6 Money and Finansial System_week06

8/3/2019 6 Money and Finansial System_week06

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Week-06


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outline

The Meaning of Money and its functions

The Money Supply and the demand formoney

The Financial system

Financial intermediaries and the moneysupply

Financial markets and the market forloanable funds


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Moneyis the set of assets in an economythat people regularly use to buy goods andservices from other people.

Moneyis anything that serves as acommonly accepted medium of exchange

According to the economists definition,money include only few types of wealth

that regularly accepted by seller inexchange for goods and services


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The Functions of Money

1. Medium of exchange is an item thatbuyers give to sellers when they wantto purchase goods and services.

2. Unit of account is the yardstick peopleuse to post prices and record debts.

3. Store of value is an item that people

can use to transfer purchasing powerfrom the present to the future.


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Types of Money

Commodity moneytakes the form of acommodity with intrinsic value.

Examples: Gold, silver, cigarettes.

Fiat moneyis used as money becauseof government decree.

It does not have intrinsic value.

Examples: Coins, currency, check deposits.


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The quantity of money available in theeconomy calledmoney supply

Two measure of the money supply

M1, that is the sum of coins and papercurrency in circulation outside the banksplus checkable deposits.

M2 includes assets such as savingsaccounts in addition to coins, papercurrency and checkable deposits


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Moneys Functions (recall)

a medium of exchange

the unit of account

a store of value The opportunity cost of holding money is

the sacrifice in interest that we must incurby holding money rather than a riskier; less

liquid asset or investment. The sources of money demand

Transactions demand for money

Asset Demand


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The financial system consists of the group ofinstitutions in the economy that help to match onepersons saving with another persons investment.

Financial institutions can be grouped into :

Financial intermediaries are financial institutionsthrough which savers can indirectly providefunds to borrowers (banks and other financialinstitutions)

Financial markets are the institutions throughwhich savers can directly provide funds toborrowers (stock market, bond market)


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Financial intermediaries accept checkingdeposits from households and firms, and

then lend these funds out to otherhouseholds and business for a variety ofpurposes.

Bank money and many other financial

services are today provided by financialintermediaries (commercial banks andother financial institutions)


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BANKS AND THE MONEYSUPPLY

Whenever a person deposits some money,the bank keeps the money in its vault until

the depositor comes to withdraw it or writesa check against his or her balance. Deposits that banks received but have not

loaned out are called reserves


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BANKS AND THE MONEYSUPPLY Reservesare deposits that banks have

received but have not loaned out.

Bank reserves are assets bank hold in the

form of cash on hand or of funds depositedby the bank with the central bank.

Bank reserves are kept above the prudentcommercial level because of legal reserve

requirements. The main function of legal reserve

requirements is to enable the central bank tocontrol money supply.


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BANKS AND THE MONEYSUPPLY

In a fractional-reserve bankingsystem,banks hold a fraction of the moneydeposited as reserves and lend out the

rest. The fraction of deposits that banks hold

as reserves is called thereserve ratio


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Money Creation with Fractional-Reserve Banking

When a bank makes a loan from itsreserves, the money supply increases.

The money supply is affected by the

amount deposited in banks and the amountthat banks loan.

Deposits into a bank are recorded as bothassets and liabilities.

The fraction of total deposits that a bank has tokeep as reserves is called the reserve ratio.

Loans become an asset to the bank.


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This T-Account shows a bank that

accepts deposits,

keeps a portion

as reserves, and lends out

the rest.

It assumes a

reserve ratioof 10%.

Assets Liabilities

First National Bank

Reserves$100.00

Loans$900.00

Deposits$1000.00

Total Assets$1000.00

Total Liabilities$1000.00


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When one bank loans money, thatmoney is generally deposited intoanother bank.

This creates more deposits and morereserves to be lent out.

When a bank makes a loan from its

reserves, the money supply increases.


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Assets Liabilities

First National Bank

Reserves$100.00

Loans$900.00

Deposits$1000.00

Total Assets$100.00


Assets Liabilities

Second National Bank

Reserves$90.00

Loans$810.00

Deposits$900.00

Total Assets$900.00


Money Supply = $1,900.00!


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The Money Multiplier

How much money is eventually createdin this economy?


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Position of BankNew

Deposits

New Loans and

Investment

New

Reserves

Originil Banks 1,000.00 900.00 100.00

2d-generation banks 900.00 810.00 90.00

3d-generation banks 810.00 729.00 81.00

4th-generation banks 729.00 656.10 72.90







Sum of first 10 generations of banks 6,513.22 5,861.90 651.32. . . .. . . .. . . .

