Meaning of Money and Types

The Meaning of Money

• Money is the assets used in an economy for purchasing goods and services from others.

Three Functions of Money

• Medium of Exchange: Anything readily accepted as payment.
• Unit of Account: A standard unit for comparing the relative values of goods.
• Store of Value: A way to store wealth in a readily spendable form for future use and to transfer purchasing power from the present to the future.

The Two Types of Money

• Commodity Money: Functions as money and possesses alternative, non-monetary uses.
  • Examples: Gold and silver.
• Fiat Money: Functions only as money and has no other significant uses.
  • Examples: Coins and currency.

Money in the Economy

• Money Stock: The quantity of money circulating in the economy.
• Different ways of measuring the money stock in the economy:
  • M1
  • M2
  • M3

Measurement of Money

• M1: The most familiar form of used money, includes currency and demand deposits (balances in bank accounts available on demand via checks).
• M2: A broader measure of money than M1.
  • Includes M1 and savings deposits (accounts maintained by commercial banks, savings and loan associations, and mutual savings banks).
• M3: An even broader measure of money than M2.
  • Includes M2 and long-term/fixed deposits.

Currency Source

• Riyals are from The Saudi Central Bank of the Kingdom of Saudi Arabia (SAMA).
• Dollars are from The Federal Reserve Bank, which is the central bank of the USA.

Establishment of World Bank and Important Central Banks

• worldbank.org/The World Bank Group: Offers loans, advice, and resources to over 100 developing countries; established in 1944 in Bretton Woods, New Hampshire, USA.
• The International Monetary Fund (IMF): Assesses country economies (including the financial sector), offering loans, advice, and restructuring.
• Saudi Arabian Monetary Agency (SAMA): Formed initial banking regulations from 1960 to 1972, later expanding its tasks.
  • See http://www.sama.gov.sa/ for more info.

Primary Functions of the Central Bank

• Issuing currency.
• Acting as a banker's bank by providing loans to other banks and serving as a lender.
• Acting as a banker to the government.
• Controlling the money supply through monetary policy.

Saudi Arabian Monetary Agency (SAMA)

• Serves as the central bank for Saudi Arabia.
• A central bank handles the following functions:
  • Serves as the bankers' bank, accepting deposits and providing loans to commercial banks.
  • Acts as banker for the government.
  • Issues the national currency (SR).
  • Controls the money supply, supervises commercial banks and money exchanges.
  • Supervises cooperative insurance companies and self-employed insurance professions.
  • Supervises finance and credit information companies.
  • Advises the government on public debt and manages the kingdoms foreign exchange reserves.
  • Conducts monetary policy promoting domestic price and exchange rate stability.
  • Promotes economic growth while ensuring the soundness of the Saudi financial system.
• SAMA's head office is in Riyadh, with ten branches in major Saudi cities.

Central Bank Monetary Policy

• Monetary policy is the primary focus of SAMA.
• Its key objectives are:
  • To stabilize inflation and the general price level
  • To maintain a fixed exchange rate against the US dollar
  • To Allow free movement of currency and capital

Central Bank Monetary Policy Instruments

• SAMA employs four policy instruments in conducting monetary policy:
  • Cash reserve ratio/minimum reserve policy.
  • Repos and reverse repos.
  • Foreign exchange swaps and placement funds.
  • Increasingly relies on repos and reverse repos, known as “open market” operations.

Policy Goals of SAMA

• Ultimate Goal: Economic growth with stable prices, meaning greater output (GDP) and low, steady inflation.
• Intermediate Targets:
  • SAMA controls the money supply rather than directly controlling output or prices.
  • SAMA sets target growth rates for the money supply consistent with its ultimate goals.
  • The money supply growth rate functions as an intermediate target, a goal used to achieve ultimate policy goals.

Open Market Operations

• Open Market Operations (OMOs): SAMA's buying and selling of government bonds to manage bank reserves and the money supply..
• If SAMA aims to increase the money supply, it buys bonds via its monetary policy tools (Repo-Reverse Repo).
• When SAMA purchases bonds, it writes checks on itself, injecting new reserves into the banks.
• Increased reserves then lead to an increase in the money supply.

