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 governments wish to influence money supply? ■ How 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 110 20 90 110 18.2 10 120 110 11 99 110 10 19 129 119 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