1. © The McGraw-Hill Companies, 2005 Chapter 22 Money and banking David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

2. © The McGraw-Hill Companies, 2005 1 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?

3. © The McGraw-Hill Companies, 2005 2 Money Any generally accepted means of payment for delivery of goods or the settlement of debt Legal money –notes and coins Customary money –IOU money based on private debt of the individual e.g. bank deposit.

4. © The McGraw-Hill Companies, 2005 3 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

5. © The McGraw-Hill Companies, 2005 4 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

6. © The McGraw-Hill Companies, 2005 5

7. 6 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 coin, 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

8. © The McGraw-Hill Companies, 2005 7 A beginner’s guide to the financial markets (continued) Perpetuities –an extreme form of bond, never repurchased by the original issuer, who pays interest forever e.g. Consols Gilt-edged securities –government bonds in the UK Industrial shares (equities) –entitlements to receive corporate dividends –not very liquid

9. © The McGraw-Hill Companies, 2005 8 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 –suppose the public needs a fixed £10m for transactions –and the commercial bank maintains a 10% cash reserve

10. © The McGraw-Hill Companies, 2005 9

11. 10 Credit creation – example Commercial bank : LiabilitiesAssets Deposits Cash Loans Total Cash ratio % Public cash holding Money supply Initial position: 100 10 90 100 Central bank issues £10m extra; the public deposits it 10 110 110 20 90 110 1 18.210 120 110 11 99 11021019 129 119 20 99 119316.810 129 200 20 180 200 n 10 210

12. © The McGraw-Hill Companies, 2005 11 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

13. © The McGraw-Hill Companies, 2005 12 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

14. © The McGraw-Hill Companies, 2005 13 Figure 22.1: Money supply determination