ECO 104: I NTRODUCTION TO M ACROECONOMICS Lecture 7 Chapter 12: Money, Banking and the Financial System Chapter 13: The Federal Reserve System (selected topics) 1 Naveen Abedin

B ARTER S YSTEM Barter is the exchanging of goods and services for other goods and services without the use of money. Barter system comes with high transaction costs. Transactions costs are the time and effort it takes to complete an exchange. This is because you have to find the person with the good you are looking for. Double Coincidence: This means you need to be able to find someone who has what you want and who wants what you have. You need double coincidence of wants to minimize your transaction costs. 2 Naveen Abedin

M ONEY Money is any good that is widely accepted for purposes of exchange (payment for goods and services) and the repayment of debt. 1) Money as a Medium of Exchange : Searching for a seller or buyer is not necessary in a money market. This is because money acts as a medium – if you want to sell your apples and buy oranges, then you sell you apples for money and then use the money to buy oranges instead of going out to look for a buyer or seller. 2) Money as a unit of account : Money is a common measure in which values are expressed. The value of every good is expressed in terms of money, i.e. A book costs $10; A house costs $50,000 3) Money is a store of value : The store of value is the ability of a good to maintain its value over time. If you earn Tk. 5, and you do not wish to spend it now, you can store it in your pocket and the Tk. 5 value will remain. Inflation may upset this store of value. 3 Naveen Abedin

D EFINITIONS OF M ONEY M1: This is the narrow definition of money supply. It is also known as transactions money because M1 refers to money that can be directly used for everyday transactions. Currency: coins and paper money Checkable deposits: you can write a cheque to pay someone Traveler's cheques: held by foreigners when they travel, so that they can exchange the cheque for an equal amount of cash in the country they have traveled to 4 Naveen Abedin

D EFINITIONS OF M ONEY ( CONT.) M2: This is known as the broad definition of money supply. Savings deposit: An interest earning account at a commercial bank. Normally, a cheque cannot be written against this account. Also any withdrawal from this account is fined. Time deposit: An interest-earning deposit with a specified maturity date Money market Deposit Account (MMDA): An interest earning account that must always hold a minimum balance Money market mutual fund (MMMF): Interest earning account at a mutual fund company 5 Naveen Abedin

T HE C ENTRAL B ANK The Central Bank of each country is responsible for printing money. The Central Bank of Bangladesh is Bangladesh Bank. Every other bank in the economy (private, commercial or other government banks) must have a checking account with Bangladesh Bank. These accounts are known as Reserve Accounts or Bank Deposits with the Central Bank. Every bank also keeps currency or cash in their vaults. This money comes from the deposits of their clients. Therefore, a bank’s total money is Reserves = Bank deposits at Central Bank + Vault Cash 6 Naveen Abedin

T HE R EQUIRED R ESERVE R ATIO Central Banks of each country mandate that all banks must hold a fraction of their checkable deposits in reserve form. This means that a fraction of the checkable deposits must remain in the Reserve Account or in the vault. The fraction of the checkable deposits that banks must hold in reserve form is called the Required Reserve Ratio(r). The dollar amount of those deposits is called Required Reserves. 7 Naveen Abedin

T HE F INANCIAL S YSTEM The purpose of the financial system is to get together people who have surplus funds with people who have a shortage of funds, i.e. it is a means of getting lenders and borrowers together. In this way, people who have a surplus of funds can lend out their money, and people who have a shortage of funds can borrow money. There are two types of borrowing and lending methods:- 1) Direct Finance 2) Indirect Finance 8 Naveen Abedin

D IRECT F INANCE Direct Finance: Lenders and borrowers come together in a market setting, such as a bond market. In the bond market, people who want to borrow funds issue bonds. The people who want to lend funds purchases bonds. For instance, if Company X issues a bond at 10% interest rate, that means Company X is promising the buyer of the bond a reward of 10% interest on their purchase amount. Bond market transactions are known as Direct Finance 9 Naveen Abedin

I NDIRECT F INANCE Indirect Finance: When borrowers and lenders go through a financial intermediary to conduct the lending and borrowing process. For instance, a commercial bank is a financial intermediary, through whom savers save their money and earn a regular interest payment, and borrowers seek loans and pay a regular interest payment. 10 Naveen Abedin

C ENTRAL B ANK AND M ONETARY P OLICY Bangladesh Bank is the executor of Monetary Policy in Bangladesh. bank.org/monetaryactivity/mps/mps_current.pdf The governor of Bangladesh Bank is the one who leads Monetary Policy Monetary Policy consists of changes in money supply that are intended to achieve macroeconomic goals and stability. Expansionary Monetary Policy: increases money supply Contractionary Monetary Policy: decrease the money supply 11 Naveen Abedin

R ESPONSIBILITIES OF THE C ENTRAL B ANK Controlling the Money Supply using different mechanisms Supplying the economy with paper money Holding Depository Institution: Banks are required to keep reserves against customer deposits in Reserve Accounts at the Central Bank Serving as the Government’s Bank: All of the Government’s financial transactions – loans, deposits – are managed by the Central Bank 12 Naveen Abedin

H OW TO C HANGE THE M ONEY S UPPLY ? Recall that the Central Bank mandates all banks to hold a fraction of their checkable deposits as reserve. This is known as the Required Reserves. This depends on the Required Reserve Ratio, r. This is the minimum amount of money banks must hold as reserves. Required Reserves = r × Checkable Deposits Excess Reserves = Reserves – Required Reserves Banks use these Excess Reserves to give out loans. 13 Naveen Abedin

H OW TO C HANGE THE M ONEY S UPPLY ? ( CONT.) 1) Open Market Operations: The buying and selling of government securities. When Central Banks buy government securities from other banks, they pay the banks cash for the securities which increases money supply. This is known as Open Market Purchases. Suppose Bangladesh Bank purchased government security worth TK from Dutch Bangla Bank. This means Bangladesh Bank paid Dutch Bangla Bank TK Dutch Bangla Bank can now use this TK to give out loans to any prospective/potential client. If Bangladesh Bank wished to reduce money supply, they enter Open Market Sales. 14 Naveen Abedin

H OW TO C HANGE THE M ONEY S UPPLY ? ( CONT.) 2) The Required Reserve Ratio: Lowering the Required Reserve Ratio will mean more money is available for loaning out. Therefore, people can now acquire more loans. 3) Discount Rate: If Dutch Bangla Bank needs a loan, it can borrow from Bangladesh Bank or other banks as well. The rate of interest charged by the Central Bank (Bangladesh Bank) is known as the Discount Rate. The rate of interest charged by other banks is known as the Federal Funds Rate. If the Central Bank wants money supply to increase, then they reduce the Discount Rate below the Federal Funds Rate. This way, more banks will take a loan from the Central Bank and that will allow them to give out more loans and increase the money supply. By taking a loan from the Central Bank rather than a private bank ensures that some other bank’s reserves are not decreasing. 15 Naveen Abedin