MONEY AND THE

FINANCIAL
SYSTEMS
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DESIRED LEARNING
OBJECTIVES

The students must be able to

comprehend:The Role of the financial system in
modern economies.
The nature of financial assets.
How the concept of money was evolved?
What are different components of money
supply and demand?
What role is played by banks in supply of
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money in the economy?

THE MODERN FINANCIAL SYSTEM

It is the circulatory system that links
together goods, services and finance in
domestic and international markets.
It is through this system that people and
firms borrow and lend.
Salient parts of this system are: Money market
Markets for fixed interest assets like bonds
and mortgages.
Stock markets
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Foreign exchange markets.

THE MODERN FINANCIAL SYSTEM

Borrowing and lending takes place in financial
markets and through financial intermediaries.
Financial markets are just like other markets,
except that their goods are stocks & bonds.
Ex: stock/bond/foreign exchange markets.
Financial intermediaries provide financial
services and products. Ex: Banks, insurance
companies, pension funds.

FUNCTIONS OF FINANCIAL SYSTEM

Transfers Resources across Time, Sectors and
Regions: It allows investments to be diverted to their most
productive uses.
Due to cheap and hardworking Chinese labour and
favourable policies of the government, China has
become No 1 place for foreign investments.

Manages Risk in the Economy: Risk management is like resource transfer: it moves
risks from those people or sectors that most need to
reduce their risk.
Fire insurance of one house is a high risk venture:
Insurance companies spread this risk over all such
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policy holders.

FUNCTIONS OF FINANCIAL SYSTEM

Pools and Subdivides Funds: Pooling Funds: Huge projects need billions rupees
investment in plant, land, infrastructure.
Investment corporations can do this task by selling
the shares of stock to many people and pool their
funds to undertake large and risky investments.
Ex: Mansha group, crescent group, Dewan-Salman
Subdividing Funds: You want to invest Rs 10,000 in a
diversified portfolio of 100 companies.
Investment in such portfolio requires Rs 10 mill.
A mutual fund having 1000 such investors, subdivides
this investment among them and charges just Rs 50/per annum from each investor.
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Ex: ICP, NIT, Atlas Fund, Habib Mudaraba, etc.

FUNCTIONS OF FINANCIAL SYSTEM

Functions as a Clearinghouse: The financial system facilitates transactions
between payers (purchasers) and payee
(sellers).
You buy a new car and make your payment
through a cheque.
Your bank credits account of the company
selling automobiles and debit your account.
Thus, the financial system allows rapid
transfer of funds across the world.
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THE SPECIAL CASE OF MONEY

Why do we need money?
Does money possess any intrinsic value?
Money is useless until we get rid of it to acquire
other useful goods and services.
Yet, money is very important from macro..
It is one of the two tools of government to
stabilise the economy, other being fiscal.
When the financial system works well, output
grows smoothly with stable prices.
But, when it does not work well, it can lead to
inflation or depression.
Worlds major economic traumas of 20th century
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bear testimony to ill-managed monetary systems.

EVOLUTION OF MONEY

What is money?
Anything that serves as commonly accepted
medium of exchange.
1. Barter: Exchange of goods for other goods.
2. Commodity Money: Cattle, olive oil, beer or wine, copper, iron, gold,
silver, diamonds, cigarettes.
By 18th century, commodity money was almost
exclusively limited to metals like silver and
gold.
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EVOLUTION OF MONEY
3. Modern Money: With the passage of time, commodity
money gave way for paper money due to
the following advantages: It is convenient to carry and recognise.
It can be saved from counterfeiting by careful
engraving, embossing, etc.
It is easier to keep its supply scarce for
retention of its value.

Paper money was gradually overtaken by

bank money the checking accounts. 10

COMPONENTS OF MONEY SUPPLY

Currency:- Coins and paper money

held outside the banking system.
In the past, the paper money was backed by
gold or silver No such requirement now.
All coins and paper money are fiat money.
The term signifies something declared to be
money even if it has no intrinsic value.
Paper money or coins are legal tender,
which ought to be accepted for all debts
public and private.
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COMPONENTS OF MONEY SUPPLY

Demand Deposits and Other Checkable

Deposits:- Funds, deposited in banks
and other financial institutions against
which one can write checks or withdraw
money from.
Ex: If you have Rs 1,000 in your bank
account, it is regarded as money and you
can pay for purchases from this amount.
Credit card, on the other hand, is not money
though you can make purchases from it.
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Why?

THE DEMAND FOR MONEY

Before discussing the demand for money,
lets note its functions: Medium of Exchange:- Without this tool,
wed be always looking for someone to
barter with.
Unit of Account:- It helps in measuring
the value of things being exchanged.
Store of Value:- Compared to risky
assets like stocks and real estate, money
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is relatively free of risk.

THE DEMAND FOR MONEY

Two Sources of Demand for Money: Transactions Demand for Money:- As
money is used to buy goods and
services, we need it to make payments.
Ex: Cash at hand or money in bank account.

Asset Demand:- Money itself can be

used as a store of value. For e.g. US
currency is widely held as a safe asset in
countries where hyperinflation occurs,
or where financial system is unreliable.14

BANKS AND THE SUPPLY OF MONEY

While money makes a tiny part (1%) of all financial

assets, the interaction between the central bank and
commercial banks plays a vital role in setting interest
rates and overall macroeconomic bahaviour.
A bank is basically a business, which provides
services for its customers and in return receives
payment from them.
See Table 23-3 for consolidated balance sheet of all
US commercial banks.
A balance sheet is a statement of a firms financial
position at a point in time.
Assets: Items that the firm owns.
Liabilities: Items that the firm owes.
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Net Worth: the difference between assets & liabilities.

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BANKS AND THE SUPPLY OF MONEY

A unique feature of a bank balance sheet

is an asset called reserves.
It refers to a special category of bank
assets that are regulated by the central
bank.
Reserves equal cash held by the bank +
deposits with the central bank.
Earlier, reserves were kept to pay
customers, but today they serve
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primarily to meet legal requirement.

A MODERN BANKING SYSTEM

Banks are required to hold at least 10%

of their checking deposits as reserves in
the form of cash and deposits with the
central bank.
The central bank can adjust both
interest rate and bank rate.
In addition to providing the service of
checking deposits, banks provide many
other services, which makes the
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banking business complicated.