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 CHAPTER 15
MONEY AND BANKING

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 DEFINITION OF MONEY
 The term ‘money’ is something that people generally accept
as a payment for goods and services. It is also used to pay
off debts.
 Money is defined as anything that acts as a medium of
exchange.
FUNCTIONS
FUNCTIONS
Medium OFMONEY
OF MONEY
Medium
of
ofexchange
exchange
Standard
Standard
of
ofdeferred
deferred
Measure
Measureof ofvalue
value Store
Store payment
payment
/unit
/unitof
ofaccount
account of
ofvalue
value

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 Acceptability Durability

Portability
Divisibility

Relative Stability
scarcity

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 Commodity
money

Legal
Token
tender
money

Demand
Demand Fiat money
deposit

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 DEMAND
DEMAND SUPPLY
SUPPLY OF
OF
FOR
FOR MONEY
MONEY MONEY
MONEY

Transactions
Transactions Speculative
Speculative
motive
motive motive
motive

Controlled
Controlled
by
by Central
Central
Precautionary
Precautionary Bank
Bank
motive
motive

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 MONEY SUPPLY

M1
M1 = Consisting of coin, currency notes and demand deposits (bank
money or cheques)

M2
M2 = M1 + Fixed and saving deposits in commercial banks, negotiable
certificates of deposit (NCD) and Bank Negara certificate

M3
M3 = M2 + Savings and fixed deposits in other banking institutions

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 MONEY MARKET
EQUILIBRIUM
 MONEY DEMAND (Md)
– Negatively related to interest rate
– Positively related to income.
 MONEY SUPPLY (MS)
– Fixed by central bank
– Not affected by interest rate

MONEY
MONEY MARKET
MARKET EQUILIBRIUM
EQUILIBRIUM –– LM
LM CURVE
CURVE
M
M == M
dd
M SS

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 LM CURVE SHIFT TO THE
RIGHT
A DECREASE IN MONEY DEMAND
Real Interest Real Interest LM1
Ms

LM2

Md1
Md2
Output Quantity of money
Factors that shift the LM curve to the right
 Decrease in price level
 Increase in expected inflation
 Decrease in the nominal interest rate on money
 Increase in the nominal money supply
 Decrease in wealth

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 LM CURVE SHIFT TO THE
LEFT
A DECREASE IN MONEY SUPPLY
Real Interest Real Interest LM2
MS2 MS1
LM1

Output Quantity of money

Factors that shift the LM curve to the left

 Increase in price level
 Decrease in expected inflation
 Increase in the nominal interest rate on money
 Decrease in the nominal money supply
 Increase in wealth
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 CONSUMER PRICE INDEX
DEFINITION
A measure of change in the average price of goods and services.

STEP 1 STEP 2 STEP 3

Selection of the Base Year Selection of CPI Basket Prices of Selected Goods

Item Base Year Current

P I Current Year Index

C (240/150) x 100 = 160

Price Year Price
Food 150
L E 240
Apparel 300
P
M 200
420 (420/300) x 100 = 140
Medical care
S
250 I (200/250) x 100 = 80
Transportation 160 180 (180/160) x 100 = 112.5
Simple CPI = Sum of all current year index 492.5 = 123.1
number of items 4
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 CONSUMER PRICE INDEX
(cont.)
Item Base Current Current Year Weight Weighted
Year Year Index Price Index
Price Price

Food 150 240

C
(240/150) x 100 =
160 PI
4 160 x 4 = 640

Apparel 300 420

E D (420/300) x 100 = 3 140 x 3 = 420

H T 140
Medical care 250

E I G 200 (200/250) x 100 =

80
1 80 x 1 = 80

Transportation 160
W 180 (180/160) x 100 =
112.5
2 112.5 x 2 = 225

Weighted CPI = Sum of all weighted Price Index 1365 = 136.5

Total weights 10

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 To calculate inflation rate:
CPI = CPI current year – CPI previous year x 100%
CPI previous year

To identify To use as
the distribution USES OF a basis for
of income CPI future contracts

To calculate changes in the value of money:

Value of money = Base year index – 1 x 100%
CPI

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 QUANTITY THEORY OF
MONEY
 Quantity theory of money states that the changes in the
money supply are related to changes in the price level,
which is measured by consumer price index (CPI).

ASSUMPTIONS
1. V is constant MV = PT
2. T is constant
3. Full employment
4. Increase in M will increase the P

Money Supply in Total

Velocity of General Price
Circulation
Circulation Level Transaction

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 Commercial Central bank
bank

ance
Finan Islamic ba
bannk
k
companies
co

Merchant Discount
banks houses

Development Employees
Financial Institutions Provident Fund

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 COMMERCIAL BANKS

 A commercial bank is an institution that is owned by

the private sector and is a profit-making institution.

FUNCTIONS
 Accepting deposits
 Providing loans and advances
 Providing other banking services and facilities

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 CREDIT CREATION

 DEFINITION
– A process where a small given deposit in a commercial
bank will lead to an increase in the supply of money.
 Assumptions:
1. Cash ratio is fixed by BNM and its value is constant.
2. Banks do not keep excess cash reserves.
3. The public must keep their money in the bank.
4. Leakage does not exist.
5. Bank’s assets are only in the form of cash and loans.
6. Liability consists of deposits only.
7. Deposits are in the form of current deposits.

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 PROCESS OF CREDIT
CREATION
Assume that Bank XYZ is the only Assume a customer, Mr. Arwin
commercial bank in the country. deposits RM 1,000 in Bank XYZ.
Balance sheet: Bank XYZ

Asset Liability
Cash (10%) RM100 Deposits RM1000
Loans (90%) RM900
Total RM1000 Total RM1000

Cash reserve = Cash Ratio x Initial deposit Assume bank’s legal cash
= 10% x 1000 = RM100 requirement is 10%.
Bank will loan out the balance to another person.

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 PROCESS OF CREDIT
CREATION (cont.)
Bank XYZ loans out to Ms. Catherine and
she deposits into the same bank. Excess reserve
from earlier
balance sheet
Balance sheet: Bank XYZ
n t il
e u
Asset Liabilitytinu
c o n is
i l l p ly
Cash (10%)
s s w
RM90 Deposits
u p RM900
c e y s
Loans (90%) pro RM810 o n e
s m
T h i t o t al .
Total the 0,00RM1000 0 Total RM900
M 1
R
Bank’s legal cash Bank will loan to
requirement is the same. another person.

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 PROCESS OF CREDIT
CREATION (cont.)

IMPORTANT FORMULAE

1. Cash Ratio = Cash reserve/Initial deposit X 100

2. Money Multiplier = 1/Cash ratio
3. Total Money Supply = 1/Cash ratio X Initial deposit
4. Total Reserves = 1/Cash ratio X Initial reserve
5. Total Credit Creation = 1/Cash ratio x Initial loan

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 PROCESS OF CREDIT
CREATION (cont.)

LIMITATION TO CREDIT CREATION

 A change in cash ratio/legal reserve requirement
 Clearing house – slows down the process
 Availability of collateral security – mortgages, land titles
 Bank Negara Malaysia’s monetary control will affect
amount of loans

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 CENTRAL BANK

 The central bank is an important financial institution in

every country and plays active role in implementing
government’s economic policy.
FUNCTIONS OF CENTRAL BANK
To issue currency and safeguard the external value of the currency

Banker to the government

Banker to other banks

Promoting monetary stability

Holder of the country’s stock of gold and foreign currency reserves

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