MONEY & BANKING

Learning Objectives

State and explain the 3 functions of money Define commodity money and fiat money State monetary supply measures and their components Explain the function of banks Explain how the banking system creates money.

What is money?

Money is variety of assets that are widely accepted in exchange for goods and services and as payment for debt.
Wealth a collection of property that store value e.g. money, bonds, stock, art, land furniture, cars and houses. Income = a flow of earning / unit of time

Function of money
1.
2. 3.

Medium of exchange Unit of account Store of value

Medium of exchange

Money i.e. currency or checks is used to pay for goods and services. Barter trade in the early days. Money is as a medium of exchange eliminates the requirement of double coincidence of wants.

Medium of exchange

Money facilitates all buying and selling transactions. Money promotes economic efficiency; less time spent in exchanging g & s. Money promotes economic efficiency; people specialize in what they do best.

Medium of exchange

1.

2. 3. 4. 5.

For a commodity to function effectively as money it must be: Easily standardized, (easier to ascertain its value) Widely accepted Easy to carry Divisible to make change Not deteriorate quickly

Unit of Account

The value of g&s is measured in terms of money. Therefore the value of g&s can be determined and compared. The values can be added up to calculate e.g. GDP, prepare profit & loss accounts for firms. Debt & Taxes owed are measured in units of money.

Store of Value (Wealth)

We either consume or saving our income. We save and store our wealth for future use. A store of value is used to transfer purchasing power in to the future. If inflation rate remains unchanged, our wealth does not loss value in the future.

WHERE DOES MONEY GET ITS VALUE

Scarcity Government Law: money must be accepted as payment for debts It is widely accepted as medium of exchange.

Types of Money

Commodity money: Has both monetary value and non-monetary value. A gold coin has been identified as commodity money. It has a monetary value equivalent to the one stated on the coin. Gold has non-monetary use e.g. making a gold chain.

Types of Money

Fiat Money The central bank that prints the notes Currency derives its value confidence from the decree by government. Confidence over fiat money that allows people to transact without doubt.

Measures of Money Supply

Money M1 (Narrow money or transaction money Type Currency outside banks Checking accounts Salient features medium of exchange. 0 interest. Most liquid money. Transaction accounts Earns no interest. A medium of exchange by issuing checks. Check issued by a financial institution. Functions as cash but is protected against loss or theft. used by people on vacation in place of cash

Travelers checks

M2 = M1 +

Savings accounts

Offered by banks Must be converted to cash or funds must be transferred into a checking account. Cert. of dep. (CD) in a F.I held for a fixed term. Withdrawal by notice. Penalty for early withdrawal. Term of 30 days or more. By Mutual Funds. Investors buy shares in the fund. Funds are invested in short-term (< 1 year) credit instruments such as T-bills and short-term certificates of deposit (i.e. money-market instruments.)

Small Time deposit accounts (CDs) < 100,000.00

Money market mutual funds (MMFD)

M3
M3 = M2 + large time deposits
Large time deposits = owned by businesses = these certificates can be sold at any time

Banking System
Banking system consist of Central bank and Financial institutions. Functions of Financial Instititions: 1. Creating Liquidity Liquidity is the ease at which an asset can be converted into money. Banks borrow short and lend long. Deposits are transform into loans = creation of liquidity

Functions of Financial Institutions

Minimizing the cost of obtaining funds Banks lower this cost of searching. The bank borrows from a large of people and spreads the cost over a large number of borrowers. In the absence of banks raising $1.0m would be costly.

Functions of Financial Institutions

3.Minimizing the cost of monitoring borrowers

Lending money is a risky business. Theres always danger that the borrowers may not repay. Banks have the expertise to monitor loans and borrowers

Functions of Financial Institutions

4. Pooling Risk Lending to a large number of different individuals can reduce the risk of default. If one person defaults on a loan, it is nuisance but not a disaster. If only one person borrows and the person defaults the entire loan is lost.

Banking System
Functions of Central bank include: Clearances of checks. Control money supply (through the monetary policy). Lender of last resort. Managing exchange rates and foreign exchange reserves. Regulating the banking system.

Banking System

Reserves are deposits that banks have

received but have not loaned out. Required Reserve: amount of deposit banks must hold reserves. The reserve ratio is the fraction of deposits that banks hold as reserves.

Banking System

Excess Reserve; Reserves over and above the legal requirement In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

Banking System

Banks can influence the quantity of demand deposits in the economy and the money supply. The money supply refers to the quantity of money available in the economy.

Banking System

When one bank loans money, that money is generally deposited into another bank. This creates more deposits and more reserves to be lent out. When a bank makes a loan from its reserves, the money supply increases.

Banking System

This T-Account shows a bank that

Bank A
Assets
Reserves $20.00
Loans

Liabilities
Deposits $100.00

accepts deposits, keeps a portion as reserves, and lends out the rest.

It assumes a reserve ratio of 20%.

