Money and modern banking

1 JOIN KHALID AZIZ FRESH CLASSES OF CA MODULE B & ICMAP STAGE 1 ECONOMICS FRESH CLASSES OF CA MODULE B & ICMAP STAGE 1 ECONOMICS FROM 18 TH JULY 2011

2 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

3 Some key questions Why does society need money? Why does society need money? Why do governments wish to influence money supply? Why do governments wish to influence money supply? How do financial markets interact with the “real” economy? How do financial markets interact with the “real” economy? What is the relationship between money and interest rates? What is the relationship between money and interest rates?

4 Money Any generally accepted means of payment for delivery of goods or the settlement of debt Any generally accepted means of payment for delivery of goods or the settlement of debt Legal money Legal money notes and coins notes and coins Token money Token money means of payment whose value or purchasing power as money greatly exceeds its cost of production means of payment whose value or purchasing power as money greatly exceeds its cost of production

5 Money and its functions Medium of exchange Medium of exchange money provides a medium for the exchange of goods and services which is more efficient than barter money provides a medium for the exchange of goods and services which is more efficient than barter Unit of account Unit of account a unit in which prices are quoted and accounts are kept a unit in which prices are quoted and accounts are kept Store of value Store of value money can be used to make purchases in the future money can be used to make purchases in the future Standard of deferred payment Standard of deferred payment a unit of account over time: this enables borrowing and lending a unit of account over time: this enables borrowing and lending

6 A firm’s balance sheet n Assets – what the firm or households owns n Liabilities – what the firm or households owes n Balance sheet – lists a firm’s assets and liabilities at a point in time

7 Suppose A has 100 TL of money and a car Suppose A has 100 TL of money and a car His assets are cash and the car that he owns His assets are cash and the car that he owns B has 250 cash B has 250 cash B’s asset is only cash B’s asset is only cash If A sells the car to B with its market value of 150 in cash If A sells the car to B with its market value of 150 in cash A’s assets become A’s assets become B’s assets become car B’s assets become car Now B owns the car so car is B’s fixed asset together with the remaining cash of 100 Now B owns the car so car is B’s fixed asset together with the remaining cash of 100

8 Consider only liquid assets money Consider only liquid assets money A has 100 money A has 100 money Assets of A = other assets Assets of A = other assets B has 250 money B has 250 money Assets of B = other assets Assets of B = other assets B lends 150 TL of money to A to be paid back after one month later B lends 150 TL of money to A to be paid back after one month later What are the new assets of A What are the new assets of A Assets of A= others Assets of A= others What are the liabilities of A What are the liabilities of A Liabilities are part of the assets that are claimed by other parties Liabilities are part of the assets that are claimed by other parties In this example B lends 150 to A so this 150 is a liability of A to B In this example B lends 150 to A so this 150 is a liability of A to B

9 It is claimed by B It is claimed by B Liabilities of A = 150: A’s debt to be paid to B in next month Liabilities of A = 150: A’s debt to be paid to B in next month What are B’s assets ? What are B’s assets ? Assets of B=100 (cash) (loans to A) + others Assets of B=100 (cash) (loans to A) + others Total assets = assets of A + assets of B Total assets = assets of A + assets of B = oth oth. = oth oth. Total liabilities= liab of A + liab of B Total liabilities= liab of A + liab of B = =150 = =150

Oth Othe. A B B lends 150 to A oth Othe. A B

11 Modern banking A financial intermediary A financial intermediary an institution that specializes in bringing lenders and borrowers together an institution that specializes in bringing lenders and borrowers together e.g. a commercial bank, which has a government licence to make loans and issue deposits e.g. a commercial bank, which has a government licence to make loans and issue deposits including deposits against which cheques can be written including deposits against which cheques can be written pays interest to the lenders or depositors pays interest to the lenders or depositors but charges higher interests to the borrowers when landing money but charges higher interests to the borrowers when landing money makes profit by the interest differential between the landing and borrowing rates makes profit by the interest differential between the landing and borrowing rates

12 Money creation by banks time=0 Depositing money to a bank: Depositing money to a bank: there are four households A, B,C,D each having 30m TL in their pockets there are four households A, B,C,D each having 30m TL in their pockets total number of banknotes = 4*30m=120m total number of banknotes = 4*30m=120m Total (financial) assets of the 4 households = 4*30m=120m Total (financial) assets of the 4 households = 4*30m=120m money in circulation =4*30=120 money in circulation =4*30=120

