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Money and modern banking

Money and modern banking. JOIN KHALID AZIZ. FRESH CLASSES OF CA MODULE B & ICMAP STAGE 1 ECONOMICS FROM 18 TH JULY 2011. JOIN KHALID AZIZ. ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

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Money and modern banking

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  1. Money and modern banking

  2. JOIN KHALID AZIZ • FRESH CLASSES OF CA MODULE B & ICMAP STAGE 1 ECONOMICS FROM 18TH JULY 2011

  3. JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. • CONTACT: • 0322-3385752 • 0312-2302870 • 0300-2540827 • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

  4. 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?

  5. Money • Any generally accepted means of payment for delivery of goods or the settlement of debt • Legal money • notes and coins • Token money • means of payment whose value or purchasing power as money greatly exceeds its cost of production

  6. 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

  7. A firm’s balance sheet • Assets • what the firm or households owns • Liabilities • what the firm or households owes • Balance sheet • lists a firm’s assets and liabilities at a point in time

  8. Suppose A has 100 TL of money and a car • His assets are cash and the car that he owns • B has 250 cash • B’s asset is only cash • If A sells the car to B with its market value of 150 in cash • A’s assets become 100 + 150 • B’s assets become 100 + car • Now B owns the car so car is B’s fixed asset together with the remaining cash of 100

  9. Consider only liquid assets money • A has 100 money • Assets of A = 100 + other assets • B has 250 money • Assets of B = 250 + other assets • B lends 150 TL of money to A to be paid back after one month later • What are the new assets of A • Assets of A= 100+150+others • What are the liabilities of A • Liabilities are part of the assets that are claimed by other parties • In this example B lends 150 to A so this 150 is a liability of A to B

  10. It is claimed by B • Liabilities of A = 150: A’s debt to be paid to B in next month • What are B’s assets ? • Assets of B=100 (cash) + 150 (loans to A) + others • Total assets = assets of A + assets of B • = 100+150+oth.+ 100+150+oth. • Total liabilities= liab of A + liab of B • = 150 + 0 =150

  11. 100+ 150+ oth 100+ 150+ Othe. A B 250+ Othe. 100+ Oth. B A B lends 150 to A

  12. 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 • pays interest to the lenders or depositors • but charges higher interests to the borrowers when landing money • makes profit by the interest differential between the landing and borrowing rates

  13. Money creation by bankstime=0 • Depositing money to a bank: • there are four households A, B,C,D each having 30m TL in their pockets • total number of banknotes = 4*30m=120m • Total (financial) assets of the 4 households = 4*30m=120m • money in circulation =4*30=120

  14. Time=1 • Each of them decides to deposit 25m to a bank • then total amount of deposits =4*25=100m • Banks assets increases by 100 at the same time liabilities increases by 100 • as the 100m deposited to the bank is claimed by the depositors households so bank is liable for this money to depositors • money in circulation = 20 • money deposited = 100 • total tokens or notes =120

  15. Depositors can withdraw all or some portion of the money any time they like • after depositing total money stock does not change • 4*5 + 4*25 = 120 • cashdeposits • in their pocket • total liabilities of the bank to households: • 4*25 = 100 • banks assets = 100 = liabilities

  16. The first bank loantime=2 • A firm F may come and ask for a loan from the bank so as to pay it back in future with a reasonable interest • So bank accepts this offer because at the time of the payment the bank will earn more due the the interest it earns • Bank gives a loan of 40 to the firm F • taking the risk of all depositors requesting their money before the firm pays its debt back

  17. What are assets and liabilities of the bank after lending the money to F • total assets: • 60 + 40 = 100 • money loans • in bank to firm F • total liabilities to households • 4*25 = 100 • households • loans

  18. Now firm F is also liable to the bank 40m TL and bank’s liability to households does not change • money in circulation = 20 + 40 = 60 • money remaining in the bank as notes = 60 • total amount of notes (tokens) = 60+60=120 • does not change • notice that • total deposits + money in circulation= • 100 + 20 +40 = 160 • increases as a result of bank’s loan to firm F

