1 Money, Banking & Interest Rate Lecture 7 BECON2101 Shan Faculty of Business Management & Globalization Tel: Ext

Money and Banking

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 3

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 4

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 $ 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. 6

QUALITIES OF MONEY 1.Acceptability 2.Durability 3.Divisibility - divided into parts 4.Stability 5.Relative scarcity 6.Portability - quality of being light enough to be carried 7

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. 8

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 Deposits 9

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 10

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 deposits ii.Savings and fixed deposits in commercial banks, mutual funds iii.Other certificates 11

MONEY SUPPLY M3 = M2 + savings and deposits in other financial institutions besides commercial banks. Quasi money = M2 – M1 Broad Near Money = M3 – M1 12

Money Defined M1M1M2M2 54% 46% M1M1 20% Savings Deposits Including Money Market Deposit Accounts (MMDA) Small Time Deposits Money Market Mutual Funds Held By Individuals (MMMF) Currency Checkable Deposits 15% 11% 54% $1,375 Billion $6,758 Billion February 2009 Totals

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 14

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 15

Financial Institutions Commercial Banks Thrifts Insurance Companies Mutual Fund Companies Pension Funds Securities Firms 16

How banks create money Simplified balance sheet for a commercial Bank. Liabilities are source of funds for the bank. Assets generate income for the bank. Why deposits considered as liabilities to the banks? 17 Assets $Liabilities $ 200 (Reserves)2000 (Deposits) 2000 Loans200 equity Total 2200

First Bank 18 AssetsLiabilities $100 Reserves$1000 Deposits $900 loans AssetsLiabilities $90 Reserves$900 Deposits $810 loans Second Bank How banks create money

Third Bank 19 AssetsLiabilities $81 Reserves$810 Deposits $729 loans AssetsLiabilities $72.9 Reserves$729 Deposits $656.1 loans Fourth Bank How banks create money

Someone walks to First bank and deposits $1000 in a checking account. Assume that banks are required to keep 10% of their deposits as reserves. Reserve ratio = 0.1. First bank keep $100 as reserves and makes a loan of $900. Suppose the person who took the loan from First bank deposits to his Checking account in Second bank. Second bank holds $90 as reserves and Lends $810. If the person who borrows the money from Second bank checking deposits 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 works The original $1000 cash deposit has created more deposit and loan accounts. Adding up the new accounts in all the banks …… $ $ $ ………. = $ How did we come up with the sum? It is from the simple formula. = (initial cash deposit) X 1 (reserve ratio) 1000 X 1 = $ 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 deposits increased by Therefore MS (M1) has increased by 9000 (10000 – 1000) The banking system, as a whole the MS expanded by a multiple of the initial cash deposit. 22

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. 23

How The Discount Rate Works? When the Central Bank increases the discount rate, the banks must pay a higher price for any reserves that they borrow from Central Bank. Faced with a higher cost of reserves, the banks are less willing to borrow reserves. The banks must decrease their lending to decrease their borrowed reserves. So when the discount rate increases, the quantity of money decreases. 24

How The Discount Rate Works? When the Central Bank decreases the discount rate, the banks pay a lower price for any reserves that they borrow from Central Bank. Faced with a lower cost of reserves, the banks are willing to borrow more reserves and increase their lending. The quantity of money increases. 25

How An Open Market Operation Works ? The Central Bank’s major policy tool. When the Central Bank buys securities in an open market operation, it pays for them with newly created bank reserves and money. The banks can use their new reserves to create even more money. When the Central Bank sells securities in an open market operation, people pay for them with money and reserves. 26

How An Open Market Operation Works ? The Central Bank’s major policy tool. When the Central Bank buys securities in an open market operation, it pays for them with newly created bank reserves and money. The banks can use their new reserves to create even more money. When the Central Bank sells securities in an open market operation, people pay for them with money and reserves. 27

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 Multiplier The 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 x Change 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 $1,587,061 1,519,399 1,494,037 1,369,546 1,325,227 1,300,648 1,291,795 1,274,219 1,227,951 1,198,942 1,134,826 1,119, Assets (Millions of U.S. Dollars)