LECTURE ONE: INTRODUCTION

BY
MR. B. M. SIMAUNDU
INTRODUCTION

 In the evening news you have just heard that the central bank is raising
the policy rate by 0.5% point.
 What effect might this have on the interest rate of an automobile loan
when you finance your purchase of a sleek new sports car?
 Does it mean that a house will be more or less affordable in the future?
 Will it make it easier or harder for you to get a job next year as you
complete?
INTRODUCTION
 This course provides answers to these and other questions by examining how financial
markets (such as those for bonds, stocks, and foreign exchange) and financial institutions
(banks, insurance companies, mutual funds, and other institutions) work and by exploring
the role of money in the economy Financial markets and institutions not only affect your
everyday life but also involve flows of trillions of kwachas of funds throughout our
economy, which in turn affect business profits, the production of goods and services, and
even the economic well-being of countries other than Zambia .
 This course stresses the economic way of thinking by developing a unifying framework
to study money, banking, and financial markets.
 What happens to financial markets, financial institutions, and money is of great concern
to politicians and can even have a major impact on elections.
 The study of money, banking, and financial markets will reward you with an
understanding of many exciting issues.
WHAT IS THE DIFFERENCE BETWEEN A "FINANCIAL SYSTEM" AND A
"MONETARY SYSTEM"?
 The monetary system is the system that manages and facilitates the provision/printing, flow and circulation of
money and credit.
 Monetary institutions are therefore the central bank (which facilitates money provision and manages circulation)
and banks (which facilitate the provision of credit).
 Monetary variables are the interest rate, deposit rate, inflation rate, etc.
 The financial system consists of institutions which partake in the transaction of money for investment and
speculative reasons.
 Money provided by the monetary system is used in the financial system to buy and sell financial securities in the
capital market (e.g. stocks, government and corporate bonds) and the money market (e.g. certificates of deposit
and treasury bills), and alternative investment securities (e.g. Mutual funds and real estate).
 Institutions that operate within the financial system are insurance companies, stockbrokers, pension funds, mutual
funds, hedge funds, etc.
 Financial variables are bond yields, stock prices, futures prices, etc.
SECOND VIEW

 Monetary systems provide money and the 'backing/guarantee' to an economic system.

 We can see this 'backing‘ for example by the actions these institutions take to prevent high inflation
(which makes money worth less).
 Financial institutions are the parties in the market that keep money circulating.
 For example banks which provide money to people/companies in the form of loans and who retrieve
money from people/companies who save money with them.
 Other institutions work in a less direct way, for example by buying and selling stock and in this way
providing liquidity to companies or people wanting to sell their stocks.
 They might also provide liquidity by bringing buyers and sellers together (this is for example done with
large foreign exchange deals, i.e. selling euro and buying dollars)
 In brief, monetary supplies money and it's relative value, financial institutions provide liquidity,
availability of money.
THIRD VIEW
 A monetary system is generally viewed as the set of institutions and related legal and
regulatory structure by
 which a government provides money in a country’s economy. For most countries today,
the monetary system
 consists of the following:
 - One or more mints, which actually make coins and print paper currency;
 - a central bank, which oversees the distribution of the coins and currency; and
 - retail banks (principally commercial banks and savings banks), through which the central
bank acts to distribute coin and currency (this is achieved when the retail banks collect
deposits, pay out cash when presented with checks drawn on bank accounts of its
depositors, and extend credit in the form of loans).
CONT’D

 A financial system is generally viewed as the set of institutions and related legal and regulatory structure that
allows for the transfer of money between those seeking to lend or invest money, on the one hand, and those
 seeking to borrow or obtain invested money, on the other hand.
 For most countries today, the financial system consists of the following:
 - Savers and investors, who have money available to lend to borrowers or invest in financial assets;
 - Borrowers and those seeking to obtain invested money;
 - financial institutions, such as retail banks, insurance companies, trust companies, and investment companies,
 which generally collect money from the public and invest it in financial assets, such as loans, bonds, and
 deposits; and
 - other intermediaries, such as securities exchanges, stock and bond brokers, and mortgage brokers, who seek
 to match savers and investors with those seeking to borrow or obtain invested money.
INTRODUCTION TO MONETARY SYSTEMS

