Topic 07A

BEC1054

F U N D A M E N TA L S O F
ECONOMICS

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Topic Outline
1) Functions of Money
2) Types of Monetary System
3) Measurements of Money in Malaysia
4) Motives for Holding Money
5) Financial System in Malaysia
6) How Banks Create Money
7) Central Bank’s Tools in Controlling Money Supply

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Money and Its Functions
Functions of Money

Money is any items that Medium of Exchange

are regularly used in
economic transactions or Unit of Account
exchanges and accepted
by buyers and sellers. Store of Value

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Money and Its Functions

Means of Payment: Functions of Money

What sellers generally Medium of Exchange
accept, and buyers
generally use to pay Unit of Account
for goods and
services. Store of Value

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Money and Its Functions

A Standard Unit: Functions of Money

In which prices can Medium of Exchange
be stated and the
value of goods and Unit of Account
services can be
compared. Store of Value

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Money and Its Functions

Serves As An Asset: Functions of Money

The property of Medium of Exchange
money that holds that
money preserves Unit of Account
value until it is used
in an exchange. Store of Value

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Different Types of Monetary Systems
Commodity money
A monetary system in which the actual money is a commodity, such as gold or silver.

Gold standard
A monetary system in which gold backs up paper money.

Fiat money
A monetary system in which money has no intrinsic value but is backed by the
government.

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ECO NO M I CS I N PRACTICE

Dolphin Teeth as Currency

In most countries commodity monies are not used
anymore, but the world is a big place and there are
exceptions.
In the Solomon Islands, dolphin teeth are being used
as a means of payment and a store of value.
Note that even with a currency like dolphin teeth
there is a concern about counterfeit currency, namely
fruit-bat teeth, but also tooth decay.

Shrinking Dollar Meets Its Match in Dolphin Teeth

Wall Street Journal

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Desirable Qualities of Money

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Measurements of Money
Money could be in the form of various assets, therefore proper measurement
for money has to be drawn. Money, generally, are measured in three
categories namely M1, M2 and M3.

M1 Transactions Money ≡ Currency held outside banks + Demand

deposits + Traveler's checks + other checkable deposits

M1 + [Savings deposits + Money market accounts deposits + Small

M2 denomination time deposits + Money market mutual funds]

M2 + Large denomination time deposits ($100,000 or more) or Fixed

M3 deposits

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Measurements of *Savings Deposits + Fixed Deposits +
NIDs + Repos** + Foreign Currency

Money in Malaysia Deposits

In Malaysia, there are slight differences in the measurement of money. The central bank of
Malaysia, Bank Negara Malaysia (BNM) measures money as follows:

M1 Currency in circulation + Demand Deposits

M2 M1 + Narrow Quasi Money*

M2 + Deposits Placed with Other Banking

M3
Institutions
Bank Negara Malaysia: Glossary

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 Where Does “Plastic Money” Fit In?
Debit Card
Like a cheque. An instruction to the user’s bank to transfer money directly and immediately
from your bank account to the seller. Thus, a debit card is every bit as much money as a
cheque.

Credit Card
It is not considered money but rather a short-term loan from the credit card company to you.

What about a Smart Card?

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Test Your Understanding
Which of these are money?
a) Currency
b) Checks
c) Deposits in checking accounts (called demand deposits)
d) Credit cards

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Test Your Understanding
Which of these are money?
a) Currency: Yes
b) Checks: No, not the checks themselves, but the funds in
checking accounts are money.
c) Deposits in checking accounts (called demand deposits)
Yes
d) Credit cards: No, credit cards are a means of deferring
payment

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 The Demand for Money
 The demand for money is the relationship between the quantity of money
people want to hold and the factors that determine that quantity.
 Demand for money implies the demand for liquid assets in the economy.
 The current price level, the current interest rate, and the real GDP determine
the amount of money that is demanded.
 Demand for money will decrease in proportion to an increase in interest rates.

To simplify our analysis, we will assume there are only two ways to hold wealth: as money
in a checking account, or as funds in a bond market mutual fund.

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The Demand Curve for Money
 The relationship between interest rates and the
quantity of money demanded is an application
of the law of demand.
 If we think of the alternative to holding money
as holding bonds, then the interest rate—or the
differential between the interest rate in the bond
market and the interest paid on money deposits
—represents the price of holding money.
 As is the case with all goods and services, an
increase in price reduces the quantity
demanded.
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Motives for Holding Money
Majorly demand for money is due to three main reasons. The reasons are as
follows:
Transactions Demand for Money
• Money people hold to pay for goods and services they anticipate buying.

