Economics 144

Unit 10
Banks, Money, and the Credit Market

1. MONEY AND WEALTH

Money: A medium of exchange used to purchase goods and services

- Money can take the form of bank notes, cheques, gold coins, bank deposits, or digital
currency (Bitcoin).

- For the concept of “money” to function, everyone needs to trust that everyone else will
accept money as payment (instead of physical goods). People need to believe that
money is worth something.

Income: The amount of money you receive over a period of time (yearly, monthly).

- Income can be made up of salaries, investment returns, government transfers etc. and
represents a flow.

Wealth: The money-value of all the things you own and are owed, minus your debts.

- Wealth = capital goods + physical goods + debts owed to you - debts you owe.

- Income builds wealth, while consumption drains wealth.

Depreciation: The reduction of value of a form of wealth that occurs, either due to physical
wear and tear or the passage of time.

Net Income: The maximum amount of money that one could spend without touching your stock
of Wealth.
 - Net Income = Gross Income - Depreciation

Earnings: Wages, salaries, and other labour-derived income.

Consumption: Spending money on consumer goods.

Savings: Income that is not consumed (and so is added to your stock of Wealth in the form of
bank deposits) or income that is used to purchase stocks, bonds, or other financial assets.

Investment: Money spent on capital goods like equipment or machinery, or on buildings or

housing.

*Note that the definition of Savings and Investment is different in economics than it is in finance.

- Savings serves a crucial component of the macroeconomy. Household and firm savings,
in the form of bank deposits or financial asset purchases, go on to be used as funding
for business ventures which help grow the economy.

- Without a strong local savings culture (households saving a lot), a country must rely on
foreign direct investment in order to fund new business ventures.

- Banks work as the middlemen between those who have excess money (savers) and
those who need money (entrepreneurs, businesses, and consumers). Banks channel
this excess money into the hands of those who need it in the form of loans, helping to
fund new businesses, expand existing businesses, finance infrastructure development
etc.

2. BORROWING

- Borrowing is the act of bringing consumption forward in time. Rather than consuming
later, we consume now.

- However, there is an opportunity cost (a trade-off) to consuming goods now instead of

later.

Opportunity Cost: The loss of the value of other alternatives (consuming later) when a specific
alternative is taken (consuming now).
 - Borrowing and lending are useful in that it allows us to reorganise our consumption over
time. If we know we’ll have R1000 in two weeks time, but we’re broke now and need to
eat, then we can borrow money in order to smooth out our consumption.

- But, there is a cost to borrowing. Borrowing allows us to buy more now at the expense of
buying less in the future. Thus, we are prioritizing our present situation over our future
situation (this is sometimes logical to do, but is often not).

Interest Rate (r): The cost of bringing our buying power forward in time. This interest rate is
charged on the amount of money you loan.

The Cost of Borrowing

You have a R1000 paycheque due to arrive in your bank account in 1 week, but you need
R500 now. So, you take out a loan at an interest rate of 20% per week and borrow R500.
Come payday, you need to pay back the R500 (the principal) plus the interest, which is easily
worked out as R500 x 20% = R100. Your total payback then is R500 + R100 = R600, leaving
you with R400 of your paycheque. How did taking out a loan impact us?

Well…

Without loan -> R0 now + R1000 later = R1000 in total.

With loan -> R500 now + R400 later = R900 in total.

By taking out a loan, we’ve brought our consumption forward but at the expense of our later
consumption. This loan has made us poorer, and by quite a lot: in total, we’ve lost 10% of our
paycheque because of it.

All forms of borrowing work like this, but the most dangerous type is borrowing to fuel
consumption (usually through credit cards or payday loans). So next time you think about
borrowing money, consider the long-term ramifications. When you borrow, you’re usually not
the one winning.

- The trade-off that we’ve just demonstrated is our Marginal Rate of Transformation (we’re
transforming consumption later into consumption now at the expense of interest).

MRT = (1 +r)
 Modelling Borrowing (MRT)

- We model borrowing much the same way we’ve modelled everything else, using MRT,
MRS, indifference curves, and feasibility sets.

- In this example, Julia has $100 in the future but wants to consume now. So, she takes
out a loan against her future money at a 10% interest rate and can borrow $91, with $9
being paid in interest (her cost to borrow).