13 Time=1 Each of them decides to deposit 25m to a bank Each of them decides to deposit 25m to a bank then total amount of deposits =4*25=100m then total amount of deposits =4*25=100m Banks assets increases by 100 at the same time liabilities increases by 100 Banks assets increases by 100 at the same time liabilities increases by 100 as the 100m deposited to the bank is claimed by the depositors households so bank is liable for this money to depositors as the 100m deposited to the bank is claimed by the depositors households so bank is liable for this money to depositors money in circulation = 20 money in circulation = 20 money deposited = 100 money deposited = 100 total tokens or notes =120 total tokens or notes =120

14 Depositors can withdraw all or some portion of the money any time they like Depositors can withdraw all or some portion of the money any time they like after depositing total money stock does not change after depositing total money stock does not change 4*5 + 4*25 = 120 4*5 + 4*25 = 120 cash deposits cash deposits in their pocket in their pocket total liabilities of the bank to households: total liabilities of the bank to households: 4*25 = 100 4*25 = 100 banks assets = 100 = liabilities banks assets = 100 = liabilities

15 The first bank loan time=2 A firm F may come and ask for a loan from the bank so as to pay it back in future with a reasonable interest A firm F may come and ask for a loan from the bank so as to pay it back in future with a reasonable interest So bank accepts this offer because at the time of the payment the bank will earn more due the the interest it earns So bank accepts this offer because at the time of the payment the bank will earn more due the the interest it earns Bank gives a loan of 40 to the firm F Bank gives a loan of 40 to the firm F taking the risk of all depositors requesting their money before the firm pays its debt back taking the risk of all depositors requesting their money before the firm pays its debt back

16 What are assets and liabilities of the bank after lending the money to F What are assets and liabilities of the bank after lending the money to F total assets: total assets: = = 100 money loans money loans in bank to firm F in bank to firm F total liabilities to households total liabilities to households 4*25 = 100 4*25 = 100 households households loans loans

17 Now firm F is also liable to the bank 40m TL and bank’s liability to households does not change Now firm F is also liable to the bank 40m TL and bank’s liability to households does not change money in circulation = = 60 money in circulation = = 60 money remaining in the bank as notes = 60 money remaining in the bank as notes = 60 total amount of notes (tokens) = 60+60=120 total amount of notes (tokens) = 60+60=120 does not change does not change notice that notice that total deposits + money in circulation= total deposits + money in circulation= = = 160 increases as a result of bank’s loan to firm F increases as a result of bank’s loan to firm F

18 Time=3 Firm F buy a track of value 40m TL from firm G in cash Firm F buy a track of value 40m TL from firm G in cash so the 40m TL transfers to firm G so the 40m TL transfers to firm G but firm G deposits 30m TL of that money to the bank again but firm G deposits 30m TL of that money to the bank again Total deposits in the bank: Total deposits in the bank: 4* = 130 4* = 130 liabilities liabilities liabilities liabilities to households to firm G to households to firm G

19 Total assets of the bank: Total assets of the bank: = = 130 cash from cash from loan to cash from cash from loan to households firm G to firm F households firm G to firm F assets of the bank = liabilities of the bank to four households and to firm G assets of the bank = liabilities of the bank to four households and to firm G Total amount of banknotes in the economy Total amount of banknotes in the economy 4* = 120 4* = 120 money in money in money in money in circulation the bank circulation the bank

20 Deposits + money in circulation= Deposits + money in circulation= = = 160

21 _________ Bank ____public_____ _________ Bank ____public_____ liabilities assets money in pockets liabilities assets money in pockets time deposits cash loans A.B,C,D F G time deposits cash loans A.B,C,D F G

22 Reserves and reserve ratio Commercial banks need to hold only a proportion of assets as cash reserves Commercial banks need to hold only a proportion of assets as cash reserves reserves = deposits - loans reserves = deposits - loans reserve ratio= reserve ratio= reserves in the bank/total deposits reserves in the bank/total deposits this enables them to create credit by lending this enables them to create credit by lending the lower the reserve ratio the more the bank is landing the lower the reserve ratio the more the bank is landing interest revenues will be higher interest revenues will be higher a greater risk of being unable to meet the creditor’s claims of their deposits a greater risk of being unable to meet the creditor’s claims of their deposits

23 Bank Bank liabilities assets liabilities assets time deposits reserves loans reserve ratio time deposits reserves loans reserve ratio /100= /100= /100= /100= /130= /130=0.69

