3BA International Business: Summary Financial Markets and institutions
Introduction
1. Introduction
Y= C + I + G + (X – M) Y- T= C + I + G – T + (X – M) Y- T – C = I + (G – T) + (X – M)
S (Savings) = I + (G – T) + (X – M)
National Income (GDP) formula -> Most important Macroeconomic identity.
Our savings is the surplus. When doing an investment you are borrowing money. What is over in the economy (savings or surplus) must equal what
we need -> S = I -> we need to get the surplus to where it is needed (debts in all its forms + Equity).
It’s the financial plumbing of the economy.
Our financial system is endogenous (its not fixed, there is no unified system in the EU).
- Its Time dependent: The financial system of today is not the same as it was 20 years ago.
- Its geography dependent: The financial system of the UK differs from that in China -> it depends on the national boundaries of that country,
how the free flow of capital is, the law that regulates bankruptcy (solvency law), the buying habits of customers, different mortgage laws.
2 countries A & B. In the beginning the money is in the hand of economic agents (consumers,
corporations, governments, institutional players) -> money is used to transaction (buy or sell)
and here financial intermediaries/auctions (exchanges/capital markets) are necessary) just as
payment systems, these are going through an important change as a result of financial and
technical innovations. Financial intermediaries are divided into: Commercial banks and shadow
banks.
This system has to be regulated. Within the banking union of the EU, the ECB and the National
Central Banks are the prime regulators.
Transactions also happen between countries -> this happens in international capital markets,
these markets can be physical places or they can be decentralised between bank
Standard derivatives require the intervention of central clearing parties (CCP)
The international financial system is also influenced by supranational authorities like the Bank
for International Settlements (BIS) or by self-regulation (ISDA/ESMA). There are as well a
number of institutions that provide advice or that follow up on specific markets (BIS, Financial
Stability Board).
Within Europe, Banking system is more important than the capital market -> we are a banking market not a capital market.
Professional parties do use capital markets extensively (mainly derivatives/bond). Limited use of the capital market to raise funding.
Systems are also becoming more digital (doing transactions via phone).
Chapter 1: Money and the creation of money
2. Origin and characteristics: definition
Money is a product that is generally accepted in exchange for goods and services, it’s a means of exchange.
The defining characteristic of money is its capacity to be generally accepted as a means of payment (makes it stand out from other goods).
It is based on convention, its money because people consider it as money. A convention based on trust, one accepts a good as money because one
assumes that others will accept it too. It represent general purchasing power.
It is an explicit or implicit agreement.
- Explicit: by law defined as a means of exchange. However, if the trust in the de facto validity in exchanges in lacking inn the public than even
legal obligation can not enforce the use of the legal tender outside of officially controlled circuit.
- Implicit: its what economic agents agree to use as means of exchange.
Gresham’s law captures part of this idea “bad money drives out good money” -> Bad money is a currency with equal or less value than its face
value. Good money has the potential for a greater value than its face value. People will choose to use bad money first and hold onto good money.
3. Origin and characteristics: Functions
Means of exchange: It acts as an intermediary good in exchanges and trades. In developed market economies a generally accepted means of
payment is necessary for the economy to thrive.
Investment: It will be considered as a vehicle that captures value and stores purchasing power. Its considered as a savings instrument, next to
other stores of value.
Unit of account: Money plays the roll of unit of account of purchasing power. The relative value of goods is not directly determined but is
represented in terms of money.
Standard for future payments: it is not limited to the current moment, but is also used for transactions that are spread out over time. This leads to
the time value of money (existence of interest rates.
4. Origin and characteristics: characteristics of money
Money has not been invented like that. Its development happened really gradually based upon some sort of survival of the fittest. Functions of
money point out some characteristics that an ideal means of payment needs to possess.
, Valuable in comparison to its weight cause we prefer a money bill over a bar of gold. Durable cause it can’t perish when you use it. Divisible cause
you can divide it in smaller units. Standardised quality cause all 5 euro notes have the same value, they are standardized. Its Easily recognisable.
Stable Purchasing power cause we want that the 5 euro can still buy something worth 5 euro, even tomorrow. The central bank does what it can
(adjust interest rates) to keep prices stable.
5. Origin and characteristics: evolution
Barter trade: One good is exchange for another Commodities used as “money” Precious metals were used as money Means of payment:
coins (minted) or paper money -> Legal tender (fiat money) = What governments determine as money, it’s the legal tender which requires firms
and people to accept it as means of payment. However, a merchant can decide to accept only electronic payments (commercial bank money)
Fiduciary money (= takes value thanks to the confidence of the public that it is generally accepted as a medium of exchange, that is has purchasing
power. The issuer of fiduciary money promises to exchange it back for a commodity or fiat money. The value of the money token > physical value of
money token) E-money – cryptocurrencies (= electronic store of monetary value on a technical device that may be used for making payments, it
does not necessarily involve bank accounts in transactions. Can be hardware (purchasing power resides in a personal physical device) or software
based (employ specialised software that functions on common personal devices such as personal computers or tablets).
