Topic - Money & Banking System & Monetary Policy STU b

8/3/2019 Topic - Money & Banking System & Monetary Policy STU b

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MONEY & BANKING


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Learning Objectives State and explain the 3 functions of money

Define commodity money and fiat money

State monetary supply measures and theircomponents

Explain the function of banks

Explain how the banking system createsmoney.


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What is money?

Money is variety of assets that arewidely accepted in exchange for goodsand services and as payment for debt.

Wealth a collection of property thatstore value e.g. money, bonds, stock,

art, land furniture, cars and houses.

Income = a flow of earning / unit of

time


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Function of money

1. Medium of exchange

2. Unit of account

3. Store of value


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Medium of exchange Money i.e. currency or checks is used to pay

for goods and services.

Barter trade in the early days.

Money is as a medium of exchangeeliminates the requirement of double

coincidence of wants.


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Medium of exchange Money facilitates all buying and selling

transactions.

Money promotes economic efficiency; lesstime spent in exchanging g & s.

Money promotes economic efficiency;

people specialize in what they do best.


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Types of Money Commodity money: Has both monetary

value and non-monetary value.

A gold coin has been identified ascommodity money.

It has a monetary value equivalent to

the one stated on the coin.

Gold has non-monetary use e.g. makinga gold chain.


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Measures of Money Supply

Money Type Salient features

M1 (Narrow money ortransaction money

Currency outsidebanks

medium of exchange.0 interest.Most liquid money.

Checking accounts Transaction accountsEarns no interest.A medium of exchangeby issuing checks.

Travelers checks Check issued by a

financial institution.Functions as cash but isprotected against loss ortheft.used by people onvacation in place of cash


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M3M3 = M2 + large time deposits

Large time deposits = owned bybusinesses

= these certificatescan be sold at anytime


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Banking System

Banking system consist ofCentralbank and Financial institutions.

Functions of Financial Instititions:1. Creating Liquidity

Liquidity is the ease at which an asset

can be converted into money. Banks borrow short and lend long.

Deposits are transform into loans =

creation of liquidity


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Functions of Financial Institutions

Minimizing the cost of obtaining funds

Banks lower this cost of searching.

The bank borrows from a large of peopleand spreads the cost over a large numberof borrowers.

In the absence of banks raising $1.0mwould be costly.


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3.Minimizing the cost of monitoringborrowers

Lending money is a risky business.

Theres always danger that theborrowers may not repay.

Banks have the expertise tomonitor loans and borrowers


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4. Pooling Risk

Lending to a large number of different

individuals can reduce the risk of default.

If one person defaults on a loan, it isnuisance but not a disaster.

If only one person borrows and theperson defaults the entire loan is lost.


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Banking System Reservesare deposits that banks have

received but have not loaned out.

Required Reserve:amount of depositbanks must hold reserves.

The reserve ratiois the fraction ofdeposits that banks hold as reserves.


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Banking System

Excess Reserve;Reserves over andabove the legal requirement

In a fractional-reserve bankingsystem, banks hold a fraction of

the money deposited as reservesand lend out the rest.


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Banking System

Banks can influence the quantity ofdemand deposits in the economy and

the money supply.

The money supplyrefers to the quantityof money available in the economy.


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Banking System

When one bank loans money, that moneyis generally deposited into another bank.

This creates more deposits and morereserves to be lent out.

When a bank makes a loan from its

reserves, the money supply increases.


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Banking System

This T-Accountshows a bankthat

accepts deposits, keeps a portion

as reserves,

and lends outthe rest.

It assumes areserve ratioof 20%.

Assets Liabilities

Bank A

Reserves$20.00

Loans

$80.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00


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Banking System

Assets Liabilities

First National Bank

Reserves$16.00

Loans

$64.00

Deposits$80.00

Total Assets$80.00

Total Liabilities$80.00


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Monetary Multiplier Banking system magnifies any Excess Reserve intolarger amount of newly created demand depositmoney.

Monetary multiplier exist because reserves lost by one

bank receives by another bank.M = 1/ required reserve ratio

M= 1/ RR Maximum demand deposit creation =

Excess Reserve * Monetary multiplier

Money MultiplierAmount of money ultimately created per dollardeposited by the banking system


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Banking System

yOriginal deposit = $100.00 1st Lending = 80.00 (=.8 x $100.00)

2nd Lending = 64.00 (=.8 x $ 80.00)

3rd Lending = 51.20 (=.8 x $ 64.00) and on until there are just pennies left to lend!

