Money and Banking

Outline What is money? The Money Market The Financial Sector Characteristics Definition The Money Market Money supply Money Demand The Financial Sector How do banks create money? A model of the money market

What is Money? Characteristics Medium of exchange Unit of account Buying and selling goods and services Unit of account Assisting measurement of relative worth of various goods, services and resources Store of value A form in which to store wealth, due to its liquidity and convenience Standard of deferred payment (e.g. wages)

The Money Market 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 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.

The Money Market 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 Sm Rate of Interest (%) QS Quantity of Money

The Singapore Money Supply (August 2008) The Money Market The Singapore Money Supply (August 2008) 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 Money Market The Monetary Base Composed of: Currency held by the public Currency held by the banks Banks’ 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: Transactions demand 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 Demand The 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 Transactions Demand, Dt Asset Demand, Da Total Demand for Money, Dm 10 7.5 5 2.5 10 7.5 5 2.5 10 7.5 5 2.5 Rate of interest, i (per cent) Rate of interest, i (per cent) Rate of interest, i (per cent) Dt Dm Da 0 50 100 150 200 250 300 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars)

The Money Market Money Demand Shifts in the Demand for Money Curve The demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs.

Effect of increase in real GDP Effect of decrease in real GDP The Money Market MD2 5 Effect of increase in real GDP MD1 4 Interest rate (percent per year) 3 Effect of decrease in real GDP MD0 500 600 700 Real money (billions of 2003/04 dollars)

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 The Money Market Equilibrium Interest Rate Sm 10 7.5 5 2.5 Dm Equilibrium Interest Rate ie Rate of interest, i (per cent) 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Financial Intermediaries The Financial Sector Figure 1 Flow of funds through financial system (transfer from savers to borrowers) Financial Intermediaries (e.g. commercial and saving banks, savings and loans associations, credit unions, insurance companies, pension funds, mutual funds) Savers/ Lenders *Households *Business firms *Government *Foreigners Borrowers/Spenders *Households *Business firms *Government *Foreigners Financial Markets markets in which funds are transferred from people with surplus funds to those with a shortage of available funds

Some Basic Definitions Bank: 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 25

Some basic definitions 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 Central Bank: regulates an economy’s financial sector and implements Monetary Policy. 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 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. 28

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 30

Assets = Liabilities + Owners’ Equity How do banks create money? 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

Formation of a Bank Transaction 1 The birth of a Bank New owners sell $250,000 worth of shares ASSETS LIABILITIES Cash 250,000 Capital

Formation of a Bank Transaction 2 Becoming a Going Concern Acquisition of property and equipment ASSETS LIABILITIES Reserves Property 10,000 240,000 Capital 250,000

Formation of a Bank Transaction 3 Accepting Deposits Citizens and businesses deposit $100,000 Change 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

Formation of a Bank Transaction 4 Setting aside Required Reserves Bank decides to keep all cash as reserves (actual reserves). ASSETS LIABILITIES Cash Reserves Property 110,000 240,000 Deposits Capital 100,000 250,000 350,000

Formation of a Bank ASSETS LIABILITIES Reserves Property 60,000 Transaction 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

Creating Money Transaction 6 Granting a loan ASSETS LIABILITIES A 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

Creating Money Transaction 7 Buying Government Bonds ASSETS 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

The Banking System Multiple banks: multiple-deposit expansion Money is created by a multiple of the banking system’s excess reserves Assume reserve ratio is 20% Bank must keep $20 000 (required reserves) Bank’s Required Reserves Bank’s Deposit Liabilities Reserve Ratio =

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 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 $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 Loan of $64 is drawn on Bank B and deposited in Bank C, and so on…

Multiple Deposit Expansion Process Acquired reserves and deposits Required reserves Excess reserves New money created Bank A B C D E F G H I J K L M N Other 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 Total amount of money created by the banking system $400.00 Change in money supply = first deposit of $100 + $400 = $500

Multiple-Deposit Expansion Total banking system has created $400 Total money supply grown by $500 How? Via the Monetary Multiplier 1 Reserve Ratio Money Multiplier = 1 R MM = where MM is the Monetary Multiplier

Multiple-Deposit Expansion 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 1 Reserve Ratio Monetary Multiplier = MM= 1 R MM = 1/0.2 =5 Initial change in reserves = $100  Money Supply = m *  Reserves  Money Supply = 5 * 100 = 500

Multiple-Deposit Expansion 1 Reserve Ratio Monetary Multiplier = 1 R 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.

References Jackson and McIver, chs 9 and 10.