 Monetary Systems
 A Monetary System is defined as a set of policies, frameworks, and institutions by
which the government creates money in an economy.
 Such institutions include the mint, the central bank, treasury and other financial
institutions.
 There are three common types of monetary systems – commodity money,
commodity-based money and fiat money.
 Currently, fiat money is the most common type of monetary system in the world.
 For example, the Zambia Kwacha is a fiat money.
DEFINITION OF MONEY

 According to Crowther, "Anything that is generally acceptable as a means of exchange and which at the same time acts as a measure and
store of value."
 Thus, anything is Money, which is generally acceptable as a medium of exchange, and at the same time it must
 act as a measure and a store of value.
 Anything implies a thing to be used as money need not be necessarily composed of any precious metal.
 The only necessary condition is that, it should be universally accepted by people as a medium of exchange.
 The word fiat means the” command of the sovereign”.
 Fiat currency is the kind of money which doesn’t have any intrinsic value and it can’t convert into valuable resource.
 The value of fiat money is determined by government order which makes it a legal instrument for all transaction purposes.
 The fiat money need to be controlled as it may affect entire economy of a country if it is misused. Today Fiat money is the basis of all the
modern money system.The real value of fiat money is determined by the market forces of demand and supply.
 Paper money doesn’t have any intrinsic value, as a fiat money it is approved by government order to be treated as legal tender through
which value exchange can happen.
 Governments print the paper money according to the requirements which is tightly controlled as it can affect the economy of the
country.
BARTER SYSTEM

 Before the evolution of money, exchange was done on the basis of direct exchange of
goods and services.
 This is known as barter.
 Barter involves the direct exchange of one good for some quantity of another good.
 For example, a horse may be exchanged for a cow, or 3 sheep or 4 goats.
 For a transaction to take place there must be a double coincidence of wants.
 For instance, if the horse-owner wants a cow, he has to find out a person who not
only possesses the cow but wants to exchange it with the horse.
FUNCTIONS OF MONEY

 Medium of Exchange
 In almost all market transactions in our economy, money in the form of currency or checks is a
medium of exchange; it is used to pay for goods and services.
 The use of money as a medium of exchange promotes economic efficiency by minimizing the time
spent in exchanging goods and services.
 To see why, lets look at a barter economy, one without money, in which goods and services are
exchanged directly for other goods and services.
 Take the case of Briven the Economics Lecturer, who can do just one thing well: give brilliant
economics lectures. In a barter economy, if Briven wants to eat, he must find a farmer who not only
produces the food she likes but also wants to learn economics. What happens when you introduce
Money in Briven’s world? Discuss.
CONT’D

 As this example shows, money promotes economic efficiency by eliminating much of the
time spent exchanging goods and services.
 It also promotes efficiency by allowing people to specialize in what they do best.
 Money is therefore essential in an economy: It is a lubricant that allows the economy to
run more smoothly by lowering transaction costs, thereby encouraging specialization and
the division of labor.
 The need for money is so strong that almost every society beyond the most primitive
invents it.
 For a commodity to function effectively as money, it has to meet several criteria: (1) It
must be easily standardized, making it simple to ascertain its value; (2) it must be widely
accepted; (3) it must be divisible, so that it is easy to "make change"; (4) it must be easy
to carry; and (5) it must not deteriorate quickly.
FUNCTIONS OF MONEY
 Unit of Account
 The second role of money is to provide a unit of account; that is, it is used to measure value in the economy.
 We measure the value of goods and services in terms of money, just as we measure weight in terms of pounds or
distance in terms of miles.
 To see why this function is important, let's look again at a barter economy where money does not perform this
function.
 If the economy has only three goods-say, peaches, economics lectures, and movies-then we need to know only
three prices to tell us how to exchange one for another: the price of peaches in terms of economics lectures
(that is, how many economics lectures you have to pay for a peach) , the price of peaches in terms of movies, and
the price of economics lectures in terms of movies.
 If there were Len goods, we would need to know 45 prices to exchange one good for another; with 100 goods,
we would need 4,950 prices; and with 1 ,000 goods, 499,500 prices
 This function is also described as money acting as a measure of exchange value, money acting as a standard of
 value, or money as a numeraire. No. prices for N goods in a barter system =
FUNCTIONS OF MONEY
 Store of Value
 Money also functions as a store of value; it is a repository of purchasing power over time. A store of
value is used to save purchasing power from the time income is received until the time it is spent.
 This function of money is useful, because most of us do not want to spend our income immediately
upon receiving it, but rather prefer to wait until we have the time or the desire to shop.
 Money is not unique as a store of value; any asset-whether money, stocks, bonds, land, houses, art, or
jewelry-can be used to store wealth.
 Many such assets have advantages over money as a store of value: They often pay the owner a higher
interest rate than money, experience price appreciation, and deliver services such as providing a roof
over one's head. If these assets are a more desirable store of value than money, why do people hold
money at all?
 Answer is Liquidity
FUNCTIONS OF MONEY

