Monetary system_chapter 4.pptx

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Chapter 4
The Monetary System & Money
Supply
© 2002 by Nelson, a division of Thomson Canada Limited

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The Meaning of Money
 Money is the set of assets in the
economy that people regularly use
to buy goods and services from
other people.

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Three Functions of Money
 Medium of Exchange: anything that is readily
acceptable as payment.When you buy a shirt at a clothing store, the
store gives you the shirt, and you give the sore your money.
 Unit of Account: serves as a unit to help us compare the
relative values of goods. When you go for shoping, you might
observe that a shirt costs 20$ and a hamburger costs $2. even
though it would be accurate to say that the price of a shirt is 10
hamburgers and the price of a hamburger is 1/10 of a shirt, prices
are never quoted in this way. When we want to measure and record
economic value, we use money as the unit of account


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 3 Store of value: a way to keep some of our
wealth in a readily spendable form for future
need. An item that people can use to transfer
purchasing power from the present to the future.
way to keep some of our wealth in a readily spendable
form for future need. An item that people can use to
transfer purchasing power from the present to the future.

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The Two Types of Money
 Commodity Money: something that performs the
function of money and has alternative, non-
monetary uses.
 Examples: Gold, silver,
 Fiat Money: something that serves as money
but has no other important uses.
 Examples: Coins, currency,

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Money in the Economy
 Money Stock is the quantity of money circulating
in the economy.
 Different ways of measuring the money stock in
the economy:
 M1
 M2
 M3

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 The most familiar form
of money used includes:
 Currency
 Demand Deposits
(balances in bank accounts
that depositors can assess
on demand by writing a
check)
Measurement of Money
M1

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 A broader measure of money than
M1, includes:
 M1 +
 Savings Deposits( Savings
deposits are accounts
maintained by commercial
banks, savings and loan
associations,and mutual savings
banks )
M2

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 A broader measure of money than
M2, includes:
 M2 +
 Long Term Deposits/ Fixed
Deposits
M 3

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Where does currency come from?
 For riyals, The Saudi Central Bank of the
Kingdom of Saudi Arabia (SAMA)
 For dollar, The Federal Reserve Bank is the
central bank of the USA


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Establishment of World Bank and
Important Central Banks
 worldbank.org - The World Bank Group offers loans,
advice, and an array of customized resources to more
than 100 developing countries. The World Bank was
established in 1944 at Bretton Woods, New Hampshire,
USA
 The International Monetary Fund (IMF)-assess a
country economy, including the financial sector, offers
loans, advice and restructuring.
 Saudi Arabian Monetary Agency (SAMA)formed initial
banking regulations during 1960 to 1972 and more tasks
later on.
http://www.sama.gov.sa/

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Primary Functions of the Central
Bank
 Issue currency.
 Act as a banker’s bank, making loans to other
banks and as a lender.
 Act as banker to the government.
 Control the money supply with monetary policy.

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Saudi Arabian Monetary Agency (SAMA)
 Saudi Arabian Monetary Agency (SAMA): services as the Central Bank for Saudi Arabia.
 A central bank typically has the following functions:
1. It is the bankers’ bank: it accepts deposits from and makes loans to commercial banks.
2. It acts as banker for the government.
3. Issuing the national currency, (SR)
4. It controls the money supply.
5. Supervising commercial banks and money exchanges
6. Supervision cooperative insurance companies and the self-employed professions relating to
the insurance activities.
7. Supervisor of finance companies
8. Supervising credit information companies.
9. Advising the government on the public debt.
10. Managing the kingdoms foreign exchange reserves.
11. Conducting monetary policy for promoting domestic price and exchange rate stability.
12. Promoting economic growth and ensuring the soundness of the Saudi financial system.
Operationally SAMA carries out these functions through its head office in capital Riyadh and through
its ten branches located in all major Saudi cities.

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Central Bank Monetary Policy
 Monetary policy is the primary focus of the Saudi
Central Bank SAMA
 Whose key objectives are:
 To stabilize inflation and the general level of
prices
To maintain a fixed exchange rate against US
dollar
And to allow a free movement of currency and
capital

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Central Bank Monetary Policy (cont’d)
 The Saudi Central Bank SAMA uses four policy
instrument in conducting monetary policy:
1. Cash reserve ratio/minimum reserve policy
2. Repos and reverse repos
3. Foreign exchange swaps and placement funds
4. It has increasingly relied on repos and reverse
repos, the so called “open market” operations.

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Policy Goals of SAMA
 Ultimate Goal:
Economic growth with stable prices. This means greater output (GDP) and a low, steady
rate of inflation.
 Intermediate Targets:
 SAMA does not control output or the prices
directly. It does control the money supply.
 SAMA establishes target growth rates for the
money supply, which it believes are consistent
with its ultimate goals.
 The money supply growth rate becomes an
intermediate target, an objective used to
achieve some ultimate policy goal.

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Open Market Operations
 Open Market Operations (OMOs): the buying and selling of government
bonds by SAMA to control bank reserves, and the money supply.
 For example, if SAMA wants to increase the money supply, it will buy bonds,
through its monetary policy tools (Repo-Reverse Repo).
 When SAMA buys bonds, it writes checks on itself, injecting new reserves
into the banks of the bond sellers.
 The increase in reserves result in an increase in the money supply.

