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

economythe M3 and broad money definitions.

Learning Objectives (cont.)

Determine what backs the supply of

moneywhat 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 A form in which to store wealth, due to its liquidity and convenience

Store of value

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

Governments 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

Transactions Demand, Dt
Rate of interest, i (per cent) 10 7.5 5 2.5

+
Rate of interest, i (per cent) 10 7.5 5 2.5

Asset Demand, Da

=
Rate of interest, i (per cent)

Total Demand for Money, Dm

10 7.5 5 2.5 0

Dt
0 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Da
0 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Dm
0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

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

Sm
Rate of interest, i (per cent)
10
7.5

ie 5
2.5

Equilibrium Interest Rate

Dm
0 50 100 150 200 250 300

Amount of money demanded (billions of dollars)

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