FAC241 Banking - Session 2 - Money and Credit PDF

FAC241 - BANKING, Monsoon 2024 SESSION 2 - MONEY AND CREDIT Learning Objectives: LO1 – Money and its functionality LO2 – Kinds of money LO3 – Understanding money supply LO4 - Credit...

FAC241 - BANKING, Monsoon 2024 SESSION 2 - MONEY AND CREDIT Learning Objectives: LO1 – Money and its functionality LO2 – Kinds of money LO3 – Understanding money supply LO4 - Credit  MONEY – medium of exchange or means of payment, qualitatively better than credit. Acceptable medium of exchange, usable by all with standardized quantity, durable, divisible and easy to transport  CREDIT / LOAN – sum of money to be returned, normally with interest / promise to pay – Loan / Debt  FINANCE – monetary resources comprising of debt and ownership funds of the state, company or person. DEFINITION Money is anything that is generally acceptable as means of payment in the settlement of all transactions, including debt. It is the commonly- used medium of exchange. Whether money is shells or rocks or gold or paper, it has three primary functions in any economy: as a medium of exchange, as a unit of account and as a store of value. Of the three functions, its function as a medium of exchange is what distinguishes money from other assets such as stocks, bonds and houses. WATCH – History of Money - https://www.youtube.com/watch?v=YCN2aTlocOw FUNCTIONS OF MONEY 1. Medium of Exchange It is a characteristic that distinguishes money from other assets. All other functions of money are derived from this primary function of being accepted as payment for goods and services. Without money, exchange will involve a direct barter of goods and services for goods and services. It promotes transactional efficiency in exchange and allocation efficiency. This function is also known as medium of payments, means of payment and circulating medium. 1 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 In almost all market transactions in our economy, money in the form of currency or cheques is a medium of exchange; it is used to pay for goods and services. The use of money as a medium of exchange promotes economic efficiency by minimizing the time spent in exchanging goods and services. The time spent trying to exchange goods or services is called a transaction cost. In a barter economy, transaction costs are high because people have to satisfy a ‘double coincidence of wants’ – they have to find someone who has a good or service they want and who also wants the good or service they have to offer. Money promotes economic efficiency by eliminating much of the time spent exchanging goods and services. It also promotes efficiency by allowing people to specialize in what they do best. Money is therefore essential in an economy: it is a lubricant that allows the economy to run more smoothly by lowering transaction costs, thereby encouraging specialization and the division of labour. The need for money is so strong that almost every society beyond the most primitive invented it. For a commodity to function effectively as money, it has to meet several criteria: a) It must be easily standardized, making it simple to ascertain its value; b) It must be widely accepted; c) It must be divisible, so that it is easy to ‘make change’; d) It must be easy to carry; and e) It must not deteriorate quickly. 2. Unit of Account Second role is to provide a unit of account - to measure value in the economy. In terms of money the values of all goods and services are expressed which makes possible meaningful accounting systems by adding up the value of goods and services, eg. National income estimates of a country. Price is only value per unit of goods and services and being expressed in a common unit, they can be directly compared with one another and the ratio of exchange between any pair of goods easily computed. Imagine how hard it would be in a barter economy to shop at a supermarket with 1,000 different items on its shelves. To make it possible to compare prices, the tag on each item would have to list up to 999 different prices, and the time spent reading them would result in very high transaction costs. The solution to the problem is to introduce money into the economy and have all prices quoted in terms of units of that money, enabling us to quote the price of each item in term of rupees. The benefits of this function of money grow as the economy becomes more complex. However, money as a measure of value is not perfect. Its own value does not stay constant (varies from time to time). 2 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 3. Store of Value People can hold their wealth in the form of money. Money also functions as a store of value; it is a repository of purchasing power over time. A store of value is used to save purchasing power from the time income is received until the time it is spent. This function of money is useful, because most of us do not want to spend our income immediately upon receiving it, but rather prefer to wait until we have the time or the desire to shop. Money is not unique as a store of value; any asset – whether money, stocks, bonds, land, houses, art or jewellery – can be used to store wealth. Many such assets have advantages over money as a store of value: they often pay the owner a higher interest rate than money, experience price appreciation, and deliver services such as providing a roof over one’s head. If these assets are a more desirable store of value than money, why do people hold money at all? The answer to this question relates to the important economic concept of liquidity, the relative ease and speed with which an asset can be converted into a medium of exchange. Liquidity is highly desirable. Money is the most liquid asset of all because it is the medium of exchange; it does not have