1. © Pearson Education 20111

2. Economics, Arab World Edition R. Glenn Hubbard, Anthony Patrick O’Brien, Ashraf Eid, Amany El Anshasy, © Pearson Education 20112 Chapter 21 Money, Banks, and the Central Bank

3. A New Sudanese Pound Is Worth a Thousand Old Pounds 21.1Define money and discuss its four functions. 21.2Discuss the definitions of the money supply used in the Arab World today. 21.3Explain how banks create money. 21.4Discuss the three policy tools the Central Bank uses to manage the money supply. 21.5Explain the quantity theory of money and use it to explain how high rates of inflation occur. Learning Objectives Confidence and trust cannot be taken for granted. …households and firms losing faith in an official money can harm trade and economic activity in an economy. © Pearson Education 20113

4. Chapter 21: Money, Banks, and the Central Bank Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset Anything of value owned by a person or a firm. Learning Objective 21.1 What Is Money and Why Do We Need It? © Pearson Education 20114

5. Chapter 21: Money, Banks, and the Central Bank What Is Money and Why Do We Need It? Learning Objective 21.1 Commodity money A good used as money that also has value independent of its use as money. Barter and the Invention of Money The Functions of Money Anything used as money—a seashells, cigarettes, or a dollar bill—should fulfill the following four functions: Medium of exchange Unit of account Store of value Standard of deferred payment © Pearson Education 20115

6. Chapter 21: Money, Banks, and the Central Bank What Is Money and Why Do We Need It? Learning Objective 21.1 Medium of Exchange The Functions of Money Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services. Unit of Account In a barter system, each good has many prices. Store of Value Money allows value to be stored easily: If you do not use all your accumulated dollars to buy goods and services today, you can hold the rest to use in the future. Standard of Deferred Payment Money is useful because it can serve as a standard of deferred payment in borrowing and lending. © Pearson Education 20116

7. Chapter 21: Money, Banks, and the Central Bank What Is Money and Why Do We Need It? Learning Objective 21.1 What Can Serve as Money? Five criteria make a good suitable to use as a medium of exchange: 1 The good must be acceptable to (that is, usable by) most people. 2 It should be of standardized quality so that any two units are identical. 3 It should be durable so that value is not lost by spoilage. 4 It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported. 5 The medium of exchange should be divisible because different goods are valued differently. © Pearson Education 20117

8. Chapter 21: Money, Banks, and the Central Bank What Is Money and Why Do We Need It? Learning Objective 21.1 What Can Serve as Money? Commodity money meets the criteria for a medium of exchange. for example Gold. Commodity Money It can be inefficient for an economy to rely on only gold or other precious metals for its money supply. Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money. Fiat Money (Paper currency) © Pearson Education 20118

9. Chapter 21: Money, Banks, and the Central Bank How Is Money Measured in the World Today? Learning Objective 21.2 M1: The Narrowest Definition of the Money Supply M1 The narrowest definition of the money supply: The sum of: currency in circulation, checking account deposits in banks, and holdings of traveler’s checks. © Pearson Education 20119

10. Chapter 21: Money, Banks, and the Central Bank Learning Objective 21.2 M1: The Narrowest Definition of the Money Supply M1 includes: 1 Currency, which is all the paper money and coins that are in circulation, where “in circulation” means not held by banks or the government 2 The value of all checking account deposits at banks 3 The value of traveler’s checks (this last category is usually very so we will ignore it in our discussion of the money supply) How Is Money Measured in the United States Today? © Pearson Education 201110

11. Chapter 21: Money, Banks, and the Central Bank Learning Objective 21.2 M1: The Narrowest Definition of the Money Supply How Is Money Measured Today? © Pearson Education 201111 FIGURE 21-1 Measuring the Money Supply in Kuwait in 2010

12. Chapter 21: Money, Banks, and the Central Bank Learning Objective 21.2 Do We Still Need the Fils, Piaster, or Penny? Making the Connection These coins are circulating in Bahrain today. One fils is 1/1000 Bahraini dinar. Unfortunately, producing these costs the government more than their monetary value. © Pearson Education 201112

13. Chapter 21: Money, Banks, and the Central Bank Learning Objective 21.2 M2: A Broader Definition of Money M2 A broader definition of the money supply: M1 plus savings account balances, small- denomination time deposits, balances in money market deposit accounts in banks, and noninstitutional money market fund shares. How Is Money Measured in the United States Today? © Pearson Education 201113

14. Chapter 21: Money, Banks, and the Central Bank Learning Objective 21.2 M2: A Broader Definition of Money There are two key points about the money supply to keep in mind: 1 The money supply consists of both currency and checking account deposits. 2 Because balances in checking account deposits are included in the money supply, banks play an important role in the process by which the money supply increases and decreases. We will discuss this second point further in the next section. What about Credit Cards and Debit Cards? Many people buy goods and services with credit cards, yet credit cards are not included in definitions of the money supply. How Is Money Measured in the United States Today? © Pearson Education 201114

15. Chapter 21: Money, Banks, and the Central Bank Solved Problem 21-2 The Definitions of M1 and M2 Learning Objective 21.2 Suppose you decide to withdraw $2,000 from your checking account and use the money to buy a bank certificate of deposit (CD). Briefly explain how this will affect M1 and M2. © Pearson Education 201115

