money and banking. outline 1.what is money? characteristics definition 2.the money market money...
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Money and Banking
Outline1. What is money?
Characteristics Definition
2. The Money Market Money supply Money Demand
3. The Financial Sector
4. How do banks create money?
5. A model of the money market
What is Money?
Characteristics
1. Medium of exchange Buying and selling goods and services
2. Unit of account Assisting measurement of relative worth of various goods,
services and resources
3. Store of value A form in which to store wealth, due to its liquidity and
convenience Standard of deferred payment (e.g. wages)
Money Supply
Most economies classify their money supply according to the following definitions:
M1; M2; M3; and Broad Money.
The Money Market
Three components of the money supply are of significance:
Currency (coins and notes) in hands of non-bank public
Current deposits in banks upon which cheques can be drawn
Non-current accounts such as savings accounts and term deposits with banks.
The Money Market
The Money Market
Currency Coin and note component of the money
supply In modern economies, currency has not real
value of itself – it has legal backing by the government that makes it acceptable as a means of payment.
Current Deposits Can be readily converted into currency Generally acceptable as a medium of
exchange Cheques enable the ownership of current
deposits to be transferred
The Money Market
Non-current Deposits Can be readily converted into currency or
current deposits Highly liquid financial assets New technologies (such as EFTPOS)
important
The Money Market
M1 total of currency outside banks and demand deposits
(non-interest-bearing chequing accounts). M1 definition is the most liquid of all assets and is the traditional definition of money supply.
M2 adds to M1 assets such as savings accounts, small
denomination time deposits, money market deposit accounts, and money market mutual fund shares. (US Federal Reserve uses this definition.)
The Money Market
M3 M1 and M2 plus assets as large denomination time
deposits. M3 is the sum of currency (notes and coins), current (or demand) deposits in banks on which cheques can be drawn, and non current deposits in banks (e.g. savings) (commonly used by RBA, although RBA uses other definition such as Broad Money)
Broad money M3 plus borrowings from the private sector of non-bank
financial intermediaries (NBFIs) less holdings of currency and bank deposits by the NBFIs
The Money Market
Rate of Interest (%)
Quantity of Money
Sm
QS
The Money Market
M1 Currency outside banks (about 50% of M1) , demand deposits at banks, checkable deposits at banks and thrift organizations (credit unions, mutual savings banks); traveler's cheques.
$73 529.1M
M2 Adds to M1 small-denomination time deposits plus money market deposit accounts and savings deposits at all depository institutions , plus retail money mkt mutual fund shares.
$317 786.2M
M3 Adds to M2 large denominations (US $100000 >) time deposits at all depository institutions, institutional money market mutual fund shares, bank repurchase agreements and Eurodollars
$326 920.2M
Source: www.mas.gov.sg
The Singapore Money Supply (August 2008)
The Money Market
The Monetary Base
Composed of:Currency held by the publicCurrency held by the banksBanks’ demand deposits with the
RBA
The Money Market
Credit Cards Not money Simply a convenient method of obtaining a
short-term loan from the card-issuer Facilitate the synchronisation of receipts and
expenditures, reducing the demand for cash
The Money Market
Money Demand
The demand for money is the demand for real money balance
2 reasons why people demand money:
1. Transactions demand
2. Asset demand
The Money Market
Transactions Demand
The demand for money as a medium of exchange (to buy goods and services)
Depends on money GDP (not interest rates)
Vertical demand curve.
The Money Market
Asset DemandThe demand for money as a financial asset and store of wealth
The interest rate reflects the opportunity cost of holding money:
The lower the interest rate in the economy, the lower the opportunity cost of holding money & more willing to hold money for its liquidity. The higher the interest rate, the greater the cost of holding money (in interest rate forgone) & so will hold less money.
Downward-sloping asset money demand curve
The Money Market
Total Demand for Money Transactions demand and assets demand
are added horizontally
DM=MDt+MDa
Changes in interest rates lead to movement along the curve
Anything that changes money GDP leads to a shift in the money demand curve
The Money Market
+ =
Rat
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i (p
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t)
Rat
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tere
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i (p
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Rat
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Amount of moneydemanded (billions
of dollars)
Amount of moneydemanded (billions
of dollars)
Amount of moneydemanded (billions
of dollars)
0 50 100 150 200 250 300
TransactionsDemand, Dt
Dt
10
7.5
5
2.5
0
10
7.5
5
2.5
0
10
7.5
5
2.5
0
AssetDemand, Da
Da0 50 100 150 200 250 300 0 50 100 150 200 250 300
Total Demandfor Money, Dm
Dm
The Money Market
Money Demand
Shifts in the Demand for Money CurveThe demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs.
