MONEY, THE BANKING SYSTEM AND MONEY CREATION · PDF filediscussion of the desirable properties...

College of Education

School of Continuing and Distance Education2014/2015 – 2016/2017

MONEY, THE BANKING SYSTEM AND MONEY CREATION

Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information: [email protected]

Session Overview

• The role of money in the macroeconomy cannot be understoodif money is not conceptualized. Here money is defined in termsof its functions, these functions are better appreciated with adiscussion of the exchange system that existed prior to theinvention of money (the barter system of trade) in addition to adiscussion of the desirable properties of money.

• Financial institutions play a key role in economy and there arebroadly two types of financial institutions, that is the CentralBank (Bank of Ghana) and the commercial banks. The centralbank and its functions are discussed, also, Commercial Banks areintroduced by emphasizing on their money creation role whichresults in derivation of the money multiplier

Priscilla T. Baffour Slide 2

Session Outline

The key topics to be discussed in the session are as follows:

– Functional definition of money

– The Barter System of exchange

– The Structure of the banking system

– Money supply defined and measured

– The role of the central bank

– Commercial banks and the money creation system

– The money multiplier


Learning Outcome

• After completing this session, you should be able to;

– Define money in terms of its functions

– Summarize the four main functions of money

– State the desirable properties of money

– Briefly discuss the barter system of exchange and identify the challenges out of which money was invented

– Outline the role of the Central Bank

– Discuss the money creation role of commercial banks through fractional reserve banking

– Explain money supply in terms of monetary aggregates (M1, and M2)


Reading List

• Read Chapter 17 of John Sloman; Economics, 8th Edition, 2011, Pearson

• Session slides

• Any other Economics text books available to students


Functional Definition of Money

• What is Money?

– Money is an asset that is generally acceptable for the payment of goods andservices.

– Money can also be defined in terms of its function, thus;

• Money is defined as a commodity that is generally acceptable as a medium ofexchange, a store of value, unit of account and a means of deferred payment.

Examples of money include paper currency, coins and demand deposits.

Based on the functional definition of money, the functions of money are deduced.


Functions of Money – Money serves as a medium of Exchange

• This is because money is said to be liquid because it can be changed into any good or service instantly at no cost. Thus It can be used in purchasing goods and services.

– Money serves as a unit of account• Money provides a denominator by which goods and services

can be valued. That is, a basic measure of economic value.

– A Store of Value• Money allows for purchases to be made in the future. This

enables households and firms to store the value of their wealth in money form.

– As a standard of deferred payment• This function allows people to borrow and make payment in

the future.


The Barter System

• The barter system of exchange was a system in which peopleexchanged commodity for commodity, service for service,commodity for service etc, as such, there was no medium ofexchange. Thus the exchange was direct without the use of aspecific money asset.

• This primitive system of exchange was plagued with a lot ofchallenges. For example, how does a singer exchange his/herservices for food?

• The advent of money was as a result of the numerousinconveniences of the barter system.

Priscilla T. Baffour

Problems of the Barter System

• Why was barter inconvenient?

– The problem of lack of double coincidence of wants.

• An individual seeking to trade under the barter system had to identify someone who had what he/she wanted and needed what he/she had. For instance how will a seamstress who needs bread go about it?

– Problem of Measurement of Value.• There was no common measure of value. Even if double coincidence

of wants existed, the problem arises in what proportion the two goods are to be exchanged. Absence of a common denominator in order to express exchange ratios created many difficulties. For example how many loaves of bread were to be exchange for a dress.


Problems of the Barter System

• Why was barter inconvenient?

– Difficulty in storing wealth

• It was difficult for people to store wealth for future use becauseof the perishable nature of most of the commodities. Forinstance keeping a crate of tomatoes until such a time that itcould be exchanged for something else. Storing such good wasdone a great cost

– Problem of Divisibility• How do you exchange goods of unequal value? It was impossible to

divide certain commodities to allow for exchange. Eg. A householdwants to sell his cow and get in exchange cloth equal to the value of halfthe cow, this cannot be done without killing the cow.