24 Financial panics Financial panics is Financial panics is people believe that the bank will be unable to pay. people believe that the bank will be unable to pay. In the stampede to get their money out, they ensure that the bank can not pay. In the stampede to get their money out, they ensure that the bank can not pay. It will go bankrupt It will go bankrupt

25 Money supply Money Supply Money Supply the money supply is the value of the total stock of money the money supply is the value of the total stock of money money supply = money in circulation + deposits at the bank money supply = money in circulation + deposits at the bank for the bank for the bank assets = liabilities assets = liabilities assets = money in the bank + value of loans assets = money in the bank + value of loans money supply = money in circulation money supply = money in circulation + money at the bank(reserves) + money at the bank(reserves) + bank’s loans + bank’s loans

26 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

27 Total banknotes=money in circulation Total banknotes=money in circulation +money in the bank(reserves) +money in the bank(reserves) note that total value of token money = value of banknotes < money supply note that total value of token money = value of banknotes < money supply money supply = money supply = value of banknotes + bank loans value of banknotes + bank loans

28 Bank public Bank public liabilities assets money money liabilities assets money money time deposits cash loans in circulation supply time deposits cash loans in circulation supply

29 A beginner’s guide to the financial markets Financial asset Financial asset a piece of paper entitling the owner to a specified stream of interest payments over a specified period a piece of paper entitling the owner to a specified stream of interest payments over a specified period Cash Cash Notes and coin, paying no interest Notes and coin, paying no interest the most liquid of all assets. the most liquid of all assets. Bills Bills financial assets with less than one year until the known date at which they will be repurchased by the original owner financial assets with less than one year until the known date at which they will be repurchased by the original owner highly liquid highly liquid

30 A beginner’s guide to the financial markets (continued) Bonds Bonds longer term financial assets – less liquid because there is more uncertainty about the future income stream longer term financial assets – less liquid because there is more uncertainty about the future income stream Industrial shares (equities) Industrial shares (equities) entitlements to receive corporate dividends entitlements to receive corporate dividends not very liquid not very liquid

31 Assets of banks: Assets of banks: in foreign currency in foreign currency cash cash securities securities loans loans in TL in TL cash cash securities securities loans loans

32 Cash reserves Cash reserves banks has to hold part of deposits as cash by low and to satisfy depositors demands banks has to hold part of deposits as cash by low and to satisfy depositors demands Loans Loans principal asset of banks and the essential part of their business principal asset of banks and the essential part of their business

33 Liquidity Liquidity refers to the speed and certainty with which an asset can be converted back in to money refers to the speed and certainty with which an asset can be converted back in to money money is the most liquid asset of all money is the most liquid asset of all the other main asset of banks is securities the other main asset of banks is securities loan for which a second hand market exists loan for which a second hand market exists trade is carried out all the time trade is carried out all the time

34 Liabilities of banks Liabilities of banks sight and time deposits sight and time deposits sight deposits: the depositor can withdraw money without any notice sight deposits: the depositor can withdraw money without any notice chequing accounts are sight deposits chequing accounts are sight deposits time deposits pay higher interest rates, money is tied for a designated period of time time deposits pay higher interest rates, money is tied for a designated period of time if the money were withdrawn before the maturity date the high interest rate is lost if the money were withdrawn before the maturity date the high interest rate is lost

35 The monetary base and the money multiplier The monetary base or stock of high- powered money The monetary base or stock of high- powered money the quantity of notes and coin in private circulation plus the quantity held by the banking system the quantity of notes and coin in private circulation plus the quantity held by the banking system H: high powered money H: high powered money R: quantity held by the banking system R: quantity held by the banking system C: quantity of notes and coins in circulation C: quantity of notes and coins in circulation

36 Credit creation by banks EXAMPLE: EXAMPLE: initial positions: initial positions: money supply M= 1100 money supply M= 1100 deposits= deposits= suppose the private sector deposits all of the extra cash it gets suppose the private sector deposits all of the extra cash it gets and the commercial bank maintains a 10% cash reserve ratio and the commercial bank maintains a 10% cash reserve ratio Suppose central bank issues 100m TL of new banknote and distributes it to public Suppose central bank issues 100m TL of new banknote and distributes it to public What is the total increase in money supply as a result of the injection of the new 10m TL in to the economy? What is the total increase in money supply as a result of the injection of the new 10m TL in to the economy?

