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Money, Banking and Financial System

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1 Money, Banking and Financial System
Ch. 12, Macroeconomics, Roger A. Arnold

2 12-1 All About Money Money: Any good that is widely accepted for purposes of exchange and the repayment of debt Functions of money: Medium of exchange (reduces transaction costs of exchanges) Unit of account (Values of goods are expressed in money; we can determine relative prices) Store of value (The ability of an item to hold value over time; we can keep money until we decide how to spend it)

3 Barter Economy VS Money Economy
In a barter economy transaction costs are higher because of double coincidence of wants i.e. a trader must find another trader who at the same time is willing to trade what the first trader wants and wants what the first trader has. In a money economy transaction or trade takes less time since double coincidence of want is unnecessary. People can use the extra time to work and/or for leisure. Hence a money economy is likely to produce a greater amount of output and people are likely have more leisure time. Hence, the standard of living of the average person in the money economy is likely to be higher.

4 Defining The Money Supply
Two frequently used definitions of money supply are M1 and M2 M1 : narrow definition of money supply or transactions money M1 = Currency (coins and paper money) held outside banks + checkable deposits (deposits on which checks can be written) + traveller’s checks (a check for a fixed amount that can be cashed or used as payment abroad) M2: Broad definition of the money supply M2 = M1 + Savings deposits + time deposits + Money market mutual funds

5 Savings deposits: An interest earning account at a commercial bank
Savings deposits: An interest earning account at a commercial bank. Usually, checks cannot be written on savings deposit and the funds may be withdrawn at any time without a penalty payment. Time deposit: An interest earning deposit with a specified maturity date (hence checks cannot be written). Time deposits are subject to penalties for early withdrawal. Money Market Mutual Fund: An interest earning account at a mutual fund company, where a minimum balance is usually required and most of which offer limited check-writing privileges.

6 12-3 Fractional Reserve Banking System
Fractional Reserve Banking: A banking arrangement that allows banks to hold reserves equal to only a fraction of their deposit liabilities Banks usually have an account with the central bank (Bangladesh Bank or The Fed in USA). This is referred to as a reserve account. Banks also have currency in their vaults – called vault cash. Reserves = reserve account + vault cash

7 Continued… The central bank mandates that member commercial banks must hold a certain fraction of their checkable deposits in reserve form. This fraction is referred to as the required reserve ratio (r). Required Reserves: The minimum dollar amount of reserves that a bank must hold against its checkable deposits, as mandated by the central bank. Required reserves = r x Checkable deposits The amount of required reserves that must be maintained by commercial banks as mandated by the central bank is called the Reserve Requirement Excess Reserves: Any reserves held beyond the required amount, the difference between total reserves and required reserves

8 The Financial System A financial system gets together people with surplus funds (lenders) with people who have a shortage of funds. Direct Finance: Borrowers and lenders meet in a market setting, such as the bond market. E.g. the buyer of a bond is a lender and the seller the borrower Indirect Finance: Funds are loaned and borrowed through a financial intermediary (e.g. commercial banks) Financial Intermediary: A financial intermediary transfers funds from those wo want to lend funds to those who want to borrow them

9 Adverse Selection and Moral Hazard Problems
Both the problems arise due to asymmetric information – Relates to an economic agent on one side of a transaction having information that an economic agent on the other side of the transaction does not have. Adverse selection: A phenomenon that occurs when the parties on one side of the market, who have information not known to others, self-select in a way that adversely affects the parties on the other side of the market. Occurs before a loan is made. Moral Hazard: A condition that exists when one party to a transaction changes his or her behaviour in a way that is hidden from and costly to the other party. Occurs after a loan is made. Financial intermediaries can solve / reduce both the problems

10 The Bank’s Balance Sheet
Balance Sheet: A record of liabilities and assets of a bank Asset: Anything of value that is owned or that one has claim to (e.g. reserves that bank holds and loans that bank has made to the borrowers) Liability: Anything that is owed to someone else (e.g. checkable deposits and any loans the bank has taken out) A bank’s business: Turning liabilities (deposits) into assets (loans made to borrowers) Bank Capital = Assets – Liabilities and Insolvency -> liabilities > assets

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