Ch.

9: Money and Banking

Learning Outcomes
On completion of the chapter, the student will be
able to:
Define money and explain its functions
Define money supply
Explain the functions of Bank Negara Malaysia
Define reserves and differentiate between
required reserves and excess reserves

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Money: A Definition
 In economics:

Money  income  wealth  credit

WHAT is
MONEY ???
 Money and its Functions
Money is any good that is widely accepted for purposes
of exchange and in the repayment of debts.
Functions:
 Money is a medium of exchange.
- money is used as a means of payment
as it is generally acceptable in exchange
for goods and services. As a result, it
reduces transaction costs.

 Money is a unit of account.

- Used as a measure of the value of
goods, services, and resources.
Because all goods are denominated in
money, determining relative prices is
easy.
Money and its Function

 Money is a store of value.

- Money maintains its value over time. We accept
payment for our efforts and keep money until we
spend it.

 Money serves as a standard of deferred payment

- Money used as a means of valuing future receipts
in loan contracts.
- People agree to loan contracts that call for future
repayments in terms of money.
- These contracts defer repayment of a loan until a
later date.
- Parties to the contract agree to meet financial
terms specified in units of money.
 Defining the Money Supply
 M1 is sometimes referred to as the narrow
definition of the money supply or as transactions
money.

 M1 consists of:
- currency in circulation
- demand deposits in commercial banks.

 Currency includes coins and paper money held by the

public.
 Demand deposits/current account deposits are
deposits where the depositors use cheques to make
payments.
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 Defining the Money Supply:
M2
 M2 is sometimes referred to as the broader
definition of the money supply.
 M2 is made up of :
- M1
- Fixed deposits and savings deposits in
commercial banks
- Negotiable certificates of deposit
- Repurchase agreements
- Foreign currency deposits

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 Defining the Money Supply:
M2
 Savings Deposit – An interest-earning account at a
commercial bank. Normally, cheques cannot be written
on savings deposits and the funds in a saving deposit
can be withdrawn (at any time) without a penalty
payment
 Fixed Deposit – An interest-earning deposit with a
specified maturity date. Fixed deposits are subject to
penalties for early withdrawal.
 Negotiable Certificates of Deposit – A type of fixed
deposit that does not have the bearer’s name and can
be sold before the maturity date.
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 Defining the Money Supply:
M2
 Repurchase agreements (Repos) – An agreement by a
financial institution to sell short-term securities to a
customer and to combine it with an agreement to buy
back the securities at a higher price at a specified
future date.
 Foreign Currency Deposits – Deposits held in foreign
currencies in commercial banks.

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Defining the Money Supply:
M3 – the broadest Money supply
 M2 plus Deposits placed with other
banking institutions

 Other banking institutions included investment banks

and Islamic banks.

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Functions of the Bank Negara Malaysia
 Control the Money Supply 
through various instruments of
monetary policy.

 Issuance of currency and

management of international
reserves.

 Banker and financial adviser

to the government

.Banker to the banks.

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The Money Creation Process: Definitions
 Reserves: The sum of bank deposits at the
BNM and vault cash.
 Required Reserve Ratio (r): A percentage of
each RM deposited that must be held on
reserve (at the BNM or in the bank’s vault).
 Required Reserves: The minimum amount of
reserves a bank must hold against its demand
deposits as mandated by the BNM.
 Excess Reserves: Any reserves held beyond
the required amount. The difference between
(total) reserves and required reserves.
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 Bank Reserves
 Reserves =
Bank deposits at the BNM
+ Vault cash

 Required reserves =
r x Demand deposits

 Excess reserves =
Reserves - Required
reserves
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 Money Creation Process
 People use demand deposits for most
transactions, especially for huge amount
of money transactions.
 Individual banks are prohibited from
printing their own money. But they may
create money by creating demand
deposits, which are part of the money
supply.
[M1 = currency + demand deposits]
 Most transaction accounts are created
as a result of loans from banks.
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 Money Creation Process
Suppose the BNM prints RM1000 in new paper money &
gives it to Bill.
Bill takes the newly created RM1000 and deposits it in
Bank A.
As the deposit initially is added to vault cash  bank’s
reserves ↑ by RM1000
Bank’s liabilities also ↑ by RM1000 as it owes Bill the
RM1000 he deposited in the bank.
Initial reserve Bank A

Assets Liabilities

Reserves RM1 ,000 Demand deposits (Bill) RM 1,000

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 Money Creation Process
 RM1000 reserves are divided into (a) required reserves and
(b) excess reserves.
 Assume the required reserve ratio is 10%, the bank holds
RM100 in required reserves against the demand deposit and
holds RM900 in excess reserves.

