Ximena deposits $\$1{,}000$ of her year-end bonus (aguinaldo) in the bank and still sees that $\$1{,}000$ in her app. Meanwhile, the same bank lends $\$900$ to Diego, who wants to open a juice stand. How can Ximena's $\$1{,}000$ and Diego's $\$900$ exist at the same time? We'll solve it at the end of the multiplier section.
The Financial System: Who's Who
The money that some people save is almost never the money that others need at that moment. A family in Puebla saves for the future, while a tortilla shop in Guadalajara wants to buy a new machine now. The financial system connects the two.
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Explain what the financial system is and who its main participants are. What role does it play in the economy by connecting them with one another?
Explain what the financial system is and who its main participants are. What role does it play in the economy by connecting them with one another?
Why do you accept a $\$200$ bill if you can't eat it? Because you know the person at the tortilla shop will accept it too. That is money: anything that society generally accepts as payment.
These functions are served both by cash (bills and coins) and by bank money (balances in accounts, which move by card or transfer). That is why, when a bank creates deposits by lending, it is creating money that can be used to pay, to set prices, and to store value.
Cash, Deposits, and Reserves
When you pay with a debit card, you don't hand over bills. A figure is subtracted from your account and added to the store's. That money exists only as a record in the bank's system.
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Distinguish between cash and bank money. When you pay by card, what type of money do you use and where does that money "exist"?
Distinguish between cash and bank money. When you pay by card, what type of money do you use and where does that money "exist"?
Banks don't keep everything they receive. They hold a fraction as reserves and lend out the rest. That fraction is called the reserve ratio (also known as the reserve requirement or legal reserve, "encaje legal"). What is lent almost always ends up deposited again in some bank, and so a chain begins.
Back to Ximena: her bank keeps part of her deposit and lends the rest. She keeps her claim to $\$1{,}000$ and Diego receives a new deposit of $\$900$. Both balances are bank money. They exist together because they are the bank's debts to two different customers, and the bank trusts that not everyone will ask for their money at the same time.
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A bank receives $\$20\,000$ in deposits and, by law, is only required to keep $10\ \%…
A bank receives $\$20\,000$ in deposits and, by law, is only required to keep $10\ \%$ in reserves.
a) How much does it keep in reserve and how much can it lend?
b) Explain why the bank does not keep all the money in reserve: what would it gain and what would it lose?
With a reserve ratio of $10\ \%$, an initial deposit of $\$40\,000$ can end up creating up to $\$400\,000$ of bank money. a) Calculate the money multiplier ($1$ divided…
With a reserve ratio of $10\ \%$, an initial deposit of $\$40\,000$ can end up creating up to $\$400\,000$ of bank money.
a) Calculate the money multiplier ($1$ divided by the reserve ratio) and check the final figure.
b) Explain step by step how this multiplication occurs: who deposits, who lends, and who redeposits.
The figure shows the bank money creation chain: Ana deposits, the bank lends to Bruno, Bruno pays Carla, and Carla deposits again. a) Identify at what point new money is…
The figure shows the bank money creation chain: Ana deposits, the bank lends to Bruno, Bruno pays Carla, and Carla deposits again.
a) Identify at what point new money is "created" and who creates it.
b) What would happen to the chain if Carla kept the banknotes under her mattress? Justify your answer.
In real life the multiplier is smaller than $1/c$ because of two leakages:
Banks hold voluntary excess reserves, as a precaution. Their ratio to deposits is $e$.
The public holds cash. It keeps a proportion $k$ of its deposits in bills.
What Banxico injects is the monetary base $B$ (cash plus reserves). It is split between banks' reserves and the public's cash.
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The central bank carries out a liquidity injection of 500 million pesos through the purchase of government bonds from commercial banks. The minimum reserve requirement…
The central bank carries out a liquidity injection of 500 million pesos through the purchase of government bonds from commercial banks. The minimum reserve requirement set by the monetary authority is 2 % (0,02). However, the economy is going through a recession with high uncertainty:
Commercial banks decide to retain an additional 8 % of deposits as voluntary excess reserves as a precaution against potential defaults.
