1. Money and Banking

2. Outline What is money? The Money Market The Financial Sector
Characteristics
Definition
The Money Market
Money supply
Money Demand
The Financial Sector
How do banks create money?
A model of the money market

3. What is Money? Characteristics Medium of exchange Unit of account
Buying and selling goods and services
Unit of account
Assisting measurement of relative worth of various goods, services and resources
Store of value
A form in which to store wealth, due to its liquidity and convenience
Standard of deferred payment (e.g. wages)

4. The Money Market Money Supply
Most economies classify their money supply according to the following definitions:
M1;
M2;
M3; and
Broad Money.

5. The Money Market
Three components of the money supply are of significance:
Currency (coins and notes) in hands of non-bank public
Current deposits in banks upon which cheques can be drawn
Non-current accounts such as savings accounts and term deposits with banks.

6. The Money Market Currency Coin and note component of the money supply
In modern economies, currency has not real value of itself – it has legal backing by the government that makes it acceptable as a means of payment.

7. The Money Market Current Deposits
Can be readily converted into currency
Generally acceptable as a medium of exchange
Cheques enable the ownership of current deposits to be transferred

8. The Money Market Non-current Deposits
Can be readily converted into currency or current deposits
Highly liquid financial assets
New technologies (such as EFTPOS) important

9. The Money Market M1
total of currency outside banks and demand deposits (non-interest-bearing chequing accounts). M1 definition is the most liquid of all assets and is the traditional definition of money supply. M2
adds to M1 assets such as savings accounts, small denomination time deposits, money market deposit accounts, and money market mutual fund shares. (US Federal Reserve uses this definition.)

10. The Money Market M3
M1 and M2 plus assets as large denomination time deposits. M3 is the sum of currency (notes and coins), current (or demand) deposits in banks on which cheques can be drawn, and non current deposits in banks (e.g. savings) (commonly used by RBA, although RBA uses other definition such as Broad Money)
Broad money
M3 plus borrowings from the private sector of non-bank financial intermediaries (NBFIs) less holdings of currency and bank deposits by the NBFIs

11. The Money Market Sm
Rate of Interest (%) QS
Quantity of Money

12. The Singapore Money Supply (August 2008)
The Money Market
The Singapore Money Supply (August 2008) M1
Currency outside banks (about 50% of M1) , demand deposits at banks, checkable deposits at banks and thrift organizations (credit unions, mutual savings banks); traveler's cheques.
$ M M2
Adds to M1 small-denomination time deposits plus money market deposit accounts and savings deposits at all depository institutions , plus retail money mkt mutual fund shares.
$ M M3
Adds to M2 large denominations (US $ >) time deposits at all depository institutions, institutional money market mutual fund shares, bank repurchase agreements and Eurodollars
$ M
Source:

13. The Money Market The Monetary Base Composed of:
Currency held by the public
Currency held by the banks
Banks’ demand deposits with the RBA

14. The Money Market Credit Cards Not money
Simply a convenient method of obtaining a short-term loan from the card-issuer
Facilitate the synchronisation of receipts and expenditures, reducing the demand for cash

15. The Money Market Money Demand
The demand for money is the demand for real money balance
2 reasons why people demand money:
Transactions demand
Asset demand

16. The Money Market Transactions Demand
The demand for money as a medium of exchange (to buy goods and services)
Depends on money GDP (not interest rates)
Vertical demand curve.

17. The Money Market Asset Demand
The demand for money as a financial asset and store of wealth
The interest rate reflects the opportunity cost of holding money:
The lower the interest rate in the economy, the lower the opportunity cost of holding money & more willing to hold money for its liquidity.
The higher the interest rate, the greater the cost of holding money (in interest rate forgone) & so will hold less money.
Downward-sloping asset money demand curve

18. The Money Market Total Demand for Money
Transactions demand and assets demand are added horizontally
DM=MDt+MDa
Changes in interest rates lead to movement along the curve
Anything that changes money GDP leads to a shift in the money demand curve

19. + = The Money Market Transactions Demand, Dt Asset Demand, Da
Total Demand
for Money, Dm 10
7.5 5
2.5 10
7.5 5
2.5 10
7.5 5
2.5
Rate of interest, i (per cent)
Rate of interest, i (per cent)
Rate of interest, i (per cent) Dt Dm Da
Amount of money
demanded (billions
of dollars)
Amount of money
demanded (billions
of dollars)
Amount of money
demanded (billions
of dollars)

20. The Money Market Money Demand Shifts in the Demand for Money Curve
The demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs.

