Lec # 01 Money and Banking

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Introduction to Money

Introduction to MoneyLecture # 01Barter System Of ExchangeBarter is the direct exchange of goods and services for other goods and services.Drawbacks of barter Systemdouble coincidence of wantsLack of Common Measure of ValueIndivisibility of certain articles Lack of store of Value i.e perishable productsDifficulties in transportation

Evolution of MoneyMetallic MoneyStandard Metallic MoneyToken Metallic MoneyPaper Money Convertible Paper Money: Issued by SBP convertible to Gold or Silver on demand i.e 5, 10, 50,100, 500, 1000 Notes issued by SBPInconvertible Paper Money: Issued by Govt: without keeping in reserve Gold and Silver i.e Rs. 1 in Pakistan

Credit MoneyAmount of money borrowed or loaned out to a personi.e Cheques, DD, Pay orders, Credit Card, Govt BondsAn Overview of MoneyMoney is anything that is generally accepted as a medium of exchange.Money as a means of payment, or medium of exchange, is more efficient than barter.Money is not income, and money is not wealth. Money is:a means of payment,a store of value, anda unit of account.An Overview of MoneyMoney as a store of value refers to money as an asset that can be used to transport purchasing power from one time period to another.Money is easily portable, and easily exchanged for goods at all times. The liquidity property of money makes money a good medium of exchange as well as a store of value.i.e currency notes vs diamonds or paintings An Overview of MoneyMoney also serves as a unit of account, or a standard unit that provides a consistent way of quoting prices.Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money.Fiat, or token, money is money that is intrinsically worthless.Legal tender is money that a government has required to be accepted in settlement of debts.Measuring the Supply of Moneyin the United StatesThe two most common measures of money are M1 and M2.M1, or transactions money is money that can be directly used for transactions. It includes currency held outside banks, plus demand deposits, plus travelers checks, plus other checkable depositsM1 is a stock measureit is measured at a point in timeon a specific day. On June 26, 2000, M1 was $1,103.3 billion.Measuring the Supply of Moneyin the United StatesM2, or broad money, includes near monies, or close substitutes for transactions money.M2 = M1 + savings accounts + money market accounts + other near moniesOn June 26, 2000, M2 was $4,778.2 billion.The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.The Private Banking SystemMost of the money in the United States today is bank money, or money held in checking accounts rather than currency.Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.How Banks Create MoneyTo see how banks create money, consider the origins of the modern banking system:Goldsmiths functioned as warehouses where people stored gold for safekeeping.Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves, rather than the gold that they represented, began to be traded for goods.At this point, all the receipts issued were backed 100 percent by gold.How Banks Create MoneyGoldsmiths realized that people did not come often to withdraw gold and, as a result, they had a large stock of gold continuously on hand. They could lend out some of this gold without any fear of running out.There were thus more claims than there were ounces of gold.How Banks Create MoneyKnowing there were more receipts outstanding than there were ounces of gold, people might start to demand gold for receipts.A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.The Modern Banking SystemA brief review of accounting:Assets liabilities = Net Worth, orAssets = Liabilities + Net WorthA banks most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the Fed.The Federal Reserve System (the Fed) is the central bank of the United States.A banks liabilities are the promises to pay that it has issued. A banks most important liabilities are its deposits.T-Account for a Typical BankThe balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).T-Account for a Typical Bank (millions of dollars)ASSETSLIABILITIES

Reserves

20

100

Deposits

Loans

90

10

Net worth

Total

110

110

TotalThe Creation of MoneyBanks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).

The Creation of MoneyWhen someone deposits $100, and the bank deposits the $100 with the central bank, it has $100 in reserves.If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can lend $400 and have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.Increase in MS= Excess reserves * Money Multiplier80 * 5 = 400

The Creation of MoneyBalance Sheets of a Bank in a Single-Bank EconomyPanel 1Panel 2Panel 3ASSETSLIABILITIESASSETSLIABILITIESASSETSLIABILITIESReserves 00 DepositsReserves 100100 DepositsReserves 100500 DepositsLoans 400The Creation of MoneyThe Creation of Money: Balance Sheets of Three BanksPanel 1Panel 2Panel 3ASSETSLIABILITIESASSETSLIABILITIESASSETSLIABILITIESReserves 100100 DepositsReserves 100Loans 80180 DepositsReserves 20Loans 80100 DepositsReserves 8080 DepositsReserves 80Loans 64144 DepositsReserves 16Loans 6480 DepositsReserves 6464 DepositsReserves 64115.20 DepositsReserves 12.8064 DepositsSummary:DepositsBank 1100Bank 280Bank 364Bank 451.20......Total500.00The Money MultiplierThe money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.If the required reserve ratio is 10%, then an increase in reserves of $1 could cause an increase in deposits of $10 if there were no leakage out of the system.

Find M1 & M2

Simple Balance Sheet of bank, RRR = 20%Required Reserves&Currently excess reservesbank lends fully its excess reserves. Modify the B.S to reflect the creation of the loanIncrease in MS as result of above loan creation

Assets Liabilities and net worth Reserves $1200 Checkable deposits $5000 Securities 750 Stock shares 1000 Loans 3500 Property 550 Borrower of the new loan writes a check for the amount of the loan to purchase new equipment for business. seller then deposits the check in an other bank. Show the new B.S for this bank once the check has cleared.Find excess reserves when check is cleared

Customer has deposited $30,000 in the local bank. Prior to this deposit, bank was just meeting its RR. RRR is 25%Find required increase in required reserve A/c.Find excess in reserve A/c if all this deposit is placed in reserves A/cFind Money MultiplierIncrease in the MS with this new depositMoney Multiplier * Increase in excess reserves