Total money created by this $100.00 deposit is

$500.00. (= 1/.2 x $100.00)


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Money Supply

The money supply in the economy iscontrolled by the Central Bank

The Central Bank can alter the supply ofmoney using open market operations,

changes in reserve requirement anddiscount rate.


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Thus, the supply of money is a verticalline.

MS

3.00

4.00

5.00

6.00

7.00

8.00

3.0

Quantity of money

Money Supply

Interestrates


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Money Demand

The three motives of holding money

1. Transaction Motive

2. The Precautionary Motive

3. Speculative Motive


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Money Demand

Md3.00

4.00

5.00

6.00

7.00

8.00

Quantity of money

Interestrates

Assume that the public can invest inBonds or hold money.

Interest rates is the opportunity costOf holding money

When interest rates increase the publicWill hold less money and invest more

In bonds.

When interest rates fall the publicWill demand more money thusSelling off their bonds.


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Determinants of demand formoney

1. Total output (income)

2. Increases in the price level (P) These 2 factors cause a shift

in the Md.


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Equilibrium in the MoneyMarket

MS

Md

3.00

4.00

5.00

6.00

7.00

8.00

3.0

Quantity of money

Interestrates

The interest rate adjusts to bring money demand and moneysupply into balance.


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Tools of Monetary Policy

The 3 tools monetary policy are:

1. Open market operations

2. Discount rate

3. Reserve requirement


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Open market operationCentral Bank balance sheet

+100m +100m

Commercial bank balance sheet

-100m

+100m

Balance sheets after the Purchase of bonds

Securities

Securities

Central bank buys

Security from a bank

and pays for the securities

by increasing the reserve

of the bank

Assets Liabilities

Assets Liabilities

Reserve

Reserves


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Purchase of government securities bycentral bank will.

1. Increase reserves in commercial banks.

2. Increase money supply as banks loanout the money.

Open market operation


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Central Bank balance sheet

-100m -100m

Commercial bank balance sheet

+100m

-100m

Balance sheets after the sale of bonds

Securities

Securities

Central bank sells

Security to a bank

and the bank uses its

reserves to pay for the

securities

Assets Liabilities

Assets Liabilities

Reserve of

A bank

Reservesand the bank uses its

reserves to pay for the

securities


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Sale of government securities by centralbank will.

1. decrease reserves in commercial banks.

2. decrease money supply as banks loanout less.



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Reserve Ratio

A commercial banks has:

Reserves of $5000

Demand deposit =$20,000

Reserve ratio 20%,

Required reserve = $4000.

Excess reserves of bank are therefore$1000.


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3. Discount rate

One of the functions of central bank is tobe lender of last resort.

Discount rate is the interest ratecommercial banks pay for borrow moneyfrom Central Bank


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Central Bank gives the loan by increasingthe reserve of bank.

Banks are not required to keep reservesagainst loans from Central Bank.

Loans from Central Bank increase the

excess reserves of banks and hence theirlending ability.

3. Discount rate


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Effects of an Easy MoneyPolicy

Easy money policy is used duringrecession.

To increase money supply; 3 tools can beused

Buy government securities from public

and commercial bank Lower legal reserve ratio

Lower the discount rate.


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Effects of an Easy MoneyPolicy


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Effects of an Easy Money

Policy

11.8 12 13

120

115

AD1

Real GDP (trillions)

A

AD1 + E

AD2

C

SRAS

LRAS

Pricel

evel

Lower interest rates increases aggregate demandcurve from AD1 to AD1 .+ E and eventually shiftsrightward to AD2. Real GDP increases to potentialGDP and price level rises.


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Effects of Tight Money Policy

Used when the economy is experiencingsevere demand-pull inflation

Central Bank should institute tight moneypolicy. Decrease money supply by

Selling government bond

Increase legal reserve ratio

Increase discount rate


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Pri

cel

evel

LRAS

12 12.2

125

120AD1

Real GDP (trillions)

A

AD1 + E

AD2

SRAS

Higher interest rates decreases aggregate demandcurves AD1 to AD1 -E and eventually shiftsleftwards to AD2. Real GDP decreases to potentialGDP and price level falls.

Effects of Tight Money Policy


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Relative Importance of theinstruments

The most important instrument is openmarket operation.

Has advantage of flexibility and promptimpact.

Discount rate is less important as

amount that banks can borrow is small.


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Relative Importance of theinstruments

Reserve requirement is rarely used,increasing and decreasing of reserves

would have substantial effect on thebanks profit.

Topic - Money & Banking System & Monetary Policy STU b

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