All Rights Reserved Ch. 15: 1 Principles of Economics second edition © Oxford Fajar Sdn. Bhd....

All Rights Reserved

Ch. 15: 1

Principles of Economics second edition

© Oxford Fajar Sdn. Bhd. (008974-T) 2010

MONEY AND BANKING

CHAPTER 15

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Ch. 15: 2



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.

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Medium of Medium of exchangeexchangeMedium of Medium of exchangeexchange

Measure of value/ Measure of value/ unit of accountunit of account

Measure of value/ Measure of value/ unit of accountunit of account

Standard of Standard of deferred paymentdeferred payment

Standard of Standard of deferred paymentdeferred payment

Store of valueStore of valueStore of valueStore of value

FUNCTIONS OF MONEY

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Relative scarcityRelative scarcity

PortabilityPortability

AcceptabilityAcceptability DurabilityDurability

DivisibilityDivisibility

StabilityStability

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COMMODITY MONEY

COMMODITY MONEY

FIAT MONEYFIAT MONEY

LEGAL TENDERLEGAL

TENDER

DEMAND DEPOSITDEMAND DEPOSIT

TOKEN MONEYTOKEN MONEY

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MONEY SUPPLY

M1M1 = Consisting of coin, currency notes and demand deposits (bank

money or cheques)

M2M2 = M1 + Fixed and saving deposits in commercial banks,

negotiable certificates of deposit (NCD) and Bank Negara certificate

M3M3 = M2 + Saving and fixed deposits in other banking institutions

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CONSUMER PRICE INDEX

Item Base Year Price

Current Year Price

Current Year Index

Food 150 240 (240/150) x 100 = 160

Apparel 300 420 (420/300) x 100 = 140

Medical care 250 200 (200/250) x 100 = 80

Transportation 160 180 (180/160) x 100 = 112.5

Simple CPI = Sum of all current year index

number of items

492.5 = 123.1

4

DEFINITION A measure of change in the average price of goods and services.

STEP 2 Selection of CPI Basket

STEP 3 Prices of Selected

Goods

STEP 1 Selection of the Base

Year

SIMPLE CPI

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Item Base Year Price

Current Year Price

Current Year Index

Weight Weighted Price Index

Food 150 240 (240/150) x 100 = 160

4 160 x 4 = 640

Apparel 300 420 (420/300) x 100 = 140

3 140 x 3 = 420

Medical care 250 200 (200/250) x 100 = 80

1 80 x 1 = 80

Transportation 160 180 (180/160) x 100 = 112.5

2 112.5 x 2 = 225

Weighted CPI = Sum of all weighted Price Index

Total weights

1365 = 136.5

10

STEP 4 Weightage

WEIGHTED CPI

CONSUMER PRICE INDEX (cont.)

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USES OF CPI

To identify the distribution of income

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

CPI previous year

To use as a basis for

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).

M V = P T Expenditure side Receipt side

Money Supply in Circulation

Velocity of Circulation

General Price Level

TotalTransaction

ASSUMPTIONS

1. V is constant

2. T is constant

3. Full employment

4. Increase in M will increase the P

MV=PT

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Banking InstitutionBanking InstitutionBanking InstitutionBanking Institution

Non-bank Financial Non-bank Financial InstitutionInstitution

Non-bank Financial Non-bank Financial InstitutionInstitution

Non-bank financial Non-bank financial intermediariesintermediaries

Non-bank financial Non-bank financial intermediariesintermediaries

Commercial Bank

Central Bank

Finance

Companies Islamic Bank

Development

Financial Institutions

Employees

Provident Fund

Discount

HousesMerchant Banks

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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 commercialbank 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

Asset Liability

Cash (10%) RM100

Loans (90%) RM900

Deposits RM1000

Total RM1000 Total RM1000

Assume that Bank XYZ is the only commercial bank in the country.

Assume a customer, Mr. Arwin deposits RM 1,000 in Bank XYZ.

Balance sheet: Bank XYZ

Assume bank’s legal cash requirement is 10%.

Cash reserve = Cash Ratio x Initial deposit

= 10% x 1000 = RM100 Bank will loan out the balance to another person.

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Process of Credit Creation (cont.)

Asset Liability

Cash (10%) RM90

Loans (90%) RM810

Deposits RM900

Total RM1000 Total RM900

Bank XYZ loans out to Ms. Catherine and she deposits into the same bank.

Balance sheet: Bank XYZ

Bank’s legal cashrequirement is the same.

Excess reserve from earlier balance sheet

Bank will loan to another person.

This process will continue

until the total money supply

is RM10,000

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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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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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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 andforeign currency reserves

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

CENTRAL BANK

All Rights Reserved Ch. 15: 1 Principles of Economics second edition © Oxford Fajar Sdn. Bhd....

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