Lecture 8(i)

Money and the

financial system

Reading:
Sloman and Garret,
chapter 11

ECN1014 Prepared by:

INTRODUCTORY Dr. Bawani Lelchumanan &
Dr. Chong Poh Ling (DEF,
ECONOMICS SBS)
MONEY
One of the most important invention in the history of human
civilization.
Before money, barter trade. Direct exchange of goods and services
for other goods and services. Requires double coincidence of wants.
Commodity money. Items used as money. Cowrie shells, beads,
cattle, etc.
Metallic money. Metals used as money. Iron, copper, silver, etc.
Paper money. Paper circulated as a means of payment.
Bank money. Money deposited in current/savings accounts eg. By
cheques.
Plastic money. Credit cards and debit cards.

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FUNCTIONS OF MONEY
4 specific functions. Overcame the problem of barter trade.

1) Medium of Exchange
• Money enables us to buy and sell goods & services.
• Removes the need for double coincidence of wants

2) Measure of Value of Account

• Serves as a unit of measurement, “values” of goods & services
exchanged. Yardstick for measurement. Monetary value.
• Ringgit Malaysia. Eg. Price of CD is RM15, not 15 apples.
• Basis for keeping accounts, calculating profit and loss.

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FUNCTIONS OF MONEY
3) Store of Value
• Can be held to enable people to buy and sell at different times
and different places.
• Held in reserve for future spending.

4) Standard of Deferred Payment

• Possible for people to make a contract/agreement to exchange
goods and settle debts in the future.
• Future payments stated in monetary unit.

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INFLATION AND
ACCEPTABILITY
Inflation diminishes the value of money.
Under the circumstance of hyperinflation, the
purchasing power of money is virtually destroyed,
and as such, money ceases to be:
 A medium of exchange
 A store of value
 An unit of account
BANKING SYSTEM

Classification of Banks:
1) Banking institutions
2) Non-bank financial institutions
3) Non-bank financial intermediaries

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1) BANKING
INSTITUTIONS
Includes all financial institutions that accept current deposits.
Comprise of:

a) Central Bank. Owned and controlled by the government. In

Malaysia, Bank Negara Malaysia is the central bank.

b) Commercial Banks. Most people keep their money here. Eg,

Ambank, Public Bank, RHB, Hong Leong, Maybank, etc.

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2) NON-BANK
FINANCIAL
INSTITUTIONS
a) Investment Banks. Provide support and advice to firms,
financial management and portfolio management. Eg. Affin
Investment Bank, AmInvestment Bank, Maybank Investment
Bank, etc.

b) Discount Houses. Provide short-term loans. Receive loans with

lower interest rates from financial institutions and supply loans
to the public at a higher rate, thus obtaining profits. Eg. Affin
Discount Bhd, Maybank Discount Bhd, CIMB Discount Bhd.

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3) NON-BANK
FINANCIAL
INTERMEDIARIES
a) Development Financial Institutions. Set up by the
government to promote investments in the industrial and
agriculture sectors. Provide loans and financial assistance to
firms and farmers. Eg. Bank Pembangunan Malaysia, Bank
Pertanian Malaysia.

b) Employees Provident Fund (EPF). For the benefit of

employees. The employee and employer contribute a certain
percentage of income to the EPF each month.

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 FUNCTIONS OF
COMMERCIAL BANKS
1. Accepting Deposits. Most important function. Current or demand
deposits, savings deposits, fixed deposits.
2. Providing loans and advances. Give loans such as housing, car,
education, business, personal loans, etc. Earn profits by imposing
an interest.
3. Providing other banking services and facilities.
a) Foreign exchange transactions
b)Issue bank drafts, cheques and traveler’s cheques
c) Enabling fund transfers from one place to another
d)Providing advice on financial matters
e) Providing safe deposit boxes
f) Providing credit card facilities, insurance, etc.

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FUNCTIONS OF CENTRAL
BANK
1. Issuing currency and keeping reserves. Central bank is the only financial
institution with authority to issue currency. Helps to safeguard the value of
the currency.
2. Acting as banker and financial adviser to the government. Keeps the
government’s principal bank accounts, receives taxes and revenues, makes
payments for government expenditure. Also manages national debts, sells
bonds and redeems matured treasury bills.
3. Acting as banker to other banks. Keeps cash reserves of commercial
banks, acts as custodian of the reserves for the country. Also acts as the
lender as a last resort.
4. Promoting monetary stability and a financial structure. CB is
responsible for achieving a high level of employment, maintain price
stability, maintain balance of international payments, eradicating poverty,
etc.
5. Acting as holder of country’s stock of gold and foreign currency
reserves. Implements the government’s exchange rate and balance of
payments policy. 11
SUPPLY FOR MONEY
 Controlled by the Central Bank.
 Methods used to measure the supply of money: M1, M2, M3

M1: Narrow money

Money transaction. Money is directly used for transactions. Consists
of:
oCurrency (fiat money) – coins, paper money issued by BNM.
oCheckable deposits (demand deposits) – checking (current) account
balances, convertible into cash on demand by writing cheques.