to be converted into anything else to make purchases. Other assets involve transaction costs when they are converted into money. For example, when you sell your house, you may have to pay a brokerage commission, and if you need cash immediately to pay some pressing bills, you might have to settle for a lower price if you want to sell the house quickly. Because money is the most liquid asset, people are willing to hold it even if it is not the most attractive store of value. How good a store of value money is depends on the price level. A doubling of all prices, for example, means that the value of money has dropped by half; conversely, a halving of all prices means that the value of money has doubled. During inflation, when the price level is increasing rapidly, money loses value rapidly, and people will be more reluctant to hold their wealth in this form. This is especially true during periods of extreme inflation, known as hyperinflation, in which the inflation rate exceeds 50% per month. 4. Standard of Deferred Payment Apart from the basic functions mentioned above, it also acts as a standard of deferred payment. i.e., it is used at times when the payment is not done on immediate basis as the products are purchased or services are availed. Instead, the payments for products / services is done somewhere in future, thus facilitating exchange over time. This means the payment for the products/services used is delayed to some future date. Such payments are also done with the help of money due to the ease of standardisation, common transaction value and so on. This includes payment of interest, rates, rents, salaries, insurance premium etc. 3 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 Definition of money There are two approaches to define money - Approaches Traditional approach Empiricists` approach a) its general acceptability a) is the most liquid asset of all b) its functional aspect b) serves as a common denominator value c) Other financial asset are income yielding assets while cash balances earns no interest Money and Near Money Asset Portfolio: The Liquidity Ranking of Claims PERFECT LIQUIDITY IMPERFECT LIQUIDITY MONEY COINS + CURRENCY NOTES + DEMAND DEPOSITS BONDS EQUITIES REAL BILLS CENTRAL, PREFEREN GOODS, POSTAL TREASURY TIME STATE CE SHARES LAND, SAVING BILLS ORDINARY HOUSE, DEPOSITS AND DEPOSITS EXCHANG LOCAL SHARES JEWELLER E BILLS GOVERME DEBENTU Y, CAR, NT RES ETC. INCREASING LIQUIDITY 4 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 Role of money in a capitalist economy Money is the backbone of capitalism. Following are characteristic features 1. It is a free enterprise economy 2. The means of production in this economy are owned and exploited by the private sector. 3. Under pure capitalism, there is complete economic freedom of choice as regards consumption, production, saving and investment. The customer is sovereign as he has immense freedom to make alternative choices in his consumption. 4. Similarly, a producer in a capitalist economy can put his productive resources land, labour, capital and entrepreneurial skill in any business where he finds a good scope. 5. Private entrepreneurs initiate production with a view to earning high profits. Thus production in a market-oriented free enterprise economy is usually profit-based rather than need-based. 6. Income distribution is made in a monetary form. 7. Capitalist economy is an unplanned economy. KINDS OF MONEY 1. Coins - are FIAT MONEY (legal tender) 2. Currency Notes - must be accepted or can’t be refused 3. Deposit Money - Only demand deposits of banks on which cheques can be drawn are treated as money. Does Money Exist? By William Davidow (Adapted from Forbes ASAP) Does money exist? Most of us would answer yes. Of course, we’d say, money exists. It is what we receive for our labor, what we use to pay our bills, and what we save for our retirement. But the answer to this question, increasingly, is no. The money we all learned about in Economics was defined by the agricultural and industrial ages. This "old money" was a store of value and a medium of exchange. The "new money" of the information age will be used less for these functions; instead, it will serve more and more as a measure of value. Money will be an information carrier that lets us compare the value of items, but it will become a very different commodity from the one we know today. "Old money." Back in the days when commercial transactions might take months to complete, money represented a durable store of value. A trader in England put silver coin 5 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 on a ship and sailed to Asia where he exchanged the coin for tea. The silver stored value for the duration of the trip. The same was true of savings. The introduction of money as a medium of exchange greatly facilitated trade. But the introduction of metal coins created a standard way to value assets and facilitated trade. The monarchies that issued the coins served as standards bodies. They guaranteed coins contained the proper amount of precious metal. Money became a means of measurement rather than a store of value when governments moved from issuing coins made of precious metals to printing paper money. With this transition, it also became possible for governments to back a large amount of paper money with only a small amount of gold. Not all the people who had paper money, after all, would try to convert it into gold at the same time. From there, it was an easy step to eliminate the promise to convert paper to coins. The government simply guaranteed that the money it issued was legal tender for paying debts. Unlike a gold coin, a rupee was worth a rupee because the issuing government said it was. Today, paper money is no longer a store of value for many of