MONEY , BANKING, & MONETARY POLICY

An Overview of Money

Money

is anything that is generally accepted as a medium of exchange. The sets of assets in an economy that people regularly use to buy goods and services from other people.

Money is not income, and money is not wealth. Money is: a means of payment / medium of exchange
a store of value

a unit of account

What is Money?

Barter is the direct exchange of goods and services for other goods and services.
A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem. As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

What is Money?

As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.

What is Money?

As a unit of account, money is a standard that provides a consistent way of quoting prices.

What is Money?

Money is easily portable, and easily exchanged for goods at all times. The liquidity property of money makes money a good medium of exchange as well as a store of value.

Characteristics of MONEY
Acceptability -- people must be willing to accept it as a means of payment and in settlement of a debt Durability -- must last a reasonable length of time before deteriorating Divisibility -- to function as money an asset must be capable of division into smaller units to accommodate transactions of differing value

Characteristics of MONEY

Portability / Convenience -- to function as money an asset must be portable and easy to use, it must be light, small to carry around and easy to transfer ownership Uniformity -- money of the same value must be of uniform quality Stability of Value -- in order to fulfil its various functions (especially as a store of wealth and as a means of evaluating future payment), it must retain its value Hard for Individuals to Produce Themselves -- it must be hard to forge

FORMS of MONEY
Commodity Money money that takes the form of a commodity with intrinsic value. Something that performs the function of money and also has alternative, nonmonetary uses, e.g., gold, silver, cigarettes. For hundreds of years gold could be used directly to buy things, but it also had other uses ranging from jewelry to dental fillings. Fiat Money/token money -- money without intrinsic value that is used as money because of government decree. Something that serves as money but has no other important uses, e.g., Coins, currency and checkable deposits (current account)

Definition of Money Supply (M1, M2 and M3)

Definition of Money Supply: the quantity of money available in the economy Definition of Monetary Policy: the setting of the money policymakers in the central bank

supply

by

Definition of Money Supply (M1, M2 and M3)

M1 the narrowest definition of money supply, consists of currency outside banks plus checking accounts plus travelers checks Currency held outside banks includes coins and paper money in the hands of public Checking accounts balances can be withdrawn by using check Travelers check issued in specific denominations, these are treated as cash M1 = currency held outside banks + checking accounts + travelers check

Definition of Money Supply (M1, M2 and M3)

M2 A broader definition of money supply, it includes all of the components of M1 plus time deposits and savings deposits Time deposits (fixed deposits) interest-earning deposits with a specified maturity, which are subject to penalty for early withdrawal * Savings deposits interest-earning deposits with no specific maturity * M2 = M1 + time deposits + saving deposits

Definition of Money Supply (M1, M2 and M3)

M3 = M2 + deposits with non-bank
financial institution (e.g., deposits of finance companies and post office saving)

CREDIT CARD ???

is not a form of money; when a person uses a credit card, he or she is simply deferring payment for the item serves as a temporary medium of exchange but not a store of value

BANKING
Structure of Banking System Central bank : * an institution designed to oversee the banking system and regulate the
quantity of money in the economy

Financial institution : * privately owned institutions that serve the general public
* intermediaries that stand between savers from whom they accept deposits ; and investors to whom they make loans

Functions of Bank Negara Malaysia

1.

2. 3. 4. 5.

Banker to commercial banks (bankers bank) Banker for the government Controller of money supply Lender of last resort Others

Credit Creation

To explore a process on how banks create money. To understand this process, you need to be familiar with some basic principles of accounting.

Assets are things a firm owns that are worth something. Most important among a banks assets are its loans. A firms liabilities are its debts-what it owes. A banks most important liabilities are its deposits. deposits in banks are considered as liability in banks balance sheet as deposits are held in banks, the behaviour of banks can influence the quantity of deposits in the economy, and therefore, the money supply

Credit Creation
Simple Case of 100-Percent-Reserve Banking

Definition of Reserves:
deposits that banks have received but have not loaned out.