Commercial Bank money (claims against financial institutions that can be used to purchase goods or services, the money in your bank account, can
be converted into fiat money or central bank money <-> Central bank money (money that constitutes a direct claim on the assets of the CB)
Development of banks: Money exchange -> deposit banks -> Commercial Banks- central banks.
6. Origin and characteristics: Form of money
Paper money and coins. (Central Bank Money)
Sight deposits (Commercial Bank Money): used to transact and hence it must make part of the money supply despite the fact that it is not issued
by the CB. To use this money, we use debit, credit cards, transfers, withdrawals (ATM).
E-money: electronic store of monetary value on a technical device that may be widely used for making payments. Does not involve bank accounts
Alternative forms of money (cryptocurrencies and specifically stable coins): encompass everything that can be used to make payments and that
can be generally trusted as means of payment.
- Statement: Bitcoin is a means of payment but not an alternative form of money -> It is a means of payment but it doesn’t have the
characteristics of money. Anything can be a means of payment but that doesn’t make it money.
7. Money supply
2 components of money
1) Currency = coins and notes minted by the government and issued by the central bank. Share of currency in total money supply: 9.5%
2) Cashless money = (narrow sense) amount of money on sight deposits (commercial bank money) or (large sense) savings deposits + term
accounts + financial assets with a longer maturity.
- Term accounts: You lock away an amount of money for an agreed length of time, in return you’ll get a guaranteed rate of interest.
Money supply concepts: M1 – M2 – M3
- M1: Money supply in narrow sense -> Money in circulation (issued by CB and circulating outside banking system) + “overnight” deposits with
Euro area Monetary Financial institutions (currency account).
- M2 (near money : financial assets that are not immediately redeemable but that are considered by the public as available purchasing power,
because these assets can be turned into “transaction money”): M1 + deposits with a maturity till 2 years + deposits refundable with a notice
period of 3 months.
- M3 (near, near money): The broadest definition of money, contains all sorts of financial assets that are held outside of the banking system ->
M2 + repurchase agreement + money market fund + money market paper + securities with a maturity up to 2 years.
8. Money creation
In our economic system currency is issued by the government and specifically the
European Central Bank (ECB). The total money supply is endogenous and determined by
the money creation of commercial banks.
M = m. B
- B = CP + R
- B = Base money = all the liabilities the monetary authorities (banks) and the general
public. The reserves, R that the banks hold with the central bank are considered base
money as it can always be exchanged for currency. Reserves are party decided by the ECB cause there is a minimum reserve that banks have
to keep but they can always keep more.
- Currency is issued by the government (ECB).
9. Money supply: multiplier simple example
The money creation of commercial banks (denoted by “m”) is a function of 2 factors:
- Monetary policy via the reserve coefficient and Portfolio decisions of the public and the commercial banks (preferences for cash and reserve
coefficient).
Fractional reserve system: Banks keep a fraction of deposits as reserves
Example: ECB prints 100 euro & this comes in the hands of person 1 -> they deposit in the bank, the bank keeps 10% as reserves and gives 90 euro
away as loan. The second person deposits this with their bank, and that bank hold 10% (9 euro) as reserve and loans the rest out.
Total money creation: M = 100 + 90 + 81
D = D0(1 – r) + D0(1 – r)2 + …
D = D0/r with D0 is the initial money supply (=initial amount of overnight deposits)
r: reserve coefficient (captures the behaviour of monetary policy makers & commercial banks). It is set by banks In function of their expectations
about maximum cash withdrawals by clients + by what the regulator imposes.
,10. Money supply: multiplier- more realistic example
It is possible that the person also has a preference to keep a fraction of money as cash (e.g. 10%) -> Then banks have less money to give out for
loans and there is less money creation. Preference for cash is denoted as c
E.g. Starting point: 100 euro in the hands of person 1 (r: 10% and c: 10%) -> 90 euros is put in the bank and of this money, the bank loans out 81
euro, this money goes to person 2 and that person also keeps 10% in cash and Depositing 73 Euro In the bank, of this money the bank loans out
65.7 euros.
The c differs from bank to bank.
