Money and banking

Why study money, banking and financial

markets?
A well functioning monetary system:
1)Smoothes the circular flow of income &
expenditure
2)Helps achieve both full employment &
efficient use of resources
 Learning objectives
• The origins of money
• functions of money and the components of
money supply
• What “backs” the money supply, making us
willing to accept it as payment
• The functions and responsibilities of the
central bank
• Commercial banks and their functions
 Origins of money
• Metallic money – All sorts of commodities have been used as
money in the past, but gold & silver stand out
– Advantages
– disadvantages
• Paper money – public deposited their gold with goldsmiths for
safekeeping in their secure safes. The latter would give them
deposit receipts promising to hand over their gold on demand.
When the depositor wanted to make a larger purchase she could go
to the goldsmith, reclaim some of her gold & hand it over to the
seller of the goods. When the seller of the goods did not have
immediate use for the gold he would take it back to the goldsmith
for safekeeping. But if they trusted that the goldsmith would give
the gold on demand, they would just swap the receipts – paper
money. Paper money represented a promise to pay so much gold
on demand. The promise was made first by the goldsmith & later by
banks. Paper money was backed by precious metal & was
convertible on demand into this metal
 Origins of money
• Fractionally backed paper money– Goldsmiths & banks discovered that it
was not necessary to keep a full ounce of gold in the vaults for every claim
to an ounce circulating as paper money
– Coz at any one time some bank’s customers would be withdrawing gold,
others would be depositing it, & most would be trading in the bank’s paper
notes without indicating any desire to turn then into gold.
– Advantage: Banks were able to issue more money redeemable in gold than
the amount of gold it held in its vaults. The money could be invested in
interest earning loans to individuals & firms.
– Currency issued in such a situation is said to be fractionally backed by
reserves
– Disadvantage – bank runs
• Fiat money – Over time central banks assumed a monopoly in the
provision of money to the economy.
• Originally they issued currency that was fully convertible into gold. Later the
gold standard was abandoned.
• Money that is not convertible into anything else derives its value from its
convertibility in exchange
• Fiat money is widely acceptable because government order, or fiat, declares it
to be legal tender. Legal tender is anything that by law must be accepted
when offered either for purchase or goods & services or to discharge a debt.
 Nature & functions of money
• What is money?
• Answer: Anything that performs the functions of
money is money.
• What are the functions of money?
• Medium of exchange: Money can be used for
buying and selling goods and services.
• Unit of account: Prices are quoted in dollars and
cents.
• Store of value: Money allows us to transfer
purchasing power from present to future. It is the
most liquid (spendable) of all assets, a
convenient way to store wealth
 Medium of exchange
• Without money goods would have to be
exchange by barter.
– The use of money as a medium of exchange alleviates
the problem of double coincidence of wants, which is
required for every transaction in the barter system.
– People can sell their output for money & later use the
money to buy what they wish from others.
– It cuts down transactions costs, it permits
specialization & division of labor, thus leading to
economic efficiency
• For money to serve as a medium of exchange, it
must
– Be readily acceptable & therefore of known value;
have a high value relative to its weight; it must be
divisible & it must be difficult to counterfeit
 A store of value
• Money is a convenient way to store purchasing
power; goods can be sold today, & the money
taken in exchange for them may be stored until it
is needed.
• Money is the preferred store of value for short
periods because it is the most liquid of all assets.
• For money to be a satisfactory store of value, it
must have a relatively stable value. So the
usefulness of money as a store of wealth is
undermined when the price level is highly
variable
 Unit of account
• Money may be used purely for accounting
perposes – as a yardstick for measuring the
relative worth of a wide variety of goods,
services & resources.
• The price of each item is stated only in terms
of the monetary unit, e.x., Pulas, dollars, rands
 The components of money supply
• Narrow definition of money: M1 includes currency
and checkable deposits
– Currency (coins + paper money) held by public
• Coin is “token” money, which means its intrinsic value is less
than actual value. The metal in P1 is worth less than P1.
• All paper currency consists of Bank notes issued by the central
bank
– Checkable deposits are included in M1, since they can
