Money, Banking and the Financial System

Learning Objectives

• Review the functions of money—particularly money as a medium of exchange, unit of account and store of value.

• Define what acts as money in our economy—the M3 and broad

money definitions.

Learning Objectives (cont.)

• Determine what ‘backs’ the supply of money—what gives it its value and ability to be used almost universally.

• Explain the transactions demand and asset demand for money.

• Examine the institutional structure of the financial system.

• Discuss the current role of the Central Bank.

The Functions of Money

What is money?

• Anything that performs the function of money is money

• Money is what money does

The Functions of Money (cont.)

• Medium of exchange– Buying and selling goods and services

• Unit of account– Assisting measurement of relative worth

of various goods, services and resources

• Store of value– A form in which to store wealth, due to its

liquidity and convenience

Money Defined: M3

Three components:

• Currency (coins and notes)

• Current deposits in banks upon which cheques can be drawn

• Non-current accounts such as savings

Currency

• Token money– intrinsic value is less than face value of

the money

• Coin and note component of the money supply

Current Deposits

• Cheques enable the ownership of current deposits to be transferred

• Generally acceptable as a medium of exchange

• Can be readily converted into currency

Non-Current Deposits

• Highly liquid financial assets

• Can be readily converted into currency or current deposits

• New technologies (such as EFTPOS(Electronic Funds Transfer at Point of Sale) important

Broad Money

• M3 plus borrowings from the

private sector of non-bank financial intermediaries (NBFIs) less holdings of currency and bank deposits by the NBFIs

Credit Cards

• Not money• Simply a convenient method of

obtaining a short-term loan from the card-issuer

• Facilitate the synchronisation of receipts and expenditures, reducing the demand for cash

Monetary base

Composed of:

• Currency held by the public

• Currency held by the banks

• Banks’ demand deposits with the Central Bank.

Backing the Money Supply

• Money as debt

• Acceptability of money

• Legal tender– Fiat money

• Relative scarcity

Money and Prices

Government’s responsibility in stabilising the value of money involves:

• Application of appropriate fiscal policies

• Effective monetary management

Demand for Money

• The demand for money is the demand for real money balance

2 reasons why people demand money:

• Transactions demand

• Asset demand

Transactions Demand

• The demand for money as a medium of exchange

• Level depends on money GDP (not interest rates!)

• Money demand curve is vertical

Assets Demand

• The demand for money as financial assets and store of wealth

• Level depends on interest rates

• Down-sloping money demand curve

Total Demand for Money (Dm )

• Transactions demand and assets demand are added horizontally

• Changes in interest rates lead to movement along the curve

• Anything that changes money GDP leads to a shift in the money demand curve

Demand for Money

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Amount of moneydemanded (billions

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Amount of moneydemanded (billions

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Amount of moneydemanded (billions

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0 50 100 150 200 250 300

TransactionsDemand, Dt

Dt

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AssetDemand, Da

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Total Demandfor Money, Dm

Dm

The Money Market

• The combination of the money demand and money supply determines the equilibrium interest rate

• The interest rate represents the opportunity cost of holding money balances

Equilibrium Interest Rate

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Amount of money demanded(billions of dollars)

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Sm

Equilibrium Interest Rate

The Financial System

Comprised of:

• The Central Bank

• The banks

• Financial intermediaries

The Central Bank

• Responsibilities set out in the Reserve Bank Act 1959

• Main functions:– Control of note issue– Banker to the Banks

Exchange Settlement Accounts non-callable deposits

The Central Bank(cont.)

• Main functions (cont.):– Banker to the Government

vital role in financing government deficits

– Management of the international means of payment

– Implementation of monetary policy

The Central Bank (cont.)

• Other functions:– Regulation of the payment system– Membership of the board of the

Regulation Authority – Membership of the Council of

Financial Regulators