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Money, Banking & Interest Rate

Lecture 7

BECON2101

ShanFaculty of Business Management & Globalization

Tel: 83178833 Ext. 8407Email: sanmugam@limkokwing.edu.my

Money andBanking

MONEY

•Most important inventions in the history of human civilisation.•Before evolution of money, barter trade was practiced•Barter trade – exchange of goods and services for other goods and services•Money evolution started with shells, beads, etc

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DEFINITION OF MONEY

•Metallic money – metals used as money such as iron, copper, silver etc•Paper money refers to paper circulated as a means of payment•Plastic Card

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FUNCTIONS OF MONEY

•Medium of exchange - accepted by people in exchange for goods and services.•Measure of value/unit – measurement in terms of values of goods and services, measured and expressed, exp 1 book costs $120.00•Store of value – commodity that can be held in order to enable people to buy and sell it at any different times and at different places. 5

FUNCTIONS OF MONEY

Standard of Differed Payment – Future contractual payments . Money serves as a unit or standard of differed payment or in terms of which all future payments are expressed.Exp: Possible to make a contract or an agreement to exchange goods or settle debts in the future.

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QUALITIES OF MONEY

1. Acceptability2. Durability3. Divisibility - divided into parts4. Stability5. Relative scarcity6. Portability - quality of being light

enough to be carried

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TYPES OF MONEY

1. Commodity Money – any item that has its own value and used as a means of payment

2. Fiat money – government declares to be money, issues by Central bank which includes coin & paper money, called as currencies.

3. Legal Tender – accepted as means of payments or settle debts by govt. and people.

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TYPES OF MONEY

4. Token money – money which has lower metallic value than its face value. Example 5¢, 10¢, 20¢ & 50¢

5. Demand deposits – money that is transferable by way of cheque. (current account.

6. Other Liquid Savings Deposits9

MONEY SUPPLY

M1 – Narrow money, directly used for transactions. (commercial banks)

i. Currency includes coin and paper issued by Central Bank.

ii. Checkable deposits (current account) which can be convertible into cash on demand by writing cheques.

MI = Currency + Checkable Deposits

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MONEY SUPPLY

M2 – M1 + broader definition money supply, money which are considered as near money that are highly liquid financial assets, exp saving account, fixed deposits, certificates (commercial banks and central banks)

i. M1 – currency and checkable depositsii. Savings and fixed deposits in commercial banks,

mutual fundsiii.Other certificates

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MONEY SUPPLY

M3 = M2 + savings and deposits in other financial institutions besides commercial banks.

Quasi money = M2 – M1

Broad Near Money = M3 – M1

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Money DefinedM1 M2

54%

46%M120%

Savings DepositsIncluding Money Market

Deposit Accounts (MMDA)

Small Time Deposits

Money Market MutualFunds Held By Individuals

(MMMF)

Currency

Checkable Deposits

15%

11%

54%

$1,375Billion

$6,758Billion

February 2009

Totals

++

+

+

+

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Functions of Central Bank

• Issuing Currency• Setting Reserve Requirements and

Holding Reserves• Lending Money to Banks and Thrifts

– Discount Rate• Check Collection• Fiscal Agent for the government• Supervising Banks• Controlling the Money Supply

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Functions of Central Bank

• Recent Developments– Relative Decline of Banks and Thrifts– Consolidation Among Banks and Thrifts– Convergence of Services Provided by

Financial Institutions– Globalization of Financial Markets– Electronic Payments

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Financial Institutions

•Commercial Banks•Thrifts•Insurance Companies•Mutual Fund Companies•Pension Funds•Securities Firms

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How banks create money

Simplified balance sheet for a commercial Bank.Liabilities are source of funds for the bank. Assetsgenerate income for the bank.Why deposits considered as liabilities to thebanks?

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Assets $ Liabilities $

200 (Reserves) 2000 (Deposits)

2000 Loans 200 equity

Total 2200 Total 2200

First Bank

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Assets Liabilities

$100 Reserves $1000 Deposits

$900 loans

Assets Liabilities

$90 Reserves $900 Deposits

$810 loans

Second Bank

How banks create money

Third Bank

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Assets Liabilities

$81 Reserves $810 Deposits

$729 loans

Assets Liabilities

$72.9 Reserves $729 Deposits

$656.1 loans

Fourth Bank

How banks create money

How banks create moneySomeone walks to First bank and deposits $1000 in a checking account.Assume that banks are required to keep 10% of their deposits asreserves. Reserve ratio = 0.1. First bank keep $100 as reserves andmakes a loan of $900.