Standard or deferred payment

 Money is also inevitably used as the unit in terms of which all future or deferred payments are stated.
 Future transactions can be carried on in terms of money.
 The loans, which are taken at present, can be repaid in money in the future.
 The value of the future payments is regulated by money.
Transfer of value
 Value of any asset can be transferred from one person to another or to any institution or to any place by
transferring money.
 The transfer of money can take place irrespective of places, time and circumstances.
EVOLUTION OF THE PAYMENTS SYSTEM

 We can obtain a better picture of the functions of money and the forms it has
taken over time by looking at the evolution of the payments system, the method of
conducting transactions in the economy.
 The payments system has been evolving over centuries, and with it the form of
money.
 At one point, precious metals such as gold were used as the principal means of
payment and were the main form of money.
 Later, paper assets such as checks and currency began to be used in the payments
system and viewed as money.
 Where the payments system is heading has an important bearing on how money will
be defined in the future
COMMODITY MONEY

 For any object to function as money, it must be universally acceptable; everyone must
be willing to take it in payment for goods and services.
 An object that clearly has value to everyone is a likely candidate to serve as money,
and a natural choice is a precious metal such as gold or silver.
 Money made up of precious metals or another valuable commodity is called
commodity money, and from ancient times until several hundred years ago,
commodity money functioned as the medium of exchange in all but the most
primitive societies.
 The problem with a payments system based exclusively on precious metals is that
such a form of money is very heavy and is hard to transport from one place to
another.
FIAT MONEY
 The next development in the payments system was paper currency (pieces of paper that function as a
medium of exchange).
 Initially, paper currency carried a guarantee that it was convertible into coins or into a fixed quantity of
precious metal.
 However, currency has evolved into fiat money, paper currency decreed by governments as legal
Lender (meaning that legally it must be accepted as payment for debts) but not convertible into coins
or precious metal.
 Paper currency has the advantage of being much lighter than coins or precious metal, but it can be
accepted as a medium of exchange only if there is some trust in the authorities who issue it and if
priming has reached a sufficiently advanced stage that counterfeiting is extremely difficult.
 MaJor drawbacks of paper currency and coins are that they are easily stolen and can be expensive to
transport in large amounts because of their bulk.
 To combat this problem, another step in the evolution of the payments system occurred with the
development of modern banking: the invention of checks
CHEQUES
 A cheque is an instruction from you to your bank to transfer money from your account to someone else's
account when she deposits the check. Checks allow transactions to take place without the need to carry around
large amounts of currency.
 The introduction of checks was a major innovation that improved the efficiency of the payments system.
 The use of checks thus reduces the transportation costs associated with the payments system.
 Another advantage of checks is that they can be written for any amount up to the balance in the account, making
transactions for large amounts much easier.
 Checks are also advantageous in that loss from theft is greatly reduced, and because they provide convenient
receipts for purchases.
 There are, however, two problems with a payments system based on checks.
 First, it takes time to get checks from one place to another, a particularly serious problem if you are paying
someone in a different location who needs to be paid quickly.
 Second, all the paper shuffling required to process checks is costly; it is estimated that it currently costs over $10
billion per year to process all the checks written in the United States
ELECTRONIC PAYMENT