Total money creation: M = 100 + 81 + 65.7
∞
D=1+ (1−c ) (1−r ) +( 1−c ) ( 1−r ) + …=∑ ( 1−r ) (1−c )
2 2 n n
n=0
1
D=
1− (1−c ) (1−r )
with r: reserve coefficient (captures the behaviour of policy & commercial banks) and c: preference of the public to hold currency (captures the
behaviour of the public. Important hypothesis: coefficients r & c are constants.
m = M/B
CP+ D
m= -> With CP = Cash currency in the system, D = deposits in the system, R = reserves
CP+ R
CP
+ D /D k +1
Then we can divide this equation by D -> D -> m=
m= k +r
CP/ D+ R / D
k = CP/D = the ratio of currency to deposits (k is not equal to c) and m is not constant
r = R/D = the ratio of reserves to deposits.
11. What influences the money multiplier
dm = dm/dk x dk + dm/dr x dr -> but we are interesting in a percentage change, so we will divide dm by m.
dm dk dr
=ε ( m, k ) + ε ( m ,r ) .
m k r
− ε ( m , k ) =¿ Elasticity (ratio of 2 derivatives): Percentage change in m divided by the percentage change in k
− ε ( m , r )=¿ Percentage change in m divided by the percentage change in r.
1−m k
ε ( m , k )=¿ < 0 when m> 1 -> is always negative when m is positive because when my preference for cash goes up, my multiplier goes
k +r m
down -> inverse relationship between m and k.
−r
ε ( m , r )= <0
k +r
12. What determines k and r
What determines the cash vs deposits balance in portfolios (preference for currency, k
k =k ( Y ,W ,i ,Technology ∧payment habits ,risks ,… )
– Y: Income and W: wealth -> 2 opposite effects:
1) The higher the income and the higher the wealth, the higher the consumption and the higher the demand for cash.
2) The higher the income and the higher the wealth, the more people will save and more deposits and other forms of investment will
be held (decreasing the marginal utility of consumption) -> the lower k.
The second element dominates the first and hence -> dk/dY and dk/dW < 0
Inverse relationship between Y, W and k (the higher Y and W, the lower k).
– i = Interest rate
Constitutes an opportunity cost. The higher the rates, the higher the cost of consuming instead of saving -> A strong preference for cash
is costly. It is better to invest more when interest rates are high -> dk/di < 0
– Technology: The easier the access to cash on accounts (deposits), the less need to hold cash (negative relationship between k and
technology).
– Payment habits: seasonality (“discounts”) and black economy or pandemics (positive relation to cash).
What determines the reserve coefficient, r
r =r ( i, refinan. costs ,(reserve) requirements , … )
– Interest rates form an opportunity costs. Keeping cash on the balance sheet means that this cash does not generate income (from loans),
but the bank will have to pay an interest rate to remunerate the client for its deposit with the bank (dr/di < 0) -> negative relationship
between I and r.
– The cost of alternative financing products -> if suddenly more clients were to withdraw cash, the bank may not have sufficient reserves.
In that case the bank must fund itself in the market. If this alternative funding would be expensive, then the bank would like to avoid this
financing and keep its reserves higher (dr/d(fin.costs) > 0)
– Reserve requirements are determined by the central bank.
Relationship between the interest rates and the money multiplier: ε ( m , i ) =ε ( m , k ) ε ( k ,i ) + ε ( m , r ) ε ( r ,i ) > 0
, The interest rate is a key parameter of the monetary policy. If the interest rate goes up, the money multiplier m goes up as well. Positive
relationship between interest rates and the money multiplier m.
13. Money supply: ECB
The ECB publishes on a monthly basis the evolution of the money supply in the Euro system, which is constituted of the 19 countries that form the
Eurozone. Currency in circulation is less than 15% of M1. This means that if everyone would withdraw his money from the bank, there are not
sufficient banknotes available.
A massive bank run would hence destroy our financial system. It also illustrates the need for trust in the system. If this trust would disappear, then
the government must step in. the last this happened in Europe was in 2008/2009.
The composition of money is not a constant. Since the Great Financial Crisis M1 has become more important.
Just before and also a during the crisis of 2008/2009 M1 was becoming somewhat less popular. This is probably due to a combination of risk
aversion and the effects of monetary policy.
14. Belgian monetary history
till 1935 : Belgian banknotes exchangeable in gold (BEF is by law defined as a certain weight in gold)
As of 1976: Link between currency and gold is dropped (no longed lied to the physical stock of gold, which means your stock of currency in
circulation can change more)
till 1988 : conversion of BEF/banknotes legally exchangeable in gold.
after 1988 : BEF no longer tied to gold or any other commodity.
after 01.01.99 : EURO replaces BEF.
after 01.01.02 : disappearance of Belgian currency: EURO notes & coins.
