https://www.ecb.europa.

eu/explainers/tell-me/html/
minimum_reserve_req.en.html

https://www.ecb.europa.eu/pub/annual/balance/html
/ecb.eurosystembalancesheet2022~4a2e481250.en.h
tml
 EEM Week 3
Money and Finacial Markets
Chapters:
KW 18: Money, Banking (not Federal Reserve)
BW 18: The Financial markets and the Euro
Important:
· What is money
• Money creation
• Reserve requirement and Money multiplier
• Banking sector in EU
 What is money?
An asset that can be used to purchase goods and
services (Krugman)

Legal tender for all debts, public and private (dollar bill)
Money is legal tender
 Types of Money
• Commodity money
• Intrinsic value
• E.g. gold, cigarettes

• Commodity backed money

• Promised exchange to e.g. gold, silver

• Fiat money
• Generally accepted (Fiat = ‘let it be’)
 Value of Money
Intrinsic value:
Value ‘in itself’ ; e.g. gold, cigarettes

Nominal value:
Value ‘in name only’
(= value printed on bank note)

Seignorage:
Profit made by a government by issuing currency
= the difference between the nominal value of coins
and their production costs
 A Short Monetary history of Europe

1870 1914 1944 1971

ǀ ǀ ǀ ǀ

Classical gold gold exchange Bretton Woods Floating exchange

standard standard Golden standard rates

Currency linked Currency linked Currencies linked Fiat money

to gold to gold to US dollar
Paper money in Dollar to gold
circulation
 A Short Monetary history of Europe

1971 1979 1999

ǀ ǀ ǀ

Snake in the European Monetary European Monetary

Tunnel System (EMS) Union (EMU)

Fixed exchange Fixed exhange rates Single currency

rates
 1999
ǀ

Snake in the European Monetary European Monetary

Tunnel System (EMS) Union (EMU)

Fixed exchange Fixed exhange rates Single currency

rates
 Functions of Money
• Medium of Exchange

• Store of Value

• Unit of Acccount
 Definitions of Money Supply

M0 = Bank notes + Coins

M1 = M0 + chequing account = ‘cash’ = money in

circulation

M2 = M1 + near-money (checkable bank deposit)

M3 = M2 + ‘near, near money’ (assets that are less liquid)

Money in circulation
 Monetary base
Monetary Base =
sum of currency in circulation and reserves held by banks

M1
 Balance sheet
(‘T-account’)

Assets Liabilities
------------------------------------------------------------------
Investments ‘Sources of finance’
What do you do with the money? Where does the money come
from?
Balance sheet
Private Equity $25,000

KW p. 511
Balance sheet small shop
Commercial bank balance sheet

Private Equity $300,000

Commercial bank balance sheet
Too big to fail?

2013
Central bank balance sheet

KW p. 522
 Central bank balance sheet

https://www.ecb.europa.eu/pub/annual/balance/html/index.en.html
Money creation

KW p. 516
 How banks create money
Suppose:

Sila deposits $ 1000

Reserve requirement = 10%
 How banks create money
Assets Liabilities Money supply
-------------------------------------------------------------------------------------
deposit $ 1000 1000

Sila deposits $ 1000

Has no effect on money supply
 How banks create money
Assets Liabilities Money supply
-------------------------------------------------------------------------------------
deposit $ 1000 1000

Reserves 1000
 How banks create money
Assets Liabilities Money supply
-------------------------------------------------------------------------------------
deposit $ 1000 1000

New loan 900 1900

Reserve 100

New loan to Maya ($ 900) - is used to buy a TV

TV shop owner makes a new deposits
 How banks create money
Assets Liabilities Money supply
-------------------------------------------------------------------------------------
deposit $ 1000 1000

New loan 900 1900

Reserve 100 New money
created here!!

New loan to Maya ($ 900) - is used to buy a TV

TV shop owner makes a new deposits
 How banks create money
Assets Liabilities Money supply
-------------------------------------------------------------------------------------
deposit $ 1000 1000

New loan 900 1900

Reserve 100

deposit $ 900
New loan 810 2710
Reserve 90
Money multiplier

KW 517
Money multiplier
 Money multiplier
How big is the reserve fraction in the Eurozone?

Answer: 2% ……..oh no, sorry, 1%.

Money multiplier = 100

https://www.ecb.europa.eu/explainers/tell-me/html/minimum_res
erve_req.en.html
Money multiplier
 B&W Ch 18: What do Financial Markets?

3 important functions financial markets:

1) Mediate between savings (S) and investments (I)

2) Price risk
3) Risk diversification
 1) Mediate between
savings and investments
Financial institutions:
Banks
Insurance companies
Bond market
Stock market
Investment funds
Pension funds

Intermediaries between supply and demand of capital

 2) Pricing Risk

Financial institutions:
Banks
Insurance companies
Bond market
Stock market
Investment funds
Pension funds

Intermediaries between supply and demand of capital

 Ad 2) Pricing Risk

Assumptions:
• People are risk-averse (prefer less risk over more risk)
• But risk is valued differently across people

=> Risk can be priced by trade

Ad 2) Pricing Risk
 Ad 3) Diversification of risk

Don’t put your eggs in one basket

 Why are financial markets special?

1) Returns to scale:
More customers → better matching borrowers and
lenders = Network externalities

2) Asymmetric information:
Borrowers know the real risks but want to hide them
from the lender = adverse selection
– overpricing risk
- Refusal to lend money
 Why are financial markets special?

3) High interdependence
Mutual loans

4) Limited competition between banks

Customers have a long-term relationship with banks
Changing banks is difficult (switching costs)

No 'perfect competition' financial markets; regulation

needed
 Regulation and supervision

Common financial market calls for a single supervisor

Instead:
National supervisors working together

Can lead to inefficiencies:

In sufficient information in case of crisis

In banking union: supervision by ECB

 Effects of Euro on Financal Markets

Euro eliminates exchange rate risk in the Eurozone

Should lead to better exploitation of economies of scale:

- More competition between financial institutions
- Larger institutions create less competition

More efficient financial markets:

drove down interest rate in Eurozone
 Development of banking sector in EU

Banks merge, but mainly within the same country:

- Difference in local regulation
- Cultural differences
- Tax considerations (tax evasion)
- Protection

Result: more concentration and less competition

Source ECB website
 Bond Market

Bonds: homogeneous product

No longer segmented due to exchange rate risk between

different currencies:

Result: Strong convergence of interest rates

Bond Market
Bond Market
 Banking Union

2008 Financial crisis was a ‘bail-out’

5.000.000.000.000 euro (5000 billion euro) transfer

From taxpayers to banking sector
 Banking Union

Cornerstone of banking union: ‘bail-in’

Bail in:
depositors and bondholders must inject capital first

Single Resolution Mechanism

 Banking Union

3 building blocks:

1) Single Rule Book

Common regulation
2 Single Supervision Mechanism
ECB supervises cross border banks
3) Single Resolution Mechanism (SRM)
Fund filled with money from banks
Homework: analyse the ECB balance sheet

https://www.ecb.europa.eu/pub/annual/balance/
html/ecb.eurosystembalancesheet2022~4a2e481
250.en.html
Homework: analyse the ECB balance sheet

End