Money &Commercial Banking

 1-Assets  5-Interest rate

 2-Components of  6-Demand for Money
money supply  7-Money demand curve
 3-How do Commercial  8-Money Market
Banks create
deposits(money)
 4-Money Supply curve
1- Assets
Real Assets Financial Assets
 Eg. Land, real estate……….  Eg.Bonds: a promise to pay a
certain amount of money at
maturity & paying a certain
interest rate( bonds can be sold
& bought at a certain market
price)
 Treasury Bills:Gov. borrows
from the public by issuing
TBs(it`s usually for 3 months &
gov. pays a certain interest rate
2-Components of Money Supply
Money Supply
definitions

Narrow Definition Broad Definitions

M1:
M2: M3:
:Coins & currency in
M1+ saving accounts M2+long time
Circulation
& short time deposits Deposits &
Demand deposits
ie near money certificates
Traveler checks
How do commercial banks create
money (deposits)
 If the Central Bank allows the commercial banks to
create deposits, the money supply increases .
 HOW???
Remember that Commercial Banks do not
hold 100% of deposits as idle reserves. They
only hold fractional reserves against their
deposits, then they use the rest to give out
loans &buy bonds………

The following case study shows the credit

creation process:
CASE STUDY
 IF Central Bank injected new reserves as it
had bought a governmental bond worth
$1000 from a Bondholder who deposits that
amount in Commercial bank (1) If the legal
reserve ratio set by the Central Bank was
equal to the required reserve ratio set by the
Commercial Bank( 10%) & if every new
created deposit was withdrawn in favor of
clients who prefer dealing with other
Commercial Banks:
Questions regarding the case study:
 1) Show the initial & final balance sheets of
commercial banks 1 & 2.
 2) What is the money supply multiplier?
 3) In one equation , show by how much will the
money supply increase after all banks end the
credit creation process.
 4- What are the main assumptions of the previous
calculations regarding the increase in money
supply?
1-Balance Sheet of Comm. Bank 1(initially)
Assets Liabilities
 Reserves 1000  Deposits 1000
 Loans or inv. 900  Deposits 900
(900 is withdrawn). (900 is withdrawn)
 …………………………  …………………………
…………1000………… ……………1000………
Final Balance Sheet of Comm. Bank
(1)
 Assets  Liabilities
 --------------------------  --------------------------
 Reserves 100  Deposits 1000
 Loans or inv. 900
 -------------------------  ------------------------
 1000  1000

Try initial & final sheets of Bank (2) yourself

2- Money Supply Multiplier:
 Shows how money supply changes due to an
initial change in reserves.
 3-Money supply multiplier=
Change in money supply/ initial change in
reserves
 Money supply multiplier= 1/legal reserve ratio=
1/10% = 10 in the previous case study
 Thus, Change in MS= (10)(+1000)=$ 10,000
4-Main assumptions of previous calculations:
 Legal reserve ratio = required reserve ratio
 There is no cash drain
----------------------------------------------------
 The previous case shows that Central Bank can change money
supply by affecting the ability of Commercial Banks to create
deposits through some of its instruments: changing the legal reserve
ratio,( when legal reserve ratio decreases money supply increases
)& by open market operations (ie Central Bank buying & thus
injecting the financial body & increasing Money supply or selling &
thus decreasing money money supply)
 Money supply curve is vertical as it can be controlled by the Central
bank
5-Money supply reflects the Central Bank`s
desires-5-
Interest Rate
Money supply curve

Quantity Supplied of money

6-Interest rate: is the cost of
borrowing money.
 If people hold money (ie they do not financially
invest it by buying bonds or investing in other
interest earning assets), do they face any cost?
 YES, as they have sacrificed the interest rate
that could have been obtained if they would have
invested their money in bonds……
Thus, cost of holding money is the interest
rate.
But why do we have various interest rates?
Interest rates may vary as:
 Loans have different dates of maturity
 Assets have different levels of liquidity (ability
to convert the asset into cash with little loss of
value)
 Risk element. Risky assets provide a higher
interest rate
When we speak of THE INTEREST RATE, we refer generally to
the interest rate on a short term security (eg. TB rate).MOST
OTHER RATES RISE & FALL IN STEP WITH IT
Real interest rate= nominal interest – rate of
inflation
 When taking savings decisions real interest rate
should be considered.
 Real interest rate may be negative ,when rate of
inflation is greater than nominal interest rate, thus
negatively affecting savings.
7-Demand for money?
Why the public desires to hold some money (cash)
 1-Transactions demand for money: the demand for
money as a medium of exchange by household &
business sectors( to pay for their needs)
 Transactions demand for money=f(GDP,GPL) +
 2-Asset demand for money( demand for money as a
store of value)ie people try to diversify their wealth
among a broad group of investments eg bonds, time
deposits……
 Asset demand for money= f( interest rate) -
 As interest rate on financial assets increases, cost of
holding money without investing it is high, thus quantity
demanded of holding money(& not investing it) falls,
&vise versa.
Total demand for money:
 Demand for money=f( I, GDP,GPL)
-------------------------------- --------------
other
factors
Money demand curve that shift
the curve
7-Demand curve for money
 Shows the desires of the public to hold money as
interest rate changes is negatively sloping.

Demand for money

Quantity Demand of money

8-Money Market
 Is the market where short term funds are lent &
borrowed eg TBs,gov. short term bonds…….
 It consists of money demand & supply

I
Money Supply curve (Ms)

Eq. I Money Demand curve (Md)

Quantity of money
Graphs of a free money market
Ms
I

Equilibrium interest rate

“The” interest rate
Md

Quantity of money
Case 1. show what happens to the
interest rate when:
 Money supply increases as Central Bank
decreased the legal reserve ratio.(loose monetary
policy)
Md Ms Ms1
I
Notice: when money
supply increases,
INTEREST RATE falls
I0

I1

Quantity of money
Case 2: show how the interest rate is
affected if GDP or GPL increase

Md Md1 Ms
I

I1

Note: INTEREST RATE

I0
increased.

Quantity of money