Money and Banking

Money and Banking

Money vs. Barter

Ø Money – Any good that is widely accepted for purposes of exchange and in the repayment of debt.

Ø Barter – Exchanging goods and services for other goods and services without the use of money.

Functions of Money

Money as a Medium of Exchange – Anything that is generally acceptable in exchange for goods and services. Money reduces the transactions cost of making exchanges.

Functions of Money

Money as a Unit of Account – A common measure in which relative values are expressed. Because all goods are denominated in money, determining relative prices is easy.

Functions of Money

Money as a Store of Value – The ability of an item to hold value over time. Allows us to accept payment in money for our productive efforts and to keep that money until we decide how to spend it.

From Barter to a Money Economy

Ø Money evolved out of a barter economy as traders attempted to make exchange easier.

Ø In a barter economy, before a trade can be made, a trader must find another trader who is willing to trade what the first trader wants and at the same time wants what the first trader has.

Ø A few goods that have been used as money include gold, silver, copper, cattle, rocks, and shells.

What Gives Money Its Value?

Our money today has value because of its general acceptability.

Money Supply – M1

M1 =  Currency in circulation

+  Demand/Checkable deposits

Money Supply – M2

M2 =  M1 + Time Deposits (Fixed Deposits)

Are Credit and Debit Cards Money?

Ø Credit card use represents loans which must be repaid.  They represent the use of someone else’s money.

Ø Debit cards  give access to checkable deposits which are already part of the money supply.

Self-test Questions

Ø Why (not how) did money evolve out of a barter economy?

Ø If individuals remove funds from their checkable deposits and transfer them to their money market accounts, will M1 fall and M2 rise? Explain your answer.

Ø How does money reduce the transaction costs of making trades?

Early Banking

Ø Gold coin was used as a medium of exchange.

Ø Goldsmiths, equipped with safe storage facilities,  stored other people’s gold for them, issuing warehouse receipts.

Ø Receipts, being more convenient, were used to make purchases and pay debts.

Ø These paper receipts circulated as money.

Fractional Banking

Ø On an average day, very few people came to redeem their gold receipts.

Ø Some goldsmiths began lending out some of the stored gold, issuing additional receipts instead of gold, and earning interest.

Ø This was the beginning of “fractional reserve banking*.”

Bank Reserves

Reserves – The sum of bank deposits at Bangladesh Bank and vault cash.

Required Reserve Ratio (r) – A percentage of each taka deposited that must be held as reserve.

Required Reserves – The minimum amount of reserves a bank must hold against its checkable deposits as mandated by Bangladesh Bank.

Excess Reserves – Any reserves held beyond the required amount. The difference between (total) reserves and required reserves.

Reserve Ratios in Bangladesh

Ø Statutory Liquidity Requirement (SLR): The term used by Bangladesh Bank for reserve.

Ø Cash Reserve Requirement (CRR): CRR is a part of SLR that must be held in cash.

Reserve Ratios in Bangladesh

Ø  For interest based banks: Currently SLR is 18.5% of which CRR is 5.5%. That means each commercial bank has to keep at least 18.5% percent of its total collected deposits as reserves. Say  Bank Z collects 100 crore taka from its depositors then Bank Z has to keep 18.5 crore taka as reserves. Out of this 18.5 crore taka, at least 5.5 crore taka has to be kept in cash (CRR) with Bangladesh Bank and the commercial bank will not earn any interest on this amount. The rest 13% can be kept as government securities which provides interest.

Reserve Ratios in Bangladesh

For interest free (Islamic) banks: SLR:10%, CRR:5%. Islamic banks have to keep at least 5% of their total collected deposits as cash. The rest 5% of the SLR can be invested in Government Islamic Investment Bond (GIIB) which runs in a profit-loss sharing (PLS) mode and avoids interest.

Bank Reserves

Reserves  = SLR + Vault cash

Required reserves =  r x Checkable deposits

Excess reserves =  Reserves – Required reserves

The Banking System Creates
Checkable Deposits (Money)

Simple Deposit Multiplier

Maximum change in checkable deposits = (1/r ) x ?R where r = the required reserve ratio and ?R = the change in reserves resulting from the original injection of funds.

In the previous example:

Maximum change in checkable deposits =

= (1 / 0.10) x Tk.1,000

= 10 x Tk.1,000

= Tk.10,000

In the equation, the reciprocal of the required reserve ratio(1/r ) is known as the simple deposit multiplier

Shrinking the Money Supply

Ø  Bangladesh takes receives a check and “cashes” it at the bank upon which it is drawn

Ø  Those funds are not deposited in any bank and are removed from the money supply.

Ø  Reserves fall.

Ø  Thus excess reserves fall.

Ø  Fewer loans are made, and checkable deposits fall.

Ø  Because checkable deposits are part of the money supply, the money supply falls.

The Money Supply Expansion and Contraction Processes

Self-test Questions

Ø  If a bank’s deposits equal $579 million and the required reserve ratio is 9.5 percent, what dollar amount must the bank hold in reserve form?

Ø  If the Fed creates $600 million in new reserves, what is the maximum change in checkable deposits that can occur if the required reserve ratio is 10 percent?

Ø  Bank A has $1.2 million in reserves and $10 million in deposits. The required reserve ratio is 10 percent. If bank A loses $200,000 in reserves, by what dollar amount is it reserve deficient?