The Challenge of a Liquidity Trap

• A liquidity trap occurs when nominal interest rates near zero.
  • This happened during the Great Depression of the 1930s, and again in 2008-2009 in the United States.
• Short-term safe securities become equivalent to money, causing the demand for money to become completely elastic relative to the interest rate.
• In this situation, banks do not minimize their reserve holdings, essentially earning the same interest rates on reserves as on risk-free short-term investments.
  • For example, banks in early 2009 could earn 0.10% annually on reserves and 0.12% on Treasury bills.
• Central bank open-market operations have minimal impact on interest rates and financial markets.
  • When the Fed purchases securities, banks simply increase their excess reserves; excess reserves rose to over $900 billion in 2008-2009.
  • Banks are using the Fed as a safe deposit box for their funds making open-market operations are ineffective in a liquidity trap.
• The Fed cant lower short-term interest rates, which inhibits the normal monetary transmission mechanism to stimulate the economy.

Central Bank vs Commercial Bank

• Central Bank:
  • Works for public welfare and economic development of the country.
  • Doesn't deal directly with the public, but issues guidelines to commercial banks for economic development
  • Act as a state-owned institution.
  • Act as custodian of foreign exchange and acts as the government banker.
• Commercial Bank:
  • Operates for profit.
  • Deals directly with the public, providing services such as loans.
  • Operates as an agent of the central bank.
  • May be state or private owned institution.

Bank Reserves

• Fractional Reserve Banking System: A system where banks hold a fraction of deposits as reserves and lend out the remainder.
• The Central Bank sets reserve requirements that are the minimum amount banks must hold against deposits.
• Banks can hold more than this minimum if desired.
• Reserve Ratio (R): Fraction of deposits held as reserves; calculated as total reserves divided by total deposits.

Bank Liabilities and Assets

• Deposits are liabilities since they represent depositors' claims on the bank.
• Loans are assets because they symbolize the banks' claims on its borrowers.
• Reserves are assets since they are funds available to the bank.

Bank T-Account

• T-account: A simplified accounting statement revealing a bank's assets & liabilities.
• Banks' liabilities consist of deposits, whereas assets include loans and reserves.
• The reserve ratio, R, is calculated as reserves/deposits = 10%.

Banks and the Money Supply

• $100 of currency is in circulation, we can determine banks' impact on money supply in 3 different cases:
  • No Banking System: Public holds the $100 as currency, so money supply = $100.
  • 100% Reserve Banking System: Banks hold 100% of deposits as reserves making no loans. Money creation does not affect the money supply.

Banks and the Money Supply: Fractional Reserve Banking

• Banks loan out some deposits creating money.
• Depositors have money in deposits while borrowers have money in currency.
• Money Supply = Currency + Deposits

The Money Multiplier

• Money process does not stop with the first national bank.
• Each time that money is deposited and a bank loan is made, more money is created.
• Money Multiplier: The amount of money the banking system generates with each dollar of reserves, and equals 1/R.

What Determines the Size of the Money Multiplier?

• The money multiplier is the reciprocal of the reserve ratio.
  • Given a reserve requirement of 10% or 1/10, multiplier = 10.

Tools of Monetary Control

• Central banks use tools of monetary control:
  • Open-Market Operations: Buying and selling bonds.
  • Foreign Exchange Market Operations : Buying and selling foreign currency.
  • Changing the Reserve Ratio: Increase or decrease the ratio.
  • Changing the Bank Rate: The interest/profit/service rate central banks charge other Commercial banks for loans.

Problems in Controlling the Money Supply

• Central banks face central problems:
  • Inability to control the amount of money households deposit in banks.
  • Difficulty in controlling the amount of money commercial banks lend.

The Equation of Exchange and the Velocity of Money

• Velocity: Formally introduced in the equation of exchange: MV = PQ
  • M = Money supply.
  • V = Velocity of money.
  • P = Overall price level.
  • Q = Total real output.
• Velocity of Money = PQ/M
• Income Velocity of Money: Measures PQ as total income or output (nominal GDP).
• The rate at which money circulates through the economy is measured as the ratio of nominal GDP to the stock of money.

Banking Panics

• Bank Insolvency and Bank Failure: Banks become insolvent when total assets are less than total liabilities, making shareholders' equity negative and causing bankruptcies.
• Bank Run: Many depositors simultaneously decide to withdraw money from a bank.
• Bank Panic: Many banks experience runs at the same time.