 The development of inexpensive computers and the spread of the Internet now make it cheap to pay bills
electronically.
 In the past, you had to pay your bills by matting a check, but now banks provide websites at which you just log on,
make a few clicks, and thereby transmit your payment electronically.
 Not only do you save the cost of the stamp, but paying bills becomes (almost) a pleasure, requiring little effort.
 Electronic payment systems provided by banks now even spare you the step of logging on to pay the bill.
 Instead, recurring bills can be automatically deducted from your bank account.
E-MONEY

 Electronic payments technology can substitute not only for checks, but also for cash, in the form of
electronic money (or e-money)-money that exists only in electronic form.
 The first form of e-money was the debit card. Debit cards, which look like credit cards, enable
consumers to purchase goods and services by electronically transferring funds directly from their bank
accounts to a merchants account.
 Debit cards are used in many of the same places that accept credit cards and are now often becoming
faster to use than cash.
 At most supermarkets, for example, you can swipe your debit card through the card reader at the
checkout station, press a button, and the amount of your purchases is deducted from your bank
account.
 Most banks and companies such as Visa and MasterCard issue debit cards, and your ATM card typically
can function as a debit
 card.
MONEY AND MONETARY AGGREGATES

 As noted earlier on, money may be regarded as something which is generally used as a means of
payment and accepted for the settlement of debts.
 The term 'supply of money' means the total stock of money held by the public in expenditure form.
 The term 'public' refers to the individuals and the business firms in the economy, excluding the central
government, the central bank and the commercial banks.
 Thus, the cash balances held by the central government, the central bank and the commercial bank do
not form money supply because they are not in actual circulation.
 When money supply is viewed at a point of time, it is a stock, and when viewed over a period of time,
it is a flow.
 Money supply at a particular moment of time is the stock of money held by the public at a moment of
time.
MONEY AND MONETARY AGGREGATES

 It refers to the total currency notes, coins and demand deposits with the banks held
by the public.
 Over a period of time, money supply becomes a flow concept.
 It may be spent several times during a period of time.
 The average number of times a unit of money passes from one hand to another
during a given period is called the velocity of circulation of money. Thus, the flow of
money supply over the period of time can be known by multiplying a given stock of
money held by the public by the velocity of circulation of money.
 In Fisher's equation, PT = MV, MV refers to the flow of money supply over a period
of time, where M stands for the stock of money held by the public and V for the
velocity of circulation of money
CONSTITUENTS OF MONEY SUPPLY

 Monetary economists hold different views regarding the constituents of money supply.
 Broadly, there are two views: the traditional view and the modern view.
 i. Traditional View: According to the traditional view, money supply is composed of (a)
currency money and legal tender, i.e. coins and currency notes, and (b) bank money, i.e.
checkable demand deposits with the commercial banks.
 ii. Modern View: According to the modem view, the phenomenon of money supply refers to
the whole spectrum of liquidity in the asset portfolio of the individual. Thus, in the modem
approach, money supply is a wider concept which includes (a) coins, (b) currency notes, (c)
demand deposits with the banks, (d) time deposits with the banks, (e) financial assets, such as
deposits with the non-banking financial intermediaries, like the post-office saving banks,
building societies, etc., (f) treasury and exchange bills, (g) bonds and equities.
BASIC DIFFERENCE BETWEEN THE TRADITIONAL AND MODERN
VIEWS

 The basic difference between the traditional and modern views is due to
their emphasis on the medium of exchange function of money and the
store of value function of money respectively.
 While the acceptance of medium of exchange function of money supply
gives a narrow view of money supply, the recognition of the store of
value function of money provides a broader concept of money supply
and allows for the substitutability between money (which is traditionally
defined as a medium of exchange) and the whole spectrum of financial
assets.
CURRENCY MONEY

 Currency money is legal tender money and thus is called high-powered money.
 It includes the currency notes and coins issued by the central bank of a country.
 Generally the central bank possesses the monopoly of note issue.
 But, in certain countries, the treasury or the ministry of finance also issues notes or
coins along with the central bank.
 In India, one rupee note and the coins are issued and managed by the Finance
Ministry of the Government of Zambia.
 All other notes are issued and managed by the Bank of Zambia.
MONEY AGGREGATES