Suppose the person who took the loan from First bank deposits to hisChecking account in Second bank. Second bank holds $90 as reserves

andLends $810.

If the person who borrows the money from Second bank checkingdeposits to his Third bank. Third bank keeps $81 and lends $729.

This process continues with new loans and deposits and the process goes

on. 20

How money multiplier worksThe original $1000 cash deposit has created more deposit and loanaccounts. Adding up the new accounts in all the banks ……$1000 + $900 + 810 + 729 + $656.10 + ………. = $10000.

How did we come up with the sum? It is from the simple formula.

= (initial cash deposit) X 1

(reserve ratio)

1000 X 1 = $10000. 0.1

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Total Increase in account balance throughout the bank

How money multiplier works

The term 1/ reserve ratio in the formula is called the money multiplier.

Recall that M1 is the sum of deposits in commercial banks. Therefore the

change in MS , M1 increases or decreases

In this example First bank holds $1000 . However the total depositsincreased by 10000. Therefore MS (M1) has increased by 9000

(10000 –1000)

The banking system, as a whole the MS expanded by a multiple of theinitial cash deposit.

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CENTRAL BANK CONTROL OF MONEY SUPPLY When Central Bank increases the required reserve ratio, the

Banks must hold more reserves.

To increase their reserves, the banks must decrease their

lending, which decreases the quantity of money.

When the Central Bank decreases the required reserve ratio,

the banks may hold fewer reserves.

To decrease their reserves, the banks increase their ending,

which increases the quantity of money.

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How The Discount Rate Works?When the Central Bank increases the discount rate, the banksmust pay a higher price for any reserves that they borrowfrom Central Bank.

Faced with a higher cost of reserves, the banks are less willingto borrow reserves.

The banks must decrease their lending to decrease theirborrowed reserves.

So when the discount rate increases, the quantity of moneydecreases.

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How The Discount Rate Works?When the Central Bank decreases the discount rate,the banks pay a lower price for any reserves thatthey borrow from Central Bank.

Faced with a lower cost of reserves, the banks arewilling to borrow more reserves and increase their lending.

The quantity of money increases.

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How An Open Market Operation Works ?

The Central Bank’s major policy tool.

When the Central Bank buys securities in an openmarket operation, it pays for them with newly createdbank reserves and money. The banks can use theirnew reserves to create even more money.

When the Central Bank sells securities in an openmarket operation, people pay for them with moneyand reserves.

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How An Open Market Operation Works ?

The Central Bank’s major policy tool.

When the Central Bank buys securities in an openmarket operation, it pays for them with newly createdbank reserves and money. The banks can use theirnew reserves to create even more money.

When the Central Bank sells securities in an openmarket operation, people pay for them with moneyand reserves.

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CENTRAL BANK CONTROL OF MONEY SUPPLY

The following sequence of events takes place:• An open market purchase creates excess

reserves.• Banks lend excess reserves.• The quantity of money increases.• New money is used to make payments.• Some of new money is held as currency.• Some of the new money remains on deposit in

banks.• Banks’ required reserves increase.• Excess reserves decrease but remain positive.

CENTRAL BANK CONTROL OF MONEY SUPPLY

• The Money MultiplierThe number by which an increase in the

monetary base is multiplied to find the resulting increase in the quantity of money.

The larger the currency drain and the larger the required reserve ratio, the smaller is the money multiplier.

Change in quantity of

money=

Money multiplier

xChange in monetary

base

Financial Institutions

• Barclays (U.K.)• UBS (Switzerland)• Citigroup (U.S.)• ING Group (Netherland)• Mizuho Financial (Japan)• Allianz Worldwide (Germany)• Bank of America (U.S.)• HSBC Group (U.K.)• BNP Paribus (France)• JPMorgan Chase (U.S.)• Deutsche Bank Group (Germany)• Royal Bank of Scotland (U.K.)

World’s Largest Financial Institutions

Source: Forbes Global 2000

$1,587,0611,519,3991,494,0371,369,5461,325,2271,300,6481,291,7951,274,2191,227,9511,198,9421,134,8261,119,901

2005 Assets (Millions of U.S. Dollars)