Chapter 23 Money and modern banking David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

23.1 Some key questions n Why does society need money? n Why do governments wish to influence money supply? n How do financial markets interact with the “real” economy? n What is the relationship between money and interest rates?

23.2 Money n Any generally accepted means of payment for delivery of goods or the settlement of debt n Legal money – notes and coins n Customary money – IOU money based on private debt of the individual n e.g. bank deposit.

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

23.4 Modern banking n A financial intermediary – an institution that specializes in bringing lenders and borrowers together n e.g. a commercial bank, which has a government licence to make loans and issue deposits n including deposits against which cheques can be written n Clearing system – a set of arrangements in which debts between banks are settled

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

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

23.7 Credit creation by banks n Commercial banks need to hold only a proportion of assets as cash reserves – this enables them to create credit by lending n EXAMPLE: – suppose the public needs a fixed £10m for transactions – and the commercial bank maintains a 10% cash reserve

23.8 Credit creation – example Commercial bank : LiabilitiesAssets Deposits Cash Loans Total Cash ratio % Public cash holding Money supply Initial position: Central bank issues £10m extra; the public deposits it n

23.9 The monetary base and the money multiplier n 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 n The money multiplier – the change in the money stock for a £1 change in the quantity of the monetary base

23.10 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