Speculative Demand for Money

• The money held in response to concern that bond prices and the prices of other financial
assets might change.

Precautionary Demand for Money

• The money people hold for contingencies like for medical needs.

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Test Your Understanding
Assume that there are no management costs associated with buying and selling
bonds. What is the impact of an increase in the interest rate on money
holdings and interest revenue?
a) Both money holdings and interest revenue would rise.
b) Both money holdings and interest revenue would decline.
c) Money holdings would rise and interest revenue would decline.
d) Money holdings would decline, and interest revenue would rise.

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Test Your Understanding
Assume that there are no management costs associated with buying and selling
bonds. What is the impact of an increase in the interest rate on money
holdings and interest revenue?
a) Both money holdings and interest revenue would rise.
b) Both money holdings and interest revenue would decline.
c) Money holdings would rise and interest revenue would decline.
d) Money holdings would decline, and interest revenue would rise.

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Interest Rate and Demand for
Money
 The quantity of money people hold to pay for transactions and to satisfy
precautionary and speculative demand is likely to vary with the interest rates
they can earn from alternative assets such as bonds.
 When interest rates rise relative to the rates that can be earned on money
deposits, people hold less money.
 When interest rates fall, people hold more money.
 The logic of these conclusions about the money people hold and interest rates
depends on the people’s motives for holding money.

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Overview of Modern Banking and
Financial System
In today’s modern banking system, we see the active role of financial intermediaries
in “mediating” or acting as a link between those individuals or firms with excess
funds to lend to those who need to borrow funds (Case and Fair, 2004).
Basically, financial intermediaries provide two important advantages to the lenders.
1. First, they reduce the risks of investing as depositors can participate in a more
diverse and high-quality portfolio than they otherwise could invest individually
and obtain specialties in investing that insures them from substantial losses.
2. Second, it gives savers liquidity, which is the ability to convert assets into a
spendable form, money, quickly.

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 The Financial System In Malaysia

Structure of Financial System

Financial Institutions Financial Market

Non-Bank Financial
Banking System
Intermediaries

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Banks as Financial Intermediaries
 Banks act as financial intermediaries
because they stand between savers and
borrowers.
 Savers place deposits with banks, and
then receive interest payments and
withdraw money.
 Borrowers receive loans from banks and
repay the loans with interest.
 In turn, banks return money to savers in
the form of withdrawals, which also
include interest payments from banks to
savers.

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How Banks Create Money
A Banks Balance Sheet: Where the Money Comes from and Where It Goes
Balance sheet
An account statement for a bank that shows the sources of its funds (liabilities) as well as the uses of
its funds (assets).
Liabilities
The sources of funds for a bank, including
deposits and owners’ equity.

Assets
The uses of the funds of a bank, including loans
and reserves.

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How Banks Create Money
A Banks Balance Sheet: Where the Money Comes from and Where It Goes
Reserves
Funds that a bank keeps at the central bank and on hand.

Deposits
The sources of funds for a bank.

Net Worth
The excess of the asset value over and above the
amount of the liability; total assets minus total
liabilities.

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How Banks Create Money
A bank’s financial position is then being
kept using a simplified balance sheet
called a “T-account.”

By convention, the bank’s assets are listed

on the left-hand side of the T-account and
its liabilities and net worth, on the right
side.

By definition, the balance sheet always

balances, so that the sum of the items on
the left side of the T-account is exactly
equal to the sum of the items on the right-
hand side.
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How Banks Create Money
A Banks Balance Sheet: Where the Money Comes from and Where It Goes
Reserves
The portion of banks’ deposits set aside in either vault cash or as deposits at the Federal
Reserve or Central Bank (e.g. Bank Negara Malaysia or BNM).

Required reserves
The specific fraction of their deposits that banks are required by law to hold as reserves.
(e,g. Statutory Reserve Requirement for commercial banks was set as 2% by Bank Negara
Malaysia.)

Excess reserves (ER)

Any additional reserves that a bank holds above required reserves.

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 1) Assume an individual initially deposits

How Banks Create Money RM1,000 in cash to open a checking

account in Public Bank.

2) Suppose Public Bank lends the funds to

a furniture manufacturer and opens a
checking account at Public Bank with
the RM900 he borrowed.

3) Assume the manufacturer then buys

wood from a supplier, who accepts his
RM900 cheque and deposits it in
Maybank.