be spent almost as readily as currency & can easily be
changed into currency
 Institutions that offer checkable deposits
• Commercial banks are a main source of checkable
deposits for households and businesses.
– They accept deposits of households & businesses, keep the
money safe until it is demanded by checks, & in the meantime
use to make loans
• Thrift institutions (savings & loans, credit unions,
mutual savings banks) also have checkable
deposits.
– Savings & loans associations & mutual savings banks accept
deposits of households & businesses & then use the funds to
finance house mortgages
– Credit unions accept deposits from and lend to “members” who
are usually a group of people working for same company
 Qualification!
• Currency and checkable deposits held by the
government, the central bank, commercial
banks, or other financial institutions are not
included in M1
– A P1 in the hands of Kago constitues just P1 in the
money supply.
– If we counted the Pulas held by the banks, the
same P1 would be counted for P2 when it was
deposited in a bank. It would count for a P1
checkable deposit owned by Kago & also as P1 of
currency resting in the bank’s till or vault.
Components of the Money Supply
• Broader Money Definition: M2 = M1 + some
near-monies
– Near monies are certain highly liquid financial
assets that do not function directly or fully as a
medium of exchange but can be readily converted
into currency or checkable deposits
– The 3 categories of near monies are
• Savings deposits and money market deposit accounts.
• Small time deposits (certificates of deposit)
• Money market mutual fund balances, which can be
redeemed by phone calls, checks, or through the
Internet.
Savings deposits and money market deposit
accounts
• A depositor can withdraw funds from a
savings account by simply requesting that the
funds be transferred from a savings account
to a checkable account
• A person can withdraw funds from a money
market deposit account (MMDA). However,
MMDAs have a minimum balance & a limit on
how often a person can withdraw funds.
Examples?
 Small time deposits
• Funds from time deposits become available at
their maturity.
• A person can cash on these deposits but will
pay a heavy penalty for this.
• Financial institutions pay a higher interest rate
on these deposits than on MMDAs
• Examples?
Components of the Money Supply
• Broadest Money Definition: M3 = M2 + large
time deposits, usually owned by businesses as
certificates of deposits
• Which definitions are used? M1 is simplest
and often cited, but M2 and M3 are often
used by economists.
• Are Credit Cards Money?
– Credit cards are not money, but their use involves
short‑term loans
What “backs” the money supply?
• The money supply is backed by the
government’s ability to keep its value stable.
• Money is debt; paper money is a debt of
central banks and checkable deposits are
liabilities of banks and thrifts because
depositors own them. They do not have any
intrinsic value.
 Value of money
• Value of money arises not from its intrinsic
value, but its value in exchange for goods and
services.
– It is acceptable as a medium of exchange. We are
confident it will be exchageable for real goods &
services when we spend it.
– Currency is legal tender or fiat money. In general, it
is a legal means of repayment of debt.
– The relative scarcity of money compared to goods
and services will allow money to retain its purchasing
power. It derives its value from its scarcity relative to
its utility.
 Money & Prices
• Money’s purchasing power determines its value.
• Purchasing power of money is the amount of goods &
services a unit of money will buy
• Higher prices mean less purchasing power
• Value of money (V) = 1/P, where p is price index
• Excessive inflation may make money worthless and
unacceptable. An extreme e.g. of this is the
hyperinflation in Zim.
• Worthless money leads to use of other currencies
that are more stable.
• Worthless money may lead to barter exchange
system
 Maintaining the value of money
• The government tries to keep supply stable
with appropriate fiscal policy.
• Monetary policy tries to keep money
relatively scarce to maintain its purchasing
power, while expanding enough to allow the
economy to grow
• In general, the conduct of monetary policy is
done by the central bank
 Functions of the central bank
• Issues the currency used in the monetary system.
• Sets reserve requirements and holds the reserves of
banks and thrifts not held as vault cash.
• May lend money to banks and thrifts, charging them an
interest rate called the discount rate (bankers’ bank).
• Provides a check collection service for banks (checks are
also cleared locally or by private clearing firms).
• Acts as the fiscal agent for the government.
• supervises member banks.
• Conducts monetary policy and control of the money
supply is the “major function” of the central bank
 The Financial system

