Banking System and Money Creation - Lecture Notes

 LEARNING OUTCOMES Discuss the functions Definition and 1 of central banks 4 function of money The role of monetary 2 policy tools 5 Aggregate money supply 3 Functions...

 LEARNING OUTCOMES Discuss the functions Definition and 1 of central banks 4 function of money The role of monetary 2 policy tools 5 Aggregate money supply 3 Functions of commercial banks ‹#› CENTRAL BANK Major financial institutions in a country. The general roles are Managing monetary policy Controlling financial stability Supervise the banking system Controlling the money supply and interest rates Ensuring economic stability - inflation, unemployment, price stability Central bank operations are not aimed at making a profit ‹#› THE ROLE OF CENTRAL BANK 1 Currency Supply Controlling the Local Currency Supply Example Malaysia: Bank Negara Malaysia - the currency of the Malaysian Ringgit (MYR). China: People's Bank of China - (Yuan/Renminbi (RMB). Singapore - Monetary Authority of Singapore (MAS) - Singapore Dollar (SGD). United States: uses the Dollar (USD) – the main currency widely used in international trade. ‹#› THE ROLE OF CENTRAL BANK 2 Holding Reserves Reserve holders to protect the domestic currency. Among the forms of reserves are Gold Total reserves in IMF Special Drawing Rights A wide portfolio of foreign exchange assets in foreign currencies (bank balances, treasury bills, and long-term securities) Without reserves - currencies do not have any value because there is no backing. ‹#› THE ROLE OF CENTRAL BANK 3 Bankers and Advisors to the Government Bankers to the Government Responsible for managing government accounts, providing checking services, receiving deposits, making payments on behalf of the government and financing government investments (treasury bills and government securities. Fiscal agents Advising the government and managing public debt and government loans. Financial adviser to the government To be an advisor to the government in all economic and financial affairs of the country. ‹#› THE ROLE OF CENTRAL BANK 4 Banker to Commercial Banks ▪ Custodians of Statutory Reserve Accounts and Clearing Accounts The statutory reserve account allows financial control to be exercised. Clearing account - settlement of interbank transactions after the cheque has been cashed. (Including to commercial banks). ▪ Periodic/Regular Inspections To regulate commercial banks to follow practices and procedures in line with the demands and requirements outlined by legislation related to national finance. ▪ Lender of Last Instance Banker to commercial bank - lender of last resort to commercial bank in obtain case if there is cash shortage. ‹#› THE ROLE OF CENTRAL BANK 5 Implementing Monetary Policy Conduct Monetary Policy by altering and regulating the money supply and interest rates in financial markets - promoting monetary stability conducive for a sustainable economic growth. ‹#› MONETARY POLICY TOOLS TO CONTROL THE MONEY SUPPLY Central banks control the money supply in the economy using several monetary policy tools ‹#› 1 Open Market Operations Reduce Money Supply The sale of treasury bills, bonds, and government securities by the central bank to commercial banks and the public. The transaction is made using a cheque - CB will make a claim at the relevant commercial bank the commercial bank's reserves being transferred to the central bank account - decreases the money supply When public buy the bond/treasury bill – decreased the money hold by them – decreases the money supply  1 Open Market Operations Increase Money Supply The CB will buy government bonds from commercial banks and households. If commercial banks and the public deposit cash from the resale of government bonds - into commercial banks, then the amount of commercial bank reserves increases. Subsequently, commercial banks can use the reserve money to provide loans to other parties. When the borrower deposits the loan into an account at a commercial bank, then the amount of deposits and loans by the commercial bank will increase.  2 Reserve Ratio Increase Money Supply Reducing money supply CB will reduce the statutory CB will raise the statutory reserve reserve ratio → increases the ratio → decreases the share of share of deposits that become deposits that are excess reserves to excess reserves to be given as be given as loans to the public. loans to the public. This limits the expansion of the This will expand the creation of creation of new loans/credits and loans/credits) and new deposits. deposits. ‹#›  3 Discount Rates Charge imposed by CB on loans given to CB The Central Bank Increase Central Banks Reduce Money Money Supply in the Market Supply in the Market Steps Steps CB will reduce discount rates CB raises discount rate This will reduce borrowing costs and The high discount rate discourages encourage commercial banks to commercial banks from obtaining additional make loans reserve loans from CB due to high borrowing costs. The ability of commercial banks to create new loans and deposits will Commercial banks are less willing to add to increase, and hence increased the the creation of loans, new deposits and money supply. money offerings. Hence, decreased the money supply ‹#›  COMMERCIAL BANKS Commercial banks are the most important financial intermediaries in connecting households, firms, and the government through the receipt of deposits and the granting of loans. Commercial banks have several main functions that are closely related to financial and banking activities in the economy. ‹#› Main Functions of Commercial Banks 1 2 Accepting Deposits Providing Loans/Credit Commercial banks accept