4) Assume Maybank lends RM810 to an

owner of café and opens a checking
account for the owner with RM810. The
loan was then spent on computer
equipment with a cheque of RM810,
which then deposited in Southern
Bank.
Assume 10% statutory reserve requirement by BNM on total deposits.

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How Banks Create Money

RM1,000 RM900 RM810 RM729 + … RM10,000

The total deposit created of RM10,000 is derived based on the following simple formula:

= RM1,000/ 0.1 = RM10,000

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How Banks Create Money:
Money Multiplier
 The term “” in the formula is called the “money multiplier,” by assuming the
banking system is closed or no money left the bank system.
 It is more specifically referred as the “deposit multiplier” or “ratio” because it
tells us the total increase in checking account deposits would be for any
initial cash deposit.

How the Money Multiplier Works in Reverse

The money multiplier working in reverse decreases the money supply.

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Central Bank’s Tools in Controlling the
Money Supply: Required Reserve Ratio
There are three tools that the central bank (e.g. BNM) used to control the
quantity of money supply in the economy:
1) Required Reserve Ratio
The higher the required reserve ratio, the more the deposit amount which banks have to keep
in the form of reserves and the less will be the deposit amount that banks can lend out.

Example:  required reserve ratio (r)  excess reserves   loans   new checkable
deposits created through lending , vice versa

r = 10% , CD = RM1,000  required reserve = RM100, excess reserves (i.e. Loans) = RM900
r= 20% , CD = RM1,000  required reserve = RM200, excess reserves (i.e. Loans) = RM800

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Test Your Understanding
1) If a bank’s deposits equal RM579 million and the required-reserve ratio is
9.5%, how much the bank hold in reserve form?
2) If the BNM creates RM600 million in new reserves, what is the maximum
change in demand deposits that can occur if the required-reserve ratio is 10%?
3) Bank A has RM1.2 million in reserves and RM10 million in deposits. The
required-reserve ratio is 10%. If Bank A loses RM200,000 in reserves, by
what dollar amount is it reserve deficient?

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Test Your Understanding
Answers:
1) Reserves = RM579 million × 0.095 = RM55 million
2) Maximum change = RM600 million × (1 ÷ 0.10) = RM6 billion
3) RM0.
Bank A was required to hold only RM 1 million (0.10 x RM10 million)
but held RM1.2 million instead (meaning: ER = RM0.2m). Therefore, its loss
of RM200,000 in reserves does not cause it to be reserve deficient.

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Central Bank’s Tools in Controlling the
Money Supply: Required Reserve Ratio

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Central Bank’s Tools in Controlling
the Money Supply: Discount Rate
There are three tools that the central bank (e.g. BNM) used to control the
quantity of money supply in the economy:
2) Discount Rate
Discount rate is the interest rate banks have to pay to the central bank whenever they wish to
borrow fund from the central bank. Higher the discount rate means higher the cost of
borrowing for banks, and this discourages banks to borrow from the central bank.

A lower discount rate encourages commercial banks to obtain additional reserves by

borrowing from the BNM. When the commercial banks lend new reserves, the money supply
increases.
A higher discount rate discourages commercial banks from obtaining additional reserves
through borrowing from the BNM. So, the BNM may raise the discount rate whenever it wants
to restrict the money supply.
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Central Bank’s Tools in Controlling the
Money Supply: Open Market Operations
There are three tools that the central bank (e.g. BNM) used to control the
quantity of money supply in the economy:
3) Open Market Operations
Central bank can also control the amount money supply in the economy using open market
operation, which are buying and selling government securities in the open market.

When central bank purchases government securities (Open Market Purchase), it pays for it by
writing a check that, when cleared, expands the quantity of reserves in the system, and
therefore increasing the money supply.
When central bank sells government securities (Open Market Sales), individuals or institutions
pay for it with a check that, when cleared, reduces the quantity of reserves in the system.

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Central Bank’s Tools in Controlling the
Money Supply: Open Market Operations
Example: Assume reserve ratio (r) = 20%.

BNM purchases RM1,000 bonds from the public

Checkable deposit (CD) of RM1,000 is created

RM200 goes to reserves & RM800 is out for loans

Banks expands the money supply (MS) by RM4,000 (i.e.

RM800 × 1÷0.2) through making loans

Total increase in MS = CD + RM4,000 = RM5,000

In short, when BNM buys bonds  bank reserves ↑ & the MS ↑ by a multiple of these reserves
via money multiplier.
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~END~
TOPIC 07

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