16. Chapter 21: Money, Banks, and the Central Bank Learning Objective 21.2 Is Money the Same as Income or Wealth? Making the Connection Prince Al-Waleed bin Talal has a very large income, but how much money does he have? Only a small proportion of Al-Waleed’s wealth is likely to be in currency or checking accounts. Most of his wealth will be invested in real estate, stocks, and bonds and other financial assets that are not included in the definition of money. © Pearson Education 201116

17. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 Bank Balance Sheets Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits. Required reserve ratio (RR) The minimum fraction of deposits banks are required by law to keep as reserves. Excess reserves (ER ) Reserves that banks hold over and above the legal requirement. © Pearson Education 201117

18. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 Using T-Accounts to Show How a Bank Can Create Money © Pearson Education 201118

19. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 Using T-Accounts to Show How a Bank Can Create Money © Pearson Education 201119 Banks required to keep 10% as reserves. So $100 as reserve and $900 as an excess reserves.

20. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 Using T-Accounts to Show How a Bank Can Create Money © Pearson Education 201120 Now the person who took out the $900 used the money to by a car and pays by writing a check on his account at the NCB. The seller now deposit the check in his Bank (Arab Bank) which is going to send it to NCB to clear and thus NCB has lost $900 in deposits,

21. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 Using T-Accounts to Show How a Bank Can Create Money © Pearson Education 201121 Now the Arab Bank has 10% reserves of this new $900 deposit. So is going to lend out $810 to the other.

22. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 Using T-Accounts to Show How a Bank Can Create Money © Pearson Education 201122

23. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 The Simple Deposit Multiplier Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. © Pearson Education 201123 Example: If Banks required to keep 10% and the initial deposit = $ 1000. The Simple Deposit Multiplier = 1/0.10 = 10 Change in deposits = $ 1000 x 10 = $ 10000 Or =1000 x 1/1.10 = 1000

24. Chapter 21: Money, Banks, and the Central Bank Solved Problem 21-3 Showing How Banks Create Money Learning Objective 21.3 © Pearson Education 201124 Suppose you deposit 5000 in currency into your account of Arab Bank, which we assume has no excess reserves, also assume that the RR is 0.10. a.Use T-account to show the initial effect of this transaction on Arab Bank’s balance sheet. b.Use T-account to show the initial effect of this transaction on Arab Bank’s balance sheet from granting the loan (include transaction for a.

25. Chapter 21: Money, Banks, and the Central Bank How Do Banks Create Money? Learning Objective 21.3 The Simple Deposit Multiplier versus the Real-World Deposit Multiplier 1 Whenever banks gain reserves, they make new loans, and the money supply expands. 2 Whenever banks lose reserves, they reduce their loans, and the money supply contracts. We can summarize these important conclusions: © Pearson Education 201125 Many people are surprised that banks do not keep in their vaults all funds that are deposited into checking accounts.

26. Chapter 21: Money, Banks, and the Central Bank The Central Bank Learning Objective 21.4 Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves. Bank run A situation in which many depositors simultaneously decide to withdraw money from a bank. Bank panic A situation in which many banks experience runs at the same time. © Pearson Education 201126 A central bank can help stop a bank panic by acting as lender of last resort.

27. Chapter 21: Money, Banks, and the Central Bank The Central Bank Learning Objective 21.4 How the Central Bank Manages the Money Supply Monetary policy The actions the Central Bank takes to manage the money supply and interest rates to pursue economic objectives. To manage the money supply, the Central Bank uses three monetary policy tools: 1 Open market operations 2 Discount policy 3 Reserve requirements © Pearson Education 201127

28. Chapter 21: Money, Banks, and the Central Bank Open Market Operation How an Open Market Operation Works? When the central bank conducts an open market operation by buying a government security, it increases banks’ reserves. Banks loan the excess reserves. By making loans, they create money. That is buying  R   ER   L   M1 . The reverse occurs when the central bank sells a government security. That is selling  R   ER   L   M1 . The Central Bank Learning Objective 21.4

29. Chapter 21: Money, Banks, and the Central Bank The Central Bank Learning Objective 21.4 © Pearson Education 201129 Discount Policy Discount loans Loans the Central Bank makes to banks. Discount rate The interest rate the Central Bank charges on discount loans. Reserve Requirements When the Central Bank reduces the required reserve ratio, it converts required reserves into excess reserves. That is DR   ER   L   M1 , and vice versa. That is Required RR   R   ER   L   M1 

30. Chapter 21: Money, Banks, and the Central Bank The Central Bank Learning Objective 21.4 Putting It All Together: Decisions of the Nonbank Public, Banks, and the Central Bank Using its three tools—open market operations, the discount rate, and reserve requirements—the Central Bank has substantial influence over the money supply, but that influence is not absolute. Two other actors—the nonbank public and banks—also influence the money supply. © Pearson Education 201130

31. Chapter 21: Money, Banks, and the Central Bank K e y T e r m s Asset Bank panic Bank run Commodity money Discount loans Discount rate Excess reserves Federal Open Market Fiat money Fractional reserve banking system M1 M2 Monetary policy Money Open market operations Required reserve ratio Required reserves Reserves Simple deposit multiplier © Pearson Education 201131

32. Chapter 21: Money, Banks, and the Central Bank