Week-06

MONEY AND
FINANSIAL SYSTEM
outline
 The Meaning of Money and its functions
 The Money Supply and the demand for
money
 The Financial system
Financial intermediaries and the money
supply
Financial markets and the market for
loanable funds
THE MEANING OF MONEY
 Money is the set of assets in an economy
that people regularly use to buy goods and
services from other people.
 Money is anything that serves as a
commonly accepted medium of exchange
According to the economist’s definition,
money include only few types of wealth
that regularly accepted by seller in
exchange for goods and services
The Functions of Money
1. Medium of exchange is an item that
buyers give to sellers when they want
to purchase goods and services.
2. Unit of account is the yardstick people
use to post prices and record debts.
3. Store of value is an item that people
can use to transfer purchasing power
from the present to the future.
Types of Money
 Commodity money takes the form of a
commodity with intrinsic value.
Examples: Gold, silver, cigarettes.
 Fiat money is used as money because
of government decree.
It does not have intrinsic value.
Examples: Coins, currency, check deposits.
THE MONEY SUPPLY
 The quantity of money available in the
economy called money supply
 Two measure of the money supply
M1, that is the sum of coins and paper
currency in circulation outside the banks
plus checkable deposits.
M2 includes assets such as savings
accounts in addition to coins, paper
currency and checkable deposits
THE DEMAND FOR MONEY
 Money’s Functions (recall)
 a medium of exchange
 the unit of account
 a store of value
 The opportunity cost of holding money is the
sacrifice in interest that we must incur by
holding money rather than a riskier; less
liquid asset or investment.
 The sources of money demand
 Transactions demand for money
 Asset Demand

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THE FINANCIAL SYSTEM
 The financial system consists of the group of
institutions in the economy that help to match one
person’s saving with another person’s investment.
 Financial institutions can be grouped into :
Financial intermediaries are financial institutions
through which savers can indirectly provide
funds to borrowers (banks and other financial
institutions)
Financial markets are the institutions through
which savers can directly provide funds to
borrowers (stock market, bond market)
FINANCIAL
INTERMEDIARIES AND THE
MONEY SUPPLY
• Financial intermediaries accept checking
deposits from households and firms, and
then lend these funds out to other
households and business for a variety of
purposes.
• Bank money and many other financial
services are today provided by financial
intermediaries (commercial banks and
other financial institutions)
BANKS AND THE MONEY SUPPLY

• Whenever a person deposits some money,

the bank keeps the money in its vault until
the depositor comes to withdraw it or writes
a check against his or her balance.
• Deposits that banks received but have not
loaned out are called reserves
BANKS AND THE MONEY SUPPLY
 Reserves are deposits that banks have
received but have not loaned out.
Bank reserves are assets bank hold in the
form of cash on hand or of funds deposited
by the bank with the central bank.
Bank reserves are kept above the prudent
commercial level because of legal reserve
requirements.
The main function of legal reserve
requirements is to enable the central bank to
control money supply.
BANKS AND THE MONEY SUPPLY

 In a fractional-reserve banking system,

banks hold a fraction of the money
deposited as reserves and lend out the
rest.
 The fraction of deposits that banks hold
as reserves is called the reserve ratio
Money Creation with Fractional-
Reserve Banking
 When a bank makes a loan from its
reserves, the money supply increases.
 The money supply is affected by the
amount deposited in banks and the
amount that banks loan.
Deposits into a bank are recorded as both
assets and liabilities.
The fraction of total deposits that a bank has
to keep as reserves is called the reserve ratio.
Loans become an asset to the bank.
Money Creation with Fractional-
Reserve Banking
 This T-Account shows a bank that…
accepts deposits,
First National Bank
keeps a portion
as reserves, Assets Liabilities
and lends out
the rest. Reserves Deposits
It assumes a $100.00 $1000.00
reserve ratio
Loans
of 10%.
$900.00
Total Assets Total Liabilities
$1000.00 $1000.00
Money Creation with Fractional-
Reserve Banking
 When one bank loans money, that
money is generally deposited into
another bank.
 This creates more deposits and more
reserves to be lent out.
 When a bank makes a loan from its
reserves, the money supply increases.
Money Creation with Fractional-
Reserve Banking
First National Bank Second National Bank
Assets Liabilities Assets Liabilities

Reserves Deposits Reserves Deposits

$100.00 $1000.00 $90.00 $900.00

Loans Loans
$900.00 $810.00

Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $1000.00 $900.00 $900.00

Money Supply = $1,900.00!