  19. Time=3 • Firm F buy a track of value 40m TL from firm G in cash • so the 40m TL transfers to firm G • but firm G deposits 30m TL of that money to the bank again • Total deposits in the bank: • 4*25 + 30 = 130 • liabilities liabilities • to households to firm G

  20. Total assets of the bank: • 60 + 30 + 40 = 130 • cash from cash from loan to • households firm G to firm F • assets of the bank = liabilities of the bank to four households and to firm G • Total amount of banknotes in the economy • 4*5 + 10 + 90 = 120 • money in money in • circulation the bank

  21. Deposits + money in circulation= • 130 10+20 = 160

  22. _________ Bank ____public_____ • liabilities assets money in pockets • time deposits cash loans A.B,C,D F G • 0 0 0 0 120 0 • 1 100 100 0 20 0 • 2 100 60 40 20 40 • 2 100 60 40 20 0 40 • 3 130 90 40 20 0 10

  23. Reserves and reserve ratio • Commercial banks need to hold only a proportion of assets as cash reserves • reserves = deposits - loans • reserve ratio= • reserves in the bank/total deposits • this enables them to create credit by lending • the lower the reserve ratio the more the bank is landing • interest revenues will be higher • a greater risk of being unable to meet the creditor’s claims of their deposits

  24. Bank • liabilities assets • time deposits reserves loans reserve ratio • 0 0 0 0 • 1 100 100 0 100/100=1 • 2 100 60 40 60/100=0.6 • 2 100 60 40 60/100=0.6 • 3 130 90 40 90/130=0.69

  25. Financial panics • Financial panics is • people believe that the bank will be unable to pay. • In the stampede to get their money out, they ensure that the bank can not pay. • It will go bankrupt

  26. Money supply • Money Supply • the money supply is the value of the total stock of money • money supply = money in circulation + deposits at the bank • for the bank • assets = liabilities • assets = money in the bank + value of loans • money supply = money in circulation • + money at the bank(reserves) • + bank’s loans

  27. JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. • CONTACT: • 0322-3385752 • 0312-2302870 • 0300-2540827 • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

  28. Total banknotes=money in circulation • +money in the bank(reserves) • note that total value of token money = value of banknotes < money supply • money supply = • value of banknotes + bank loans

  29. Bank public • liabilities assets money money • time deposits cash loans in circulation supply • 0 0 0 0 120 120 • 1 100 100 0 20 120 • 2 100 60 40 60 160 • 2 100 60 40 60 160 • 3 130 90 40 30 160

  30. 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

  31. 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 • Industrial shares (equities) • entitlements to receive corporate dividends • not very liquid

  32. Assets of banks: • in foreign currency • cash • securities • loans • in TL • cash • securities • loans

  33. Cash reserves • banks has to hold part of deposits as cash by low and to satisfy depositors demands • Loans • principal asset of banks and the essential part of their business

  34. Liquidity • refers to the speed and certainty with which an asset can be converted back in to money • money is the most liquid asset of all • the other main asset of banks is securities • loan for which a second hand market exists • trade is carried out all the time

  35. Liabilities of banks • sight and time deposits • sight deposits: the depositor can withdraw money without any notice • chequing accounts are sight deposits • time deposits pay higher interest rates, money is tied for a designated period of time • if the money were withdrawn before the maturity date the high interest rate is lost

  36. 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 • H: high powered money • R: quantity held by the banking system • C: quantity of notes and coins in circulation

  37. Credit creation by banks • EXAMPLE: • initial positions: • money supply M= 1100 • deposits= • suppose the private sector deposits all of the extra cash it gets • and the commercial bank maintains a 10% cash reserve ratio • Suppose central bank issues 100m TL of new banknote and distributes it to public • What is the total increase in money supply as a result of the injection of the new 10m TL in to the economy?

