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Chapter 30
The Monetary System
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Key Termsmoneymedium of exchangeunit of accountstore of valueliquiditycommodity moneyfiat moneycurrencydemand depositscentral bankmoney supplymonetary policy
reservesfractional-reserve bankingreserve ratiomoney multiplierbank capitalleverageleverage ratiocapital requirementopen-market operationsdiscount ratereserve requirements
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Two Choices
Make
or
Trade
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Barter
Direct trade - stuff for stuff
No money
Double coincidence of wants
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Both sides have to want what the other side has
Double coincidence of wants
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Both must want what the other has at the
same time
Double coincidence of wants
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Money makes trade easier
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Money
Something people use to trade with
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Why would you accept a cigarette if you didn’t smoke?
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Functions of Money
Medium of exchange
Unit of account
Store of value
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Medium of Exchange
Buyers give to sellers
Sellers accept from buyers
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Unit of Account
Measurement
Prices
Debts
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Store of ValueTrading time for time
Today for tomorrow
Tomorrow for today
Earn - Save - Spend
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LiquidityHow easy is it to convert
something to money
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Kinds of MoneyCommodity
Fiat
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Commodity MoneyIntrinsic value
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Easy to carry
Easy to measure
Easy to verify
Hard to copy
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=
Gold Standard
Central Bank will convert paper money to gold at a fixed rate
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Fiat Money
No intrinsic value
Declared money by government decree
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Fiat Money
Why do people accept fiat money?
Trust that someone else will also accept it
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Money
Trust inscribed
If people lose trust, money loses it value
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Coins
Currency
Checks
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Card Type Payment
Credit Defer
Debit Instant
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Why credit and debit cards are not money
Not a method of payment, but a method of
making payment
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Debit card is like a check
Takes money out of your bank account
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Credit Card
Defer the payment
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Demand Deposits
Bank account that you can access by writing a check or using a debit
card
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Saudi Arabia Monetary Agency
The Central Bank of Saudi Arabia
SAMAsama.gov.sa
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Central Bank
The bank that oversees the banking system and
regulates the money supply in a country
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Dr. Fahad Al Mubarak
Chairman of the BoardGovernor
Saudi Arabia Monetary AgencySAMA
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Six Functions• Issues national currency, the Saudi Riyal.
• Acts as a banker to the government.
• Supervises commercial banks.
• Manages Kingdom’s foreign exchange reserves.
• Conducts monetary policy for promoting price and exchange rate stability.
• Promotes the growth and ensures the soundness of the financial system.
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Source: sama.gov.sa
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Money Supply
The quantity of money available in a country.
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Monetary Policy
Setting the money supply by the central bank policymakers
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Two Types of Banks
100 Percent Reserve
Fractional Reserve
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100-Percent Reserve Bank
All the deposits are kept in a safe vault.
No loans
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Fractional-Reserve Bank
Bank only holds a fraction of the deposits
as reserves
Loans out the remainder
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Reserve Ratio
The fraction of deposits that banks hold as
reserves
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Fractional-Reserve Banking
Creates money
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Bank DepositReserve
10%Loan
Remainder
1000 100 900
900 90 810
810 81 729
• • • •
• • • •
• • • •
Total 10,000
How does 1000 become 10,000?
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Reserve Ratio
Fraction Reciprocal MoneyMultiplier
100% 1 1÷1 1
50% 0.5 1 ÷ 0.50 2
25% 0.25 1 ÷ 0.25 4
10% 0.1 1 ÷ 0.10 10
5% 0.05 1 ÷ 0.05 20
1% 0.01 1 ÷ 0.01 100
Money multiplier is the reciprocal of the reserve ratio
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Bank Capital
The money the bank’s shareholders have put in
to the bank
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Leverage
OPM
Using other people’s money
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Leverage1. I have 10
2. I borrow 90 from you
3. I buy something for 100
4. I resell the item for 150
5. I pay back your 90
6. I keep the 60
7. I earned 50 profit on my 10
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Leverage Ratio
The ratio of assets to bank capital
AssetsBank Capital
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Bank Balance Sheet
AssetsLiabilities and Owner Equity
Reserves 200 Deposits 800
Loans 700 Debt 150
Securities 100 Capital 50
Total 1000 Total 1000
Totals must balance or be equal
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What is the leverage ratio?
AssetsLiabilities and Owner Equity
Reserves 200 Deposits 950
Loans 800 Capital 50
Total 1000 Total 1000
Assets ÷ Capital1000 ÷ 50 = 20
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Leverage Ratio of 20
Owners put up 1
Depositors put up 19
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Leverage is Risky!If leverage ratio is 20,
5% increase in asset value = 100% return to owners
5% decrease in asset value = 100% loss to owners
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Capital Requirement
Government rule on minimum amount of
bank capital
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Insolvent
Liabilities are more than the assets
You owe more than you own
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Three Tools of Central Banks
Open-Market Operations
Discount Rate
Reserve Ratio
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Open-Market Operations
Purchase and sale of government bonds
Buy bonds increases supply
Sell bonds decreases supply
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Banksnow have
more cash to loan
Central Bank
Public Banks
Increase Money Supply?Buy bonds for cash
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Banksnow have less cash to loan
Central Bank
Public Banks
Decrease Money Supply?Sell bonds for cash
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Discount RateThe rate the central bank charges to make loans to
member banks
Called the Official Repo Rate or ORR rate in Saudi Arabia
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Official Repurchase Rate or Discount Rate
2.0%
Dropped from 2.5% on January 19, 2009
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SAMA Official Repo Rate
Dropped from5.5% October 2008
to 2.0% by January 20093 month period of
global financial crisisRate increased
as economyheated up
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Reserve Ratio
Increase reserve ratio will reduce money multiplier
Decrease reserve ratio will increase money multiplier
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1 2 4 6 8 10 12 14 16 18 20
ReserveRatio
Money Multiplier
The Power of the Reserve Ratio to Multiply Money
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Reserve RatioNot changed very often
What is the current reserve ratio in Saudi Arabia? 7%
What is the Money Multiplier?
1÷7% = 14.28
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Bank Deposit Insurance
Protects against bank runs
Moral Hazard to take more risk because government
will pick up losses
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Bank RunCustomers all want their money at the same time
Many banks runs at once
Bank Panic
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Zimbabwe, Nov. 2008 Highest monthly inflation: 79,600,000,000%Prices doubled every: 24.7 hours
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The Meaning of MoneyThree Functions of Money
Medium of ExchangeUnit of AccountStore of Value
Two Kinds of MoneyCommodityFiat
Money in the EconomyCurrencyDemand Deposits
Central BanksSAMA
Banks and the Money Supply100-Percent Reserve BankingFractional-Reserve BankingReserve RatioMoney MultiplierLeverageCapital Requirement
Tools of Monetary ControlOpen-Market OperationsDiscount Rate - ORRReserve RatioBank Runs and Deposit Insurance