Marginal Rate of Transformation (MRT): The rate at which Julia can transform
Consumption Later into Consumption Now. This depends on the interest rate, where MRT =
(1 + r).

- (1+r) represents our MRT because to consume 1 unit now, we have to give up 1 unit +
interest (r) later.

Feasibility Frontier (FF): Julia’s maximum possible consumption at all the variations of
Consumption Later and Consumption Now. Remember, our MRT = the slope of the FF.

- Instead, Julia could consume $70 now and consume $23 later, with $7 being paid in
interest.
 - If Julia had been given a much higher interest rate (78%), her Feasibility Frontier
would change and her Feasibility Set (the shaded red area) would become much,
much smaller.

- But which combination of consumption will Julia choose? Well, this will depend on her
Consumption Preferences (her Indifference Curve)!

3. CONSUMPTION PREFERENCES - DMRC

- An individual’s decision of how much consumption to bring forward will depend on how
much Consumption Smoothing is required and their Impatience.

- Consumption Smoothing depends greatly on Diminishing Marginal Returns to

Consumption.
Diminishing Marginal Returns to Consumption (DMRC): The more consumption a person
has, the less value an additional unit of consumption holds. (Utility decreases).

i.e. When you’re hungry, the first bite of food tastes phenomenal. However, the 120th
bite of food probably doesn’t taste as great. The more you eat (consume), the less
pleasure it brings (the less value it holds)
 - Thus, we smooth our consumption to avoid consuming a lot in one period and too little in
another.

Modelling Borrowing (MRS)

- In this example, the dotted line represents our MRT (the rate at which Julia is able to
transform Consumption Later into Consumption Now) and Julia’s indifference curve
represents our MRS (the rate at which Julia would want to transform Consumption
Later into Consumption Now).

Marginal Rate of Substitution (MRS): The slope of Julia’s indifference curve is our MRS,
and depends on the diminishing marginal returns to consumption (DMRC). The more goods
she has now, the less she’d value them compared to later. The more goods she has later, the
less she’d value them compared to now.

- As we know, we maximise utility when MRS = MRT. We also know that we always
want to maximise utility! So, we can see that Julia’s choice would lie somewhere
between C and E.

- MRS falls as we move along the IC.

C -> MRS is high. Julia has low consumption now and high consumption later, so she’d prefer
to move that consumption forward. She’d move down the IC.
 E -> MRS is low. Julia has high consumption now and low consumption later, so she’d prefer
to move that consumption to the future. She’d move up the IC.

- Neither C or E provide the perfect choice for Julia, so she’ll move to a higher
indifference curve and select point F, where MRS = MRT. (See below figure).

4. CONSUMPTION PREFERENCES - IMPATIENCE

- Why do we want to smooth our consumption between now and later? Is it because we
need to, or is it just because we’re impatient (Pure Impatience)?

Pure Impatience: When a person values an additional unit of consumption now over an
additional unit later, because they place less value on consumption in the future for reasons of
myopia, weakness of will, or for other reasons. This is not rational behaviour.

Myopia: People experience present satisfaction more strongly than they imagine they would
experience the same satisfaction later.

Prudence: People realise they may not be around in the future, so choosing to consume now
may be smart.
 - Thus, consumption preferences (the indifference curve = MRS) will depend on a
person’s impatience.

5. OPTIMAL DECISION MAKING WHEN BORROWING

Discount Rate (ρ) = A measure of a person’s impatience.

- Now it’s clear than because our MRS depends on consumption smoothing, which
depends on impatience, we would use our Discount Rate (ρ) to determine the MRS.

Optimal Decision-making when Borrowing

MRS = MRT
1+ρ=1+r
Discount Rate = Interest Rate

6. SAVERS VS BORROWERS

Reservation Indifference Curve: All the combinations of consumption at which the

saver/borrower would be equally as well off as at their reservation position (their endowment).

Endowment: For a borrower, their endowment is the money they’re getting in the future. For a
saver, their endowment is the money they have right now.

- Thus, savers and borrowers will have different reservation IC’s because their
endowments differ.
 Reservation Indifference Curves

- Julia is getting R100 in the future and so wants to borrow to smooth out her
consumption from the future to now. Her reservation IC thus represents all the
combinations at which she’d be equally as happy as just waiting to collect the R100.

- Marco has R100 now and so wants to save in order to smooth out his consumption
(earning interest as he does so) from now to the future. His reservation IC thus
represents all the combinations at which he’d be equally as happy as just spending the
R100 now.