Providing loans/credit different types of deposits facilities to individuals, from individuals, companies, businesses and the and institutions. government. Current deposits, fixed - Helping to stimulate deposits and savings economic activity by deposits - the main sources financing projects, capital of loans and investments. purchases and similar ‹#› Main Functions of Commercial Banks 3 4 Payment Services Money and Investment Management Provide payment services such as money transfers, cheques, ▪ Assist individuals and credit cards and cash companies in managing their withdrawal services including finances. international transactions - ▪ Offers investment products letters of credit and electronic (fixed deposits, savings payments. accounts, investment funds) ▪ Providing advice on financial strategies and investment planning. ‹#› Main Functions of Commercial Banks 5 6 Currency Exchange Risk Management Services ▪ Provide products to help ▪ Making foreign currency individuals and companies exchange for customers manage financial risks such as (international insurance and derivatives that trade/tourism). can protect them from ▪ Providing foreign currency- unexpected changes in interest related financial products rates, commodity such as futures/options prices/currency exchange rates. contracts. ‹#›  DEFINITION OF MONEY Money - something that is generally accepted as a means of exchange/payment for goods and services as well as the payment of debts. Characteristics: Generally accepted, stable value, uniform shape, limited supply, easy to break into small units, durable, and not easy to change, as well as easy to carry and save. ‹#›  DEFINITION OF MONEY Use of Money ▪ Replacing the Barter System - facing various problems. ▪ Gold was used as money – it had intrinsic value used at the end of the 19th century. ▪ Fiat money is used – paper money – because commodity money (gold/silver) is difficult to determine its originality and difficult to carry. Fiat money has no intrinsic value and nowadays its use has become popular in most economies. ▪ Modern technology – Credit cards, checks, tradable certificates, bitcoin and similar are used as money. ‹#›  MONEY FUNCTION 1 2 Tools/Medium of Exchange/ Standard Value Intermediary of Exchange Measure/Unit of Account Refers to materials that can be used Money provides a method for to purchase goods and services/to measuring the value of a variety of transact, as well as debt payments different goods and services. BENEFITS BENEFITS Eliminate the disadvantages of ▪ A value comparison can be made barter transactions through the between one item and another in facilitation of trade in an the market. economy based on specialization ▪ Money gives a price to all goods and exchange. because each good is expressed in a The use of money reduces certain monetary value. transaction costs and saves time. ▪ Determination of relative prices between goods can be made easily and quickly. ‹#›  MONEY FUNCTION 3 4 Store of Value Deferred Payment Instruments/ Debt Payment Money can maintain its value for some time Allows the debt/amount of money to be paid in the future to BENEFITS be recorded ▪ Shows that money can transfer BENEFIT purchasing power from the current period to the future. ▪ Each loan requires the borrower to ▪ Money can be spent by people in repay a certain amount of money the future. in the future. ‹#›  MONEY SUPPLY AND FINANCIAL AGGREGATES Money Supply, 𝑀 =𝐷+𝐶 D = Demand deposits C = Currency The amount and composition of components C and D will change according to current needs or community demand. Commercial banks influence money supply through their lending and deposit-taking activities. CB influences money supply in the market through the monetary policy it implements. The interaction between the community (households, individuals), banks and CB in the process of raising money can be seen through i. Currency-deposit ratio ii. Reserve-deposit ratio iii. High-power money ‹#›  1 Currency - Deposit Ratio ▪ Refers to the comparison between the amount of cash held by individuals/communities and the amount of deposits held in banks. Intuitive: It shows how much people are more likely to hold cash than deposits in banks. ‹#›  1 Currency-Deposit Ratio The Currency-Deposit Ratio is determined: i. The tendency of people to hold cash People are more likely to hold/ask for cash than deposits if they prefer to pay for transactions using cash. This will affect the amount of cash you will hold compared to the amount of deposit. ‹#›  1 Currency-Deposit Ratio The Currency-Deposit Ratio is determined: ii. Cost and convenience of cash withdrawal The absence of a cash dispensing machine nearby will cause people to hold less cash. They tend to use checks from the deposit account while in day-to-day business. iii. Seasonal factors Spending a lot of money at festive times. ‹#›  2 Reserve-Deposit Ratio Total Statutory Reserves - the minimum amount of reserves a commercial bank must keep in the Central Bank. Examples: Bank Negara Malaysia, Federal Reserve/Central Bank Europe. These reserves are part of the deposits received by commercial banks from customers and are intended to ensure that banks have sufficient cash/assets that can be liquidated to meet the demands of cash withdrawals/other financial transactions. ‹#›  2 2 Reserve-Deposit Ratio Purpose of Statutory Reserves 1 Financial System Stability ▪ Statutory Reserves ensure that commercial banks do not use all deposits received for loans/investments, but instead keep a portion of them as reserves. 