Fundamentals of Economics - Money and Banking

Definition and Functions of Money

• Definition of Money: Money refers to any items that are regularly used in economic transactions or exchanges and are accepted by both buyers and sellers.

• The Three Primary Functions of Money:

  • Medium of Exchange: Acts as a means of payment. It is what sellers generally accept and buyers generally use to pay for goods and services.

  • Unit of Account: Acts as a standard unit. It is the unit in which prices are stated and where the values of various goods and services can be compared.

  • Store of Value: Serves as an asset. This property holds that money preserves value or purchasing power until it is used in an exchange.

Types of Monetary Systems

• Commodity Money: A monetary system where the actual money used is a physical commodity, such as gold or silver. The money has intrinsic value based on the material it is made of.

• Gold Standard: A monetary system where paper money is backed by gold, meaning currency can be converted into a specific amount of gold.

• Fiat Money: A monetary system where money has no intrinsic value but is backed by the government's decree or authority.

• Case Study: Dolphin Teeth in the Solomon Islands:

  • While commodity money is rare today, some cultures still use it.

  • In the Solomon Islands, dolphin teeth are utilized as both a means of payment and a store of value.

  • Concerns with Dolphin Teeth Currency: Even this non-traditional currency faces issues such as counterfeit currency (specifically fruit-bat teeth) and physical degradation (tooth decay).

Desirable Qualities of Money

According to McEachern (2006), there are six essential qualities that make a medium effective as money:

• Durable: Money should not wear out quickly (physical longevity).

• Portable: It must be easy to carry, even when dealing with relatively large sums.

• Divisible: Market exchange is facilitated if denominations support a wide range of possible price points.

• Uniform Quality: If money quality varies, people will hoard the high-quality versions and spend the lower-quality ones (Gresham's Law), which reduces the overall quality of currency in circulation.

• Low Opportunity Cost: The fewer resources tied up in the physical creation/production of money, the more resources are available for other productive uses.

• Stable Value: People are only willing to hold and accept money if they trust it will maintain its value over time.

Measurement of Money and "Plastic Money"

Money is measured in different categories based on liquidity, ranging from $M1$ to $M3$.

General Measurements

• Transactions Money ($M1$): Includes currency held outside banks + demand deposits + traveler’s checks + other checkable deposits.

• Broad Money ($M2$): Includes all of $M1$ plus:

  • Savings deposits.

  • Money market accounts deposits.

  • Small denomination time deposits.

  • Money market mutual funds.

• $M3$: Includes all of $M2$ plus large denomination time deposits ($RM 100,000$ or more) or fixed deposits.

Measurements of Money in Malaysia (Bank Negara Malaysia - BNM)

• $M1$: Currency in circulation + Demand Deposits.

• $M2$: Includes $M1$ + Narrow Quasi Money (Savings Deposits + Fixed Deposits + NIDs + Repos + Foreign Currency Deposits).

• $M3$: Includes $M2$ + Deposits placed with other banking institutions.

The Status of "Plastic Money"

• Debit Card: Functionally identical to a check. It is an instruction to the bank to transfer money immediately from a bank account to a seller. Therefore, it is considered money.

• Credit Card: Not considered money. It is a tool for a short-term loan from a credit card company to the user, acting as a means of deferring payment.

• Smart Card: Posed as a question for consideration regarding its fit in the monetary hierarchy.

The Demand for Money

• Definition: The relationship between the quantity of money people want to hold and the factors determining that quantity. It represents the demand for liquid assets.

• Determinants of Demand:

  • The current price level.

  • The current interest rate.

  • The real GDP.

• The Law of Demand for Money: There is an inverse relationship between interest rates and the quantity of money demanded. As interest rates (the "price" or opportunity cost of holding money instead of interest-bearing bonds) increase, the quantity of money demanded decreases.

• Simplifying Assumption: Wealth is held in only two forms: money (checking accounts) or funds in a bond market mutual fund.

Motives for Holding Money

1. Transactions Demand: Money held to pay for anticipated purchases of goods and services.

2. Precautionary Demand: Money held for unforeseen contingencies, such as medical emergencies.

3. Speculative Demand: Money held due to concerns that the prices of bonds or other financial assets might fluctuate.

The Financial System in Malaysia

Financial Intermediaries

Banks and other institutions act as links between individuals/firms with excess funds (lenders) and those who need funds (borrowers). They offer two key advantages:

1. Risk Reduction: Depositors participate in diverse, high-quality portfolios that minimize individual loss.

2. Liquidity: They provide the ability to convert assets into spendable money quickly.

Structure of the Malaysian Financial System

1. Banking System:

   • Bank Negara Malaysia (BNM): The Central Bank.

   • Banking Institutions: Commercial Banks, Finance Companies, Merchant Banks, Islamic Banks, Discount Houses, and representative offices of foreign banks.

2. Non-Bank Financial Intermediaries:

   • Provident and Pension Funds.

   • Insurance Companies (including Takaful).

   • Development Finance Institutions.

   • Saving Institutions (e.g., National Savings Bank, Co-operative societies).

   • Others: Unit Trusts, Pilgrims Fund Board (Tabung Haji), Housing Credit Institutions (Cagamas Berhad), Credit Guarantee Corporation, Leasing, Factoring, and Venture Capital companies.