37 Step 1 Step 1a: Public deposits %100 of the money which is 100m TL to the bank(s) Step 1a: Public deposits %100 of the money which is 100m TL to the bank(s) notes in circulation does not change notes in circulation does not change Step 1b: Bank lent 90% of the new deposits as new loans Step 1b: Bank lent 90% of the new deposits as new loans loans increase by 0.9*100=90 loans increase by 0.9*100=90 Changes in quantities are Changes in quantities are Banks Public Banks Public Assets Liabilities Assets Liabilities reserves loans  D  C  M reserves loans  D  C  M a a b b

38 Step 2 Step 2a: Public depositsall of the new loans to the bank(s) Step 2a: Public depositsall of the new loans to the bank(s) deposits increases by 90 deposits increases by 90 Step 1b: Bank lent 90% of the new deposits (81) as new loans Step 1b: Bank lent 90% of the new deposits (81) as new loans loans increase by 0.9*90=81 loans increase by 0.9*90=81 Changes in quantities are Changes in quantities are Banks Public Banks Public Assets Liabilities changes in Assets Liabilities changes in reserves loans  D  C  M reserves loans  D  C  M a a b b

39 Step 3 Step 3a: Public deposits all of the new loans to the bank(s) Step 3a: Public deposits all of the new loans to the bank(s) deposits increases by 81 deposits increases by 81 Step 1b: Bank lent 90% of the new deposits (81) as new loans Step 1b: Bank lent 90% of the new deposits (81) as new loans loans increase by 0.9*81=72.9 loans increase by 0.9*81=72.9 Changes in quantities are Changes in quantities are Banks Public Banks Public Assets Liabilities changes in Assets Liabilities changes in reserves loans  D  C  M reserves loans  D  C  M a a b b

40 Notice that each step starts with tthe public sector’s depositing all of its money in to banks Notice that each step starts with tthe public sector’s depositing all of its money in to banks then assets of the banks increases at the same time liabilities are increases by the same amount then assets of the banks increases at the same time liabilities are increases by the same amount in the second round of each step banks lend %90 of their new assets as loans to private sector which inject money in to public again in the second round of each step banks lend %90 of their new assets as loans to private sector which inject money in to public again

41 Summary of the steps Changes in quantities are Changes in quantities are  D  C  M  H  D  C  M  H notice that when H increased by 100 notice that when H increased by 100 M the money supply increases much more than that M the money supply increases much more than that  M =  M = =100*( ) =100*( ) = = 1000 = =

42 Why people hold cash? Why people hold cash? Some purchases are made using notes or coins. Instead of using credit cards or writing cheques Some purchases are made using notes or coins. Instead of using credit cards or writing cheques buying bread buying bread buying coffee tea buying coffee tea Many people do not trust bank Many people do not trust bank they kept their savings under the bed they kept their savings under the bed note that in our economy there is no inflation yet people lose interest by keeping money under their pillow the purchasing power of money dose not declines note that in our economy there is no inflation yet people lose interest by keeping money under their pillow the purchasing power of money dose not declines

43 The monetary base and the money multiplier The money multiplier The money multiplier the change in the money stock for a 1 TL change in the quantity of the monetary base the change in the money stock for a 1 TL change in the quantity of the monetary base money stock = money multiplier* money stock = money multiplier* monetary base monetary base M = m*H M = m*H or when m is a constant or when m is a constant M 2 =m*H 2,M 1 =m*H 1  M 2 -M 1 =m*(H 2 -H 1 ) M 2 =m*H 2,M 1 =m*H 1  M 2 -M 1 =m*(H 2 -H 1 )  M = m*  H  M = m*  H

44 Where Where M: money stock or money supply M: money stock or money supply m: money multiplier m: money multiplier then we have the following basic relations then we have the following basic relations M = D + C M = D + C H = R + C H = R + C

45 The value of the money multiplier depends on two key rations, The value of the money multiplier depends on two key rations, the banks’ desired ratio of cash reserves to total deposits the banks’ desired ratio of cash reserves to total deposits c b = R/D c b = R/D the private sector’s desired ratio of cash in circulation to total bank deposits the private sector’s desired ratio of cash in circulation to total bank deposits c p =C/D c p =C/D

46 The lower the desired cash reserves ratio, The lower the desired cash reserves ratio, the larger the quantity of deposits the banks will create against given cash reserves the larger the quantity of deposits the banks will create against given cash reserves and the larger will be the money supply and the larger will be the money supply