us. Because transactions can be made very quickly in an information age, we choose to store much of our wealth in other forms, such as stocks and bonds. These financial instruments derive value from the underlying assets. Money stored in a mutual fund, for example, is backed not by the full faith and credit of the government but by publicly traded stocks. These stocks, in turn, derive their value from the corporate assets they represent and from the opinions financial analysts have of the companies. Today, money functions, less and less as a medium of exchange. Instead it is a measurement, a way of communicating value in a common language. "New money." For many of us, money exists only for instants of time. A very small portion of our assets are kept as paper money. We sell one stock and convert the proceeds to cash until we buy another. As the tools of the electronic age permit companies to create more and more financial instruments, our options will increase and, also, the amount of time assets are actually stored as money will continually shrink. The "old money" will constitute a smaller and smaller fraction of our asset base and exist for shorter and shorter periods of time until, for all practical purposes, it won't exist at all. As money evolves into a measurement system, the implications are dramatic. For example, one might anticipate the growth of competing monetary systems such as "Bitcoin". Or the return of private money systems. A harbinger of all this is that governments are losing control of their monetary systems. Relative values of national currencies are increasingly set by the market rather than by government policy. More and more private institutions are moving to create new forms of money, such as stored-value cards, that are beyond the control of governments. 6 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 So one has to wonder if it will be possible for governments to have effective monetary policies in the future. Maybe we should prepare for a world in which "old money" no longer exists. EVOLUTION OF THE PAYMENTS SYSTEM We can obtain a better picture of the functions of money and the forms it has taken over time by looking at the evolution of the payments system, the method of conducting transactions in the economy. The payments system has been evolving over centuries and with it the form of money.  Commodity Money At one point, precious metals such as gold were used as the principal means of payment and were the main form of money. Money made up of precious metals or another valuable commodity is called commodity money, and from ancient times until several hundred years ago, commodity money functioned as the medium of exchange in all but the most primitive societies. The problem with a payments system based exclusively on precious metals is that such a form of money is very heavy and is hard to transport from one place to another.  Fiat Money The next development in the payments system was paper currency (pieces of paper that function as a medium of exchange). Initially, paper currency carried a guarantee that it was convertible into coins or into a fixed quantity of precious metal. However, currency has evolved into fiat money, paper currency decreed by governments as legal tender (meaning that legally it must be accepted as payment for debts) but not convertible into coins or precious metal. Paper currency has the advantage of being much lighter than coins or precious metal, but it can be accepted as a medium of exchange only if there is some trust in the authorities who issue it and if printing has reached a sufficiently advanced stage that counterfeiting is extremely difficult. Because paper currency has evolved into a legal arrangement, countries can change the currency that they use at will. Indeed, this is what happened when the Eurozone was created in 2002. Major drawbacks of paper currency and coins are that they are easily stolen and can be expensive to transport in large amounts because of their bulk. To combat this problem, another step in the evolution of the payments system occurred with the development of modern banking: the invention of cheques.  Cheques Later, paper assets such as cheques and currency began to be used in the payments system and viewed as money. Where the payments system is heading has an important bearing on how money will be defined in the future. A cheque is an instruction from you to your bank to 7 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 transfer money from your account to someone else’s account when they deposit the cheque. Cheques allow transactions to take place without the need to carry around large amounts of currency. The introduction of cheques was a major innovation that improved the efficiency of the payments system.  Electronic Payments The development of inexpensive computers and the spread of the Internet now make it cheap to pay bills electronically. In the past, you had to pay your bills by mailing a cheque, but now banks provide websites at which you just log on, make a few clicks, and thereby transmit your payment electronically. Electronic payment systems provided by banks now even spare you the step of logging on to pay the bill. Instead, recurring bills can be automatically deducted from your bank account. The cost per transaction of a payment made through electronic payment is extremely low. Electronic payment is thus becoming far more common.  