The Money Market
Inte
rest
rat
e (p
erce
nt
per
yea
r)
3
4
5
0
Effect of increase in real
GDP
Effect of decrease in real GDP
MD1
MD2
MD0
Real money (billions of 2003/04 dollars)500 600 700
The Money Market
The Money Market
The combination of the money demand and money supply determines the equilibrium interest rate
The interest rate represents the opportunity cost of holding money balances
Equilibrium Interest Rate
Ra
te o
f in
tere
st,
i (p
er c
en
t)
Amount of money demanded(billions of dollars)
10
7.5
5
2.5
0
Dm
ie
0 50 100 150 200 250 300
Sm
Equilibrium Interest Rate
The Money Market
Figure 1 Flow of funds through financial system (transfer from savers to borrowers)
Savers/ Lenders*Households
*Business firms*Government*Foreigners
Financial Intermediaries (e.g. commercial and saving banks, savings and loans
associations, credit unions, insurance companies, pension funds, mutual funds)
Borrowers/Spenders*Households
*Business firms*Government*Foreigners
Financial Marketsmarkets in which funds are transferred from people with surplus funds to those
with a shortage of available funds
The Financial Sector
Some Basic DefinitionsBank: an institution that takes funds from one group of investors and re-deploys those funds by investing in financial assets.
Non-bank Financial Institution (NBFI): permanent building societies, credit cooperatives, money market corporations (merchant banks), pastoral finance companies, finance companies, general financiers, insurance companies and cash management trusts.
Deposit: funds placed into a bank account Current deposit: no minimum term requirement Non-current Deposit: minimum term bank deposit
Loan: repayable funds given out by a bank for a specific period of time
Reserves: currency held by private banks to meet operating requirements.
A bank uses its reserves to meet depositors’ demand for currency and to make payments to other banks. A bank’s reserves are made up of: Actual reserves: how much reserves a bank holds. Desired Reserves: the reserves that a bank wishes to
hold. Excess reserves: how much reserves a bank can loan
out. actual reserves minus desired reserves.
Some basic definitions
COUNTRY CENTRAL BANK
China
Malaysia
Australia
Singapore
Hong Kong
Japan
New Zealand
Philippines
Russia
Sri Lanka
Thailand
Soloman Islands
Peru
Papua New Guinea
Pakistan
India
Indonesia
South Korea
The People’s Bank of China
Bank Negara Malaysia
The Reserve Bank of Australia
Monetary Authority of Singapore
Hong Kong Monetary Authority
Bank of Japan
Reserve Bank of New Zealand
Bangko Sentral ng Pilipinas
Central Bank of Russia
Central Bank of Sri Lanka
Bank of Thailand
Central Bank of Solomon Islands
Central Reserve Bank of Peru
Bank of Papua New Guinea
State Bank of Pakistan
Reserve Bank of India
Bank of Indonesia
Bank of Korea
Some Basic DefinitionsCentral Bank: regulates an economy’s financial sector and implements Monetary Policy.
Some basic definitions:
Liquidity : ability to convert an asset into cash quickly with little loss in value.
Bond: liability issued by a government or a business (corporate bond) promising to pay the holder a fixed cash amount at a specified maturity date and usually to make regular interest payments in the interim.
Securities: financial instruments representing ownership or debt, such as stocks and bonds, that provide claims to future expected cash flows.
The Role of Banks
Economic Functions of Banks Create Liquidity Minimise the cost of obtaining funds Minimise the cost of monitoring borrowers Pool Risk.
Banks and Financial Instability
Banks may contribute to business fluctuations Can exacerbate recession, by holding back
on credit expansion May amplify inflationary pressures, by
increasing lending and credit creation
A Bank’s Balance Sheet
A statement of assets and claims that summarises the financial position of a firm at a point in time
Each side balances: Assets are items of economic and financial value.
Example, loans, reserves. Liabilities are claims of other parties on the bank.
Example, deposits
Assets = Liabilities + Owners’ Equity
How do banks create money?
Formation of a BankTransaction 1
The birth of a Bank
New owners sell $250,000 worth of shares
ASSETS LIABILITIES
Cash 250,000 Capital 250,000
250,000 250,000
Formation of a Bank
Transaction 2Becoming a Going ConcernAcquisition of property and equipment
ASSETS LIABILITIES
Reserves
Property
10,000
240,000
Capital 250,000
250,000 250,000
Formation of a BankTransaction 3Accepting DepositsCitizens and businesses deposit $100,000Change in the composition but not the quantity of the
Money Supply
ASSETS LIABILITIES
Cash
Property
110,000
240,000
Deposits
Capital
100,000
250,000
300,000 300,000
Formation of a BankTransaction 4
Setting aside Required Reserves
Bank decides to keep all cash as reserves (actual reserves).
