Money and Credit

Outline
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1. Credit sources of credit demand credit creation (supply) 2. Money what is money? money creation (supply) sources and determinants of money demand LM curve Attention: this lecture differs from material of chapters 8-9 of the textbook
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1. Credit

M.Brzoza-Brzezina: Macroeconomics II - Money and credit

Sources of credit demand

Intertemporal optimization may require borrowing or lending The main source of external funds in the Polish (and most EU countries) economies is provided by the banking sector These funds are called credit
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Figure 5.01

Demand for credit - example,

Consumption tomorrow D M (student, low Y1 today, high Y2 tomorrow she borrows)

M.Brzoza-Brzezina: Macroeconomics II - Money and credit

Consumption today 5

Credit creation (supply)

Student comes to the bank and asks for credit The bank checks her creditworthiness The bank looks for funds money market central bank deposit
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Credit creation (2)

Assume central bank provides funds via open market operation Interest rate is given by the central bank (as explained in lecture on monetary policy) At this given interest rate central bank lends to bank A 100 PLN. Bank A grants credit to the student
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Credit creation (3)

The credit is given to the student as a deposit in her current account Part of deposit (e.g. 10%) disappears (e.g. cash withdrawal, required reserve) Second student comes to take credit Bank looks for funds and finds deposit of the first student (90 PLN) Bank grants the credit ...
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Credit creation (4)

Total credit supply = 100*10=1000 PLN Supply of credit is created jointly by the central bank and commercial banks Commercial banks can create much more credit than they initially borrow from the central bank

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2. Money

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What is money?
This is money:

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What is money (2)

Is this money? Are time deposits money?

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Monetary aggregates
Statistical approach to money M0 (monetary base, central bank money, high powered money) = currency in circulation (incl. vault cash), commercial banks reserves with the CB M1 = currency in circulation (excl. vault cash) + overnight deposits M3 = M1 + deposits with agreed maturity up to 2 years + repurchase agreements
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Monetary aggregates - example

700 000 600 000 500 000 400 000 300 000 200 000 100 000 0 gru 96 gru 97 gru 98 gru 99 gru 00 gru 01 gru 02 gru 03 gru 04 gru 05 gru 06 gru 07 M0 M1 M3

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Money supply
Money is calculated as sum of cash and deposits The former is created by the CB, the later by commercial banks Money and credit creation is the same process Again: only small part of supply comes from the CB
800 000,0 700 000,0 600 000,0 500 000,0 400 000,0 300 000,0 200 000,0 100 000,0 0,0 gru gru gru gru gru gru gru gru gru gru gru gru gru 96 97 98 99 00 01 02 03 04 05 06 07 08 Credit M3

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Money demand
We model demand for cash But similar rules apply to wider aggregates Assume two types of assets: money (cash) and bonds Interest rate i paid on bonds (i determined by CB)

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Money demand (2)

Determinants of money demand - Price level proportional change - Real income - Nominal interest rate
+ MD = f (Y , i ,...) P

Formal model: e.g. Baumol, Tobin model

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LM curve
LM (Hicks 1937) is the money demand curve In the standard textbook approach used together with the IS curve to determine jointly money and goods market equilibrium Because of inconsistency (real vs. nominal interest rate) and change in monetary policy instrument (interest rate vs. money supply) we will use (picture) them separately Note: traditionaly LM pictured in Y/i space. We prefer M/i space.
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Traditional LM curve
Central bank controls money supply The LM curve shows combinations of i and Y such that MD=MS (for given MS) Shifts in monetary policy = shifts of LM curve
i LM1 LM2

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Our LM (money demand) curve

When CB controls the interest rate money supply adjusts to meet money demand LM shows money demand for given output Shifts in monetary policy = shifts of interest rate i i1 i2 LM M1 M2
M.Brzoza-Brzezina: Macroeconomics II - Money and credit

MD
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Exercises
Baumol-Tobin Credit constraints

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