Electronic Money (E-Money) Electronic payments technology can substitute not only for cheques, but also for cash, in the form of electronic money (or e-money) – money that exists only in electronic form. The first form of e-money was the debit card. Debit cards, which look like credit cards, enable consumers to purchase goods and services by electronically transferring funds directly from their bank accounts to a merchant’s account. Debit cards are used in many of the same places that accept credit cards and are now often becoming faster to use than cash. Most banks and companies such as Visa and MasterCard issue debit cards, and your ATM card typically can function as a debit card. Other forms of E-money are now making an appearance in the international markets. For example: M-Pesa.  Crypto Currency A cryptocurrency is a digital currency, an alternative form of payment created using encryption algorithms. Encryption technologies mean that cryptocurrencies function both as a currency and a virtual accounting system. These digital currencies are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation. A cryptocurrency is a digital or virtual currency secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. One needs a cryptocurrency wallet to store and use it. As of March 2023, there are 22,904 cryptocurrencies in existence. However, not all cryptocurrencies are active or valuable. The most commonly known cryptocurrency is Bitcoin. Cryptocurrency is not legally approved and acceptable in India. 8 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024  Central bank digital currencies (CBDCs) CBDCs are the digital form of a government-issued currency that is not pegged to a physical commodity. They are issued by central bank of a country. They are similar to cryptocurrencies, except that their value is fixed by the central bank and equivalent to the country's fiat currency. Fiat money is a government-issued currency that has no backing from a physical commodity like gold or silver. It is considered as a legal tender. The main goal of CBDCs is to provide businesses and consumers with privacy, transferability, convenience, accessibility, and financial security and at the same time decrease in the cost of maintenance for each stakeholder. Countries that have issued CBDC - USA, Eastern Caribbean Central Bank (ECCB), China, Singapore, Jamaica, Nigeria, the Bahamas, UAE, Ghana, Malaysia, Thailand, including India. MEASURES OF MONEY SUPPLY  Meaning of Money Supply: The supply of money means the total stock of money (paper notes, coins and demand deposits of bank) in circulation which is held by the public at any particular point of time. Briefly money supply is the stock of money in circulation on a specific day i.e., (i) Currency / Fiat Money (Paper notes and coins) (ii) Demand deposits of commercial banks. Again it needs to be noted that (like difference between stock and supply of a commodity) total stock of money is different from total supply of money. The stock of money held by government and the banking system are not included because they are suppliers or producers of money and cash balances held by them are not in actual circulation. In short, money supply includes currency held by public and net demand deposits in banks. Supply of money is only that part of total stock of money which is held by the public at a particular point of time. In other words, money held by its users (and not producers) in spendable form at a point of time is termed as money supply. Sources of Money Supply: (i) Government (which Issues one-rupee notes and all other coins) (ii) RBI (which issues paper currency) (iii) Commercial banks (which create credit on the basis of demand deposits). 9 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 Various monetary and liquidity aggregates are compiled in India. Measures of Monetary and Liquidity Aggregates:  Reserve Money (M0) – largely includes currency in circulation and deposits with RBI  M1 – Reserve money + demand deposits with banks  M2 – M1 + Savings deposit with POSB  M3 – M1 + time deposits with banks DETERMINANTS OF MONEY SUPPLY 1. The size of the monetary base An important determinant of the extent of the money supply in a modern economy is the magnitude of the monetary base. The term “monetary base” here refers to the group of assets which empowers the monetary authorities- the central bank- to issue high-powered money for use in the economy, from time to time. The monetary base, in general, is composed of the following:  Monetary gold stock;  Reserve assets, such as government securities, bonds and bullion, foreign exchange reserve etc; with the central bank, and  Amount of central bank credit outstanding’s 2. Community’s choice regarding cash and credit proportions in holding money The relative amounts of cash and demand deposits which the community wishes to hold have a great significance in this regard. If the community chooses to make payments by cheques rather than by cash in a great proportion, then the total volume of money that will be maintained by a given monetary base will be larger. 3. Extent to Monetisation Monetisation refers to the use of money in the system of exchange in an economy. A fully monetized economy apparently needs more money supply than a partially monetized economy of the same order. The demand of money also rises with the growth of monetisation. 4. The cash reserve ratio (CRR) The cash reserve ratio is also an important determinant of the quantity of money in a modern economy because it determines the multiplier coefficient of credit creation by banks. The cash reserve ratio refers to the ratio of banks cash holdings to its total deposit liabilities. 