Banking Moneny

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The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Chapter 2

Money and the Payments

System


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SECTION I


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Money and the Payments System

The Big Questions

1. What is money?

2. How do we use money?

3. How do we measure money?


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Money:

The Definition

Money is an asset that is generally

accepted as payment for goods andservices or repayment of debt.


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Money:

Characteristics

1. Means of payment

Used in exchange for goods & services

2. Unit of accountUsed to quote prices

3. Store of value

Used to move purchasing powerinto the future


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Barter System

Direct exchange of one commodity or

service for another without the use of

money. It is a Money Less Economy.


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Difficulties of Barter System

Double co-incidence of wants

Common Measure of Value

Tax Collection

Store of Value

Transfer of Wealth

Divisibility Problem

Economic Measurements Estimation & Budgeting Problems


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Stages of Evolution of Money

a) Commodity Money: Skin, arrows, cattle, wheat,rice etc.

b) Metallic Money: gold & silver

c) Coins: 11thCentury BC in China

Full Bodied Coins of Gold & Silver

Now a days only Token Coins are issued.

d) Paper Money: Initiated in 17thcentury in Sweden.

Currency Notes are used as Legal Tender now a days.

e) Bank Deposits: The final stage of evolution so far.


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Money & Currency

Currencyrefers to legal tender which is issued bythe government or the Central Bank in the form ofMetallic Money and Paper Money.

Moneyis a wider terms and not only includes

Currency but also the Credit Money, which includesbank drafts, cheques, B/Ex etc.

Credit money dont have the Legal Authority by theGovt.

Near Money: Not the Legal Tender but quite like Money e..g. Cheques, Bills of Exchange, and other Money Market

Instruments


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Functions of Money

Primary Functions: Medium of Exchange

Store of Value

Unit of Measurement Secondary Functions

Monetary & Fiscal Management

Deferred Payments / Future Payments

Economic Activities & Determination of Prices Promotion of Foreign Trade

Transfer of Wealth

Basis for Credit System


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Demerits of Money

Cause of Crime

Inequalities in Distribution

Fluctuations in Value

Cyclic Fluctuations

Good servant & Bad master


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Money:

How We Pay for Things (I)

Commodity Money:Objects with intrinsic value

Fiat Money:Value comes from government decree (or fiat)

Checks:Instructionsto the bank to shifts funds from youraccount to that of the person or firm whose name is

written in the Pay to the Order of line.


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The Path of a Paper Check


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Checks are legal proof of payment

Customers wanted them back

Starting in 2004 Banks can transmit digital images

Substitute checks are proof of payment

Paper checks are now disappearing


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Debit cards:

Like a check

Electronic message to your bank totransfer funds immediately

Credit cards:

Deferred payment

Issuer makes payment for you You have to pay it back


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The Future of Money

Which function of money will be

with us for a long time?

Means of payment: disappearing Unit of account: likely to remain

Store of value: disappearing


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Technological advances create new

methods of payment.

Cell phones and other types of hand-held mobile devices are providing

access to the payments system.

What will be next?


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SECTION II

Measuring Money


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Measuring Money

Changes in the quantity of money are

related to

Interest Rates Economic Growth

Inflation

How do we measure money?


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Measuring Money: Monetary Aggregates

Different Definitions of money are basedupon degree of liquidity.In USA

M1:Narrowest definitionOnly most liquid assets

M2: Broader definition

Includes assets not usedas means of payment.


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Monetary Aggregates In General

There are three approaches to thedefinitions of money:

1. Traditional Approach:

Money is regarded only as a Medium ofexchange

Emphasizes the liquidity aspect i.e. onlyhighly liquid instruments are included.

Is expressed as M = C + D(Currency +Demand Deposits only)


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2. Monetarists Approach Money is a temporary abode of Purchasing

Power

It includes Currency (C), Demand Deposits (D)

and Time Deposits (T)

M = C + D + T

3. Liquidity Approach Broader Definition

Also includes all other financial instruments which

have high liquidity.

It includes, M = C + D + T + Repos + Comm. Papersetc.


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Components of Monetary Assets

as per SBP: M0, M1 & M2

1. Currency Issued

2. Currency held by SBP

3. Currency in tills of Scheduled Banks

4. Currency in Circulation (M0=1+2+3)5.Scheduled Banks Demand Deposits

6. Other Deposits with SBP

7. Narrow Money (M1=4+5+6)8. Scheduled Banks Time Deposits

9. Resident Foreign Currency Deposits

10. Broad Money = Total Monetary Assets (M2=7+8+9)


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Money Growth and Inflation


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SECTION III

Issuance of Paper Money


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Paper Money

Paper Money means documents with

a value stated on them but having no

intrinsic value in them.Kinds of Paper Money:

1. Representative Paper Money

2. Convertible Paper Money3. Non-convertible Paper Money


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Representative Paper Money

Paper Money that has 100% metallic

reserves behind it, held by the govt.

and payable to the holder on demand.