Individuals and firms decide to hold the equivalent of 10 % of their bank deposits in cash.
a) Calculate the theoretical potential money multiplier (assuming there is no cash drain or voluntary reserves) and compare it with the effective multiplier that occurs under the actual behavior described.
b) An analyst states on television: «The central bank has injected 500 million; therefore, banks are going to flood households with credit and will multiply the money supply fiftyfold immediately». Technically refute this statement using the calculations from the previous section and distinguishing between the supply of credit and the creditworthy demand for it.
c) Predict what would happen to the money supply and inflation risk if the economy suddenly regains confidence and both banks and households reduce their excess reserves and cash holdings to a minimum.
Your deposit isn't stored as bills in a box with your name on it. It is a debt the bank owes you, and the bank has already lent most of it out. That is why we need to distinguish two different problems.
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The commercial bank «Banco Sureste» presents the following simplified balance sheet: Assets: Liquid cash reserves and central bank deposits: 10 million pesos; Mortgage…
The commercial bank «Banco Sureste» presents the following simplified balance sheet:
Assets: Liquid cash reserves and central bank deposits: 10 million pesos; Mortgage loans and corporate loans maturing in 15 years: 90 million pesos.
Liabilities and Equity: Demand deposits of its clients: 85 million pesos; Equity capital contributed by shareholders: 15 million pesos.
a) Following a piece of fake news that goes viral on social media, clients arrive to withdraw 18 million pesos within 24 hours. Prove numerically whether the bank faces a liquidity problem, a solvency problem, or both at that moment.
b) A parliamentary group proposes: «To end bank runs forever, let us require banks by law to keep a 100 % reserve requirement, keeping all deposit money in a safe». Economically refute this proposal by analysing its impact on the creation of bank money, on credit available for productive investment, and on the account maintenance costs for households.
c) If the central bank decides to act as a «lender of last resort» to bail out this institution, under what prior balance sheet requirement must it do so and what «moral hazard» problem would be generated if it bailed out banks that are genuinely insolvent?
If Mateo's car crashes, the repair can cost $\$40{,}000$. Few families have that money on hand. The financial system also offers a solution: insurance.
Everyday examples:
Auto insurance: it covers damage to the car or to third parties. Mateo pays an annual premium of $\$8{,}000$ and, if he crashes, the insurer pays for the repair minus a deductible.
Major medical expense insurance: it covers costly hospitalizations and surgeries that the public system or your own pocket couldn't withstand.
IMSS: it is social insurance. Formal workers and their employers pay contributions and in return receive medical care, sick leave, and a pension. It is mandatory, unlike private insurance.
Insurance is part of the financial system because it turns a large, unpredictable risk into a small, known payment. In addition, insurers invest the premiums they collect in bonds and other assets, so they also channel savings toward financing.
Banxico and Monetary Policy
Functions that only the central bank performs: it issues legal-tender banknotes, sets the benchmark interest rate, acts as lender of last resort, manages international reserves, and is the bank of the banks (bank reserves are held at Banxico).
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Explain what the European Central Bank is and how it differs from a local commercial bank. Mention at least two functions that only the central bank performs.
Explain what the European Central Bank is and how it differs from a local commercial bank. Mention at least two functions that only the central bank performs.
Credit doesn't just reflect the economy: it also pushes it. Think of mortgage credit when it grows faster than the economy.
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In an economy, mortgage credit granted by banks is growing at a rate of 14 % per year, housing prices are rising by 11 % year-on-year, and headline consumer inflation…
In an economy, mortgage credit granted by banks is growing at a rate of 14 % per year, housing prices are rising by 11 % year-on-year, and headline consumer inflation stands at 2.1 %, very close to the central bank's target.
a) Explain the procyclical feedback loop: how do rising property prices increase borrowers' collateral, what role does the creation of bank money play in this process, and why do financial institutions not curb lending on their own initiative?
b) Faced with this situation, the central bank hesitates between two measures:
2) Keeping interest rates stable and imposing macroprudential measures on banks: capping the loan-to-value (LTV) ratio at a maximum of 70 % of the appraised value and requiring an additional countercyclical capital buffer of 2.5 %.
Predict and justify the asymmetric effects of both options on: households that already hold a variable-rate mortgage, young people seeking to access their first home, and non-real estate industrial companies.