M1 = Currency + Checkable deposits

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SUPPLY FOR MONEY
M2: Near money + M1
Is a broader definition of the supply of money. Comprises M1 and near
money. Near money (quasi money) - highly liquid financial assets:

oSavings accounts in commercial banks

oFixed deposits in commercial banks
oNegotiable certificates of deposits (NCD)
oRepo (Repurchase agreement) – short term borrowings for government
securities
oBank Negara Malaysia certificates.

M2 = M1 + Savings and fixed deposits + NCD + Repo + BNM

certificate

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SUPPLY FOR MONEY
M3: Broad Money

Broadest definition of the supply of money.

M3 = M2 + savings and fixed deposits in other financial

institutions

(Other financial institutions: merchant banks, finance companies,

discount houses)

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 CREDIT CREATION
 Commercial bank gains most of its profit from interest
earned through loans and investments to its customers.
 Uses depositors’ money to provide loans. By granting
loans, the bank increase money supply via credit
creation.
 Credit creation is a process. A small deposit in the
commercial bank will lead to an increase in the supply of
money.

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PROCESS OF CREDIT
CREATION
Assume Bank ABC is the only commercial bank in the country.
Its legal cash reserve requirements is 10%. Bank keeps 10% deposit
& lend 90% out.
Suppose a customer, Mr Z deposits RM1000 into Bank ABC.

Bank ABC: Balance Sheet

Assets Liabilities
Cash (10%) RM100 Deposits RM1000
Loans (90%) RM900
Total RM1000 Total RM1000

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PROCESS OF CREDIT
CREATION
Next, Bank ABC gives a loan of RM900 to another customer, Ms Y.
She receives the loan and go back to Bank ABC to deposit the
whole amount as a deposit.

Bank ABC: Balance Sheet

Assets Liabilities
Cash (10%) RM90 Deposits RM900
Loans (90%) RM810
Total RM900 Total RM900

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PROCESS OF CREDIT
CREATION
Again, Bank ABC gives a loan of RM810 to another customer, Mr
X.
He deposits the money in the same bank.

Bank ABC: Balance Sheet

Assets Liabilities
Cash (10%) RM81 Deposits RM810
Loans (90%) RM729
Total RM810 Total RM810

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PROCESS OF CREDIT
CREATION
The process continues until total deposits equal
RM10,000 (Maximum amount that can be created).

Money multiplier formula – to derive maximum

amount that can be created.

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 PROCESS OF CREDIT
CREATION
a) Cash Ratio = x 100% c) Total money supply = x Initial Deposit
Cash Ratio = x 100% = 10% Total money supply = x 1000 = RM10,000

b) Money multiplier = d) Total Credit Creation = x Initial Loan

Money multiplier = = 10 Total credit creation = x 900 = RM9,000

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MONEY SUPPLY AND THE
RATE OF INTEREST
Money supply is assumed to be determined and
controlled by the central bank.
It is thus perfectly inelastic to changes in the rate of
interest.
 The Supply Curve of Money
Rate of interest MS

Money supply determined

independently of the demand for
money and interest rates

O Quantity of Money
 DEMAND FOR MONEY
People demand for money due to 3 motives for holding money (rather than other
forms eg. Shares or bonds).
1. Transaction Demand
• People and firms want to have ready cash to buy goods & services.
• Called demand for liquidity for a transaction motive.

2. Precautionary Motive
• People and firms choose to save some money for unforeseen circumstances.
• Called demand for money for a precautionary motive.

3. Speculative Motive
• Some people like to have ready cash to take advantage of price changes in
stocks and bonds.
• If prices of stocks and bonds are expected to fall in the future, speculators
would need ready cash to purchase these stocks and bonds. 23
MONEY DEMAND: LIQUIDITY
PREFERENCE CURVE
There is opportunity cost involved in holding wealth in the
form of either cash or interest-bearing financial assets.
 Holding cash: more liquidity, but without interest return
 Holding financial assets: less liquidity, but with interest
return
The liquidity preference curve shows the demand for
money at various rates of interest.
 There is a negative link between interest rate and the
quantity of money demanded.
 Higher the rate of interest, lower the appeal of holding
cash.
 Liquidity Preference Curve:
A Change in the Rate of Interest
Rate of Interest

1. An increase in the rate of interest

from r1 to r2…
2. …reduces the quantity of money
demanded from Q1 to Q2.

r2

r1

LP

O Q2 Q1 Quantity of Money
 Liquidity Preference Curve:
A Change in Non-Interest Factors (e.g. nominal income,
Rate of Interest aggregate price level, expectations of future asset prices, etc.)

An increase in nominal income, for

instance, raises the demand for
money, shifting the LP curve
rightward from LP1 to LP2.

LP2

LP1
O Q1 Q2 Quantity of Money
MONETARY
EQUILIBRIUM
Equilibrium in the money market is where the
demand for money (LP) equals the supply of
money (MS).
A shift in either the MS or the LP curve will lead
to a new monetary equilibrium.
 Monetary Equilibrium

Rate of interest
MS

re

LP

O Qe Quantity of Money