10Priscilla T. Baffour

Characteristics of Money

• To show how money is distinct from other assets andto show the functions it plays, the desirablecharacteristics of money need to be examined.– Durability

• Durability means that money must be able to exist for a longtime. Durability is critical for money to perform the relatedfunction of medium of exchange and store of value.Currency, coins and paper bill used as money meet thisrequirement.

– Divisibility• money can be easily divided into smaller units to allow for

general acceptance as a medium of exchange in allcircumstances.


Characteristics of Money

• Money is distinct from other assets and this is shown in thefunctions money performs, what then are the desirablecharacteristics of money?

– Portability

• People should be able to conveniently carry on themconsiderable amount of money for transactions

– Acceptability

• One good characteristics of money is that it should be widely accepted by all as a medium of exchange.

– Easily Recognizable

• To facilitate daily transactions, money should be easilyrecognizable by all otherwise people will refuse to accept itas a medium of exchange.


THE STRUCTURE OF THE BANKING SYSTEM AND THE MONEY SUPPLY

Topic Two


THE STRUCTURE OF BANKING SYSTEM

• The central bank is at the apex (top)of the banking system.

• The Bank of Ghana acts as the central bank in Ghana with two mainresponsibilities;

– Control money supply and undertake monetary policy

– Oversight and regulation of financial markets

• Their main mandate is to promote low inflation, economic growth, andstable financial markets.


ROLES OF THE CENTRAL BANK

• The central bank acts as a banker and financial adviser to thegovernment.

• Regulate, supervise and direct the banking system and creditsystem to ensure smooth operation of a safe and sound bankingsystem.

• Issue and redeem currency notes and coins.

• Formulate and implement monetary policy aimed at achievingthe objectives of the bank.

• Acts as the Bankers bank. It acts as the Lender of Last Resort.


Money Supply

• Money supply is the total stock of money, that is currency andother liquid assets circulating in an economy.

• How is money supply measured?

– M1 is the narrowest definition of money. It is a measure of moneysupply that includes all physical cash (coins and currency) as well asdemand deposits. It is the most liquid components of money supply asit contains assets that can quickly be converted into different things.

M1=C+D

where

C=Currency

D=Demand Deposits/Checkable deposits/current accounts


Money Supply

– M2 is a broader definition of money than M1, it includes all assets that can beused as money like time and other liquid bonds. it is less liquid as compared toM1 money supply. M2 is defined as M1 plus savings and time deposits plusforeign currency deposits.M2=M1+STD+FCDs

STD=Savings and Time deposits with Commercial Banks

FCDs=Foreign Currency Deposit

Monetary authorities normally consider M1 as the relevant definition of money,however for monetary policy purposes, money is normally defined in terms ofM2


COMMERCIAL BANKS AND MONEY CREATIONSYSTEM

Topic Three


Functions of Commercial Banks

• The main function of commercial banks are acceptingdeposits from the public and advancing loans to firmsand individuals

• However, besides these functions, commercial banksperform many others functions which include;

– Disbursement, thus making payment upon thedirection of its depositors.

– Safeguard money. Banks are considered a safe placeto store wealth.

– Invest fund in securities for return.


Commercial Banks and the Creation of Money

• For the purpose of discussing the money creation function of commercialbanks, money supply is defined in terms of M1 which is currency incirculation plus demand deposits.

• M1=C+D

• Currency: A generally accepted form of money including coins and papernotes which is issued by the government

• Demand deposits: the amount of money in current accounts is counted aspart of the money supply because cheques can be drawn against them.

• Before we proceed, it is important to know what reserves are and thedifferent type of reserves.

– Reserves: The portion of demand deposits not given out as loans to thegeneral public.



– Total Reserves = Required reserves +Excess reserves

– Required Reserve is the portion of demand deposits that banks must keepwith the central bank against liabilities. In essence required reserves are notavailable to commercial banks to lend.

– Excess reserve is the portion of demand deposits held in a banks own cashvaults.

• Banks keep excess reserves for the purpose of meeting depositorswithdrawals and payments.

• The Required reserve ratio(rr) is the fraction(%) of the value of abanks deposit that must be held with the central bank by law.


Required Reserve Ratio

• Required reserves ratio is calculated on received deposits.