3. Financial Markets:

   • Money and Foreign Exchange Market: Money market and Foreign exchange market.

   • Capital Market: Equity Market and Bond Market (Public and Private debt securities).

   • Derivatives Market: Commodity Futures, KLSE CI Futures, KLIBOR Futures.

   • Offshore Market: Labuan International Offshore Financial Center (IOFC).

How Banks Create Money

The Bank Balance Sheet (T-Account)

• Assets (Left side): Uses of funds, including loans and reserves.

• Liabilities (Right side): Sources of funds, including deposits and owners' equity (Net Worth).

• Net Worth: Calculated as: $\text{Total Assets} - \text{Total Liabilities}$.

• Reserves: Funds kept at the central bank or as vault cash.

  • Required Reserves: The specific fraction of deposits banks must hold by law. (e.g., Malaysia's Statutory Reserve Requirement was noted at $2\%$).

  • Excess Reserves (ER): Any reserves held above the legal requirement.

The Money Creation Process and Multiplier

• Banks create money when they lend out their excess reserves. This creates a chain of deposits across the banking system.

• The Money Multiplier Formula: $\frac{1}{\text{Reserve Ratio}}$.

• Total Deposit Creation Formula: $\frac{\text{Initial Deposit}}{\text{Reserve Ratio}}$.

• Example: If an individual deposits $RM 1,000$ with a $10\%$ reserve requirement ($r = 0.1$):

  • The total potential money created is $\frac{RM 1,000}{0.1} = RM 10,000$.

  • This includes the initial $RM 1,000$ plus subsequent loans ($RM 900 + RM 810 + RM 729 \dots$).

• Reverse Effect: The money multiplier also works in reverse; a withdrawal of reserves decreases the money supply by a multiple.

Central Bank’s Tools for Controlling Money Supply

1. Required Reserve Ratio (r)

• Mechanism: Adjusting the fraction of deposits banks must hold.

• Expansion: Decreasing $r$ leaves banks with more excess reserves, increasing loans and money supply.

• Contraction: Increasing $r$ leaves banks with fewer excess reserves, decreasing loans and money supply.

• Example: At $r = 10\%$, a deposit of $RM 1,000$ allows for $RM 900$ in loans. At $r = 20\%$, the same deposit only allows for $RM 800$ in loans.

2. Discount Rate

• Definition: The interest rate commercial banks pay to the Central Bank (BNM) to borrow funds.

• Expansion: A lower discount rate encourages banks to borrow more reserves, leading to more lending and an increased money supply.

• Contraction: A higher discount rate increases the cost of borrowing for banks, discouraging them from obtaining additional reserves, thereby restricting the money supply.

3. Open Market Operations (OMO)

• Mechanism: The buying and selling of government securities (bonds) in the open market.

• Open Market Purchase (Expansion): BNM buys bonds from the public. BNM pays with a check that increases reserves in the banking system, leading to a multiple increase in the money supply.

  • Example Calculation: If BNM buys $RM 1,000$ in bonds and $r = 20\%$ ($0.2$):

  • Initial deposit created = $RM 1,000$.

  • Excess reserves available for loans = $RM 800$.

  • Additional money supply from loans = $RM 800 \times \frac{1}{0.2} = RM 4,000$.

  • Total Increase in MS = $RM 1,000 + RM 4,000 = RM 5,000$.

• Open Market Sales (Contraction): BNM sells bonds. Buyers pay via checks that, when cleared, reduce the total reserves in the system, decreasing the money supply.

Questions & Discussion

• Question: Which of these are money? a) Currency, b) Checks, c) Deposits in checking accounts, d) Credit cards.

  • Response:

    • Currency: Yes.

    • Checks: No, the check is just the instrument; the funds in the account are the money.

    • Deposits in checking accounts: Yes, these are demand deposits.

    • Credit cards: No, they are a means of deferring payment (a loan).

• Question: Assume no management costs for bonds. What is the impact of an increase in the interest rate on money holdings and interest revenue?

  • Response: Money holdings would decline (as the cost of holding cash increases), and interest revenue would rise. (Correct answer: d).

• Question: If a bank's deposits equal $RM 579 \text{ million}$ and the reserve ratio is $9.5\%$, how much must the bank hold in reserves?

  • Response: $RM 579 \text{ million} \times 0.095 = RM 55 \text{ million}$.

• Question: If BNM creates $RM 600 \text{ million}$ in new reserves with a $10\%$ reserve ratio, what is the maximum change in demand deposits?

  • Response: $RM 600 \text{ million} \times \frac{1}{0.10} = RM 6 \text{ billion}$.

• Question: Bank A has $RM 1.2 \text{ million}$ in reserves and $RM 10 \text{ million}$ in deposits. The reserve ratio is $10\%$. If Bank A loses $RM 200,000$ in reserves, is it reserve deficient?

  • Response: No. Required reserves were $0.10 \times RM 10 \text{ million} = RM 1 \text{ million}$. Since it held $RM 1.2 \text{ million}$, it had $RM 200,000$ in excess reserves. Losing that amount brings reserves exactly to the required $RM 1 \text{ million}$, so the deficiency is $RM 0$.