Chapter 23Money and modern banking

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000

Power Point presentation by Peter Smith

23.2

Some key questions

Why does society need money? Why do governments wish to

influence money supply? How do financial markets interact

with the “real” economy? What is the relationship between

money and interest rates?

23.3

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.

23.4

Money and its functions

Medium of exchange– money provides a medium for the exchange of goods and

services which is more efficient than barter

Unit of account– a unit in which prices are quoted and accounts are kept

Store of value– 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

23.5

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

23.6

A beginner’s guide to the financial markets

Financial asset– a piece of paper entitling the owner to a specified

stream of interest payments over a specified period Cash

– 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

23.7

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 e.g. Consols

Gilt-edged securities– government bonds in the UK

Industrial shares (equities)– entitlements to receive corporate dividends

– not very liquid

23.8

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

23.9

Credit creation – example

Commercial bank :Liabilities Assets

Deposits Cash Loans Total

Cashratio

%

Publiccash

holding

Moneysupply

Initial position:100 10 90 100

Central bank issues £10m extra; the public deposits it10 10 110

110 20 90 1101 18.2 10 120

110 11 99 1102 10 19 129

119 20 99 1193 16.8 10 129

200 20 180 200n 10 10 210

23.10

The monetary base and the money multiplier The monetary base or stock of high-

powered 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

23.11

The money multiplier

Suppose the banks wish to hold cash reserves R asas fraction (cb) of deposits (D), and the private sectorwish 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

So M = (cp + 1)

(cp + cb)H

Money supply = money multiplier × monetary base