21. Effect of increase in real GDP Effect of decrease in real GDP
The Money Market
MD2 5
Effect of increase in real GDP
MD1 4
Interest rate (percent per year) 3
Effect of decrease in real GDP
MD0
500
600
700
Real money (billions of 2003/04 dollars)

22. The Money Market
The combination of the money demand and money supply determines the equilibrium interest rate
The interest rate represents the opportunity cost of holding money balances

23. Equilibrium Interest Rate
The Money Market
Equilibrium Interest Rate Sm 10
7.5 5
2.5 Dm
Equilibrium
Interest Rate ie
Rate of interest, i (per cent)
Amount of money demanded
(billions of dollars)

24. Financial Intermediaries
The Financial Sector
Figure 1 Flow of funds through financial system (transfer from savers to borrowers)
Financial Intermediaries
(e.g. commercial and saving banks, savings and loans associations, credit unions, insurance companies, pension funds, mutual funds)
Savers/ Lenders
*Households
*Business firms
*Government
*Foreigners
Borrowers/Spenders
*Households
*Business firms
*Government
*Foreigners
Financial Markets
markets in which funds are transferred from people with surplus funds to those with a shortage of available funds

25. Some Basic Definitions
Bank: an institution that takes funds from one group of investors and re-deploys those funds by investing in financial assets.
Non-bank Financial Institution (NBFI): permanent building societies, credit cooperatives, money market corporations (merchant banks), pastoral finance companies, finance companies, general financiers, insurance companies and cash management trusts.
Deposit: funds placed into a bank account
Current deposit: no minimum term requirement
Non-current Deposit: minimum term bank deposit
Loan: repayable funds given out by a bank for a specific period of time 25

26. Some basic definitions
Reserves: currency held by private banks to meet operating requirements.
A bank uses its reserves to meet depositors’ demand for currency and to make payments to other banks. A bank’s reserves are made up of:
Actual reserves: how much reserves a bank holds.
Desired Reserves: the reserves that a bank wishes to hold.
Excess reserves: how much reserves a bank can loan out. actual reserves minus desired reserves.

27. Some Basic Definitions
Central Bank: regulates an economy’s financial sector and implements Monetary Policy.
COUNTRY
CENTRAL BANK
China
Malaysia
Australia
Singapore
Hong Kong
Japan
New Zealand
Philippines
Russia
Sri Lanka
Thailand
Soloman Islands
Peru
Papua New Guinea
Pakistan
India
Indonesia
South Korea
The People’s Bank of China
Bank Negara Malaysia
The Reserve Bank of Australia
Monetary Authority of Singapore
Hong Kong Monetary Authority
Bank of Japan
Reserve Bank of New Zealand
Bangko Sentral ng Pilipinas
Central Bank of Russia
Central Bank of Sri Lanka
Bank of Thailand
Central Bank of Solomon Islands
Central Reserve Bank of Peru
Bank of Papua New Guinea
State Bank of Pakistan
Reserve Bank of India
Bank of Indonesia
Bank of Korea

28. Some basic definitions:
Liquidity : ability to convert an asset into cash quickly with little loss in value.
Bond: liability issued by a government or a business (corporate bond) promising to pay the holder a fixed cash amount at a specified maturity date and usually to make regular interest payments in the interim.
Securities: financial instruments representing ownership or debt, such as stocks and bonds, that provide claims to future expected cash flows. 28

29. The Role of Banks Economic Functions of Banks Create Liquidity
Minimise the cost of obtaining funds
Minimise the cost of monitoring borrowers
Pool Risk.

30. Banks and Financial Instability
Banks may contribute to business fluctuations
Can exacerbate recession, by holding back on credit expansion
May amplify inflationary pressures, by increasing lending and credit creation 30

31. Assets = Liabilities + Owners’ Equity
How do banks create money?
A Bank’s Balance Sheet
A statement of assets and claims that summarises the financial position of a firm at a point in time
Each side balances:
Assets are items of economic and financial value.
Example, loans, reserves.
Liabilities are claims of other parties on the bank.
Example, deposits
Assets = Liabilities + Owners’ Equity

32. Formation of a Bank Transaction 1 The birth of a Bank
New owners sell $250,000 worth of shares
ASSETS
LIABILITIES
Cash
250,000
Capital

33. Formation of a Bank Transaction 2 Becoming a Going Concern
Acquisition of property and equipment
ASSETS
LIABILITIES
Reserves
Property
10,000
240,000
Capital
250,000

34. Formation of a Bank Transaction 3 Accepting Deposits
Citizens and businesses deposit $100,000
Change in the composition but not the quantity of the Money Supply
ASSETS
LIABILITIES
Cash
Property
110,000
240,000
Deposits
Capital
100,000
250,000
300,000

