Chapter 30

The Monetary System

Key Termsmoneymedium of exchangeunit of accountstore of valueliquiditycommodity moneyfiat moneycurrencydemand depositscentral bankmoney supplymonetary policy

reservesfractional-reserve bankingreserve ratiomoney multiplierbank capitalleverageleverage ratiocapital requirementopen-market operationsdiscount ratereserve requirements

Two Choices

Make

or

Trade

Barter

Direct trade - stuff for stuff

No money

Double coincidence of wants

Both sides have to want what the other side has

Double coincidence of wants

Money makes trade easier

Both must want what the other has at the

same time

Double coincidence of wants

What is money?

Money

Something people use to trade with

Why would you accept a cigarette if you didn’t smoke?

Functions of Money

medium of exchange

unit of account

store of value

Medium of Exchange

Buyers give to sellers

Sellers accept from buyers

Unit of Account

Measurement

Prices

Debts

Store of ValueTrading time for time

Today for tomorrow

Tomorrow for today

Earn - Save - Spend

LiquidityHow easy is it to convert

something to money

Kinds of MoneyCommodity

Fiat

Commodity MoneyIntrinsic value

Easy to carry

Easy to measure

Easy to verify

Hard to copy

=

Gold Standard

Central Bank will convert paper money to gold at a fixed rate

Fiat MoneyNo intrinsic value

Declared money by government decree

Fiat MoneyWhy do people accept fiat

money?

Trust that someone else will also accept it

Money

Trust inscribed

If people lose trust, money loses it value

Coins

Currency

Checks

Card Type Payment

Credit Defer

Debit Instant

Why credit and debit cards are not money

Not a method of payment, but a method of

making payment

Debit card is like a check

Takes money out of your bank account

Credit Card

Defer the payment

Demand Deposits

Bank account that you can access by writing a check or using a debit

card

Saudi Arabia Monetary Agency

The Central Bank of Saudi Arabia

SAMAsama.gov.sa

Central Bank

The bank that oversees the banking system and

regulates the money supply in a country

Dr. Fahad Al Mubarak

Chairman of the BoardGovernor

Saudi Arabia Monetary AgencySAMA

Six Functions• Issues national currency, the Saudi Riyal.

• Acts as a banker to the government. 

• Supervises commercial banks.

• Manages Kingdom’s foreign exchange reserves.

• Conducts monetary policy for promoting price and exchange rate stability.

• Promotes the growth and ensures the soundness of the financial system.

Source: sama.gov.sa

Money Supply

The quantity of money available in a country.

Monetary Policy

Setting the money supply by the central bank policymakers

Two Types of Banks

100 Percent Reserve

Fractional Reserve

100-Percent Reserve Bank

All the deposits are kept in a safe vault.

No loans

Fractional-Reserve Bank

Bank only holds a fraction of the deposits

as reserves

Loans out the remainder

Reserve Ratio

The fraction of deposits that banks hold as

reserves

Fractional-Reserve Banking

Creates money

Bank Deposit Reserve10%

LoanRemainder

1000 100 900

900 90 810

810 81 729

• • • •

• • • •

• • • •

Total 10,000

How does 1000 become 10,000?

Reserve Ratio

Fraction Reciprocal MoneyMultiplier

100% 1 1÷1 1

50% 0.50 1 ÷ 0.50 2

25% 0.25 1 ÷ 0.25 4

10% 0.10 1 ÷ 0.10 10

5% 0.05 1 ÷ 0.05 20

1% 0.01 1 ÷ 0.01 100

Money multiplier is the reciprocal of the reserve ratio

Bank Capital

The money the bank’s shareholders have put in

to the bank

Leverage

OPM

Using other people’s money

Leverage1. I have 10

2. I borrow 90 from you

3. I buy something for 100

4. I resell the item for 150

5. I pay back your 90

6. I keep the 60

7. I earned 50 profit on my 10

Leverage Ratio

The ratio of assets to bank capital

AssetsBank Capital

Bank Balance Sheet

AssetsAssetsLiabilities and Owner EquityLiabilities and Owner Equity

Reserves 200 Deposits 800

Loans 700 Debt 150

Securities 100 Capital 50

Total 1000 Total 1000

Totals must balance or be equal

What is the leverage ratio?

AssetsAssets Liabilities and Owner EquityLiabilities and Owner Equity

Reserves 200 Deposits 950

Loans 800 Capital 50

Total 1000 Total 1000

Assets ÷ Capital1000 ÷ 50 = 20

Leverage Ratio of 20

Owners put up 1

Depositors put up 19

Leverage is Risky!If leverage ratio is 20,

5% increase in asset value = 100% return to owners

5% decrease in asset value = 100% loss to owners

Capital Requirement

Government rule on minimum amount of

bank capital

Insolvent

Liabilities are more than the assets

You owe more than you own

Three Tools of Central Banks

Open-Market Operations

Discount Rate

Reserve Ratio

Open-Market Operations

Purchase and sale of government bonds

Buy bonds increases supply

Sell bonds decreases supply

Banksnow have

more cash to loan

Central Bank

Public Banks

Increase Money Supply?Buy bonds for cash

Banksnow have less cash to loan

Central Bank

Public Banks

Decrease Money Supply?Sell bonds for cash

Discount RateThe rate the central bank charges to make loans to

member banks

Called the Official Repo Rate or ORR rate in Saudi Arabia

Official Repurchase Rate or Discount Rate

2.0%

Dropped from 2.5% on January 19, 2009

SAMA Official Repo Rate

Dropped from5.5% October 2008

to 2.0% by January 20093 month period of

global financial crisisRate increased

as economyheated up

Reserve Ratio

Increase reserve ratio will reduce money multiplier

Decrease reserve ratio will increase money multiplier

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 4 6 8 10 12 14 16 18 20

ReserveRatio

Money Multiplier

The Power of the Reserve Ratio to Multiply Money

Reserve RatioNot changed very often

What is the current reserve ratio in Saudi Arabia? 7%

What is the Money Multiplier?

1÷7% = 14.28

Bank Deposit Insurance

Protects against bank runs

Moral Hazard to take more risk because government

will pick up losses