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Chapter 22Money and banking

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005

PowerPoint presentation by Alex Tackie and Damian Ward

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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?

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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.

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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

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Modern banking• A financial intermediary

– an institution that specialises 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

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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

• Bonds– longer term financial assets – less liquid because there is

more uncertainty about the future income stream

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A beginner’s guide to the financial markets (continued)

• 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

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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

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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 it

10 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

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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

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The money multiplierSuppose 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

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Figure 22.1: Money supply determination