$80.00 Total Assets $100.00

Total Liabilities $100.00

Banking System
First National Bank
Assets
Reserves $16.00

Liabilities
Deposits $80.00

Loans
$64.00

Total Assets $80.00

Total Liabilities $80.00

Banking System; Money creation

Bank A B C D 400.00 Acquired Deposit 100 80.00 64.00 Required Reserve 20.00 16.00 12.80 Excess Reserve 80.00 64.00 51.20 New $ created 80.00 64.00 51.20

Monetary Multiplier

Banking system magnifies any Excess Reserve into larger amount of newly created demand deposit money. Monetary multiplier exist because reserves lost by one bank receives by another bank.

Maximum demand deposit creation = Excess Reserve * Monetary multiplier

M = 1/ required reserve ratio M= 1/ RR

Money Multiplier Amount of money ultimately created per dollar deposited by the banking system

Banking System
Original deposit = $100.00 1st y Lending = 80.00 (=.8 x $100.00) 2nd Lending = 64.00 (=.8 x $ 80.00) 3rd Lending = 51.20 (=.8 x $ 64.00) and on until there are just pennies left to lend! Total money created by this $100.00 deposit is $500.00. (= 1/.2 x $100.00)

Money Supply

The money supply in the economy is controlled by the Central Bank

The Central Bank can alter the supply of money using open market operations, changes in reserve requirement and discount rate.

Money Supply

Thus, the supply of money is a vertical line.

MS
8.00

Interest rates

7.00 6.00 5.00 4.00 3.00

3.0 Quantity of money

Money Demand
The three motives of holding money 1. Transaction Motive 2. The Precautionary Motive 3. Speculative Motive

Money Demand
8.00

Interest rates

7.00 6.00 5.00 4.00

Assume that the public can invest in Bonds or hold money. Interest rates is the opportunity cost Of holding money When interest rates increase the public Will hold less money and invest more In bonds. When interest rates fall the public Will demand more money thus Selling off their bonds.

3.00

Md

Quantity of money

Determinants of demand for money

1.
2.

Total output (income) Increases in the price level (P) These 2 factors cause a shift in the Md.

Equilibrium in the Money Market

The interest rate adjusts to bring money demand and money supply into balance.
MS

8.00

Interest rates

7.00 6.00 5.00 4.00 3.00

Md
3.0 Quantity of money

Tools of Monetary Policy

1. 2. 3.

The 3 tools monetary policy are: Open market operations Discount rate Reserve requirement

Open market operation

Balance sheets after the Purchase of bonds
Central Bank balance sheet Assets Securities
+100m

Liabilities Reserve
+100m

Central bank buys Security from a bank

and pays for the securities by increasing the reserve of the bank

Commercial bank balance sheet Assets Liabilities

-100m
+100m

Securities
Reserves

Open market operation

1. 2.

Purchase of government securities by central bank will. Increase reserves in commercial banks. Increase money supply as banks loan out the money.

Open market operation

Balance sheets after the sale of bonds Central Bank balance sheet Assets Liabilities Securities
Central bank sells Security to a bank

-100m

Reserve of A bank

-100m

and the bank uses its reserves to pay for the securities

Commercial bank balance sheet Assets Liabilities -100m Reserves and the bank uses its +100m Securities
reserves to pay for the securities

Open market operation

1. 2.

Sale of government securities by central bank will. decrease reserves in commercial banks. decrease money supply as banks loan out less.

Reserve Ratio

A commercial banks has: Reserves of $5000 Demand deposit =$20,000 Reserve ratio 20%, Required reserve = $4000. Excess reserves of bank are therefore $1000.

3. Discount rate

One of the functions of central bank is to be lender of last resort. Discount rate is the interest rate commercial banks pay for borrow money from Central Bank

3. Discount rate

Central Bank gives the loan by increasing the reserve of bank. Banks are not required to keep reserves against loans from Central Bank. Loans from Central Bank increase the excess reserves of banks and hence their lending ability.

Effects of an Easy Money Policy

Easy money policy is used during recession. To increase money supply; 3 tools can be used Buy government securities from public and commercial bank Lower legal reserve ratio Lower the discount rate.

Effects of an Easy Money Policy

Effects of an Easy Money Policy

LRAS

Price level

SRAS C 120 115 A AD2 AD1 11.8 12 Real GDP (trillions) AD1 + E 13

Lower interest rates increases aggregate demand curve from AD1 to AD1 .+ E and eventually shifts rightward to AD2. Real GDP increases to potential GDP and price level rises.

Effects of Tight Money Policy

Used when the economy is experiencing severe demand-pull inflation Central Bank should institute tight money policy. Decrease money supply by Selling government bond Increase legal reserve ratio Increase discount rate

Effects of Tight Money Policy

Effects of Tight Money Policy

LRAS

Price level

125 120

SRAS A AD1 AD1 + E AD2 12 Real GDP (trillions) Higher interest rates decreases aggregate demand curves AD1 to AD1 -E and eventually shifts leftwards to AD2. Real GDP decreases to potential GDP and price level falls. 12.2

Relative Importance of the instruments

The most important instrument is open market operation. Has advantage of flexibility and prompt impact. Discount rate is less important as amount that banks can borrow is small.

Relative Importance of the instruments

Reserve requirement is rarely used, increasing and decreasing of reserves would have substantial effect on the banks profit.