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Money

Functions Characteristics Banking EMU

Money
Money is anything accepted by the majority of people in exchange for goods and services. We use lumps of metal
Coins

We use coloured pieces of paper


Bank notes

We use plastic cards


Credit cards

And we write letters to each other


Cheques

Barter
Barter is the direct exchange of goods and services for other goods and services. FAULTS The Double Coincidence of Wants: I must find someone with the good I want, and the other person must want my good. How can we decide on a rate of exchange: Is one horse the equivalent of two cows? Goods are not in uniform quality: differences in quality of goods. Divisibility: Someone with a valuable item who only wants a small item will have great difficulty.

Functions of Money
1. Money acts as a medium of exchange.
Overcomes the difficulty of the double coincidence of needs and wants.
1. Money acts as a unit of account or measure of value, we can measure exactly what something is worth

For example: A CD costs 20 and a book costs 10. This indicates that one CD has the same (exchange) value as two books. That is, the relative value of products is shown by the amount of money that must be given for them.

Functions of Money (cont.)


1. Money acts as a store of wealth/value.
o
o

That is, it facilitates savings.


It enables the operation of an efficient credit system. The barter system was not suitable for lending and borrowing purposes. This is an essential feature of money as:
Industry can not develop if it cannot borrow. Most consumers could not buy expensive consumer durables if they could not borrow (for example, most people need a mortgage to enable them to buy a house).

2. Money acts as a standard of deferred payment.

Characteristics of a Good Money Form


1. It must be instantly recognisable as money. 2. It must be portable (that is, people must be able to carry around large values of the money safely and inconspicuously). 3. It must be divisible into units of small value.
o

This enables the purchase of goods of small value and goods of uneven value (for example, people must be able to pay for a good costing 15 and for a good costing 8.91). This also facilitates the giving of change in shops.

4. It must be reasonably durable (that is, it must not be costly to replace). 5. It must be scarce in relation to the demand for it. This is a characteristic of any economic good.

Forms of Money
There are two forms of money: 1. Cash notes and coins 2. Claims on banks deposits and loans.

How is it possible for banks to create credit (give out loans) Credit = Loans
1. Commercial banks accept cash deposits from their customers e.g. say 100, for safekeeping. 2. These banks know from experience that their customers will only demand back a small amount of these deposits in cash - say 10% because of their use of cheques as an acceptable method of payment. 3. So they now have surplus cash with which to give loans 90. 4. The amount of loan they give is related to, but in excess of their cash deposits and is based on their reserve ratio.

How is it possible for banks to create credit (give out loans)it can create is calculated as follows: The amount

Definitions
Banking ratios The Primary Liquidity Ratio (PLR) is the ratio of cash, which the banks must hold, to claims on the banks. The Secondary Liquidity Ratio (SLR) is the ratio of liquid assets held by the banks to claims on the banks. This is not obligatory.

Credit Creation
Customers deposit money into the bank. The Bank know from experience that only a certain amount of this will be demanded in cash at any one time e.g. 10% The Bank only holds the 10% in cash , the PLR (Reserve Ratio) to meet customers demand for cash. The Bank now has surplus deposits with which they can create credit (give out loans)

CREDIT CREATION Example


Mr X Lodges 100 into the bank The Bank know only 10% will be demanded at any one time. They now have surplus deposits in which to create loans/credit. Total deposits = 1000. Bank can now give out loans of 900. It must hold 100 (10%) in cash to fulfil customers demand for cash (Reserve Rate)

Credit Creation Example 2, Smaller Deposit


A lodges 5,000 cash into a bank. Assuming a PLR of 10% (i.e. 1:10) the bank must keep 500 of this in cash for any cash claim from A. This leaves the bank with 4,500 cash. This 4,500 cash represents 10% of the maximum loan that the bank could give another customer, B. The value of Bs loan would be 45,000. To satisfy the PLR for this claim the bank must have 4,500 in cash it has. Thus the bank has created a 45,000 claim on the bank, i.e. money. The amount of the loan has increased in line with the increase in the cash.

Credit Creation Example 3, Lower PLR


A lodges 5,000 cash into a bank. Assuming a PLR of 5% (i.e. 1:20) the bank must keep 250 of this in cash for any cash claim from A. This leaves the bank with 4,750 cash. This 4,750 cash represents 5% of the maximum loan that the bank could give another customer, B. The value of the loan would be 95,000. To satisfy the PLR for this claim the bank must have 4,750 in cash it has. Thus the bank has created a 95,000 claim on the bank, i.e. money. The amount of the loan has increased in line with the increase in the cash.

Credit Creation
Conclusions The banks ability to create credit increases as cash deposits increase. As PLR decreases the banks ability to create credit also increases. Therefore the ability of the bank to create credit that is, to give loans depends on the value of their cash deposits and on the size of the PLR.

