Money and Banking: Principles of Economics

CHAPTER 15
MONEY AND BANKING
PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 15– 1
What is Money
Money is anything that is generally acceptable

to sellers in exchange for goods and services.
A liquid asset is an asset that can easily (i.e.,

quickly, cheaply, conveniently) be exchanged
for goods and services.

DEFINITION OF MONEY
 The term ‘money’ is something that people generally accept
as a payment for goods and services. It is also used to pay
off debts.
 Money is defined as anything that acts as a medium of
 exchange.
FUNCTIONS
Medium OF MONEY
of exchange
Standard
of deferred
Measure of value Store payment
/unit of account of value

Function of Money
 Medium of exchange: A medium of exchange is any commodity

that is generally accepted by people in exchange for goods and
services. Money enables us to buy and sell goods and services.
 Measure of value of Account: Money as a unit of value of
account serves as a unit of measurement, in terms of which the
values of all goods and services exchanged in the economy are
measured and expressed.
 Store of Value: Store of value refers to any commodity that can be
held in order to enable people buy and sell it at different times and
different places.
 Standard of deferred Payment: Money serves as a unit or standard
of deferred payment or a unit in terms of which all future payment
are expressed

Commodity
money
Legal
Token
tender
money
Demand Fiat money

deposit

Types of Money
 Commodity Money: any item that has its own value and is used as a
means of payment e.g. tobacco, cigarettes and so on.
 Fiat Money: Anything that the government has ordered or declared to be a

money.
 Legal Tender: paper money that a government approves to be accepted as

a means of payment and means of settling debts.
 Token Money: Money which has a lower metallic value than its face value,
e.g. 50 paise, 1 rupees, 5 rupees , 10 rupees coins produced in India.
 Demand Deposit: money that is transferable by way of cheques. This is

generally accepted by the public, since the issuing authority is trustworthy
DEMAND SUPPLY OF
FOR MONEY MONEY
Transactions Speculative
motive motive
Controlled
by Central
Precautionary Bank
motive

Demand for Money
 Transaction Motive: Transaction demand for money – the money

we need to purchase goods and services in day to day life.
 Precautionary Motive: Precautionary demand for money – the

money we may need for unexpected purchases or emergencies.
 Speculative Motive: Some individuals like to have ready cash with

them to take advantage of price changes in stocks and bonds. Demand
for money for speculative motive is inversely related to interest rates

 However, since 1977 RBI is publishing data on four alternative
measures of money supply denoted by M1, M2, M3and M4 as
follows:
 M1 = C + DD + OD
 M2 = M1 + Savings deposits with post office saving banks
 M3 = M1 + net time deposits of banks
 M4 = M3 + total deposits with post office saving banks.

MONEY SUPPLY
M1
M1 = Consisting of coin, currency notes and demand deposits (bank
money or cheques)
M2
M2 = M1 +
M3
M3 = M2 + Savings and fixed deposits in other banking institutions

MONEY MARKET
EQUILIBRIUM
 MONEY DEMAND (Md)
– Negatively related to interest rate
– Positively related to income.
 MONEY SUPPLY (MS)
– Fixed by central bank
– Not affected by interest rate
MONEY MARKET EQUILIBRIUM – LM CURVE

Md = MS

LM CURVE SHIFT TO THE
RIGHT
A DECREASE IN MONEY DEMAND
Real Interest Real Interest LM1
Ms
LM2
Md1
Md2
Output Quantity of money
Factors that shift the LM curve to the right
 Decrease in price level
 Increase in expected inflation
 Decrease in the nominal interest rate on money
 Increase in the nominal money supply
 Decrease in wealth

LM CURVE SHIFT TO THE
LEFT
A DECREASE IN MONEY SUPPLY
Real Interest Real Interest LM2
MS2 MS1
LM1
Output Quantity of money
Factors that shift the LM curve to the left

 Increase in price level
 Decrease in expected inflation
 Increase in the nominal interest rate on money
 Decrease in the nominal money supply
 Increase in wealth
CONSUMER PRICE INDEX
DEFINITION
A measure of change in the average price of goods and services.
STEP 1 STEP 2 STEP 3

Selection of the Base Year Selection of CPI Basket Prices of Selected Goods
Item Base Year Current

P I Current Year Index
C (240/150) x 100 = 160

Price Year Price
Food 150
L E 240
Apparel 300
P 420
M 200
(420/300) x 100 = 140
Medical care
S
250 I (200/250) x 100 = 80
Transportation 160 180 (180/160) x 100 = 112.5
Simple CPI = Sum of all current year index 492.5 = 123.1
number of items 4
CONSUMER PRICE INDEX
(cont.)
Item Base Current Current Year Weight Weighted
Year Year Index Price Index
Price Price
Food 150 240
C
(240/150) x 100 =
160 PI
4 160 x 4 = 640
Apparel 300 420

E D (420/300) x 100 = 3 140 x 3 = 420
H T 140
Medical care 250
E I G 200 (200/250) x 100 =

80
1 80 x 1 = 80
Transportation 160
W 180 (180/160) x 100 =
112.5
2 112.5 x 2 = 225
Weighted CPI = Sum of all weighted Price Index 1365 = 136.5

