CHAPTER 17: MONEY
and BANKING
Layout of Chapter:
1.
Money
§
Functions of
Money
§
Characteristics
of Money
2.
The Supply of
Money
3.
Financial
Institutions: Their Role in Business
§
Commercial
Banks
§
Non-Banking
Financial Institutions
4.
Government
Involvement in Money and Banking
5.
The Future of
Banking
1.
MONEY
Money is an item
which is commonly accepted as a means of paying for goods and services.
–
Money has not always been the coins
and paper bills. In ancient times, salt, furs, metals (valuable, i.e. gold) etc.
were used as money.
–
Money, as a common medium for
exchange, replaced the bartering system.
–
One must differentiate between money and currency. Currency, which
is Taka and Paisa, fits most of the definition of money. However, checks are
accepted as payment for purchases, and checking account deposits are also considered
money, but not currency. Currency of one country is bought and sold using currency
of another at different prices (exchange rate of currency). To define money as
currency would be too narrow for most economists.
Functions of
Money
Money has three basic functions. Its serves as –
a)
Medium of exchange
·
no need to barter if money is used for exchanges
·
money can be exchanged for goods and/or services
b)
Measure of Relative Value
·
it works as a ‘measurement of value’ of different products
·
Money helps us to compare the value of various items in terms of one
common value base. For example,
how many milk carton = one suit?
milk carton » some amount of money » suit
c)
Store of value
·
Hold value over time
·
If we had to barter milk for suit, we’d have to do it quickly before the
milk goes sour and loses its value. No such problem with money.
Characteristics
of Money
To be useful as a medium of exchange, money needs to have
certain characteristics:
Ö
Acceptance: To be useful, money must be accepted by the general population it is
meant to serve.
Ö
Divisibility: It must be dividable into smaller parts namely 50 paisa, 25 paisa or quarter
etc. this helps to buy items of any monetary value.
Ö
Portability: Money must be portable. You can fold money and tuck them into your
pocket easily and go shopping.
Ö
Durability: Money must be durable. Paper money and coin both are relatively durable; they last a long time.
Ö
Stability: To maintain
acceptability, money needs to be relatively stable. People lose faith in money
when its value is not stable. So, government should keep both inflation and
deflation in control.
Ö
Scarcity: ‘Supply of Money’ cannot be unlimited. Money cannot grow on trees and everyone
cannot have all they want, or it would have little value.
2.
THE SUPPLY OF MONEY
To measure the money supply, amount of money in the economy
needs to be measured (what to measure is a problem, is a home/ boat/ car to be
measured as money? They can be bought or sold using money!!).
Concept of liquidity must be understood first.
Liquidity: a measure of how quickly an item can be converted to cash.
Obviously, the most liquid item is cash itself, since it
does not need to be converted. Many other items function as cash in many
transactions, i.e. demand deposits, time deposits, money market funds.
Two levels of money supply are referred to as M1 and M2.
Ø M1 is the first level of money supply measurement; includes the most highly
liquid forms of money: currency and demand deposits.
Currency + Demand Deposits = Total M1
Currency: The coins and paper money spent to purchase things. Cashier’s cheques,
money orders, and traveler’s cheques are also considered currency.
Demand Deposits: Bank
accounts against which an account holder can write cheques, withdrawing money
immediately and without prior notice.
Ø M2 is the second level of money supply measurement; includes time deposits
and money market accounts, in addition to (or plus) the currency and demand
deposits.
Total M1 + Time Deposits and Money Market Accounts = Total M2
Time Deposits: Savings accounts that allow the
financial institution to require notice before withdrawal or to assess a
penalty for early withdrawal.
Money Market Accounts: Deposits that pay interest rates very competitive with those paid on
other short-term investments. E.g. US treasury bills.
Credit cards: Represent an
individual’s approval for credit. They represent a special credit arrangement
between the cardholder and the financial institutions issuing the card. Each
time the credit card is used, the card holder takes a loan, which is repaid
later with interest.
3.
FINANCIAL INSTITUTIONS: THEIR ROLE IN BUSINESS
Financial institutions that serve businesses include banking
institutions and non-banking institutions.
ª Commercial Banks
Commercial Bank is a profit making institution that holds
the deposits of individual’s and business in checking and savings accounts and
then uses these funds to make loans.
Services
offered by Commercial Banks:
Ø Checking and savings accounts
Ø Personal and business loans
Ø Bank credit cards
Ø Safe-deposit boxes
Ø Financial advice
Ø Traveler’s checks etc.
ª Non-Banking Financial Institution
Insurance companies
Large brokerage houses – buy &
sell stocks, bonds and other assets for their customers. Some have accounts for
their customers, such as Merril Lynch’s Cash management account, which pay
interest on deposits and allow clients to write cheques, borrow money and
withdraw cash.
Commercial and Consumer Finance
companies – offer short-term loans, typically at a higher interest rate, to
businesses and individuals unable to obtain loans elsewhere. E.g. Lease
finances.
4.
GOVERNMENT INVOLVEMENT IN MONEY AND BANKING
The Central Bank
§
Federal Reserve System- Federal Reserve Bank of USA
§
Bangladesh Bank in Bangladesh
Major Functions include:
·
Check clearing
·
Monetary policies (size of money
supply, both M1 and M2 using tools like reserve
requirement, open market etc).
·
Reserve requirement – The percentage
of money from deposits that a bank must keep on hand or on deposit with the
central bank. Rest of the fund can be loaned out. Lowering or raising it can
significantly affect money supply. Deposit $100 and reserve requirement is 10%
then money supply = $100 / 10% = $1,000.
·
Open Market Operations – sale &
purchase of savings bonds, treasury notes and Treasury bills.
·
Supervising banks
·
Depository insurance
·
Services to the treasury
5.
THE FUTURE OF BANKING
Electronic Fund
Transfer (EFT): The transfer of funds by means of an
electronic terminal, telephone, computer, or magnetic tape that orders a bank
or other financial institution to debit or credit an account.
*
Automated Teller Machine (ATM) – machine that
dispenses cash from a customer’s account, accepts deposits, or performs other
banking functions – transfer funds from checking to savings account or display/
print account transactions/ balance.
–
provide 24 hour service.
–
Helps reduce transaction costs for
banks as well as providing convenience for bank customers. Each teller
transaction costs a bank an estimated 50 cents; each ATM transaction only costs
about 20 cents.
*
Automated Clearing Houses (ACHs) – An
automated clearinghouse allows payments or withdrawals to and from a bank
account by magnetic computer tape.
–
Employers use ACHs to make payroll
withdrawals and to transfer employee salary directly to employee accounts.
–
Also used for paying bills for
telephone, electricity, gas, water etc.
*
Point-of-Sale Systems – allows merchants/
retailers to draw money directly from a customer’s bank account at the time a
purchase is made. These systems work through the use of a debit / credit card.
–
reduces cheque processing costs and
does away with bad cheque problems.
*
Plastic Money
§
Debit Card – a plastic card similar to credit
card that deducts funds directly from the customer’s account rather than
creating a loan
§
Credit Card.
*
In-Home Banking – Computer based home banking.
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