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After studying this chapter you will be able to: Define money and describe its functions Explain the economic functions of banks and other financial institutions Describe the functions of the central bank Explain how the banking system creates money Explain what determines the demand for money Explain how the quantity of money and the interest rate are determined
What is Money?
What is Money?
Medium of Exchange
Money is any commodity or token that is generally acceptable as a means of payment. Money has three other functions: Medium of exchange Unit of account Store of value
A medium of exchange is an object that is generally accepted in exchange for goods and services. In the absence of money, people would need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. Unit of Account A unit of account is an agreed measure for stating the prices of goods and services.
What is Money?
Store of Value As a store of value, money can be held for a time and later exchanged for goods and services. Money Today Money today consists of: Currency Deposits at banks and building societies
What is Money?
Currency is the general term for notes and coins. Narrow money is currency in circulation plus the current account deposits in banks banks. Broad money is narrow money plus the time deposits (include both savings deposits and fixed deposits).
What is Money?
Cheques, Debit Cards and Credit Cards are not Money Cheques are not money. A cheque is an instruction to your bank to move some funds from your account to someone elses account. Debit cards are not money. Using a debit card is like writing a cheque except the transaction takes place in an instant. Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money.
Financial Intermediaries
A financial intermediary is a firm that takes deposits from households and firms and makes loans to other households and firms. The main financial intermediaries are: Commercial banks Building societies
Financial Intermediaries
Financial Intermediaries
Building Societies A building society is a private firm, licensed to accept deposits and make loans. Difference between building societies and banks is: A building society is usually owned by its depositors whereas banks are not
Commercial Banks A commercial bank is a private firm, licensed to take deposits and make loans.
Central Banking
Central Banking
The Bank of England
A central bank is the public authority that provides banking services to governments and commercial banks, p g supervises and regulates financial institutions and markets and conducts monetary policy. Monetary policy is the attempt to control inflation and moderate the business cycle by changing the quantity of money, interest rates and the exchange rate.
The Bank of England is the central bank of the United Kingdom. Central Banking in the Eurozone The European Central Bank (ECB) is the central bank of the Eurozone. The ECB was established in 1998. Bangladesh Bank is the Central bank of Bangladesh
Central Banking
The Functions of a Central Bank A central bank performs the following functions: Governments bank Bankers Bankers bank A central bank provides banking services to the government and the commercial banks similar to those that the commercial banks provide to individuals and firms.
Central Banking
Central Banks Policy Tools Central Bank uses two tools to influence the supply of money and the interest rate. They are: Bank Rate Open market operations
Central Banking
Bank Rate Bank Rate is the Central Banks official interest rate. It applies to transactions between the central bank and the commercial banks. Central Bank pays interest to commercial banks on their reserve deposits and commercial banks pay interest on loans of reserves from the Central Bank. Bank Rate influences the supply of money higher bank rate increases commercial banks reserves with the central bank reduces the reserves held by the commercial banks themselves reduces money supply. As a result market rate of interest rate rises.
Central Banking
Open Market Operations An open market operation is the purchase or sale of government bonds by the central bank in the open market market. The term open market refers to commercial banks and the general public but not the government.
The Monetary Base The monetary base is the sum of notes and coins and banks banks deposits at the central bank bank. The monetary base limits the total amount of money that the banking system can create because banks have a desired level of reserves.
The fraction of a banks total deposits held as reserves is the reserve ratio. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Excess reserves equal actual reserves minus desired reserves.
The Money Creating Process The money creating process begins when the monetary base i b increases and the b ki system h excess d h banking has reserves.
The supply of money is the relationship between the quantity of money supplied and the interest rate. The higher the interest rate, the greater the percentage of deposits the banks want to lend and the smaller the percentage they want to hold as reserves And the smaller the desired reserve ratio, the greater the quantity of money supplied.
Money Market Equilibrium Money market is in equilibrium when the demand for money and the supply of it are equal and the equilibrium rate of interest is determined at that equilibrium equilibrium.
r*
If income rises, demand for real money balances curve shifts to the right and with fixed Ms., equilibrium occurs at higher interest rate and vice versa.
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Md Money
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Bank Rate The interest rate that the Bank sets is Bank Rate, which is linked li k d to the i h interest rate that b k earn or pay on h banks reserves lent or borrowed from other banks.
When the Central Bank lowers the Bank Rate: 1 Other short-term interest rates and the exchange rate fall. 2 The quantity of money supply increases. 3 Other interest rates falls. 4 Consumption expenditure, investment and net exports increase.
5 Aggregate demand increases. 6 R l GDP growth and th i fl ti rate i Real th d the inflation t increase. When the Central Bank raises Bank Rate, the ripple effects go in the opposite direction.
Bank Rate change three components of aggregate expenditure: 1 Consumption expenditure 2 Investment 3 Net exports The change in aggregate expenditure plans changes aggregate demand, real GDP and the price level.
A decrease in domestic interest rate causes depreciation (decrease in the value of domestic currency relative to foreign y g currency) Interest rate affects exchange rate through flows of capital between countries.
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