Assumption: * currency is the only form of money * total quantity of currency is RM100, and therefore * the supply of money is RM100

Credit Creation
Simple Case of 100-Percent-Reserve Banking
the bank will keep the deposits until the depositor comes to withdraw or write a check against his balances therefore, all deposits are held as reserves 100-percent-reserve banking

FIRST NATIONAL BANK Assets Reserves RM Liabilities 100 Deposits RM 100

Money Creation Fractional-Reserve Banking

Definition of fractional reserve banking:

a banking system in which banks hold only a fraction of deposits as reserves the fraction of deposits that banks hold as reserves

Definition of Reserve Ratio:

bank reserves consist of cash in the bank plus its deposits at central bank (BNM) The required reserve ratio is the ratio of reserves to deposit that banks are required , by law , to hold
A banks required reserve = deposits x required reserve ratio Therefore, actual reserves - required reserves = excess reserves

Money Creation Fractional-Reserve Banking

If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1
ASSETS LIABILITIES

Panel 2
ASSETS LIABILITIES

Panel 3
ASSETS LIABILITIES

Reserves 0

0 Deposits

Reserves 100 100 Deposits

Reserves 100 500 Deposits

Loans 400

Money Creation Fractional-Reserve Banking

The Creation of Money When There Are Many Banks Panel 1
ASSETS
Reserves 100

Panel 2
ASSETS
Reserves 100 Loans 80 Reserves 80 Loans 64 Reserves 64 Summary: Bank 1 Bank 2 Bank 3 Bank 4 . . . Total

Panel 3
ASSETS
Reserves 20 Loans 80 Reserves 16 Loans 64

LIABILITIE S
100 Deposits

LIABILITIE S
180 Deposits

LIABILITI ES
100 Deposits

Reserves 80

80 Deposits

144 Deposits

80 Deposits

Reserves 64

64 Deposits

115.20 Deposits Deposits 100 80 64 51.20 . . . 500.00

Reserves 12.80 64 Deposits

The Money Multiplier

Summary: Bank 1 Bank 2 Bank 3 Bank 4 . . . Total Deposits 100 80 64 51.20 . . . 500.00

The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.
1 Money multiplier = Required reserve ratio

In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.

MONETARY POLICY
Definition of Monetary Policy: the setting of the money supply by policymakers in the central bank.
The mechanics of monetary policy include all the measures which influence the supply of money the price of money (the rate of interest)

MONETARY POLICY
2 types of monetary policy
* contractionary, restrictive or tight monetary policy * expansionary or cheap monetary policy

Aims of monetary policy

* to maintain stability of domestic prices * fluctuating prices will cause disturbances in economy * to achieve higher rates of economic growth * to eliminate fluctuations in productions and employment * if demand is too low, workers will be retrenched; unemployment will occur * To achieve full employment of resources

MONETARY POLICY Tools of Monetary Control

Quantitative tools - includes the required reserve ratio, the discount rate and open market operations where the central bank can estimate what amount of money supply will be affected.

1. Open-Market Operation (OMO)

Definition of Open Market Operations: the purchase and sale of government securities in financial market so as to influence the size of bank deposits. Government has authorized the BNM to buy and sell government securities.

MONETARY POLICY Tools of Monetary Control

2. Reserve Requirements
*

regulations on the minimum amount of reserves that * an increase in hold against means that banks must reserve requirementsdeposits

- banks must hold more reserves and - can loan out less of each RM that is deposited * as a result, it raises the reserve ratio, lowers the money multiplier, and decrease the money supply

* * *

* as a result, it raises the money multiplier and increases the money supply

* a decrease in reserve requirements means that lowers the reserve ratio banks hold less reserves have excess reserves to be lent out

 if r = 20% and original deposit RM1,000, then money supply = 1/r @ RM1,000 = RM5,000
money created = RM4,000 (money supply-original deposit)

MONETARY POLICY Tools of Monetary Control

iif r = 50% and original deposit RM1,000, then money supply = RM2,000; money created = RM1,000

There is an inverse relationship between the required reserve ratio and the money supply

MONETARY POLICY Tools of Monetary Control

3. Discount Rate Banks may borrow from BNM The interest rate on the loans that BNM makes to banks is called the discount rate a bank borrows from BNM when it has too few reserves to meet reserve requirements this might occur because the bank made too many loans or it has experienced recent withdrawals therefore, the banking system has more reserves and this allow to create more money BNM can alter the money supply by changing the discount rate

MONETARY POLICY Tools of Monetary Control

4. Funding term given to the conversion of short term loans to medium term loans or long term loans objective to lengthen the payment so that the bank cannot create multiple credits

5. Special Deposits commercial banks are sometimes required to deposit in the central bank an additional percentage of their deposits however, this tool is not used in Malaysia

MONETARY POLICY Tools of Monetary Control

Qualitative tools

Selective Credit Control Moral suasion Special directives Interest rate policy Mortgage control