UNIVERSITY COLLEGE LONDON
DEPARTMENT OF ECONOMICS
Economics BSc (Econ)
Third Year – Term 2
THE ECONOMICS OF
MONEY AND BANKING
ECON0038
Rodrigo Antón García
rodrigo.garcia.20@ucl.ac.uk
London, 2023
,
, Contents
Topic 1 – Money (and Credit) Makes the World Go Around.
o Topic 1.1 – The Role of Money, Credit and Financial Intermediaries. 1
o Topic 1.2 – Impact of Credit on Economic Growth: Overview. 2
o Topic 1.3 – Credit on Economic Growth: Consumption and Investment. 5
o Topic 1.4 – Credit on Economic Growth: Monetary Policy. 7
o Topic 1.5 – Does the Type of Financial System Matter? 9
o Topic 1.6 – Topic 1 Questions. 10
Topic 2 – The Economics of Cryptocurrencies and Digital Money.
o Topic 2.1 – Bitcoin and Cryptocurrencies. 12
o Topic 2.2 – Cryptography and Economics. 15
o Topic 2.3 – Guest Lecturer 1: Crypto Overview and FTX Case Study. 18
o Topic 2.4 – Topic 2 Questions. 22
Topic 3 – Why Do Banks Exist and How Do Banks Compete?
o Topic 3.1 – Why Do Banks Exist: Economic Intuition. 24
o Topic 3.2 – What Do Banks Do and How Have They Changed Overtime. 28
o Topic 3.3 – Overview and History of Competition in Banking: Price Competition,
Risk Management and Non-Price Competition. 31
o Topic 3.4 – Price Competition: Lending Rate Decisions. 34
o Topic 3.5 – Risk Management. 38
o Topic 3.6 – Non-Price Competition: Increasing Market Power. 42
o Topic 3.7 – Non-Price Competition: Consumer Inertia. 45
o Topic 3.8 – Conclusions: Banks Existence and Competition. 46
o Topic 3.9 – Guest Lecturer 2: Risk Analytics in Banking. 46
o Topic 3.10 – Topic 3 Questions. 48
o Topic 3.11 – Sample MCQ Quiz. 53
,Topic 4 – The Why and How of Bank Regulation in Normal and Crisis Times.
o Topic 4.1 – Why Regulate Banks? 54
o Topic 4.2 – The Objectives of Bank Regulation. 55
o Topic 4.3 – Who Regulates Banks and What Tools Do They Use? 55
o Topic 4.4 – Regulation I: Safety Nets (Back Stop Protections). 57
o Topic 4.5 – Regulation II: Structural Regulation. 57
o Topic 4.6 – Regulation III: Behavioural Micro- and Macro- Prudential. 58
o Topic 4.7 – Managing Failing Banks. 61
o Topic 4.8 – Limitations of Bank Regulation. 62
o Topic 4.9 – Guest Lecturer 3: Estimable Artificial Intelligence. 63
o Topic 4.10 – Topic 4 Questions. 64
Topic 5 – Post Global Financial Crisis 2007-2009 Debates.
o Topic 5.1 – What Can We Learn from the Causes and Responses to the Great
Financial Crisis (GFC) of 2007 – 2009. 69
o Topic 5.2 – Regulation: Corporate Governance and Bankers Bonuses. 71
o Topic 5.3 – Are Basel III Capital Requirements Too Low? 73
o Topic 5.4 – Should Universal banks Be Required to Separate? 79
o Topic 5.5 – Topic 5 Questions. 84
,ECON0038 – The Economics of Money and Banking Rodrigo Antón García
ECON0038: THE ECONOMICS OF MONEY AND BANKING
Topic 1 – Money (and Credit) Makes the World Go Around I.
o Topic 1.1 – The Role of Money, Credit and Financial Intermediaries.
Money: The circulating medium of exchange as defined by a government. It can either
have intrinsic value (like gold) or it can be in the form of notes and coins distributed by a
central bank (notes still technically have intrinsic value, but they have much lower
intrinsic value than items such as gold). The ultimate aim of money is to enable agents
to specialise in one job and use their earnings to purchase goods and services elsewhere.
The Functions of Money:
- Medium of Exchange: Money has to be accepted universally (by buyers and
sellers and other forms of intermediaries) for the payment of goods, services and debt
as an asset that can be used in a transaction to exchange goods and services.