- This shows that the lowest IC an individual wants to be on is that IC which lies on their
endowment.

Savers:

- Smooth their consumption by postponing it to the future (saves their money for another
day).

- You generally save by lending your money at interest, which expands your feasibility set
(increases your total possible consumption). Simply storing your money under your
mattress would not earn interest and therefore not expand your feasibility set. In fact,
simply storing your money would decrease its value due to the effects of inflation.
 Modelling Saving (Storage & Lending)

- Marco has $100 worth of grain and he wants to smooth his consumption out into the
future (he wants to save).

- Now, Marco can either choose to (1) simply store his grain in a silo and risk it getting
eaten by rats, or he can (2) lend his grain out to another farmer and earn interest when
he gets it paid back.

Store Grain -> Suffer 20% losses due to rats eating some of the grain.

Lend Grain -> Increase total by 10% due to earning interest.

- Now, anyone can see that lending his grain would be the best option as it allows him
to reach a higher indifference curve (expanding his feasibility set).
 - Thus, Marco moves up to a higher IC and decides to consume at point J, where the
MRS = MRT.

MRS = Marco’s indifference curve. The rate at which he’s willing to substitute consumption
now for consumption later.

MRT = The feasibility set. The rate at which Marco can transform consumption now into
consumption later (the interest rate he can lend at).

7. INVESTMENT

Investment: Using surplus wealth or income productively, like by investing in the construction of
a factory which will earn you a good rate of return (thus increasing your consumption over time).

- A dual combination of investment and borrowing can help increase consumption both
now and later.

- An individual’s wealth and income influences their opportunities to engage in investment,

For example, it’s far easier for someone worth R10 000 000 to grow that money by
building homes than it is for someone worth R100 000 who would otherwise be shut out
of such an opportunity.
- Notice the difference between saving for future consumption (lending money, storing it,
or buying stocks etc.) and investment (using surplus money productively to earn a
healthy return).

Modelling Investment

- Instead of lending his grain out or storing it, Marco could invest it by planting it. If he
had to plant all $100 worth of grain, he would see a rate of return of 50% and end up
with $150 worth of grain.

- Marco’s actual choice of investment will be where he gets the highest utility, so where
MRS (IC) = MRT (return rate).

- The slope of the feasibility curve represents our 1 + our return of investment. In this
case, it’s 1 + 0.5 or 1 + 50%.

- If Marco invests at $40 as he does in the graph, he will be able to consume $60 now
and $60 later ($40 x 1.5 = $60).
 Modelling Investment & Borrowing

- If Marco could get a loan, however, he would be able to consume more both now and
later. That is, both borrowing and investing would be more productive than just simply
investing.

- Thus, if Marco were to invest his entire $100, he would get $150 in the future. If Marco
borrowed against this future amount with a 10% loan, he could drastically increase his
consumption now to $135 (his feasibility set expands outwards towards the dotted
line).

- But, Marco’s actual choice of consumption using this investment + borrowing approach
will depend on his preferences (IC).
 - Using Marco’s new IC, it’s clear that using this investment + borrowing approach
(where he’s able to invest everything) his highest utility would be at point L where he
consumes $80 now and $62 later.

- Contrast this with his pure investment (where he's only able to invest part of it)
approach at point K, where he’s able to only consume $60 now and $60 later.

- From this we can see that borrowing is a powerful, sustainable tool to increase
consumption when coupled with investment.

8. BALANCE SHEETS

Balance Sheet: Summarises what a household, individual, or firm owns (assets) and owes
(liabilities).

Assets: Anything of value which is owned by you or owed to you.

Liabilities: Anything of value which is owed to someone else.

Net Worth = Assets - Liabilities

- Your net worth does not change when you lend or borrow money.
 - Borrowing money increases your assets (the extra money) but also increases your
liabilities (you have to pay it back), and so they balance out.

- Lending money decreases your assets (the money you gave to someone else) but then
increases your assets (they owe you that money), and again they balance out.

8. BANKS AND MONEY

Bank: A firm which generates profit by lending money to people at a higher interest rate than
what it cost the bank to borrow that money.

1. Banks borrow money from households (bank deposits), other banks, and the central
bank.
2. Banks lend this money out to households, firms, and other banks.
3. The interest they ask when lending is higher than the interest they pay when borrowing,
which is how they make a profit.

