Money and Banking Chapter 1 PDF

Dr. Rana Sherif Basic Principles Aggregate Output Gross Domestic Product (GDP) = Value of all final goods and services produced in domestic economy during year. Aggregate Income Total income of factors of production (land, capital, labor) during year. Distinction Between Nominal and Real Nomina...

Dr. Rana Sherif Basic Principles Aggregate Output Gross Domestic Product (GDP) = Value of all final goods and services produced in domestic economy during year. Aggregate Income Total income of factors of production (land, capital, labor) during year. Distinction Between Nominal and Real Nominal = values measured using current prices. Real = quantities, measured with constant prices. Aggregate Price Level GDP Deflator = nominal GDP / real GDP x 100 Consumer Price Index (CPI) price of “basket” of goods and services. Inflation: the increase in the general price level, it reduces the purchasing power of money. Interest rate: the cost of borrowing money. Why do we study “Money, Banking and Financial institutions? 1. Financial markets channel funds from savers to investors, thereby promoting economic efficiency 2. Banks and Money Supply have crucial role in creation of money. 3. Affect personal wealth and behavior of business firms. 4. Influence on business cycles, inflation, and interest rates  Money supply  The stock of money circulating in the economy.  The total amount of money – cash, coins, deposits – in hands of public. The Definition of Money  Anything that is generally accepted in payment for goods and services.  Not the same as wealth (stock) or income. Economists define money as anything that is generally accepted in payment for goods or services or in the repayment of debts. When most people talk about money, they are talking about currency (paper money and coins). To define money merely as currency is too narrow for economists, because cheques are also accepted as payment for purchases, chequing account deposits are considered money as well.  Money, Income & Wealth: The word money is frequently used synonymously with wealth. Economists make a distinction between money in the form of currency, demand deposits, and other items that are used to make purchases, and wealth.  Wealth is the total collection of pieces of property that serve to store value. Wealth includes not only money but also other assets such as bonds, common stock, land and jewelry.  Income is a flow of earnings per unit of time. Money, by contrast, is a stock: it is a certain amount at a given point in time.  Characteristics of Money: For a commodity to function effectively as money, it has to meet several criteria: 1) It must be easily standardized, making it simple to ascertain its value. 2) it must be widely accepted. 3) it must be divisible so that it is easy to make change. 4) it must be easy to carry. 5) it must not deteriorate quickly  Functions of Money: 1. 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 eliminating much of 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. 2. Unit of Account Money is used to measure value in the economy. We measure the value of goods and services in terms of money. The formula for telling us the number of prices we need when we have N good X = N (N - 1) / 2  3. Store of Value Money 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.  Money is not unique as a store of value. Any asset, whether money, stocks, bonds, land, houses, or jewelry could be considered as a store of value, thus Why do people are more willing to hold money?  Because 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  Money as a store of value depends on the price level.  Evolution of the Payment System  The method of conducting transactions in the economy. After the barter system, the payments system has been evolving over centuries, and with it the form of money. 1. Commodity Money Everyone must be willing to take it in payment for goods and services. Gradually, particular commodities began to be treated as the standards against which we would determine the value of other items. An early form of commodity money were cattle &grains. Later on, objects that clearly have value to everyone, and a natural choice was a precious metal such as gold or silver.  The problem with a payments system based exclusively on precious metals was that: its weight is very heavy, hard to carry& transport from one place to another, and the limited availability of gold and silver.  2. 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 embodied a promise that it was convertible into coins or into a 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  3. Cheques The introduction of cheques was a major innovation that improved the efficiency of the payments system. A cheque is an instrument from you to your bank used to transfer money from your account to someone else’s account when she deposits the cheque. They allow transactions to take place without the need to carry around large amounts of currency; making transactions for large amounts much easier.  The use of cheques thus, reduces the transportation costs associated with the payments system and improves economic efficiency. They are advantageous in that loss from theft is greatly reduced, and they provide convenient receipts for purchases  Disadvantage; it may take time to get cheques from one place to another.  4. Electronic Money (E - Money) The spread of the Internet now make it cheap to pay bills electronically. Money in its electronic form. The first form of e-money was the debit card.  Debit cards (or ATM cards) are plastic cards that provide you electronic access to your bank account Debit cards, which look like credit cards, enable customers 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. This method of payment reduces time and cost  Measures of Money Supply:  M1 is the narrow definition of money. It includes the most liquid assets that could be used as money, i.e. as mediums of exchange.  M2 is the broad definition of money, or domestic liquidity. It includes M1 plus the less liquid assets that are close in liquidity to assets in M1 but cannot be used as mediums of exchange. Those assets are commonly referred to as quasi-money or near-money. Therefore, M2 is also referred to as money plus quasi-money.  M1 = Currency in circulation + checkable Demand deposits  M2 = M1 + short- term time deposits + savings deposits  M3 = M2 + long-term time-deposits