Total weights 10

To calculate inflation rate:
CPI = CPI current year – CPI previous year x 100%
CPI previous year
To identify To use as
the distribution USES OF a basis for
of income CPI future contracts
To calculate changes in the value of money:

Value of money = Base year index – 1 x 100%
CPI

QUANTITY THEORY OF
MONEY
 Quantity theory of money states that the changes in the money supply are related to changes in the price level, which is
measured by consumer price index (CPI).
ASSUMPTIONS
1. V is constant MV = PT
2. T is constant
3. Full employment
4. Increase in M will increase the P
Money Supply in Total

Velocity of General Price
Circulation
Circulation Level Transaction

Commercial Central bank
bank
Finance Islamic bank

companies
Merchant Discount
banks houses
Employees
Development Provident
Financial Institutions Fund

COMMERCIAL BANKS
 A commercial bank is an institution that is owned by

the private sector and is a profit-making institution.
FUNCTIONS
 Accepting deposits
 Providing loans and advances
 Providing other banking services and facilities

CREDIT CREATION
 DEFINITION
– A process where a small given deposit in a commercial
bank will lead to an increase in the supply of money.
 Assumptions:
1. Cash ratio is fixed by BNM and its value is constant.
2. Banks do not keep excess cash reserves.
3. The public must keep their money in the bank.
4. Leakage does not exist.
5. Bank’s assets are only in the form of cash and loans.
6. Liability consists of deposits only.
7. Deposits are in the form of current deposits.

PROCESS OF CREDIT
CREATION
Assume that Bank XYZ is the only Assume a customer, Mr. Arwin
commercial bank in the country. deposits RM 1,000 in Bank XYZ.
Balance sheet: Bank XYZ
Asset Liability
Cash (10%) RM100 Deposits RM1000
Loans (90%) RM900
Total RM1000 Total RM1000
Cash reserve = Cash Ratio x Initial deposit Assume bank’s legal cash
= 10% x 1000 = RM100 requirement is 10%.
Bank will loan out the balance to another person.

PROCESS OF CREDIT
CREATION (cont.)
Bank XYZ loans out to Ms. Catherine and
she deposits into the same bank. Excess reserve
from earlier
balance sheet
Balance sheet: Bank XYZ
n t il
e u
Asset Liabilitytinu
c o n i s
Cash (10%) RM90 l
il Depositsp l y RM900
s s w u p
e y s
Loans (90%) proc RM810o n e
i s m
T h to t a l .
Total 0
the 0,00RM1000 Total RM900
M 1
R
Bank’s legal cash Bank will loan to
requirement is the same. another person.

PROCESS OF CREDIT
CREATION (cont.)
IMPORTANT FORMULAE
1. Cash Ratio = Cash reserve/Initial deposit X 100

2. Money Multiplier = 1/Cash ratio
3. Total Money Supply = 1/Cash ratio X Initial deposit
4. Total Reserves = 1/Cash ratio X Initial reserve
5. Total Credit Creation = 1/Cash ratio x Initial loan

PROCESS OF CREDIT
CREATION (cont.)
LIMITATION TO CREDIT CREATION

 A change in cash ratio/legal reserve requirement
 Clearing house – slows down the process
 Availability of collateral security – mortgages, land titles
 Bank Negara Malaysia’s monetary control will affect
amount of loans

CENTRAL BANK
 The central bank is an important financial institution in

every country and plays active role in implementing
government’s economic policy.
FUNCTIONS OF CENTRAL BANK
To issue currency and safeguard the external value of the currency
Banker to the government
Banker to other banks
Promoting monetary stability
Holder of the country’s stock of gold and foreign currency reserves


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CHAPTER 15

MONEY AND BANKING

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Money is anything that is generally acceptable

A liquid asset is an asset that can easily (i.e.,

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 Medium of exchange: A medium of exchange is any commodity

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Demand Fiat money

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 Fiat Money: Anything that the government has ordered or declared to be a

 Legal Tender: paper money that a government approves to be accepted as

 Demand Deposit: money that is transferable by way of cheques. This is

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 Transaction Motive: Transaction demand for money – the money

 Precautionary Motive: Precautionary demand for money – the

 Speculative Motive: Some individuals like to have ready cash with

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

MONEY MARKET EQUILIBRIUM – LM CURVE

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Output Quantity of money

Factors that shift the LM curve to the left

STEP 1 STEP 2 STEP 3

Item Base Year Current

C (240/150) x 100 = 160

Food 150 240

Apparel 300 420

E I G 200 (200/250) x 100 =

Weighted CPI = Sum of all weighted Price Index 1365 = 136.5

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

To calculate changes in the value of money:

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Money Supply in Total

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Finance Islamic bank

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 A commercial bank is an institution that is owned by

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

1. Cash Ratio = Cash reserve/Initial deposit X 100

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

LIMITATION TO CREDIT CREATION

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 The central bank is an important financial institution in

Banker to the government

Banker to other banks

Promoting monetary stability

Holder of the country’s stock of gold and foreign currency reserves

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

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