Marcro micro econmiy david begg chapter 023

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


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?
23.2


Money

Any generally accepted means of payment
for delivery of goods or the settlement of
debt
■ Legal money
■

–

■

notes and coins

Customary money
–

IOU money based on private debt of the
individual
■ e.g.

bank deposit.

23.3


Money and its functions
■

Medium of exchange
–

■

Unit of account
–

■

a unit in which prices are quoted and accounts are kept

Store of value
–

■

money provides a medium for the exchange of goods and
services which is more efficient than barter

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

23.4


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

Clearing system
–

a set of arrangements in which debts between
banks are settled

23.5


A beginner’s guide to the financial markets
■

Financial asset

–

■

Cash
–
–

■

a piece of paper entitling the owner to a specified
stream of interest payments over a specified period
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

23.6


A beginner’s guide to the financial markets
(continued)

■

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
■

■

Gilt-edged securities
–

■

e.g. Consols

government bonds in the UK

Industrial shares (equities)
–

–

entitlements to receive corporate dividends
not very liquid

23.7


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:
–
–

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 :
Cash Public Money
Liabilities
Assets
ratio cash supply
Deposits Cash Loans Total
% holding
Initial position:
10
100
10
90
100 10
110
Central bank issues £10m extra; the public deposits it
1

110

20

90

110

18.2

10

120

2

110

11

99

110

10

19

129

3

119

20

99

119

16.8

10

129

n

200

20

180

200

10

10

210
23.9


The monetary base and the
money multiplier
■

The monetary base or stock of highpowered 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
23.10


The money multiplier
Suppose the banks wish to hold cash reserves R as
as fraction (cb) of deposits (D), and the private sector
wish to hold cash (C) as a fraction (cp) of bank
deposits (D).
Then R = cbD and C = cp D
Monetary base H = C + R = (cb + cp) D
Money supply = C + D = (cp + 1) D
(cp + 1)
So M =
H
(cp + cb)
Money supply = money multiplier × monetary base
23.11