– if rr = 20% that means if demand deposits total 100,000cedis then:

– Required Reserves = 20% (0.2) x 100,000 = 20,000 cedis

– Excess reserve = Demand deposits- Required reserves =100,000 - 20,000 = 80,000

• The process by which commercial banks create money is oftenreferred to as the process of deposit creation.

– If all deposits to banks are held as reserves, no loans will be madeand banks will hold on to deposits until individuals makewithdrawals. This type of banking is known as 100% reservebanking.



• With 100% reserve banking, it is impossible for banks to create moneybecause all deposits are required reserves and there is no excess reservesout of which demand deposits can be created.

• If we consider the case where banks can give out loans, the banks mustkeep a proportion of deposits(reserves) on hand so that wheneverdepositors want to make withdrawals their demand can be met.

– This type of system is called fractional-reserve banking.

• There is an opportunity for money creation through deposit creationunder fractional reserve banking.

• At the end of the deposit creation process from an initial deposit, themoney supply in the economy will be a multiple of the initial deposit.


An Illustration of Deposit Creation Process

• Suppose Bank A receives new deposit equal to 10,000 cedis. And has a required reserve ratio of 20%.

• Here the following assumptions are made:

Individuals who go for loans do no hold currency

Banks hold zero excess reserves

• The bank keeps 20% of their deposit as reserves and this is equal to 2,000 cedis (0.2 x 10,000)

• The bank then loans out the rest. That is total deposits minus required reserves (10,000 – 2,000) = 8,000.


An illustration of Deposit Creation Process

• Assume Bank A gives all the 8,000 cedis out as a loan to Kofi who deposits it inhis account with Bank B.

• Bank B now receives new deposit of 8,000 cedis

• Bank B has to keep the 20% required reserves with the central bank:

• 20% of 8,000 = 1,600

• Excess reserves for Bank B of = 8,000 – 1,600 = 6,400 is given out as loan toAma who deposits it into an account with Bank C.

• Bank C also lends all its excess reserves of 5,120 out Yaa.

• Bank C has require reserve as 20% of 6,400 = 1,280

• So its excess reserves = 6,400 – 1,280 = 5,120

• The process goes on and on. Each time money is deposited and a bank loan ismade, more money is created.


An illustration of Deposit Creation Process

• How much money is eventually created in this economy? lets add it up:

Original Deposit =10000

Bank A lends to Kofi = 8000[0.8*10000]

Bank B lends to Ama = 6400[0.8*8000]

Bank C lends to Yaa = 5120[0.8*6400]

* *

* *

* *

Total Money Supply = 50000


Deposit Creation Process

• It turns out that this process of money creation can continue inperpetuity since excess reserves will never be zero.

– The money multiplier therefore gives an estimate of the amountof money the banking system can generate with each cedi ofreserves.

– The money multiplier is the reciprocal of the required reserveratio. As a result, if rr is the reserve ratio for all banks, then eachcedi of reserves generate 1/rr cedis of money.

– In our example, the money multiplier then is 1/0.2 = 5.

– Money Multiplier(mm) =1

𝑟𝑟


Changes in Money Supply

• Using the money multiplier one can determine how muchmoney supply will increase as a result of the receipt of thenew deposits.

• For instance if 20,000 deposit is made, with a requiredreserve ratio of 20%, this means,

• ΔMs = (1/rr)*ΔD=(1/0.2)*20,000=5*20,000=100,000

• What are the details?

• ΔMs=(20,000+16,000+12,800+10,240+........)=100,000

• We can see that it’s the same as going through the longprocess.

• Therefore ΔM =1

𝑟𝑟* ΔD


Sample Questions1. If Commercial Banks receive a total of ₵100m in deposits with a 10%

required reserves out of total deposits. If the commercial banks hold noexcess reserves;

a. Find the quantum of the money multiplier?

b. How much money is in circulation?

c. If the central bank now raises required reserve to 20% of deposits,what is the change in reserves and the change in money supply?

2. You take ₵200 you have kept under your pillow and deposit it in your bankaccount. If the required reserves is 5% of total deposits, Find the change inmoney supply as a result of your deposit.


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