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Fiat Money

Currency that a government has declared to be legaltender, despite the fact that it has no intrinsic valueand is not backed by reserves. Historically,most currencies were based on physical

commodities such as gold or silver, but fiat money isbased solely on faith.

Most of the world's paper money is fiatmoney. Because fiat money is not linked to physical

reserves, it risks becoming worthless due tohyperinflation. If people lose faith in a nation's papercurrency, the money will no longer hold any value.


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Quantity Theory of Money

According to Irving Fisher (1911):

P = f(M)

Other things remaining the same, asthe quantity of money in circulationincreases, the price level alsoincreases in the direct proportion and

the value of money decreases and viceversa.


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P = MV + MV / T

Where

P = Price Level

M = the Total Quantity of Legal Tender Money

V = the Velocity of Money in Circulation

M = the Total Quantity of Credit Money

V = the Velocity of Circulation of M

T = the Total Amount of Goods & Servicesexchanged for Money, i.e. Transactions


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Assumptions of the Theory

1. T, V & V remains the same.

2. The Proportion of M & M remains

constant.3. There is full employment in the

economy.

4. The theory is applicable in the longrun.


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Remember .

PT = MV + MV

Demand for Money = Supply of Money

Example:P = 100 x 3 + 200 x 1 = Rs. 10

50

Now Doubling the M = Rs.200P = 200 x 3 + 400 x 1 = Rs. 20

50

& . One half the M = Rs.50

P = 50 x 3 + 100 x 1 = Rs. 550


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SECTION IV

Value of MoneyInflation, Deflation, Stagflation etc.


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Core vs. Headline Inflation

HEADLINE INFLATION:

The raw inflation figureas reported through the Consumer PriceIndex(CPI) that is released monthly by the Bureau of Labor Statistics.

The CPI calculates the cost to purchase a fixed basket of goods as away of determining how much inflation is occurring in the broadeconomy.

The CPI uses a base year and indexes current year prices based onthe base year's values.

The headline figure is not adjusted for seasonality or for the oftenvolatile elements of food and energy prices, which are removed in the

Core CPI.

Headline inflation will usually be quoted on an annualized basis,meaning that a monthly headline figure of 4% inflation equates to amonthly rate that, if repeated for 12 months, would create 4% inflationfor the year.

Comparisons of headline inflation are typically made on a year-over-year basis.
http://www.investopedia.com/terms/c/consumerpriceindex.asphttp://www.investopedia.com/terms/c/consumerpriceindex.asphttp://www.investopedia.com/terms/c/consumerpriceindex.asphttp://www.investopedia.com/terms/c/consumerpriceindex.asp


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Core vs. Headline Inflation

CORE INFLATION:

A measure of inflation that excludes certainitems which face volatile price movements.

Core inflation eliminates products that can have

temporary price shocks because these shocks candiverge from the overall trend of inflation and give afalse measure of inflation.

Core Inflation is thought to be an indicator of underlyinglong-term inflation.

Core inflation is most often calculated by taking theConsumer Price Index and excluding certain items fromthe index, usually energy and food products.


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Other Terminologies:

Deflat ion :Increasing value of Money

Hyper Inf lat ion :Very High Rate Inflation (>25%)

Stagflat ion :Inflation + High Rate UnemploymentCreepin g Inf lat ion:Slow Rate of Inflation (


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Assignment:

Causes of Inflation in General

Causes of Inflation in Pakistan

Remedial Measures for Inflation inGeneral

Remedial Measures for Inflation in

Pakistan


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Money Growth and Inflation

When inflation is high, money growth

helps forecast inflation.

When inflation is low, the relationship isnot as close.


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The CPI answers the question:"How much more would it cost for people to

purchase today the same basket of goods

and services that they actually bought at

some fixed time in the past?


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Measuring Inflation

Visit the site:

http://www.statpak.gov.pk/depts/fbs/statis

tics/price_statistics/methodology_price_statistics.html


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Computing CPI Inflation

Survey people to see what they bought

Figure out what it would cost to buy thesame basket of goods & service today.

Compute the percentage change in the

cost of the basket of goods.


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Measures of Inflation

Fixed-weight Index - CPI

DeflatorGDP or PersonalConsumption Expenditure Deflator

Chain-weight indexHalf waybetween fixed-weight and a deflator.


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Chapter 2

End of Chapter

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Banking Moneny