Chapter 23 Money and modern banking
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith
Some key questions
n Why does society need money? n Why do governments wish to
influence money supply?
n How do financial markets interact
with the “real” economy?
n What is the relationship between
money and interest rates?
23.2
Money
n Any generally accepted means of
payment for delivery of goods or the settlement of debt
– notes and coins n Customary money
– IOU money based on private debt of the
n Legal money
individual n e.g. bank deposit.
23.3
Money and its functions
n Medium of exchange
– money provides a medium for the exchange of goods
and services which is more efficient than barter
n Unit of account
– a unit in which prices are quoted and accounts are kept
n Store of value
– money can be used to make purchases in the future
n Standard of deferred payment
– a unit of account over time: this enables borrowing and
lending
23.4
Modern banking
n A financial intermediary
– an institution that specializes in bringing
n e.g. a commercial bank, which has a government
lenders and borrowers together
licence to make loans and issue deposits
n including deposits against which cheques can be
written
n Clearing system
– a set of arrangements in which debts between
banks are settled
23.5
A beginner’s guide to the financial markets
n Financial asset
– a piece of paper entitling the owner to a
n Cash
– Notes and coin, paying no interest – the most liquid of all assets.
n Bills
– financial assets with less than one year until
specified stream of interest payments over a specified period
– highly liquid
the known date at which they will be repurchased by the original owner
23.6
A beginner’s guide to the financial markets (continued)
n Bonds
– longer term financial assets – less liquid because there is more uncertainty about the future income stream
n Perpetuities
– an extreme form of bond, never repurchased by the
original issuer, who pays interest forever
n e.g. Consols n Gilt-edged securities
– government bonds in the UK n Industrial shares (equities)
– entitlements to receive corporate dividends
– not very liquid
23.7
Credit creation by banks
n Commercial banks need to hold only
a proportion of assets as cash reserves – this enables them to create credit by
lending n EXAMPLE:
– suppose the public needs a fixed £10m
for transactions
– and the commercial bank maintains a
10% cash reserve
23.8
Credit creation – example
Commercial bank :
Assets
Money supply
Liabilities Deposits Cash Loans Total Public cash holding Cash ratio %
Initial position:
10 100 10 90 100 10 110
Central bank issues £10m extra; the public deposits it
110 20 90 110 18.2 10 120 1
2 110 11 99 110 10 19 129
3 119 20 99 119 16.8 10 129
n 200 20 180 200 10 210
10 23.9
The monetary base and the money multiplier
n 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 n The money multiplier
– the change in the money stock for a £1 change in the quantity of the monetary base
23.10
The money multiplier
Suppose the banks wish to hold cash reserves R as as fraction (cb) of deposits (D), and the private sector wish 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
(cp + 1) So M = H
(cp + cb)
Money supply = money multiplier × monetary base
23.11