The Money Multiplier

 How much money is eventually created

in this economy?
The Money Multiplier
New New Loans and New
Position of Bank
Deposits Investment Reserves
Originil Banks 1,000.00 900.00 100.00
2d-generation banks 900.00 810.00 90.00
3d-generation banks 810.00 729.00 81.00
4th-generation banks 729.00 656.10 72.90
5th-generation banks 656.10 590.49 65.61
6th-generation banks 590.49 531.44 59.05
7th-generation banks 531.44 478.30 53.14
8th-generation banks 478.30 430.47 47.83
9th-generation banks 430.47 387.42 43.05
10th-generation banks 387.42 348.68 38.74
Sum of first 10 generations of banks 6,513.22 5,861.90 651.32
. . . .
. . . .
. . . .
Sum of remaining generations of banks 3,486.78 3,138.10 348.68
Total for bank system as a whole 10,000.00 9,000.00 1,000.00
The Money Multiplier
 The algebraic solution can be shown as
follows:
1000 + 900 + 810 + ….
= 1000 x [1 + 9/10 + (9/10)2
+ …]
= 1000 x 1/(1-9/10)
= 1000 x 1/0.1 = 10000

Money supply multiplier

= 1/required reserve ratio
The Money Multiplier

 The money multiplier is the amount of

money the banking system generates
with each dollar of reserves.
 The money multiplier is the reciprocal of
the reserve ratio:
M = 1/R
 With a reserve requirement, R = 10% or
1/10,
 The multiplier is 10.
The Money Multiplier

 The money multiplier is the reciprocal of

the reserve ratio:
M = 1/R
 With a reserve requirement, R = 10% or
1/10,
 The multiplier is 10.
The Money Multiplier
 What would happen if some money leaked into
circulation or if some banks had excess
reserves?
If $ 100 were to leak into circulation outside the
banks and only $ 900 of new reserves were to
remain in the banking system, the new
checking deposits created would be $9000.
If the bank decided to keep rather than lend the
new reserves, then the whole process of
multiple deposit creation would stop dead with
no expansion of deposit at all.
MONETARY POLICY

 The objectives of the central bank in

exercising its control over money,
interest rates, and credit conditions.
 The instrument of monetary policy are
primarily open-market operations,
reserve requirements, and the discount
rate.
MONETARY POLICY
 Open-Market Operations
The Central Bank conducts open-market
operations when it buys government
bonds from or sells government bonds to
the public:
○ When the Central Bank buys
government bonds, the money supply
increases.
○ The money supply decreases when the
Central Bank sells government bonds.
MONETARY POLICY

 Reserve Requirements
The central bank also influences the
money supply with reserve
requirements.
Reserve requirements are regulations
on the minimum amount of reserves
that banks must hold against deposits.
MONETARY POLICY

 Changing the Reserve Requirement

The reserve requirement is the
amount (%) of a bank’s total reserves
that may not be loaned out.
○ Increasing the reserve requirement
decreases the money supply.
○ Decreasing the reserve requirement
increases the money supply.
MONETARY POLICY

 Changing the Discount Rate

The discount rate is the interest rate
the central bank charges banks for
loans.
○ Increasing the discount rate
decreases the money supply.
○ Decreasing the discount rate
increases the money supply.
FINANCIAL MARKETS AND THE
MARKET FOR LOANABLE FUNDS
 Financial markets coordinate the
economy’s saving and investment in the
market for loanable funds
 The market for loanable funds is the
market in which those who want to save
supply funds and those who want to
borrow to invest demand funds.
 Loanable funds refers to all income that
people have chosen to save and lend out,
rather than use for their own consumption.
Supply and Demand for Loanable
Funds
 The supply of loanable funds comes from
people who have extra income they want
to save and lend out.
 The demand for loanable funds comes
from households and firms that wish to
borrow to make investments.
 The equilibrium of the supply and
demand for loanable funds determines
the price of the loans, that is, the real
interest rate
Equilibrium of the market for loanable
funds

Interest Supply
rate

5%

Demand

$1,200 Loanable funds

(in billions of dollars)
Recall: Some Important Identities
 A Closed economy
Y=C+I+G
 Now, subtract C and G from both sides of the
equation:
Y – C – G =I
 The left side of the equation is the total
income in the economy after paying for
consumption and government purchases and
is called national saving, or just saving (S)
Recall: Some Important Identities
 Substituting S for Y - C - G, the equation
can be written as:
S=I
 National saving, or saving, is equal to:

S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
Where: Y – T – C is called private saving and
T – G is called public saving
A decrease in tax on interest income

Interest Supply, S1
rate S2

5% 1. Tax incentives for

saving increase the
4% supply of loanable
fund
2. . . . which
raises the
equilibrium
Demand
interest rate . . .

$1,200 $1,600 Loanable funds

(in billions of dollars)

3. . . . and raises the equilibrium

quantity of loanable funds.
A tax incentives for investment
Interest
rate Supply

1. An investment
6% tax credit
increases the
5% demand for
loanable funds . . .
2. . . . which
raises the
equilibrium
interest rate . . . D2
Demand, D1
$1,200 $1,400 Loanable funds
(in billions of dollars)

3. . . . and raises the equilibrium

quantity of loanable funds.
The Effect of a Government Budget
Deficit
Interest S2
rate Supply, S1

1. A budget deficit
6% decreases the
supply of loanable
5% funds . . .

2. . . . which
raises the Demand
equilibrium
interest rate . . .

$800 $1,200 Loanable funds

(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.
 Thank you
for your attention
DIKERJAKAN SEKARANG
1. C = 150 + 0,8y
2. I = 150 + 0,02y ( I = I +iy)
3. G = 210
4. T = 70 + 0,01y
Ditanyakan
a. C =f(y)
b. S =f(y)
c. Yeq
d. Berapakah Y baru apabila T mengalami kenaikan
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e. Gambarkan!