All Rights Reserved Ch. 15: 1 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 MONEY AND BANKING CHAPTER 15

All Rights Reserved Ch. 15: 2 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 DEFINITION OF MONEY The term ‘money’ is something that people generally accept as a payment for goods and services. It is also used to pay off debts. Money is defined as anything that acts as a medium of exchange.

All Rights Reserved Ch. 15: 3 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 Medium of exchange Measure of value/ unit of account Standard of deferred payment Store of value FUNCTIONS OF MONEY

All Rights Reserved Ch. 15: 4 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 Relative scarcity Portability Acceptability Durability Divisibility Stability

All Rights Reserved Ch. 15: 5 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 COMMODITY MONEY FIAT MONEY LEGAL TENDER DEMAND DEPOSIT TOKEN MONEY

All Rights Reserved Ch. 15: 6 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 MONEY SUPPLY M1 M1 = Consisting of coin, currency notes and demand deposits (bank money or cheques) M2 M2 = M1 + Fixed and saving deposits in commercial banks, negotiable certificates of deposit (NCD) and Bank Negara certificate M3 M3 = M2 + Saving and fixed deposits in other banking institutions

All Rights Reserved Ch. 15: 7 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 CONSUMER PRICE INDEX ItemBase Year Price Current Year Price Current Year Index Food150240(240/150) x 100 = 160 Apparel300420(420/300) x 100 = 140 Medical care250200(200/250) x 100 = 80 Transportation160180(180/160) x 100 = Simple CPI = Sum of all current year index number of items = DEFINITION A measure of change in the average price of goods and services. STEP 2 Selection of CPI Basket STEP 3 Prices of Selected Goods STEP 1 Selection of the Base Year SIMPLE CPI

All Rights Reserved Ch. 15: 8 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 ItemBase Year Price Current Year Price Current Year Index WeightWeighted Price Index Food150240(240/150) x 100 = x 4 = 640 Apparel300420(420/300) x 100 = x 3 = 420 Medical care250200(200/250) x 100 = x 1 = 80 Transportation160180(180/160) x 100 = x 2 = 225 Weighted CPI = Sum of all weighted Price Index Total weights 1365 = STEP 4 Weightage WEIGHTED CPI CONSUMER PRICE INDEX (cont.)

All Rights Reserved Ch. 15: 9 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 USES OF CPI To identify the distribution of income To calculate inflation rate: CPI = CPI current year – CPI previous year x 100% CPI previous year To use as a basis for future contracts To calculate changes in the value of money: Value of money = Base year index – 1 x 100% CPI

All Rights Reserved Ch. 15: 10 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 QUANTITY THEORY OF MONEY Quantity theory of money states that the changes in the money supply are related to changes in the price level, which is measured by consumer price index (CPI). M V = P T Expenditure side Receipt side Money Supply in Circulation Velocity of Circulation General Price Level Total Transaction ASSUMPTIONS 1. V is constant 2. T is constant 3. Full employment 4. Increase in M will increase the P ASSUMPTIONS 1. V is constant 2. T is constant 3. Full employment 4. Increase in M will increase the P MV=PT

All Rights Reserved Ch. 15: 11 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 Banking Institution Non-bank Financial Institution Non-bank financial intermediaries Commercial Bank Central Bank Finance Companies Islamic Bank Development Financial Institutions Employees Provident Fund Discount Houses Merchant Banks

All Rights Reserved Ch. 15: 12 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 COMMERCIAL BANKS A commercial bank is an institution that is owned by the private sector and is a profit-making institution. FUNCTIONS  Accepting deposits  Providing loans and advances  Providing other banking services and facilities

All Rights Reserved Ch. 15: 13 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 CREDIT CREATION Definition A process where a small given deposit in a commercial bank will lead to an increase in the supply of money. Assumptions: 1. Cash ratio is fixed by BNM and its value is constant. 2. Banks do not keep excess cash reserves. 3. The public must keep their money in the bank. 4. Leakage does not exist. 5. Bank’s assets are only in the form of cash and loans. 6. Liability consists of deposits only. 7. Deposits are in the form of current deposits.

All Rights Reserved Ch. 15: 14 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 Process of Credit Creation AssetLiability Cash (10%) RM100 Loans (90%) RM900 Deposits RM1000 Total RM1000 Assume that Bank XYZ is the only commercial bank in the country. Assume a customer, Mr. Arwin deposits RM 1,000 in Bank XYZ. Balance sheet: Bank XYZ Assume bank’s legal cash requirement is 10%. Cash reserve= Cash Ratio x Initial deposit = 10% x 1000 = RM100 Bank will loan out the balance to another person.

All Rights Reserved Ch. 15: 15 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 Process of Credit Creation (cont.) AssetLiability Cash (10%) RM90 Loans (90%) RM810 Deposits RM900 Total RM1000Total RM900 Bank XYZ loans out to Ms. Catherine and she deposits into the same bank. Balance sheet: Bank XYZ Bank’s legal cash requirement is the same. Excess reserve from earlier balance sheet Bank will loan to another person. This process will continue until the total money supply is RM10,000

All Rights Reserved Ch. 15: 16 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 Process of Credit Creation (cont.) IMPORTANT FORMULAE 1.Cash Ratio = Cash reserve/Initial deposit X Money Multiplier = 1/Cash ratio 3.Total Money Supply = 1/Cash ratio X Initial deposit 4.Total Reserves = 1/Cash ratio X Initial reserve 5.Total Credit Creation = 1/Cash ratio x Initial loan

All Rights Reserved Ch. 15: 17 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 LIMITATION TO CREDIT CREATION  A change in cash ratio/legal reserve requirement  Clearing house – slows down the process  Availability of collateral security – mortgages, land titles  Bank Negara Malaysia’s monetary control will affect amount of loans Process of Credit Creation (cont.)

All Rights Reserved Ch. 15: 18 Principles of Economics second edition © Oxford Fajar Sdn. Bhd. ( T) 2010 To issue currency and safeguard the external value of the currency Banker to the government Banker to other banks Promoting monetary stability Holder of the country’s stock of gold and foreign currency reserves The central bank is an important financial institution in every country and plays active role in implementing government’s economic policy. FUNCTIONS OF CENTRAL BANK CENTRAL BANK