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The Challenge of a Liquidity Trap
 One of the greatest challenges for a central bank arises as nominal interest rates approach
zero. This is referred to as the liquidity trap. Such a situation occurred in the Great
Depression of the 1930s and then again in 2008 –2009 in the United States.
 When short-term safe securities are equivalent to money. The demand for money becomes
infinitely elastic with respect to the interest rate. In this situation, banks have no reason to
economize on their reserve holdings; they get essentially the same interest rates on
reserves as on riskless short-term investments. For example, in early 2009, banks could
earn 0.10 percent annually on reserves and 0.12 percent on Treasury bills.
 Central bank open-market operations therefore have little or no impact upon interest rates
and financial markets. Instead, when the Fed purchases securities, the banks just increase
their excess reserves. This syndrome appeared with a vengeance in 2008 –2009 as
excess reserves rose from a normal level of $1 billion to over $900 billion. In essence,
banks were using the Fed as a safe deposit box for their funds! (Make sure you understand
why open-market operations are ineffective in a liquidity trap.) Because the Fed cannot
lower short-term interest rates, it is unable to use the normal monetary transmission
mechanism to stimulate the economy in a liquidity trap.

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The different between central
bank and commercial bank
Central bank Commercial bank
• Work for the public welfare and
economic development of a country
• Operate for profit motive
• Doesn’t deal directly with the public
it issue guidelines to commercial
banks for the economical
development of the country
• Deals directly with the public, it
serves the financial requirement of
public by providing loans and
secure money that can be drawn on
demand
• Act as a state owned institution
• Act as custodian of foreign
exchange of the country
• Act as the banker of the
government
• Act as agent of the central bank
• Act as as a state or private owned
institution

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Bank Reserves
 In a fractional reserve banking system,
banks keep a fraction of deposits as reserves
and use the rest to make loans.
 The Central Bank establishes reserve requirements,
regulations on the minimum amount of reserves that banks
must hold against deposits.
 Banks may hold more than this minimum amount
if they choose.
 The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits

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 Deposits are liabilities to the bank because they
represent the depositors’ claims on the bank.
 Loans are an asset for the bank because they represent
the banks’ claims on its borrowers.
 Reserves are an asset because they are funds available
to the bank.

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Bank T-Account
 T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
 Example:
 Banks’ liabilities include deposits,
assets include loans & reserves.
 In this example, notice that R = $10/$100 = 10%.

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Banks and the Money Supply: An Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system

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CASE 1: No banking system
Public holds the $100 as currency.
Money supply = $100.

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CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank
(FNB).
FNB holds
100% of
deposit
as reserves:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
Loans $ 0
Deposits $100
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.

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CASE 3: Fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $10
Loans $ 90
Deposits $100
Depositors have $100 in deposits,
borrowers have $90 in currency.
Money supply = C + D = $90 + $100 = $190 (!!!)

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The money multiplier
 The creation of money does not stop with first
national bank. Suppose the borrower from first
national uses the $90 to buy something from
someone who then deposits the currency in
second national bank

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The Money Multiplier
If second national also has reserve ratio of 10%, it
keep assets of $9 in reserve and make $81 in loan
SECOND NATIONAL BANK
Assets Liabilities
Reserves $9
Loans $ 81
Deposits $90
borrowers have $81 in currency.
Money supply = C + D = $81 + $90 = $171 (!!!)

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If this $81 is eventually deposited in Third National
Bank, which also has a reserve ratio of 10%, this
bank keep $8.10 in reserve
And makes$72.90
in loan
THIRD NATIONAL BANK
Assets Liabilities
Reserves $8.10
Loans $ 72.90
Deposits $81
borrowers have $72.90 in currency.
Money supply = C + D = $72.90 + $81 = $153.9 (!!!)

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 The process goes on and on.
 Each time that money is deposited and a bank
loan is made, more money is created

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 Money multiplier: the amount of money the
banking system generates with each dollar of
reserves
 The money multiplier equals 1/R.
 In our example,
R = 10%
money multiplier = 1/R = 10
R=20%
Money multiplier= 1/20=5

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 Thus higher the reserve ratio, smaller the money
multiplier.

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 When one bank loans money, that money is
generally deposited into another or the same
bank thus creating more deposits and more
reserves to be lent out.
 The Money Multiplier is the amount of money
that the banking system generates

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What determines the size of the money
multiplier?
 The money multiplier is the
reciprocal of the reserve ratio.
 With a reserve requirement
(R) of 10% or 1/10 . . .
 The multiplier will be 10.
1
R
M =

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Tools of Monetary Control
The Central Bank has following instruments of
monetary control:
 Open-Market Operations:
 Buying and selling bonds.
 Foreign Exchange Market Operations:
 Buying and selling foreign currency.
 Changing the Reserve Ratio:
 Increasing or decreasing the ratio.
 Changing the Bank Rate:
 The interest/profit rate/service charges Central
Bank charges other Commercial banks for loans.

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Problems in Controlling the Money Supply
 Two problems that the Central Banks face
here are:
The Central Bank can not entirely control the
amount of money that households choose to
hold as deposits in banks.
The Central Bank can not totally control the
amount of money that commercial banks
decide to lend(loan).

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The Equation of Exchange and the
Velocity of Money
 The concept of velocity is formally introduced in the equation
of exchange. This equation states MV PQ (p1q1 p2q2 · · ·)
 where M is the money supply, V is the velocity of money, P is
the overall price level, and Q is total real output. This can be
restated as the definition of the velocity of money by dividing
both sides by M:
 V = PQ/M
 We generally measure PQ as total income or output (nominal
GDP) the associated velocity concept is the income velocity of
money.
 Velocity is the rate at which money circulates through the
economy. The income velocity of money is measured as the
ratio of nominal GDP to the stock of money.

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Banking Panics
Bank Insolvency and Bank Failure A bank becomes insolvent when its
total assets are less than its total liabilities, so that shareholders’ equity is
negative. The most frequent reason for bank to become insolvent is the
bankruptcies of businesses and households that have borrowed money
from the bank.
Bank run Many depositors simultaneously decide to withdraw money from a
bank.
Bank panic Many banks experiencing runs at the same time.

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