Money and

Banking
Money, Money, Money
 Money and banking

• Why study money, banking and financial markets?

• Answer:
• It is because a well functioning monetary system,
• i) provides the life blood of the circular flow of
income & expenditure,
• ii) helps achieve both full employment & efficient
use of resources
 Learning objectives
• Should be able to:
• List and explain functions of money
• Define money supply & distinguish amongst its
components
• Explain what “backs” the money supply, making us
willing to accept it as payment
• Explain the reasons for the people’s demand for money
• Explain the functions and responsibilities of the central
bank
• Explain the functions and responsibilities of
Commercial banks and their functions
• Describe & explain the money creation process
• Describe the structure of the Botswana banking system
 Nature & functions of money
• What is money?
• Broad answer: Anything that performs the functions of
money.
• Narrow answer: Money is anything that is used as a
medium of exchange to facilitate transactions of goods
and services and in the settlement of debts..
• Functions of money
• Medium of exchange: Money can be used for buying and
selling goods and services.
• Unit of account: can be used as a yardstick for measuring
the relative worth of goods, services & resources, price of a
car, an ox, legal services, etc.
• 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
• Medium of exchange: Money can be used for buying and
selling goods and services.
• 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 (properties of money)
Zimbabwe's new 'goat economy' now includes school
fees, BBC News

Parents in Zimbabwe who cannot afford

school fees can offer livestock such as
goats or sheep as payment, a
government minister has said.
 A store of value
• 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

• 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
Inflation cartoons
 Unit of account
• Money may be used purely for accounting
purposes – as a yardstick for measuring the
relative worth of a wide variety of goods,
services & resources, e.g., price of a car, an ox,
legal services, etc.
• The price of each item is stated only in terms
of the monetary unit, e.g., pulas, dollars,
rands
 Properties of money - summary
General acceptability – must be accepted by everyone who buys,
sells, lends & borrows.
Durability – since it constantly passes from one person to another
during exchange, it needs to be durable and not lose value by
wastage or attrition.
Portability – the mass should be low in relation to its value.
Homogeneity – money of a given value should be made of the same
material, in order to avoid confusion.
Divisibility – it should be divisible into lesser units (small coins)
Recognizable – one should be able to recognize it easily
Stable value – since it’s also a store of value, its value should not
fluctuate. Otherwise it will not be trusted as a store of value or
medium of exchange
Relative scarcity – For it to be desired, the medium of exchange
must be relatively scarce, otherwise its value would fall.
 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
 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 it 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 notice 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.
 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
 Components of the Money Supply
• Broadest Money Definition: M3 = M2 + large
time deposits, usually owned by businesses as
certificates of deposits (check s-32, BoB
Annual Report, 2010).
• 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.
– How does government make its value stable?
 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
• Excessive inflation may make money worthless and
unacceptable. An extreme e.g. of this is the
hyperinflation in Zimbabwe, 2008.
• Worthless money leads to use of other currencies that
are more stable.
• Worthless money may lead to barter exchange system –
goats, fuel, labour, etc.
 Maintaining the value of money
• The government tries to keep supply stable
with appropriate fiscal policy.
• Central bank (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
 The Demand for Money: 2 Components
• Why do people hold money? 2 reasons
• Transactions demand, Dt, people hold money to buy
with it (medium of exchange)
– The level of nominal GDP is the main determinant of
the amount of money demanded for transactions.
Therefore transactions demand for money varies
directly with nominal GDP
• Asset demand, Da, is money kept as a store of value for
later use. Here we assume people make choices on the
form to hold their financial assets: either as bonds or
money. The attraction of money as a store of wealth is
its liquidity & absence of capital losses. It has the
disadvantage of earning little or no interest
 The Demand for Money: 2 Components
• Bonds earn interest, but are not as liquid & their prices
may fall resulting in capital losses to their holder.
• When would one hold her assets as money instead of
bonds? It depends on the interest rate. When holding
money, one forgoes the interest income from bonds
• Thus if interest rate is high the opportunity cost of
holding money is high, & people will hold less money
• Thus, the asset demand for money varies inversely with
the interest rate. If i goes up, Da goes down
• Total money demand will equal quantities of money
demanded for assets plus that for transactions
• Dm= Dt+ Da
 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 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 (highly liquid)
 Capital markets deal with 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 Commercial 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
 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 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 inter-
bank rate
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
– African Banking Corporation
• Micro-lenders
• Money and capital markets
 Functions of the central bank
• Issues the currency and coins used in the monetary system.
• Sets reserve requirements and holds the reserves of commercial
banks not held as vault cash.
• May lend money to commercial banks, charging them an interest
rate called the discount rate (bankers’ bank).
• Acts as banker, fiscal agent & adviser to the government.
• Supervises member banks.
• Conducts monetary & exchange rate policies
• Control of the money supply/control of credit creation by banks
is the “major function” of the central bank
• Manages country’s international reserves
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 or with the central bank
 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
• 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.
• Legal reserves (LR) or actual reserves (AR) are those assets
acceptable for meeting reserve requirements behind the public’s
deposits
• LR/AR may be divided into required reserves (RR) & excess
reserves (ER); LR/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 = LR/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 cash 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 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
(LR/AR)(P1000) times the reciprocal of the R ratio 1/0.20
 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
Cash 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 Cash 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
Cash 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) = LR/AR x m
• Total 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 sersa
 Monetary Policy

