1. Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: Money and Modern banking

2. 1.Some Key Questions  Why does society need money?  Why do governments wish to influence money supply?  How do financial markets interact with the “real” economy?  What is the relationship between money and interest rates?

3. 2.Money  Any generally accepted means of payment for delivery of goods or the settlement of debt  Commodity Money – ordinary goods with industrial uses (gold) and consumption uses (cigarettes) which can also serve as medium of exchange  Token Money – a mean of payment whose value or purchasing power as money greatly exceeds it cost of production or value uses other than money. The survival of token money requires a restriction on supply.

4. 2.Money  Society enforces the use of token money by making it legal tender – by law, it must be accepted as a means of payment  Token money is supplemented by customary money –IOU money based on private debt of the individual e.g. bank deposit, it is a debt of the bank, the bank owes you money

5. 3.Money and Its Functions  Medium of exchange –money provides a medium for the exchange of goods and services which is more efficient than barter  Unit of account –a unit in which prices are quoted and accounts are kept  Store of value –money can be used to make purchases in the future  Standard of deferred payment –a unit of account over time: this enables borrowing and lending

6. 4.Modern Banking  A financial intermediary –an institution that specializes in bringing lenders and borrowers together e.g. a commercial bank, which has a government licence to make loans and issue deposits including deposits against which cheques can be written  The Central Bank is the mother bank  Goldsmiths acted as ‘safe-keepers’, with whom people deposited their gold - which was picked up latter for making payment

7. 4.Modern banking  Fractional Reserve Banking: a banking system in which commercial banks are required are required to keep a fraction of their deposits with the central bank  Bank reserves are the money available in the bank to meet possible withdrawals by depositors  The reserve ratio is the ratio of reserves to deposits  The money supply is the value of the stock of the medium of exchange in circulation

8. 5.The Clearing House  Clearing system –a set of arrangements in which debts between banks are settled  All cheques drawn by Bank A’s customers and deposited in Bank B are totalled and set against the total of all cheques drawn by Bank B’s customers and deposited in Bank A. They settle only the difference  The clearing of the Clearing House is the BOM

9. 6.Assets and Liabilities of Bank  Balance sheet have implications of bank liquidity and profitability  Liquidity refer to the degree of ease and certainty with which an asset can be turned into money  Profitability is the ability of the bank to make profit from assets  Assets and liabilities in balance sheet are listed according to their liquidity, the most liquid comes first (profitability the other way)

10. 6.Assets and Liabilities of Bank  The banks assets are mainly loan to firms and households, and purchases of financial securities such as bills and bonds issued by the government and firms  Liabilities include sight and time deposits – The money in sight can be withdraw ‘on sight’ without prior notice.  Time deposits, paying higher interest rate requires the depositor to give notice before withdrawing money.

11. 7.A Beginner’s Guide to the Financial Markets  Financial asset –a piece of paper entitling the owner to a specified stream of interest payments over a specified period  Cash –Notes and coin, paying no interest –the most liquid of all assets.  Bills –financial assets with less than one year until the known date at which they will be repurchased by the original owner –highly liquid

12. 7.A Beginner’s Guide to the Financial Markets  Bonds –longer term financial assets – less liquid because there is more uncertainty about the future income stream  Perpetuities –an extreme form of bond, never repurchased by the original issuer, who pays interest forever e.g. Consols  Gilt-edged securities –government bonds in the UK  Industrial shares (equities) –entitlements to receive corporate dividends – not very liquid

13. 8.Credit creation by banks  Commercial banks need to hold only a proportion of assets as cash reserves –this enables them to create credit by lending  EXAMPLE: –A bank has a deposit 100,000 –Reserve requirement is 10,000 –It lends the remaining 90,000 to B –B pays the money to P for a transaction –P in turn deposit the money in the same bank –The bank keep 10 % and lend the rest to D –The process continues –Total loans created = Initial Deposits / Reserve requirement

14. 9.The Monetary Base and the Money Multiplier  The monetary base or stock of high-powered money –the quantity of notes and coin in private circulation plus the quantity held by the banking system  The money multiplier –the change in the money stock for a £1 change in the quantity of the monetary base

15. 9.The Money Multiplier Suppose the banks wish to hold cash reserves R as as fraction (c b ) of deposits (D), and the private sector wish to hold cash (C) as a fraction (c p ) of bank deposits (D). Then R = c b D and C = c p D Monetary base H = C + R = (c b + c p ) D Money supply = C + D = (c p + 1) D So M = (c p + 1) (c p + c b ) H Money supply = money multiplier × monetary base