2 ▪ Fulfilling cash withdrawal requests from customers without the risk of running out of money. ‹#›  2 Reserve-Deposit Ratio Purpose of Statutory Reserves 2 Controlling the Money Supply ▪ CB can change the statutory reserve ratio to control the amount of money circulation in the economy. ▪ If the central bank increases the statutory reserve ratio, commercial banks will have to keep more reserves and this will reduce the amount of money that can be lent to customers. ▪ On the other hand, if the reserve ratio is lowered, commercial banks can lend more money and this will increase the money supply in the economy. ‹#›  2 Reserve-Deposit Ratio Purpose of Statutory Reserves 3 Preventing Financial Uncertainty By setting rules on statutory reserves, CB was able to avoid a situation where commercial banks lacked liquidity to meet withdrawal demand/faced the risk of default. This gives customers and financial markets confidence about the banking system’s stability. ‹#›  2 Reserve-Deposit Ratio Purpose of Statutory Reserves 4 Ensuring Liquidity Statutory Reserves help ensure that commercial banks always have sufficient liquidity, which is an easily liquidated amount of cash or assets to meet their financial obligations without causing disruption to the bank's day-to-day operations. By setting rules on statutory reserves, CB was able to avoid a situation where commercial banks lacked liquidity to meet withdrawal demand/faced the risk of default. ‹#›  3 High-Power Money ▪ High-Powered Money Refers to the type of money used by CB to influence the money supply in the economy. Consists of two main components Cash issued by central banks (currency) Bank reserves held by commercial banks at CB ‹#›  3 High-Power Money ▪ High-Powered Money 𝐵=𝐶+𝑅 B = High-power money/financial fundamentals C = Money in circulation R = Total reserves held by commercial banks If RM1 is withdrawn from a person's account at a commercial bank, then C will increase by RM1 and at the same time, R will decrease by RM1. This means that individual demand for currency and control over the reserves of commercial banks will affect the money supply over a certain period. ‹#›  3 High-Power Money The Three Main Components of Money/Financial Aggregate In Malaysia M1 = C + D ▪ M1 - Money narrowly has the highest degree of liquidity. Includes money (paper and coins) in circulation and deposit requests (excluding amounts held by Commercial Banks and Islamic Banks). Deposit request - non-private sector current account Banks and investment banks deposited with banks trade and Islamic banks.  3 High-Power Money The Three Main Components of Money/Financial Aggregate In Malaysia ▪ M2 = M1 + Narrow quasi money (Savings deposits, deposits + NID + Repo and foreign currency deposit). M3 = M2 + deposits held with other banking institutions. referred as broad money that has lowest degree of liquidity  MONEY CREATION Money creation process – how Commercial Banks create new money in the economy through the banking system. Steps for the money creation process 1. Receiving deposits - Individuals/companies who deposits money in the bank. 2. Statutory reserves (10%) - CB sets ratio of reserves that need to be saved. 3. Banks provide loans. 4. Money multiplier – A loan given becomes a new deposit at another bank – which can be lent. ‹#›  PROCESS OF MONEY CREATION The deposit multiplier refers to a ratio that measures the potential growth of bank deposits in the banking system based on the amount of mandatory reserves that banks are required to hold. If statutory reserve ratio at 10% , hence 1 Deposit multiplier = = 10 0.1 For every RM1 of reserves held, the banking system can create RM10 in the money supply through new loans and deposits.  PROCESS OF MONEY CREATION Money creation through monopoly of a bank: If Ainnur deposits RM2,000 at Bank A The statutory reserve ratio is 5% PROCESS OF MONEY CREATION Money creation through monopoly of a bank: PROCESS OF MONEY CREATION PROCESS OF MONEY CREATION  PROCESS OF MONEY CREATION If Ainnur then issues a cheque for RM500 to open a current account at Bank B This transfer of deposits from Bank A to Bank B does not change the amount of the commercial bank's statutory reserves recorded on the liabilities side of the central bank's balance sheet (remains at RM100).  PROCESS OF MONEY CREATION Granting of Loans After receiving deposits from customers, commercial banks will usually use the excess reserves or deposit balance (total deposits – reserves) to lend to other customers. Bank A received a RM2,000 deposit from Ainnur with a statutory reserve ratio which at that time was 5%, as in the previous section; suppose Bank A granted a loan taken from Ainnur's deposit to Hakim. Next, Hakim takes the loan received and deposited into his current account at Bank C. PROCESS OF MONEY CREATION Based on Panel C, the loan provided by Bank A to Hakim caused the total deposit to increase from RM2,000 to RM3,900 (deposit at Bank A + deposit at bank C) and the total new deposit that could be created is RM1,900 (RM3,900 – RM2,000). The statutory reserve account of commercial banks also increased from RM100 to RM195 , (RM100 + RM95) At this level, the total money supply (currency + deposits) also increases from RM402,000 (currency + Deposits at Bank A = RM400,000 + RM2,000) to RM403,900 (currency + Deposits at Bank A + Deposits at Bank C = RM400,000 + RM2,000 + RM1,900). With an initial deposit of RM2,000, the maximum amount of deposits created is RM40,000 (deposit multiplier × initial deposit = 1÷r × RM2,000 = 20 × RM2,000) and the total amount of loans created is RM38,000 (deposit multiplier × initial loan = 1÷r × RM1,900 = 20 × RM1,900). The process of expanding the total money supply Thanks! Any questions? Please keep this slide for attribution ‹#›