35. Formation of a Bank Transaction 4 Setting aside Required Reserves
Bank decides to keep all cash as reserves (actual reserves).
ASSETS
LIABILITIES
Cash
Reserves
Property
110,000
240,000
Deposits
Capital
100,000
250,000
350,000

36. Formation of a Bank ASSETS LIABILITIES Reserves Property 60,000
Transaction 5
Withdrawal of Funds
A citizen who has substantial deposits in the bank withdraws $ to buy goods
The seller of the goods deposits the cheque in another bank
The banking system as a whole has not lost or gained
ASSETS
LIABILITIES
Reserves
Property
60,000
240,000
Deposits
Capital
50,000
250,000
300,000

37. Creating Money Transaction 6 Granting a loan ASSETS LIABILITIES
A company borrows $ from the bank
Money is created
Balance sheet after loan is negotiated:
ASSETS
LIABILITIES
Reserves
Loans
Property
60,000
50,000
240,000
Deposits
Capital
100,000
250,000
350,000

38. Creating Money Transaction 7 Buying Government Bonds ASSETS
Bank buys $ of government bonds instead of lending $50 000
Money is created
ASSETS
LIABILITIES
Reserves
Bonds
Property
60,000
50,000
240,000
Deposits
Capital
100,000
250,000
350,000

39. The Banking System Multiple banks: multiple-deposit expansion
Money is created by a multiple of the banking system’s excess reserves
Assume reserve ratio is 20%
Bank must keep $ (required reserves)
Bank’s Required Reserves
Bank’s Deposit Liabilities
Reserve Ratio =

40. Multiple-Deposit Expansion
Assume initially: 20% reserve requirement
Bank A
Accepts a deposit for $100
Gains $100 in Actual Reserves and Deposits
ASSETS
LIABILITIES
Reserves
+100
Current Deposits
100
Keeps 20% ($20) of the new deposit as Desired Reserves and loans out 80% ($80).

41. Multiple-Deposit Expansion
A loan of $80 is negotiated
ASSETS
LIABILITIES
Reserves
Loans 20 80
Current Deposits
100
$80 loan deposited in Bank B…

42. Multiple-Deposit Expansion
Bank B
Gains $80 in Actual Reserves and Deposits
Keeps 20% ($16) of the new deposit as Desired Reserves and loans out 80% ($64).
ASSETS
LIABILITIES
Reserves
Loans 16 64
Current Deposits 80
Loan of $64 is drawn on Bank B and deposited in Bank C, and so on…

43. Multiple Deposit Expansion Process
Acquired reserves
and deposits
Required
reserves
Excess
reserves
New money
created
Bank A B C D E F G H I J K L M N
Other banks
$100.00
80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
21.97
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Total amount of money created by the banking system
$400.00
Change in money supply = first deposit of $100 + $400 = $500

44. Multiple-Deposit Expansion
Total banking system has created $400
Total money supply grown by $500
How?
Via the Monetary Multiplier 1
Reserve Ratio
Money Multiplier = 1 R
MM =
where MM is the Monetary Multiplier

45. Multiple-Deposit Expansion
Total banking system has created $400
Total money supply grown by $500
1/0.2 = 5; then 5 X excess reserves ($80)= $400
And there was the initial $100 tax refund from the Central Bank

46. Multiple-Deposit Expansion1
Reserve Ratio
Monetary Multiplier =
MM= 1 R
MM = 1/0.2 =5
Initial change in reserves = $100
 Money Supply = m *  Reserves
 Money Supply = 5 * 100 = 500

47. Multiple-Deposit Expansion1
Reserve Ratio
Monetary Multiplier = 1 R
MM =
MM = 1/0.2 = 5
Excess reserves = $80
 Deposits = m * Excess Reserves
 Deposits = 5 * 80 = 400

48. Possible Leakages Currency drains
Loan may be paid in cash and remain in circulation
Transfer of deposits to non-bank financial institutions
Excess reserves
Individual banks may choose to have larger reserves than required (say 25% instead of 20%)

49. Willingness to Borrow For the full multiplier effect to take place:
Borrowers must be willing and able to utilise the loans
Borrowing is likely to be low during a recession

50. Monetary base & money creation
We saw that the tax refund cheque started the process of multiple deposit expansion for the banking system.
The monetary base is important.
How can the government or RBA increase the monetary base?
by running deficits;
by tax refund cheques;
by buying government bonds from public;
by purchasing foreign currencies.

51. References
Jackson and McIver, chs 9 and 10.