© The McGraw-Hill Companies, 2008 Chapter 22 Money and banking David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

© The McGraw-Hill Companies, 2008 Some key questions Why does society need money? Why do governments wish to influence money supply? How do financial markets interact with the ‘real’ economy? What is the relationship between money and interest rates?

© The McGraw-Hill Companies, 2008 Money Any generally accepted means of payment for delivery of goods or the settlement of debt Commodity money: cigarettes, gold Legal money (fiat money) –notes and coins Customary money –IOU money based on private debt of the individual e.g. bank deposit.

© The McGraw-Hill Companies, 2008 Money and its functions Medium of exchange –money provides a medium for the exchange of goods and services which is more efficient than barter Unit of account –a unit in which prices are quoted and accounts are kept Store of value –money can be used to make purchases in the future Standard of deferred payment –a unit of account over time: this enables borrowing and lending

© The McGraw-Hill Companies, 2008 Modern banking A financial intermediary –an institution that specialises in bringing lenders and borrowers together e.g. a commercial bank, which has a government licence to make loans and issue deposits including deposits against which cheques can be written Clearing system –a set of arrangements in which debts between banks are settled

© The McGraw-Hill Companies, 2008 A beginner’s guide to the financial markets Financial asset –a piece of paper entitling the owner to a specified stream of interest payments over a specified period Cash –notes and coins, paying no interest –the most liquid of all assets Bills –financial assets with less than one year until the known date at which they will be repurchased by the original owner –highly liquid Bonds –longer term financial assets – less liquid because there is more uncertainty about the future income stream

© The McGraw-Hill Companies, 2008 A beginner’s guide to the financial markets (continued) Industrial shares (equities) –entitlements to receive corporate dividends –not very liquid

© The McGraw-Hill Companies, 2008 Credit creation by banks Commercial banks need to hold only a proportion of assets as cash reserves –this enables them to create credit by lending EXAMPLE –the commercial bank maintains a 10% cash reserve. Then the increase in money supply for a 100 TL increase in cash can be= =1000 because of the deposit creation.

© The McGraw-Hill Companies, 2008 The monetary base and the money multiplier 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 money multiplier –the change in the money stock for a £1 change in the quantity of the monetary base. =1/reserve ratio