1. MONEY AND BANKING

2. “money is what money does”
What is Money?
“… whatever is generally accepted in exchange for goods and services; accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power to be used for buying still other goods and services.” (Friedman, 1992).
“money is what money does”
“Anything that performs the functions of money is money”

3. Functions of Money?
Medium of exchange: Used to buy & sell goods and services (it eliminates the need for double coincidence of wants and brings efficiency in the economic system)
Store of value: Allows people to transfer purchasing power from one period to another.
Unit of account: Yardstick for measuring the relative worth of a wide variety of goods and services.

4. Characteristics of Money
Recognisable
Acceptable
Portable
Must have intrinsic value
Divisible
Durable
Difficult to counterfeit

5. The Supply of Money

6. Definitions of Money 3 basic measurements of MS: M1 and M2:
M1 (narrow money) comprises:
Currency (notes and coins in circulation),
Cheque accounts (demand deposits)
Traveler's cheques .
M2 (broad money / near money) includes: M1
Savings deposits,
Time deposits, and,
Money market mutual funds.
* Narrow money is directly usable as medium of exchange while near monies serve the store-of-value function. However, they are highly liquid financial assets that can be readily converted into currency or cheque deposits for use in exchange

7. Definitions of Money M3 comprises: M2 Large time deposits
Large time deposits are usually owned by businesses as savings not as money. These include government securities such as treasury bonds and bills
What are the definitions of money in Zimbabwe?

8. The Business of Banking
Banks are profit-seeking institutions. They accept deposits and use part of them to extend loans and make investments.
Banks play a central role in the capital market by bringing together savers and borrowers.
Other financial institutions: insurance companies, mutual fund companies, pensions funds, securities firms.

9. Functions of Commercial Banks
Banks provide services and pay interest to attract chequing, savings, and time deposits (liabilities).
Most of these deposits are invested and loaned out.
Banks hold a portion of their assets as reserves (either as cash or deposits with the central bank) to meet their daily obligations toward their depositors.

10. Functions of Central Banks
Issuing of currency (notes & coins)
Setting reserve requirements & holding reserves
Banker to commercial banks: lender of last resort
Financial system regulation: supervision & surveillance
Banker to government: sells and redeems bonds on behalf of Govt
Clearing of cheques (central payment system)
Controlling MS

11. How banks create money
Banking system is a fractional reserve system; banks required to maintain part of their assets as reserves (vault cash & deposits held with RBZ) against the deposits of customers.
Excess reserves can be used to extend new loans and make new investments.
Under fractional reserve system, an ↑ in deposits will provide the bank with excess reserves.

12. Creating Money from New Reserves
New cash deposits: Actual Reserves
Potential demand deposits created by extending new loans
New Required Reserves
Bank (RRR=20%)
Initial deposit (bank A)
$100.00
$20.00
$80.00
Second stage (bank B)
80.00
16.00
64.00
Third stage (bank C)
64.00
12.80
51.20
Fourth stage (bank D)
51.20
10.24
40.96
Fifth stage (bank E)
40.96
8.19
32.77
Sixth stage (bank F)
32.77
6.55
26.21
Seventh stage (bank G)
26.21
5.24
20.97
All others (other banks)
104.89
20.97
83.89
Total
$500.00
$100.00
$400.00
$100 of new deposits will potentially increase MS to $500.

13. Creating Money from New Reserves
A banking system with a reserve ratio of v can change its deposits by 1/v times the initial deposit
Money Supply (Deposits) = Initial Deposit x (1/v)
1/v is the money multiplier.
The lower the RR, the greater the potential expansion.
Actual multiplier will be less than the potential:
some persons will hold currency rather than bank deposits,
some banks may not use all their excess reserves to extend loans.

14. Central Bank Control of MS
3 major tools:
Reserve Requirements: setting the fraction of assets that banks must hold as reserves (vault cash or deposits with the central bank), against their chequeing deposits.
Open Market Operations: the buying and selling of government securities in the open market.
Discount Rate: setting the interest rate at which it loans funds to commercial banks and other depository institutions.

15. Reserve Requirements
% of a specified liability category (e.g. chequeing deposits) that banks are required to hold as reserves against that type of liability.
Lower RRR expands the MS.
Higher RRR lowers MS growth!

16. Open Market Operations
Buying & selling of bonds by the central bank.
Primary tool used to control the MS.
Buying bonds expands MS.
Selling bonds contracts MS.

17. The Discount Rate
Interest rate the central bank charges banking institutions for borrowed funds in its function as ‘LOLR.’
Borrowing increases banks excess reserves & enhances extension of credit.
Lowering discount rate → ↑ borrowing by banks → ↑ MS.
Increasing discount rate → bank borrowing → ↑ MS.

18. Money Demand
Amount of wealth people wish to hold in the form of money.
Assuming 2 types of assets (bonds & money), households and firms will either hold their wealth in either form.
The OC of holding money: the interest that could have been earned if the money had purchased an interest bearing asset.

19. Motives of Holding Money
Transactions motive: Payments and receipts are not synchronized. Provides convenience when transacting (planned transactions).
Precautionary motive: Uncertainty about the degree to which payments and receipts will be synchronized (potential transactions).
Speculative motive: OC of holding money balances is forgone interest. Implies that demand for money is negatively related to the interest rate.

20. Real & Nominal Money Balances
Real money demand: amount demanded at a constant price level derived by dividing nominal quantity demanded by the price level.
Nominal money demand varies with the price level; when price level doubles, desired money balances all doubles.

21. Determinants of Money Demand
Interest rate: ceteris paribus, the demand for money is negatively related to interest rate.
Real GDP: an increase in the real GDP increases the volume of transactions in the economy and therefore leads to an increase in desired money holdings.
Price level: an increase in the price level increases the dollar value for a given volume of transactions causing an increase in desired money holdings.
In sum: MD is negatively related to the interest rate and positively related to real GDP and the price level.

22. MD as f(Int. Rate, Real GDP, Price Level)
Money interest rate
MD0
Quantity
of money i0 i1 B A M1 M0
MD1
An increase in Y or P leads to an increase in MD at any given interest rate, thus a shift in the MD curve from MD0 to MD1
A fall in interest rate from i0 to i1 lowers the OC of holding money because the return on bonds declines.

23. Monetary Equilibrium MD = MS.
Interest rate is the relevant price in the money market.
Monetary authorities set the interest rate and money supply adjusts to become equal to the quantity of money demanded at the policy determined rate of interest (assuming one policy set interest rate).

24. The Demand for Money
Money interest rate
Money Demand
Quantity
of money
The Demand for Money is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earning assets like bonds.

25. The Supply of Money
Quantity
of money
Money interest rate
Money Supply
The supply of money is vertical because it is established by the Central Bank and, hence, determined independently of the interest rate.

26. Equilibrium
Money interest rate
Money Supply
Money Demand i3 ie i2
Excess supply at i2
Excess demand at i3
At ie, people are willing to hold the money supply set by the Central Bank
Quantity
of money
The money interest rate gravitates toward the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the central bank has supplied.