47 The lower the private sectors desired ratio of cash in circulation to private sector bank accounts The lower the private sectors desired ratio of cash in circulation to private sector bank accounts the larger will be the money supply for any given quantity of high-powered money issued by the central bank the larger will be the money supply for any given quantity of high-powered money issued by the central bank

48 The money multiplier Suppose the banks wish to hold cash reserves R as as fraction (c b ) of deposits (D), and the private sector wish to hold cash (C) as a fraction (c p ) of bank deposits (D). Then R = c b D and C = c p D Monetary base H = C + R = (c b + c p ) D Money supply = C + D = (c p + 1) D So M = (c p + 1) (c p + c b ) H Money supply = money multiplier × monetary base

49 Example cb = 0.1, cp=0.2 cb = 0.1, cp=0.2 What is money multiplier? What is money multiplier? m = (1+cp)/(cb+cp) m = (1+cp)/(cb+cp) m = (1+0.2)/( )=4 m = (1+0.2)/( )=4 increasing H by 1 billion TL increases money supply by 4 billion increasing H by 1 billion TL increases money supply by 4 billion if C = 1000 What is H,D, R,M? if C = 1000 What is H,D, R,M?

50 What happens C b or C p increases What happens C b or C p increases C b  or C p   m   C b  or C p   m   M  hence money supply decreases M  hence money supply decreases What determines C b What determines C b interest rates r   C b  interest rates r   C b  What dose C p depends on? What dose C p depends on? Institutional factors Institutional factors firms pay wages by cheque of cash firms pay wages by cheque of cash credit card reduce the amount of cash used credit card reduce the amount of cash used

51 Measures of money Money supply = cash in circulation + bank deposits Money supply = cash in circulation + bank deposits which bank deposits which bank deposits spectrum of liquidity spectrum of liquidity cash cash sight deposits chequing accounts sight deposits chequing accounts time deposits time deposits

52 Money stock definitions used by the Central Bank of Turkey M1= currency in circulation + sight deposits (excluding official) M1= currency in circulation + sight deposits (excluding official) M2 = M1 + time deposits (excluding officials) M2 = M1 + time deposits (excluding officials) M2Y = M2 + foreign exchange deposits M2Y = M2 + foreign exchange deposits M3 = M2 + public sight and time deposits with deposit money banks M3 = M2 + public sight and time deposits with deposit money banks + other deposits with C.B. + other deposits with C.B. M3Y = M3 + foreign exchange deposites M3Y = M3 + foreign exchange deposites

53 During the new economic program Central Bank of Republic of Turkey increases high powered money by 100 billion. If the estimated cash to deposit ratio is 0.2 and reserve to deposit ratio is 0.1 During the new economic program Central Bank of Republic of Turkey increases high powered money by 100 billion. If the estimated cash to deposit ratio is 0.2 and reserve to deposit ratio is 0.1

54 a. What is the change in money supply? a. What is the change in money supply? b.What is the change in deposits? b.What is the change in deposits? c.What is the change in bank reserves? c.What is the change in bank reserves? d.What is the change in money in circulation? d.What is the change in money in circulation?

55  H=100  H=100 H= (cb+cp)D or  H = (cb+cp)  D H= (cb+cp)D or  H = (cb+cp)  D  D= 100/( )=333  D= 100/( )=333  C=cp  D= 0.2*333  C=cp  D= 0.2*333  R=cb  D= 0.1*333  R=cb  D= 0.1*333  M=m  H= ((1+0.2)/0.3)*100  M=m  H= ((1+0.2)/0.3)*100

56 In the new economic program governmet is planning to increase money supply by both open market operations: increasing high powered money by 200 (  H=200) and decreasing reserve to deposit ratio c b. from 0.2 to 0.1. Initially H=1000,estimated value of cash to deposit ratio is c p =0.2. In the new economic program governmet is planning to increase money supply by both open market operations: increasing high powered money by 200 (  H=200) and decreasing reserve to deposit ratio c b. from 0.2 to 0.1. Initially H=1000,estimated value of cash to deposit ratio is c p =0.2.

57 a.What is the targeted or planned increase in money supply? (3 pnt) a.What is the targeted or planned increase in money supply? (3 pnt) b.At the end of 2001 the value of money supply is found to be What is the difference between targeted and realized values of money supply What might be the reason for this difference between the targeted and realized money supply? (3 pnt) b.At the end of 2001 the value of money supply is found to be What is the difference between targeted and realized values of money supply What might be the reason for this difference between the targeted and realized money supply? (3 pnt)

58 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.