10 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 When commercial banks grant credit, the money supply expands in the form of bank money or credit money. This tends to be a multiple expansion of credit in the banking system as a whole, so the flow of money supply increases over the period of time when banks create credit. The process of credit creation by banks technically depends on the cash reserve ratio, since the cash reserve ratio determines the excess funds with a bank on the basis of which it can grant loans. MONEY SUPPLY FUNCTIONS Supply Behaviour in the money market can be specified by the money supply function. A money supply function expresses the functional relationship between the quantity of money supplied and its determinant variables. A commonly adopted money supply function is that money supply function is that money supply is a function of the rate of interest, that is Ms = f(i) where ∆Ms/∆i > 0 (which implies that there is a positive relationship between the rate of interest and money supply). Here, ∆Ms denotes a marginal change in money supply; ∆i implies a marginal change in interest rate i; while >0 implies a positive change or an increase. The actual factors influencing money are: (i) The quantity of total legal tenders (l) possessed by the banks. (ii) The cash reserve ratios for demand deposits and time deposits (dr and tr, respectively) (iii) The rate of interest (i), and (iv) The national income Y, because it determines the currency require by the public. Thus, Ms = f (l, dr, tr, I, Y) Where, ∆Ms/∆i > 0; ∆Ms/∆dr < 0; ∆Ms/∆tr < 0; ∆Ms/∆l > 0; and ∆Ms/∆Y > 0 The factors l, dr and tr are under the control of the central bank, while factors such as i and Y are determined by the market forces. CREATION OF MONEY Changes in money supply arise out of the action of the treasury, the central bank and the commercial banks in any country. 11 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 The two most important agencies in the structure of money and credit are the commercial banks and the central bank. The commercial banks are private institutions and the creators of the largest element of the money supply, namely demand deposits. The central bank is an agency of the government, which exercises central control over the monetary structure of the country.  Money creating action of commercial banks Commercial banks have the power to create demand deposits (deposits which can be withdrawn at any point of time) through the granting of loans. When a bank lends or advances credit to a customer, it does not usually give direct cash but opens an account in the customer’s name itself. He/She is then allowed to withdraw the sum by drawing cheques on his/her account. Thus, when the commercial banks as a system, expand their loans and investments, they create demand deposits which constitute a part of money supply in the modern economy. As such, credit creation activities of the bank lead to changes in the money supply.  State Treasury and Central Banks as Creators of Money The central bank, with its various methods of quantitative credit control, like the bank rate, open market operations (OMOs), and reserve requirements (CRR, SLR), can influence the reserve funds of the commercial banks and their credit creating capacity. The primary tool of monetary policy is open market operations: the central bank buys and sells financial assets such as treasury bills (T-bills), government bonds (G-Sec), or foreign currencies from private parties. Purchases of these assets result in currency entering market circulation (inflow), while sale of these assets reduce currency from circulation (outflow). Usually, open market operations are designed to target a specific short-term interest rate. The treasury can control the money supply through open market operation of treasury bills and other government securities and debt management. CREDIT Credit is finance made available by one party (lender, seller, or shareholder/owner) to another (borrower, buyer, corporate or non-corporate firm). Credit is the trust which allows one party to provide money or resources to another party where that second party does not reimburse the first party immediately (thereby generating a debt), but instead promises either to repay or return those resources (or other materials of equal value) 12 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 at a later date. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people. The resources provided may be financial (e.g. granting a loan), or they may consist of goods or services (e.g. consumer credit). Credit encompasses any form of deferred payment. Credit is extended by a creditor, also known as a lender, to a debtor, also known as a borrower. Credit does not necessarily require money. The credit concept can be applied in barter economies as well, based on the direct exchange of goods and services. However, in modern societies, credit is usually denominated by a unit of account. Money Multiplier Theory A money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Money Multiplier is the amount of money the banking system generates with each rupee of reserves. It works like this. Money multiplier = 1 / R, where R is the reserve ratio (CRR). A reduction in R leads to an increase in the money multiplier and vice versa. Say you deposit 100 Rs with a bank. Banks are required to maintain a percentage of deposits collected as cash reserves with central bank. The central bank imposes this reserve on the bank to manage liquidity situation in an economy. In India we call this Cash reserve ratio (CRR). So let us assume CRR is 10%. Then Bank deposits Rs 10 with RBI and lends the Rs 90 to another customer X. X takes the loan and say buys machinery from Y. Y takes the payment and deposits the money in his bank. The bank again gives the money for credit after netting out the reserves. And the cycle goes on this manner. So 100 Rs of deposit with a bank leads to multiplies of the same amount. This is called money multiplier. 13 Hetal Jhaveri, AMSOM, Ahmedabad University  FAC241 - BANKING, Monsoon 2024 Sources: Money Banking and Finance – Sinha N.K.; Money, Banking, International Trade and Public Finance – Mithani D.M. ***** 14 Hetal Jhaveri, AMSOM, Ahmedabad University