To be a proper medium of exchange, an asset must have the following characteristics:
- It must be readily acceptable. It is generally true if the medium of exchange has
a known value. People know how much a $100 dollar bill is worth and have at least an
idea of what it can buy at any given moment.
- It must be easily divisible. A good medium of exchange should allow small
transactions, as well as large transactions. Banknotes and coins are generally available
in different denominations in order to allow large value transactions, as well as small
value ones.
- It must have a high value relative to its weight. It is because a good medium of
exchange should be easy to transport. Banknotes and coins are light and easy to carry.
- It must be difficult to counterfeit. If it’s not, its value would be difficult to know with
reasonable certainty, and it wouldn’t be accepted in transactions.
- Unit of Account: Money can be used as a universal unit of account to measure
the value of all the goods and services exchanged in an economy. It allows goods to be
compared, so that prices of products and assets reflect the value society places on them.
- Store of Value: Money can be easily stored, retrieved, and used at a later time,
and, at least in times of low inflation, it is able to maintain most of its value. In a sense
money has to be non-diminishable or perishable by other than economic constraints.
- Standard of Deferred Payment: Money must be an accepted way to value and
settle a debt in the future. A firm may borrow money to buy stock of a good, which they
can then sell and use to pay back the debt (e.g., borrowing £100 to buy a TV at wholesale
price, selling it for £250, and then using £100 of the £250 to pay back the debt).
Other functions that define money are many times encapsulated by the properties
described before, and so, ultimately follow characteristics stemming from these above.
1
,ECON0038 – The Economics of Money and Banking Rodrigo Antón García
Money allows for trade and exchange to happen that would not happen in the absence
of double coincidence of wants. It also improves the allocation of resources to those that
value them most and facilitates specialisation and associated efficiency gains.
Barter System: A system that relies on the exchange of goods and services for other
goods and services, without the use of money, to make transactions across agents e.g.,
a potato farmer trading a sack of potatoes for a cut of beef. Of course, this is not an ideal
system by any means as it requires both parties having a double coincidence of wants.
Double Coincidence of Wants: An economic phenomenon where two parties each hold
an item the other wants so they exchange these items directly without monetary medium.
• Development of Money in the Economy: Stage of Value Transfer.
A) Economy with Exchange/Barter only.
B) Economy with “Existing” Money (cash-in-hand). Money without time dimension
or intermediaries.
C) Economy with Credit. Money with time dimension and intermediaries.
- Transition from Economy A to B: Reducing of Transaction Costs.
In a barter economy (no cash available) if two persons have something that each other
wants, exchange can exist, trade occurs due to double coincidence of wants. However,
if the agents do not like each other’s goods, there will be no trade, as they are dissatisfied
with the value that the good entails for them, there is an absence of coincidence of wants.
Example: Agent B has what A needs (bananas). B likes money. A is willing to pay 10p
per banana, and it costs B 9p to grow one, MC is therefore 9. Thus, depending on the
marginal cost, if the price A is willing to pay B something more than he is accepting, B
will make a profit. So, A has got his bananas, and B has received a profit (1p per banana).
Now B can use that 1p to buy other goods he wants, which could not be satisfied by A.
With more than two people, there will be a lot more trade. Money allows for better trade
and exchange, because sometimes there is an absence of double coincidence of wants.
When there is an absence of double coincidence of wants money lubricates transactions.
2
,ECON0038 – The Economics of Money and Banking Rodrigo Antón García
- Transition from Economy B to C: Improves Efficiency.
In reality, economic decisions have time dimension. Agents maximise utility over time
subject to a life-time budget constraint and money is not always available when needed
to make consumption and investment choices. The role of credit becomes important now.
Credit: A contractual agreement in which a borrower receives something of value
immediately and agrees to pay for it later. Credit is required given the time dimension to
economic decisions, the fact money is not always available when needed for consumption
and that agents maximise utility/profits over time subject to budget constraint/costs.
For example, consider A needs $1 on Monday and can repay it on Wednesday, B has
$1 to lend out on Monday but needs it back on Tuesday and C has $1 on Tuesday
available to loan out but needs it back on Wednesday. In such case, on Monday: B lends
to A, on Tuesday: C lends to B, and on Wednesday: A pays back to B, and B back to C.