Bank A

Assets Liabilities
Required Demand
Reserves RM 100 deposits (Bill) RM 1,000
Excess
Reserves RM 900
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 Money Creation Process
Suppose bank A uses its excess reserves of RM900 to
make loans to Amita.

Bank A

Assets Liabilities
Required Reserves RM 100
Excess Reserves RM 900 See the next T-account

Loans RM 900

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 Money Creation Process
When bank A gives Amita a RM900 loan, it doesn’t give her
RM900 cash. Instead, the bank A opens a current account for
Amita with a balance of RM900 in the account.
Through the lending activities of the bank, demand deposits
(M1 of the money supply) have increased by RM900.
When a bank makes loans, it creates money (i.e., in Demand
Deposit =M1).
Bank A
Assets Liability
Demand Deposits
Required Reserves RM 100 (Bill) RM 1,000
Demand Deposits
Excess Reserves RM 900 (Amita) RM 900
Loans RM 900 18
 Money Creation Process
Now suppose that Amita spends the RM900 on a new DVD
player. She write a RM900 cheque to the DVD retailer, who
then deposits the full amount of her cheque in bank B.
 Bank A uses its excess reserves to honour Amita’s cheque
when it’s presented by bank B and simultaneously reduces her
current account balance from RM900 to zero.
Bank A
Assets Liabilities
Demand deposits
Required Reserves RM 100 (Bill) RM 1,000
Demand deposits
Excess Reserves RM 0 (Amita)  RM 0
Loans RM 900
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 Money Creation Process
Because of the DVD retailer’s deposit, bank B now has RM900
and this increases bank B’s reserves and liabilities by RM900.

Note: the DVD purchase has not changed the overall money
supply. RMs have simply moved from Amita’s current account to
the DVD retailer’s current account.

Bank B
Assets Liabilities
Demand deposits
Reserves RM900 (DVD Retailer) RM900
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The Banking System and The
Money Creation Process
 The process continues in much the same way
for bank B as it did for bank A.
 10% of the DVD retailer’s RM900 has to be
kept on reserve (required reserves on RM900
= RM90). The excess reserves of RM810 can
be lent to still another borrower.
 That loan will create RM810 in new demand
deposit and thus expand the money supply by
that amount.
 The process continues with banks C, D, E and
so on until no new excess reserves can be
created.
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 The Banking System:
Creates Checkable Deposits (Money)
The required
reserve ratio is 10
percent.

Assume that
there is no cash
leakage and that
excess reserves are
fully lent out; that
is, banks hold zero
excess reserves.
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 Simple Deposit Multiplier
 Maximum change in checkable deposits = (1/r ) x ΔR
where r = the required reserve ratio and ΔR = the
change in reserves resulting from the original injection
of funds.
 In the previous example:
Maximum change in demand deposits =
= (1 / 0.10) x RM1,000
= 10 x RM1,000
= RM10,000
 In the equation, the reciprocal of the required reserve
ratio(1/r ) is known as the simple deposit multiplier
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Money Destruction Process
 Money creation process in reverse.

 Eg When a bank A is reserve deficient,

it can correct this situation by calling in
its outstanding loans of RM900
The Money Contraction
Process
 This
process is the Money Creation
process in reverse

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Self-Test
 If a bank’s deposits equal RM579 million and the
required-reserve ratio is 9.5%, how much must
the bank hold in reserve form?
 If the BNM creates RM600 million in new
reserves, what is the maximum change in
demand deposits that can occur if the required-
reserve ratio is 10%?
 Bank A has RM1.2 million in reserves and RM10
million in deposits. The required-reserve ratio is
10%. If Bank A loses RM200,000 in reserves, by
what dollar amount is it reserve deficient?

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 9.5% X $579 million
Answers
 RM 55 million 1/r X ∆R = 1/0.1 X $600million
 RM 6 billion
 RM0. Bank A was required to hold only
RM 1 million (0.10 x RM 10 million), but
held RM1.2 million instead (meaning:
ER = RM0.2 m). Therefore, its loss of
RM 200,000 in reserves does not cause
it to be reserve deficient.

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