- South Africa’s main banks include Standard Bank, ABSA, FNB, Capitec, and Nedbank.
New entrants include digital banks like Tyme Bank or Discovery Bank, which operates
using behavioural science.

Central Bank: The highest banking facility in every country, usually owned by the government.
The Central Bank is the only institution that can create legal tender (base money), which it then
lends out to commercial banks (ABSA, FNB etc.). By crediting the accounts of commercial
banks it can create money without actually printing money.

Base Money: Cash (notes and coins) held by households and firms, and the balances held by
commercial banks in their accounts at the Central Bank. Base money = liability of the Central
Bank.

Bank Money: Money created by banks when they lend money to firms or households. This
money is not legal tender (as it’s created by banks and not the Central Bank). Bank money =
liability of the banks.

Broad Money: Base money + Bank money, which is in the hands of non-bank public
(households and firms, excluding banks). Essentially, the money in circulation.
 1. Peter deposits R100 into Standard Bank
Standard Bank Assets Standard Bank Liabilities

R100 base money (held at Central Bank) R100 payable to Marco

2. Peter pays R20 to Jessica via EFT to her bank account

Standard Bank Assets Standard Bank Liabilities

R80 base money (sent R20 to Jessica) R80 payable to Peter (sent R20 to Jessica)

FNB Assets FNB Liabilities

R20 base money (from Peter) R20 payable to Jessica (from Peter)

3. FNB loans Jessica R100

FNB Assets FNB Liabilities

R20 base money (from Marco) R120 payable to Jessica (Peter + loan)
R100 bank money (loan to Jessica)
Total: R120

4. Jessica pays Peter R10

Standard Bank Assets Standard Bank Liabilities

R90 base money (+ R10 from Jessica) R90 payable to Peter (+ R10 from Jessica)

FNB Assets FNB Liabilities

R10 base money (- R10 to Peter) R110 payable to Jessica (- R10 to Peter)
R100 bank money (loan to Jessica)
Total: R110

Total Bank Assets Total Bank Liabilities

R100 base money R200 payable

R100 bank money
Total: R200
*Notice how at Step 1 we started with R100 in Bank Assets, but now at Step 4 we have R200 in
Bank Assets. This is money creation. Base money remains the same, but Broad money has
increased.

- Despite us making transfers throughout the day, banks only “settle” their accounts with
each other at the end of each day.

Maturity Transformation: The practice of borrowing money short-term and lending it long-term.
A bank accepts deposits, which it promises to repay at short notice, and then uses those short-
term deposits to make long-term loans.

- However, the practice of Maturity Transformation exposes the bank to risk in the form of
default risk and liquidity risk.

Default Risk: The risk that loans will not be repaid.

Liquidity Risk: The risk that the bank will not be able to meet depositors demands for
withdrawals due to the bank's limited holding of base money.

Banking Crisis: If too many depositors demand their money at once, the bank faces a liquidity
crisis due to the small amount of base money (legal tender) it has at any given time. Such a
crisis can quickly turn into a bank run.

- Banks can also fail by making bad investments (like during the ‘08 financial crisis).
Governments will intervene in such a crisis if they think that it threatens the stability of
the entire financial system (of which banks form the foundation).

Money Market: At any given time, banks need enough base money to cover their transactions.
If they don’t have enough, they can borrow base money on the money market from other banks
or the Central Bank. These borrowings are made at the short-term interest rate (REPO + .

Policy Interest Rate: The interest rate on base money set by the Central Bank. This is called
the REPO rate in South Africa, and is currently at 3.5%.

Bank Lending Rate: The average interest rate charged by banks when lending to firms and
households. The base lending rate is called PRIME, which is always REPO + 3.5%. Thus the
3.5% represents the bank’s profit margins on a loan.

- The Central Bank’s policy interest rate affects spending within the economy, because
both firms and households borrow money in order to spend. The more expensive that
borrowing, the less spending takes place.
 - Thus, Central Banks use their ability to influence interest rates to influence the economy.
In South Africa’s case, the Covid-19 pandemic has resulted in lower rates in order to
encourage spending and economic growth.

Bonds: A bond represents a loan made by an investor to a borrower (typically a firm or a

government). In exchange for the loan, the borrower agrees to pay back the principal plus
interest (called a coupon coupon). Bonds can last from 5 years to 25 years, and are a common
way for governments to raise money.

