functions of money
- a) Medium of exchange / Means of payment
b) Unit of account / Standard of value
c) Store of value
d) Standard of deferred payment
how do banks create money?
Banks create money by making loans to customers.
- They are able to do so because of the fractional reserves banking system. That is, banks only keep a fraction of the total deposits that they receive as reserves at an one time, as only a fraction will be demanded for transaction purposes at any one time.
- The other fraction of the total deposits is lent out at a positive interest rate
- The amount of each loan that is made represents new money in the economy
required reserves
the minimum amount of reserves banks are LEGALLY required to hold to back up its deposits
RRR
Reserve requirement ratio = req reserves ($)/bank’s total deposits($) x 100%
excess reserves
whatever deposits the banks have available to LEND after setting aside the RR.
changes in money supply
change in MS = IER X MM
role of MAS
- to regulate and supervise the financial services sector.
- to act as banker to and financial agent of the government, including the issue of Government Securities on behalf of the Government.
- to develop a competitive and progressive financial services sector.
- MAS also acts as an investment manager by investing and managing part of Singapore’s official foreign reserves. The rest of the country’s official foreign reserves is managed by the Government of Singapore Investment Corporation.
- MAS is responsible for ensuring the stability and orderly development of the country’s financial system and for the maintenance of high standards of prudential practice among its financial institutions.
- All commercial banks, including branches of foreign banks, merchant banks, finance companies, securities companies, futures brokers, money brokers and insurers must be granted licences by MAS before they are permitted to conduct financial business.
monetary tools
- reserve requirements
- discount/bank rate
- open market operations
- exchange rate policy
RR
- increasing RR
By increasing RRR:
* MAS can create a shortage of reserves for the banking system
* reducing the amount of bank lending puts upward pressure on interest rates
When the RRR is increased, an increased percentage of the bank’s liabilities must be held in reserve
- means that some money that once would have been excess reserves instead becomes required reserves
- since money multiplier is the reciprocal of the required reserve ratio, increase in the required reserves decreases the size of the money multiplier
*ability of banks to loan money is reduced
Rate of growth money supply is restricted - decreasing RR
Banks immediately have more excess reserves
- these excess reserves are loaned out, money is created
- money multiplier process is initiated
- money supply is increased
discount rate or bank rate
- increasing DR
By increasing the discount rate, the MAS can make it more costly for commercial banks to borrow reserves
Banks therefore become less aggressive about making loans
This reduces the impact of money multiplier and decreases money supply
*Upward pressure on interest rates
- decreasing DR
By lowering the discount rate, the MAS can encourage commercial banks to borrow more reserves
Banks therefore become more aggressive about making loans
This increases the impact of money multiplier and increases money supply
*This increases the impact of money multiplier and increases money supply
Downward pressure on interest rates
open market operations
- selling govt securities
When the MAS decides to slow down the money supply
MAS will sell government securities in the open market
Individuals, business or banks get the government securities; and MAS gets the money which are paid for with bank deposits and bank reserves
With lower reserves, banks cut their lending
*this results in a multiple contraction of the total money supply and interest rates rise
- buying govt securities
When the MAS decides to increase the money supply
MAS will buy government securities in the open market
MAS receives the government securities; and individuals, businesses or banks gets the money which increases the banks reserves
With extra reserves, the banks increase their lending
*The banking system thus starts the multiple money expansion process and interest rates fall
exchange rate policy
- Buying Singapore Dollars
When MAS buys the Singapore dollars (S$)
More of the S$ is now with MAS and no longer in circulation
Hence, the money supply falls
*This results in an increase in the interest rate - Selling Singapore Dollars
When MAS sells the Singapore dollars (S$)
More S$ is now in circulation
The money supply rises
*This results in a fall in interest rates
demand & supply for money
The demand for money graph is downward sloping.
* The higher the interest rate, the less quantity of money (cash) you want to hold as you rather put your wealth in interest-bearing assets (e.g., bonds).
* the lower the interest rate, the more quantity of money (cash) you want to hold as don’t find it worthwhile to put your wealth in interest-bearing assets (e.g., bonds).
Hence the money supply curve is a vertical line when drawn with respect to interest rate.
expansionary
An expansionary monetary policy
( RRR, discount rate, etc.)
money supply curve shifts to the right
interest rate falls
consumption and investments increase
AD increases
Output increases by a multiple
restrictive/contractionary
An restrictive or contractionary monetary policy
( RRR, discount rate, etc.)
money supply curve shifts to the left
interest rate rises
*consumption and investments decrease
AD decreases
Output decreases by a multiple
fall in interest rates affects
i) Investment
*Use monetary tools ↑money supply ↓ interest rate ↑I ↑AD ↑output by a multiple
i) Consumption
Consumers who finance their consumption through credit loan will also find it cheaper to borrow.
They will therefore borrow more to finance their consumption. Consumption increases, this will again increase AD and the GDP.
*Use monetary tools ↑money supply ↓ interest rate ↑C ↑AD ↑output by a multiple