Of course, note that adding time and widening group of parties involved introduces trust
issues and uncertainty. Also, it is difficult to identify the parties available to contract with.
Credit is needed since we do not always have enough money today to make purchases.
Credit allows for efficient transactions to take place in the economy. However, loans can
only be provided if lenders have sufficient money to lend and believe borrowers can
repay over specified time. It requires “double coincidence” of wants over time and trust.
Moreover, agents can get credit from direct or indirect financing. Direct financing involves
no intermediaries whereas Indirect Financing does involve intervention of intermediaries.
Direct Financing: No Intermediaries. Create credit yourself in the financial market by, for
example, for someone spending money: selling a bond or selling shares in company,
whereas for someone earning money: buying a bond or buying shares in a company.
Indirect Financing: Intermediaries. Transaction with the bank. For example, for someone
spending money, borrow from a bank, whereas for someone earning, deposit in a bank.
Direct financing is complicated to obtain, most households and firms lack experience of
selling shares/issuing bonds. It also involves high transaction costs and expertise to
assess potential returns. Direct financing is mainly associated with big corporations and
with the support of investment banks (independent parties). However, it has increased
in past years, particularly after the financial crisis and the popularity of crowdfunding.
This is when the role of financial intermediaries kicks in, such as retail banks. Agents
need an independent party to enforce contracts between borrowers and lenders (savers)
if they do not have or cannot identify double coincidence of wants or do not have trust.
Of course, provision of credit through financial system improves efficiency of economy.
However, note that economic decisions involving time dimension and large transactions
involve multiple layers in financial system. Therefore, it needs to be well-functioning.
Next, the big question is to analyse whether financial intermediaries and the provision of
credit through say retail banks and other business have helped achieve economic growth.
3
, ECON0038 – The Economics of Money and Banking Rodrigo Antón García
o Topic 1.2 – Impact of Credit on Economic Growth: Overview.
Historically, Economics has said little about impact of financial system on growth.
- Arrow-Debreu and Welfare Theorems have no market failures so the role of credit
was not relevant and was simply ignored. By definition, these models have no financial
intermediation because there is no effective information or transaction costs.
- Early Economic Growth Theory had suggested that technological progress,
including in the financial sector, determines long run growth, but with not much detail.
- Schumpeter (1911) also said that financial intermediaries needed to spur
innovation and economic development.
Fortunately, New Endogenous Growth Theory provided a firmer basis for analysis. This
argued that the appearance of financial systems completes contracts and rectifies
incomplete markets. Thus, investment in productivity enhances activities that would not
have happened without the mobilising of saving, allocating resources and diversifying risk.
In fact, the literature of the New Endogenous Growth Theory, comprises a variety of
studies that have found correlation between economic growth and financial system.
Positive Correlation:
- King and Levine (1993) found that financial development improves real per capita
GDP growth, rate of physical capital accumulation and improvement in efficiency at
which economies employ physical capital.
- Aghion (2010) finds that financial system alleviates liquidity constraints facilitating
long-term investment and reducing volatility of investment and growth.
- IMF (2012) finds that financial sector development increases effectiveness of
monetary policy and improves fiscal policy.
However, other studies, looking over time and across countries, show mixed experiences,
Negative Correlation:
- Reinhart and Rogoff (2009) discuss examples of countries with subdued financial
systems where some had hampered economic growth and others had historically rapid
growth. This implies that the positive effects of such correlation can be country-specific.
- Cecchetti and Kharroubi (2012) find that there is a tipping point at which a bigger
financial system can lower growth. Additionally, they found that fast growth in finance is
bad for aggregate real growth.
- Capelle-Blanchard and Labonne (2011) looked at impact of scale of employment
in financial sector on growth and found no clear and positive relationship.
- Hassan, Sanchez and Yu (2011) find that a well-functioning financial system is a
necessary but not sufficient condition for steady growth in developing countries.
Overall, when it comes to analysing any of these papers, and empirical studies in general,
it should be noted that correlation does not always mean causation and therefore an
interpretation of correlation in any of the two ways is still subject to debate.
The direction of causality is also important. It could be the case that a big economy
incentivises a big financial system and not the that a big financial system incentivises a
big economy, which would diminishing solid financial systems from a policy perspective.
4