Monetary policy is the branch of

economic policy which attempts to
achieve macroeconomic objectives
through the control of the monetary
system
 Objectives of monetary policy
• Monetary policy is believed to have a very powerful impact on the
economy
• The fundamental objective of monetary policy is to aid the
economy in achieving full-employment output with stable prices.
– To do this, the central bank changes the nation’s money supply
and interest rates.
– We have already learnt that to change money supply, the
central bank can manipulate the size of excess reserves held by
banks.
• How is the interest rate determined?
• Since interest rate is the “price” of money, we need to turn to the
demand & supply analysis
 Tools of Monetary Policy
• How can the central bank influence the money-
creating abilities of commercial banks? It can use
3 tools to do this:
• Open-market operations refer to the central
bank’s buying and selling of government bonds
• reserve ratio is the fraction of reserves required
relative to their customer deposits.
• Discount/bank rate, which is the interest rate
that the central bank charges to commercial
banks that borrow from the central bank
 Open-market operations (OMOs)
• If the central bank buys directly from banks, then bank
reserves go up by the value of the securities sold to the
central bank
• Banks’ lending ability rises with new excess reserves
• Conclusion: When the central bank buys securities, bank
reserves will increase and the money supply can rise by
a multiple of these reserves.
• When the central bank sells securities, Bank reserves will
go down, and eventually the money supply will go down
by a multiple of the banks’ decrease in reserves.
 Reserve requirements ratio
• Raising the reserve ratio increases required reserves and
decreases excess reserves. Any loss of ER shrinks banks’
lending ability and, therefore, the money supply by a multiple
of the change in excess reserves.
• Lowering the reserve ratio decreases the required reserves and
expands excess reserves. Gain in ER increases banks’ lending
ability and, therefore, the money supply by a multiple of the
increase in excess reserves.
• Changing the reserve ratio has two effects.
– It affects the size of excess reserves.
– It changes the size of the monetary multiplier.
 Discount/Bank rate
• An increase in the discount/bank rate signals
that borrowing reserves is more difficult and
will tend to shrink excess reserves.
• A decrease in the discount/bank rate signals
that borrowing reserves will be easier and will
tend to expand excess reserves
 Expansionary & contractionary MP
• When do you thing the central bank will use an expansionary
MP (easy money policy)?
– The central bank may use an expansionary monetary
policy if the economy is experiencing a recession and
rising rates of unemployment
• When do you thing the central bank will use a contractionary
MP (tight money policy)?
– Restrictive monetary policy is used to combat rising
inflation
 Monetary Policy, Real GDP, and the Price Level:
How Policy Affects the Economy
• Expansionary monetary policy: The central bank takes
steps to increase excess reserves, which increases
money supply, lowers the interest rate and increases
investment which, in turn, increases aggregate demand
and real GDP.
• Restrictive monetary policy is the reverse of an
expansionary monetary policy: Excess reserves fall,
which raises interest rate, which decreases investment,
which, in turn, reduces aggregate demand and inflation
Monetary Policy transmission mechanism

Expansionary Monetary Policy

Problem: Unemployment and Recession
CAUSE-EFFECT CHAIN Central bank Buys Bonds, Lowers Reserve
Ratio, or Lowers the bank Rate
Excess Reserves Increase

Money Supply Rises

Interest Rate Falls

Investment Spending Increases
Aggregate Demand Increases

Real GDP Rises

Monetary Policy transmission mechanism
Restrictive Monetary Policy
Problem: Inflation
CAUSE-EFFECT CHAIN Central bank Sells Bonds, Increases Reserve
Ratio, or Increases the Bank Rate
Excess Reserves Decrease

Money Supply Falls

Interest Rate Rises

Investment Spending Decreases

Aggregate Demand Decreases
Inflation Declines
 Summary
• In the fractional reserve system, commercial banks are
required to keep reserve deposits at the central bank
• Legal or actual reserves (LR/AR) are those assets acceptable
for meeting reserve requirements behind the public’s deposit
• LR/AR = RR + ER
• RR are the amount of funds equal to a specified percentage of
bank’s own deposit liabilities
• The specified percentage of the checkable deposit liabilities
that a commercial bank must keep as reserves is called the
reserve requirement ratio (R)
 Summary
• The purpose of RR is to help the central bank control the
ability of 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
• This is made possible by the multiplier effect
• m=1/R (Play with these equations)
• Total checkable deposit (TD) = LR/AR x m
• Maximum checkable deposit created (ND) = ER x m
• Maximum new money created (NM) = ER x m