9. THE CENTRAL BANKS

Review the PDF document called “SARB Information”, found on SunLearn under Week 4. It
provides a brief overview of the various central banks around the world.

This information will be assessed.

10. BUSINESS OF BANKING

- A bank's business is the buying and selling of money. They buy money (borrow it from
their depositors/the Central Bank) and then sell that money for a profit (lend it to
households, firms, and other banks).

- A bank’s profit depends on the spread between the interest it must pay on the money it
borrows and the interest it gets paid on the money it loans out.

Bank Costs:

Operational -> Property rents, salaries, technical services etc.

Interest Costs -> The interest paid on liabilities (deposits and other borrowing).

Bank Revenues: Interest on and repayment of loans.

- A bank’s expected return is the return on the loans it makes, taking into account some
portion of default risk.
Bank Assets: Money lent out which is now owed to it (loans).

Bank Liabilities: Money borrowed which it now owes (deposits).

Bank Net Worth = Assets - Liabilities

- A negative net worth (liabilities bigger than assets) means the bank is insolvent.

- The net worth of a bank is called equity, and is what is owed to shareholders.

Leverage Ratio: How much a company relies on debt.

Leverage (for banks) = Total Assets / Net Worth

Leverage (for non-banks) = Total Liabilities / Total Assets

11. POLICY RATE AND THE ECONOMY

- The Central Bank’s policy interest rate affects spending within the economy, because
both firms and households borrow money in order to spend. The more expensive that
borrowing, the less spending takes place.

Modelling the Effects of Interest Rates on Consumption

- In this example, Julia has an endowment of $100 and wants to borrow in order to
smooth her consumption over time.

- Faced with a very high interest rate of 78% (her feasibility frontier - MRT) and her
preferences (IC - MRS), Julia settles on point G as her highest utility.

- Thus, with a 78% interest rate Julia’s total consumption is $73, with $35 being
consumed now.

- But, what if Julia could borrow at a lower interest rate? Would this change her
consumption?

- If Julia’s given a much lower interest rate of 10% (her feasibility frontier - MRT), she’ll
be able to reach a higher utility (IC) and greatly expand her feasibility set.

- With a 10% interest rate, Julia settles on point E.

- Thus, with a 10% interest rate Julia’s total consumption increased to $94, with $58
being consumed now (a huge increase).

- It’s now quite clear that low interest rates can help increase spending now. This
increased spending leads to increased demand for goods and services, which leads to
higher employment and production, which all helps grow the economy.
 - The figure to the right represents Julia’s demand curve when faced with certain
interest rates. It’s clear that an interest rate has a strong influence on how much she
consumes.

12. CREDIT MARKET

- Within the credit market there exists a principal-agent problem. Lenders have limited
means to ensure borrowers will do what’s necessary to repay the loan.

Principal-agent Problem: When one party (the principal/lender) would like another party (the
agent/borrower) to act in some way, or have some attribute that is in the interest of the principal,
and that cannot be guaranteed in a binding contract.

- Part of this is also due to information asymmetry (the lender cannot have perfect
information about the borrower’s activities or attitude).

- To address this issue, lenders ask for collateral or equity from their borrowers.

Collateral: The borrower sets aside assets (home, business, car etc.) that will become the
property of the lender if the loan is not repaid.

Equity: The borrower puts some of his own wealth in the project (business, house construction
etc.) along with the loan amount, so as to better align the interests of the borrower and lender.

- The issue of the credit market’s principal-agent problem, and its solutions of collateral
and equity, can create issues for those without collateral or equity. We call this credit
rationing.
Credit Rationing: When those with less wealth are forced to borrow on unfavourable terms
(credit-constrained) compared to those with more wealth , or are refused loans completely
(credit-excluded).

- Credit rationing is because, without collateral or equity, lenders are forced to

compensate by the higher risk of the loan by increasing interest rates or shortening the
repayment period, or refusing to loan entirely.

- Credit rationing is common among young people with limited income records (and
assets) and among lower income groups.

- Inequality can increase when a minority of people are in a position to lend money to a
majority of people.

- As we’ve seen previously, investment and borrowing open up incredible opportunities to

build wealth. Thus credit rationing is a major impediment to wealth creation and the
destruction of inequality.