ASSETS LIABILITIES
Cash
Reserves
Property
0
110,000
240,000
Deposits
Capital
100,000
250,000
350,000 350,000
Formation of a BankTransaction 5
Withdrawal of Funds
A citizen who has substantial deposits in the bank withdraws $50 000 to buy goods
The seller of the goods deposits the cheque in another bank
The banking system as a whole has not lost or gained
ASSETS LIABILITIES
Reserves
Property
60,000
240,000
Deposits
Capital
50,000
250,000
300,000 300,000
Creating MoneyTransaction 6
Granting a loanA company borrows $50 000 from the bank
Money is created
Balance sheet after loan is negotiated:
ASSETS LIABILITIES
Reserves
Loans
Property
60,000
50,000
240,000
Deposits
Capital
100,000
250,000
350,000 350,000
Transaction 7Buying Government Bonds
Bank buys $50 000 of government bonds instead of lending $50 000
Money is created
ASSETS LIABILITIES
Reserves
Bonds
Property
60,000
50,000
240,000
Deposits
Capital
100,000
250,000
350,000 350,000
Creating Money
The Banking System
Multiple banks: multiple-deposit expansion Money is created by a multiple of the banking
system’s excess reservesAssume reserve ratio is 20%
Bank must keep $20 000 (required reserves)
Reserve Ratio = Bank’s Required Reserves
Bank’s Deposit Liabilities
Multiple-Deposit Expansion Assume initially: 20% reserve requirement Bank A
Accepts a deposit for $100 Gains $100 in Actual Reserves and Deposits
ASSETS LIABILITIES
Reserves +100 Current Deposits +100
100 100
Keeps 20% ($20) of the new deposit as Desired Reserves and loans out 80% ($80).
Multiple-Deposit Expansion
A loan of $80 is negotiated
ASSETS LIABILITIES
Reserves
Loans
20
80
Current Deposits 100
100 100
$80 loan deposited in Bank B…
Multiple-Deposit Expansion
Bank B Gains $80 in Actual Reserves and Deposits Keeps 20% ($16) of the new deposit as Desired
Reserves and loans out 80% ($64).
ASSETS LIABILITIES
Reserves
Loans
16
64
Current Deposits 80
80 80Loan of $64 is drawn on Bank B and deposited in Bank C, and so on…
Multiple Deposit Expansion Process
BankAcquired reserves
and depositsRequiredreserves
Excessreserves
ABCDEFGHIJKLMNOther banks
$100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97
$20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40
$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57
$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57
$400.00$400.00Total amount of money created by the banking system
New moneycreated
Change in money supply = first deposit of $100 + $400 = $500
Total banking system has created $400 Total money supply grown by $500 How?
Via the Monetary Multiplier
1
R
1
Reserve Ratio
Multiple-Deposit Expansion
Money Multiplier =
MM =
where MM is the Monetary Multiplier
Total banking system has created $400 Total money supply grown by $500
1/0.2 = 5; then 5 X excess reserves ($80)= $400
And there was the initial $100 tax refund from the Central Bank
Multiple-Deposit Expansion
Multiple-Deposit Expansion
1
R
1
Reserve RatioMonetary Multiplier =
MM=
MM = 1/0.2 =5
Initial change in reserves = $100
Money Supply = m * Reserves
Money Supply = 5 * 100 = 500
Multiple-Deposit Expansion
1
R
1
Reserve RatioMonetary Multiplier =
MM =
MM = 1/0.2 = 5
Excess reserves = $80
Deposits = m * Excess Reserves
Deposits = 5 * 80 = 400
Possible Leakages
Currency drains Loan may be paid in cash and remain in circulation
Transfer of deposits to non-bank financial institutions
Excess reserves Individual banks may choose to have larger reserves than
required (say 25% instead of 20%)
Willingness to Borrow
For the full multiplier effect to take place: Borrowers must be willing and able to utilise the
loans Borrowing is likely to be low during a recession
Monetary base & money creation
We saw that the tax refund cheque started the process of multiple deposit expansion for the banking system.
The monetary base is important. How can the government or RBA increase the
monetary base? by running deficits; by tax refund cheques; by buying government bonds from public; by purchasing foreign currencies.
Jackson and McIver, chs 9 and 10.
References