 Different measures of money supply. Not all of them are widely used and the exact classifications depend on the
country.
 M0 and M1, also called narrow money, normally include coins and notes in circulation and other money
equivalents that are easily convertible into cash.
 M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds.
 M3 includes M2 plus longer-term time deposits and money market funds with more than 24-hour maturity.
 The exact definitions of the three measures depend on the country.
 M4 includes M3 plus other deposits. The term broad money is used to describe M2, M3 or M4, depending on
the local practice.
 Money aggregates are broad categories that measure the money supply in an economy.
 In the United States, the standardized monetary aggregates are labelled M0 (physical paper and coin), M1 (all of
M0 plus travelers checks and demand deposits), M2 (all of M1, money market shares and savings deposits); an
aggregate known as M3 (which includes time deposits over $100,000 and institutional funds) has not been tracked
by the Federal Reserve since 2006 but is still calculated by analysts.
MONEY AGGREGATES

 One additional aggregate is the monetary base (MB), which differs from money supply.
 The MB aggregate is not widely observed.
 It includes the total supply of money in circulation but also includes the portion of
commercial banks' reserves that are stored within the central bank.
 The central bank uses money aggregates as a metric for how open-market
operations – such as trading in Treasury securities or changing the discount rate – affect
the economy. Investors and economists observe the aggregates closely because they offer a
more accurate depiction of the actual size of a country’s working money supply.
 Because M1 and M2 data are reported on a weekly basis, investors are able to measure the
money aggregates' rate of change and monetary velocity overall.
THE IMPACT OF MONEY AGGREGATES

 Studying monetary aggregates can generate substantial information on the financial stability and overall health of a
country.
 For example, monetary aggregates that grow at a too rapid pace may cause fear of over inflation – if there is a
greater amount of money in circulation than is needed to pay for the same amount of goods and services, prices
are likely to rise in response – which is a common example of the law of supply and demand.
 If over inflation occurs, central banking groups may be forced to raise interest rates or stop the growth in money
supply.
 For decades, monetary aggregates were essential for understanding a nation's economy and were key in
establishing central banking policies in general.
 The past few decades have revealed that there is less of a connection between fluctuations in the money supply
and significant metrics such as inflation, gross domestic product (GDP) and unemployment.
 The central bank's monetary policy is better understood by looking at the amount of the money the central bank
is releasing into the economy.
 M2 is still considered to be useful as an indicator of potential inflation when it is compared to GDP growth.
VELOCITY OF MONEY
 In order to estimate total supply of money over a period of time, say a year or so, the concept of velocity of
money is necessary.
 Total supply of money over a period of time is equal to the total amount of money in circulation multiplied by its
velocity of circulation during that period.
 Total quantity of money M (the money supply)
 If M stands for total amount of money in a given period of time, then the total supply of money during period of
time is indicated by MY.
 total amount of spending on final goods and services produced in the economy P X Y, where P is the price level
and Y is aggregate output (income).
 While M gives the money supply at a particular moment of time, MV gives a measure of money supply over a
period of time.
 Velocity of money refers to the average number of times a unit of money changes hands or is transferred from
one person to another over a given period of time.
NEUTRALITY OF MONEY

 Neutrality of money is the idea that a change in the stock of money affects only
nominal variables in the economy such as prices, wages, and exchange rates, with no
effect on real variables, like employment, real GDP, and real consumption.
 The neutrality of money is a notion or belief that any change in the money supply
makes no difference to real economic variables.
 The neutrality of money, also called neutral money, is an economic theory that states
that changes in the money supply only affect nominal variables and not real variables.
 In other words, an increase or decrease in the money supply can change the price
level but not the output or structure of the economy.
MONEY ILLUSION

 In economics, money illusion, or price illusion, is the

tendency of people to think of currency in nominal,
rather than real, terms.
 In other words, the numerical/face value (nominal value)
of money is mistaken for its purchasing power (real
value) at a previous point in the general price level (in
the past).
LIQUIDITY TRAP

 A liquidity trap is a situation, described in Keynesian economics,

in which, "after the rate of interest has fallen to a certain level,
liquidity preference may become virtually absolute in the sense
that almost everyone prefers [holding] cash [rather than]
holding a debt which yields so low a rate of interest." Japan's
Liquidity Trap.
 Japan has experienced stagnation, deflation, and low interest
rates for decades. It is caught in a liquidity trap.
THE END QUESTIONS???