  38. Step 1 • Step 1a: Public deposits %100 of the money which is 100m TL to the bank(s) • notes in circulation does not change • Step 1b: Bank lent 90% of the new deposits as new loans • loans increase by 0.9*100=90 • Changes in quantities are • Banks Public • Assets Liabilities • reserves loans  D  C  M • 0 100 1000 1100 0 1100 • 0 +100 +100 • 1a +100 0 +100 -100 • 1b -90 +90 +90 +90 • +10 +90 +100 +90 +190 • 1 110 1090 1200 +90 1290

  39. Step 2 • Step 2a: Public depositsall of the new loans to the bank(s) • deposits increases by 90 • Step 1b: Bank lent 90% of the new deposits (81) as new loans • loans increase by 0.9*90=81 • Changes in quantities are • Banks Public • Assets Liabilities changes in • reserves loans  D  C  M • 1 110 1090 1200 90 1290 • 2a +90 +90 -90 • 2b -81 +81 +81 • +9 +81 +90 -9 +81 • 2 119 1181 1290 81 1381

  40. Step 3 • Step 3a: Public deposits all of the new loans to the bank(s) • deposits increases by 81 • Step 1b: Bank lent 90% of the new deposits (81) as new loans • loans increase by 0.9*81=72.9 • Changes in quantities are • Banks Public • Assets Liabilities changes in • reserves loans  D  C  M • 2 119 1181 1290 81 1381 • 3a +81 +81 -81 • 3b -72.9 +72.9 +72.9 • 8.1 +72.9 +81 -8.1 +72.9 • 3 127.1 1253.9 1371 72.9 1453.9

  41. Notice that each step starts with tthe public sector’s depositing all of its money in to banks • then assets of the banks increases at the same time liabilities are increases by the same amount • in the second round of each step banks lend %90 of their new assets as loans to private sector which inject money in to public again

  42. Summary of the steps • Changes in quantities are •  D  C  M  H • 0 +100.00 +100.00 • 1 +100 +90 +190 • 2 +90 -9 +81 • 3 +81 - 8.1 +72.9 • notice that when H increased by 100 • M the money supply increases much more than that •  M = 100+90+81 +72.9+... • =100*(1 +0.9+0.92+0.93+...) • =100 . 1 . = 1000 • 1-0.9

  43. Why people hold cash? • Some purchases are made using notes or coins. Instead of using credit cards or writing cheques • buying bread • buying coffee tea • Many people do not trust bank • they kept their savings under the bed • note that in our economy there is no inflation yet people lose interest by keeping money under their pillow the purchasing power of money dose not declines

  44. The monetary base and the money multiplier • The money multiplier • the change in the money stock for a 1 TL change in the quantity of the monetary base • money stock = money multiplier* • monetary base • M = m*H • or when m is a constant • M2=m*H2,M1=m*H1 M2-M1=m*(H2-H1) • M = m* H

  45. Where • M: money stock or money supply • m: money multiplier • then we have the following basic relations • M = D + C • H = R + C

  46. The value of the money multiplier depends on two key rations, • the banks’ desired ratio of cash reserves to total deposits • cb = R/D • the private sector’s desired ratio of cash in circulation to total bank deposits • cp=C/D

  47. The lower the desired cash reserves ratio, • the larger the quantity of deposits the banks will create against given cash reserves • and the larger will be the money supply

  48. The lower the private sectors desired ratio of cash in circulation to private sector bank accounts • the larger will be the money supply for any given quantity of high-powered money issued by the central bank

  49. (cp + 1) So M = H (cp + cb) 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 Money supply = money multiplier × monetary base

  50. Example • cb = 0.1, cp=0.2 • What is money multiplier? • m = (1+cp)/(cb+cp) • m = (1+0.2)/(0.1+0.2)=4 • increasing H by 1 billion TL increases money supply by 4 billion • if C = 1000 What is H,D, R,M?

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