An overview
the financial system is the system that
allows the transfer of money between
savers and borrowers
 The financial system
• There are areas or people with surplus funds and there
are those with a deficit. A financial system or financial
sector functions as an intermediary and facilitates the
flow of funds from the areas of surplus to the areas of
deficit.
• A Financial System is a composition of various private
sector institutions, including banks, insurance
companies, mutual funds, finance companies &
investment banks, all heavily regulated by the
government.
• Financial System: Show flow chart (mishkin pp 24)
 Financial markets
• A Financial Market is the market in which
financial assets are created or transferred.
• Financial Assets/Financial Instruments represents
a claim to the payment of a sum of money
sometime in the future and /or periodic payment
in the form of interest or dividend.
• Borrowers borrow funds directly from lenders by
selling them securities/financial instruments
• They allow funds to move from people who lack
productive investment opportunities to people
who have such opportunities
 Structure of financial markets
• Debt and equity markets
– (debt) A firm issues a debt instrument, such as a bond, which is a
contractual agreement by the borrower to pay the holder of the
instrument fixed amounts (interest & principal payments) at
regular intervals until a specific (maturity) date, when the final
payment is made
– (equity) A firm may issue equity, such as common stock, which
are claims to share in net income (after expenses & taxes) & the
assets of a business
• Primary and secondary markets
– A primary market is one in which new issues of a security, such as
a bond or a stock, are sold to initial buyers by the corporation or
government agency borrowing the funds
– A secondary market is one in which securities that have been
previously issued are resold (NASDAQ, BSE, JSE).
• Money and capital markets
– money markets deal in short term securities (maturity less than
one year), such as Treasury bills, BoBCs
– Maturity of greater than one year (stocks, mortgages, bonds)
 Financial intermediaries
• A financial intermediary stands between the
lender-savers & the borrower-spenders &
helps transfer funds from one to the other
• It borrows funds from the lender-saver & then
use these funds to make loans to borrowers.
• This process is called financial intermediation
• Financial intermediaries are the most
important source of funds for businesses,
especially in developing countries.
 Types of financial intermediaries
• Depository institutions
– Accept deposits from surplus agents & make loans
– Include banks & thrift institutions, e.g.,
• Contractual savings institutions
– Acquire funds at periodic intervals on contractual
basis.
– Include insurance companies, pension funds, etc
• Investment intermediaries
 Functions of commercial banks
• Functions of commercial banks can be divided
into two categories: Primary & secondary
• The primary functions
– Accepting deposits
– Granting loans & advances
• Secondary functions
– Issuing letters of credit, travelers cheques etc
– Providing customers with foreign exchange facilities
– Standing guarantee on behalf of customers, when making
purchase of goods, machinery, etc
– Collecting & supplying business information
– provide reports of customer credit worthiness
 Primary functions of Banks
• Accepting deposits – the most important activity of a
commercial bank is to mobilise deposits from the
public. Surplus units deposits funds with the banks
which earn them interest
• Granting of loans & advances – the second most
important function is to grant loans & advances.
These are given to members of the public &
businesses at higher interest rates than the rates on
deposits accounts.
– Loans are for longer fixed periods; advances are for day to
day operations of businesses (shorter)
• The difference between the lending & deposit rate is
the main source of income for banks
Other financial institutions in Botswana
• Contractual savings institutions & insurance
providers
– Botswana Life; metropolitan & Regent
• Statutory banks & building societies
– Botswana savings bank; national development
bank; Botswana Building Society
• Merchant bank
• Micro-lenders
• Money and capital markets
Fractional reserve system & money creation
• People use checkable deposits, rather than
currency for most transactions.
– Most transaction accounts are “created” as a
result of loans from banks or thrifts.
– We demonstrate the money‑creating abilities of
the banking system
• Banks in most countries are only required to
keep a percentage (fraction) of checkable
deposits in cash with the central bank
 Fractional reserve system & money creation
• From history goldsmiths had safes for gold, which they kept
for consumers and merchants. They issued receipts for
these deposits
• Receipts came to be used as money in place of gold
because of their convenience, and goldsmiths became
aware that much of the stored gold was never redeemed
• Goldsmiths realized they could “loan” gold by issuing
receipts to borrowers, who agreed to pay back gold plus
interest
• Such loans began “fractional reserve banking,” because the
actual gold in the vaults became only a fraction of the
receipts held by borrowers and owners of gold
Significance of fractional reserve banking
• Banks can create money by lending more than
the original reserves on hand
• Lending policies must be prudent to prevent
bank “panics” or “runs” by depositors worried
about their funds
 The creation of money & credit
• Some definitions
• A balance sheet states the assets and claims
of a bank at some point in time.
• All balance sheets must balance, that is, the
value of assets must equal value of claims.
• The bank owners’ claim is called net worth.
• Nonowners’ claims are called liabilities.
• Basic equation: Assets = liabilities + net worth
• Therefore net worth =Assets - liabilities
 Goals of commercial banks
• Make profit – make loans for this purpose
• Safety – safety lies in liquidity, specifically
such liquid assets as cash and access reserves
• Bankers seek to strike a balance between
prudence and profit
• Banks can lend their excess reserves at the
central bank to other banks on an overnight
basis. Interest paid on this overnight loans is
called the Federal funds rate (US) or bank
rate (Botswana)
 The creation of money & credit
• Banks musts keep reserve deposits in the central bank
• Banks can keep reserves at the central bank or in cash in
vaults (“vault cash”).
• Banks keep cash on hand to meet depositors’ needs.
• Actual reserves (AR) are those assets acceptable for
meeting reserve requirements behind the public’s
deposits
• AR may be divided into required reserves (RR) & excess
reserves (ER); AR = RR + ER
• RR are equal to the Legal Reserve requirement ratio (R)
times the volume of deposits (D) s.b.t reserve
requirements (RR=D x R; R=RR/D)
• ER = AR – RR
 The creation of money & credit
• Suppose bank A receives a deposit (D) of P1000 (1)
• This will change its assets(LHS) & liabilities (RHS) as
shown on the table (next slide)
• If the reserve requirement ration (R) is 20%, bank A
would be required to put aside P200 as RR, leaving
excess reserves (ER) of P800
• Since the P800 in ER earns no interest, the banker
will immediately loan out this ER
• The banker creates a checking a/c in the borrower’s
name (2)
• Assume the P800 loaned by bank A winds up as
deposit in bank B (3)
 The creation of money & credit
• Bank B must place P160 (20%) of this deposit in RR &
then has ER of P640, which are then loaned out
• As this borrower spends the funds, the P640 loan
ends as deposits in bank C
• Bank C places P128 (20% of 640) in RR & has ER of
P512, which it loans out
• If the credit-creation process works through the entire
banking system & there are no leakages, then with a
20% R, the banking system ultimately will hold P5000
in deposits & will have created loans of P4000.
• Total deposit (TD) = initial legal reserves deposit (AR)
(P1000) times the reciprocal of the R ratio 1/0.20
• Or ∆TD=1/R x ∆D
 Creation of money & credit
1. Bank A receives new deposit 4. Loan made by Bank B
Assets Liabilities Assets Liabilities
RR 200 Deposits 1000 RR 160 Deposits 800
ER 800 Loans 640

