.
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