Question: Outline how a desire by banks to reduce their level of bad debts might affect their ability to create credit?

Answer: Reducing bad debts would reduce the banks ability to create credit as they would become more cautious about lending and would therefore be holding more cash. If banks are not issuing loans this means less credit is being created.

Limitations on Credit Creation by Banks

The bank can lend out a multiple of its cash deposits. Thus the value of its cash deposits is the first restriction on a bank to create credit. (availability of cash deposits Banks need to attract deposits) Loans that banks give must be repaid. Thus the banks can lend only to customers that are capable of repaying the loans. Thus there has to be a certain level of wealth within the economy to back up these loans. (availability of creditworthy customers) Customers Demand for Cash: The bank must keep sufficient cash to be able to meet the demands of its customers. Any changing of the PLR automatically alters the banks ability to grant loans. The banks are restricted by the credit guidelines set by the ECB and the Central Bank. Question Based on this (2008 HL) Explain two other factors which could affect their ability to create credit? Any of above

Powers of Central Bank to Control Credit Creation


1. Open market operation The central bank can sell securities (usually government bonds) on the stock exchange. This will take cash out of the banks thus reducing their credit creating capacity and vice versa. 2. Supplementary deposits (special deposits) The central bank can call in cash deposits from the banks, thus reducing their cash holdings, leading to a reduction in lending capacity. 3. Manipulation of the short-term facility rate The STF is the rate of interest that the Central Bank charges the commercial banks when they borrow cash from it on a short term basis. o If this is increased, the banks would have to increase their rates to their customers causing a contraction in demand for loans. Continued .....

Powers of Central Bank to Control Credit Creation


1. Foreign exchange swaps Banks are permitted to hold foreign currencies for their customers requirements. o If the banks are running low on cash they can temporarily swap some of their foreign currency for euros. This increases their cash holdings and so improves their credit creating capacity. 2. Altering of the PLR by the Central Bank This could mean that the banks would have to hold more cash for their customers requirements thus reducing there credit creating capacity and vice versa. 3. Advice and directives Here the Central Bank lays down guidelines on credit policy, which are normally adhered to by the banks. It is in their long-term interest to do so. They also endanger the renewal of their licences if they do not follow these guidelines. This is known as the carrot and stick approach.

Banks twin requirements of liquidity and profitability.


A bank has twin requirements: 1. Profitability: refers to the need for a bank to make as much profits as possible from its assets to satisfy its shareholders. The more profitable the asset is the less liquid it is. 2. Liquidity: refers to the need by a bank to have liquid assets in order to meet the demand for cash by its customers. The more liquid the asset is the less profitable it is. Banks must strike a balance between the twin requirements of profitability and liquidity. As a result banks structure their holding of assets along the following lines:

Explanation of Terms
Cash = Notes and Coins Money at Call = A Debt which must be paid upon demand , and Short Notice = within 14 days Exchequer Bills = 91 day loans given to the government at fixed rate of interest. Govn invites banks to tender for these. Term loans = banks issue loans between 1 5 years with variable or fixed rates of interest. Overdrafts = bank allows customers withdraw more money than is in their current account and charge interest on overdrawn amount Government Stock = bonds issued by national government promising to pay a certain amount on a certain date with a certain interest rate to a company or country. Gilt Edged Securities = High Grade Bonds issued by Governments with very low risk (Certain)

Question 2009 HL - Banks may fail by overextending their loan book. Explain this statement within the context of a banks twin requirements of liquidity and profitability?

Definitions
Bills of Exchange = unconditional promise by the drawer to pay a sum of money to the drawee at a specific future date (usually 3 months) Personal Instalment Credit = used for the purchase of cars, furniture, foreign holidays etc. Term Loans (1 7 years) Overdrafts (payable on demand) Government Stock = bought on stock exchange. Also known as Gilt-Edged Securities and earn a fixed rate of interest, with a fixed maturity date. Exchequer Bills instruments for short term borrowing by the government. They are promissory notes to pay the bearer the face value of the bill in 91 days plus interest. Money at Call and Short Notice money loaned on the inter-bank market on a very short-term basis. (Includes Overnight Loans and loans for up to 14 days Liquid because they can be turned into cash very quickly) Cash - most liquid

Question 2009 HL - Banks may fail by overextending their loan book. Explain this statement within the context of a banks twin requirements of liquidity and profitability? Continued

By focusing on profitability (extending credit) at the expense of liquidity a bank may give loans to high risk ventures e.g. commercial property development loans. Property loans are highly illiquid but can be very profitable. A bank may run the risk of increasing bad debts, falling share prices, a lack of capital and possible bank failure. By ignoring liquidity requirements, banks may not have enough cash to meet the demand of their depositors and this could result in a run on the banks and result in bank failure.