2. Loan made by Bank A 5. Deposit of loan funds in Bank C

Assets Liabilities Assets Liabilities
RR 200 Deposits 1000 RR 128 Deposits 640
loans 800 ER 512

3. Deposit of loan funds in Bank B 6. Loan made by Bank C

Assets Liabilities Assets Liabilities
RR 160 Deposits 800 RR 128 Deposits 640
ER 640 Loans 512
 Transactions within the banking system
Name Deposits Required Excess Loans made New money
of Bank received reserves reserves created
A P1000 P200 P800 P800 P800
B 800 160 640 640 640
C 640 128 512 512 512
D 512 102 410 410 410
- - - - - -
- - - - - -
All P5000 P1000 P4000 P4000 P4000
banks
 The Monetary multiplier
• The banking system magnifies any original excess
reserves into a larger amount of newly created
checkable-deposit money
• Monetary multiplier or checkable-deposit multiplier
exists because the reserves & deposits lost by one bank
become reserves of another bank
• The monetary multiplier m is the reciprocal of the
required reserve ratio (R)[the leakage into RR that occurs
at each step in the lending process]
• m = 1/R
• In our example m=1/0.20 = 5
• total checkable deposit (TD) = AR x m
• Total checkable deposit (or loans) created (ND) = ER x m
•
 Summary
• In the fractional reserve system, commercial banks
are required to keep reserve deposits at the central
bank
• RR are the amount of funds equal to a specified
percentage of bank’s own deposit liabilities
• AR = RR - ER
• The specified percentage of the checkable deposit
liabilities that a commercial bank must keep as
reserves is called the reserve requirement ratio (R)
 Summary
• R = RR/commercial bank’s total deposit (TD)
• Lets play with this equation
• RR = R x D; D = RR/R
• ER are the reserves that commercial banks may keep over &
above the minimum required by law
• ER = AR – RR
• Let R = 10% & D = 1000, calculate RR, TD. If RR=ER, calculate
AR, Change in money.
• Let R = 5% & redo the questions above.
• Let R = 50% & redo the questions above.
• ER do not earn interest, so banks loan them out
• The ability of banks to create loans depends on the existence
of ER
 Summary
• The purpose of RR is to help the central bank control
the lending ability of commercial banks
• The central bank can increase or decrease commercial
banks RR to control credit extension & money supply
• Commercial banks create money by extending credit
• Loans are created from ER
• A small deposit with one bank can lead to creation of
large amount of deposits, loans & money supply
• This is made possible by the multiplier effect
• m=1/R (Play with these equations)
• Total checkable deposit (TD) = AR x m
• Maximum checkable deposit created (ND) = ER x m
• Maximum new money created (NM) = ER x m
 Implications for monetary policy
• When monetary authorities want to reduce
the money multiplier they should raise the
reserve requirement ratio (R) & vice versa
• Higher reserve ratios mean lower money
multipliers and therefore less creation of new
checkable deposit via loans