Sum of remaining generations of banks 3,486.78 3,138.10 348.68

Total for bank system as a whole 10,000.00 9,000.00 1,000.00


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The algebraic solution can be shown asfollows:

1000 + 900 + 810 + .

= 1000 x [1 + 9/10 + (9/10)2 + ]= 1000 x 1/(1-9/10)

= 1000 x 1/0.1 = 10000

Money supply multiplier

= 1/required reserve ratio


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The money multiplieris the amount ofmoney the banking system generateswith each dollar of reserves.

The money multiplier is the reciprocal ofthe reserve ratio:

M = 1/R

With a reserve requirement, R = 10%or1/10,

The multiplier is 10.


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The money multiplier is the reciprocal ofthe reserve ratio:

M = 1/R

With a reserve requirement, R = 10%or1/10,

The multiplier is 10.


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What would happen if some money leaked intocirculation or if some banks had excess reserves?

If $ 100 were to leak into circulation outside the

banks and only $ 900 of new reserves were toremain in the banking system, the newchecking deposits created would be $9000.

If the bank decided to keep rather than lend the

new reserves, then the whole process ofmultiple deposit creation would stop dead withno expansion of deposit at all.


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MONETARY POLICY

The objectives of the central bank inexercising its control over money,interest rates, and credit conditions.

The instrument of monetary policy areprimarily open-market operations,reserve requirements, and the discount

rate.


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MONETARY POLICY

Open-Market Operations

The Central Bank conducts open-marketoperationswhen it buys government

bonds from or sells government bonds tothe public:

When the Central Bank buysgovernment bonds, the money supplyincreases.

The money supply decreases when theCentral Bank sells government bonds.


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MONETARY POLICY

Reserve Requirements

The central bank also influences themoney supply with reserve

requirements.

Reserve requirements are regulationson the minimum amount of reserves

that banks must hold against deposits.


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MONETARY POLICY

Changing the Reserve Requirement

The reserve requirementis the amount(%) of a banks total reserves that may

not be loaned out.

Increasing the reserve requirementdecreases the money supply.

Decreasing the reserve requirementincreases the money supply.


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MONETARY POLICY

Changing the Discount Rate

The discount rateis the interest ratethe central bank charges banks for

loans.

Increasing the discount ratedecreases the money supply.

Decreasing the discount rateincreases the money supply.


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Financial markets coordinate theeconomys saving and investment in themarket for loanable funds

The market for loanable fundsis themarket in which those who want to savesupply funds and those who want to borrowto invest demand funds.

Loanable funds refers to all income thatpeople have chosen to save and lend out,rather than use for their own consumption.


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Supply and Demand forLoanable Funds The supply of loanable fundscomes

from people who have extra income theywant to save and lend out.

The demand for loanable fundscomesfrom households and firms that wish toborrow to make investments.

The equilibrium of the supply and

demand for loanable funds determinesthe price of the loans, that is, the realinterest rate


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Equilibrium of the market forloanable funds

Supply

Demand

Interestrate

Loanable funds(in billions of dollars)

5%

$1,200


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Recall: Some Important Identities A Closed economy

Y = C + I + G

Now, subtract C and G from both sides of the

equation:Y C G =I

The left side of the equation is the total

income in the economy after paying forconsumption and government purchases andis called national saving, or just saving (S)


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Recall: Some Important Identities Substituting Sfor Y - C - G, the equation

can be written as:

S = I

National saving, or saving, is equal to:S = I

S = Y C G

S = (Y

T

C) + (T

G)Where: Y T C is called private saving andT G is called public saving


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A decrease in tax on interestincome

Supply, S1

Demand

Interestrate


5%

$1,200

S2

$1,600

4%

1. Tax incentives forsaving increase thesupply of loanable

fund

2. . . . which

raises the

equilibriuminterest rate . . .

3. . . . and raises the equilibrium

quantity of loanable funds.


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A tax incentives for investment

Supply

Demand, D1

Interestrate


5%

$1,200

D2

$1,400

6%1. An investment

tax credit

increases the

demand forloanable funds . . .

2. . . . which

raises the

equilibrium

interest rate . . .

3. . . . and raises the equilibrium



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The Effect of a GovernmentBudget Deficit

Supply, S1

Demand

Interestrate


6%

$800

S2

$1,200

5%

2. . . . which

raises the

equilibriuminterest rate . . .

1. A budget deficit

decreases thesupply of loanable

funds . . .

3. . . . and reduces the equilibrium



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Thank you

for your attention

6 Money and Finansial System_week06

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