Money Supply and Federal Reserve System

Concepts of Money

Money is a fundamental component of modern economies, serving as the primary medium for transactions and economic measurement.

• Acceptable as Payment: Money must be widely accepted as payment for goods and services.

• Medium of Exchange: Anything that acts as a medium of exchange can be considered money.

• Trust and Acceptance: The value and acceptance of money depend on collective trust that it will retain value and be accepted in future transactions.

Functions of Money

Money performs several essential functions in the economy:

• Medium of Exchange: Facilitates buying and selling without the need for a double coincidence of wants. Anything widely accepted as payment can serve this function.

• Unit of Account: Provides a standard measure for quoting prices and valuing goods and services, allowing for consistent price comparison.

• Store of Value: Enables individuals to transfer purchasing power from the present to the future. Durable forms of money (e.g., gold, silver, currency) are more effective in this role.

Desirable Qualities of Money

Effective money should possess several key qualities:

• Durability: Should not depreciate rapidly.

• Portability: Easy to transport, even in large amounts.

• Diverse Denominations: Should accommodate various values for ease of trade.

• Uniform Quality: Consistency in quality increases trust and usability.

• Low Production Cost: Efficient to produce, freeing resources for other uses.

• Stable Value: Retains value over time, encouraging acceptance and use.

Measurements of Money

Money supply is measured in several ways, reflecting different levels of liquidity:

• M1 (Transactions Money): Currency in circulation + Demand deposits.

• M2 (Broad Money): M1 + (Savings deposits + Fixed deposits + Negotiable instruments of deposits + Repos + Foreign currency deposits).

• M3: M2 + Deposits placed with other banking institutions.

The Financial System in Malaysia

The Malaysian financial system comprises various markets and institutions:

• Financial Markets: Includes money, foreign currency, capital, derivatives, and offshore markets.

• Banking Institutions: Central bank (Bank Negara Malaysia), commercial banks, financial companies, merchant banks, and others.

• Non-Bank Financial Intermediaries: Pension funds, insurance companies, development finance institutions, leasing companies, and more.

• Banking System Structure: Divided into conventional banking and Islamic banking.

Money Creation

Banks play a crucial role in money creation through the process of accepting deposits and making loans. This process is tracked using a simplified balance sheet known as a "T-account." The balance sheet is always balanced, with assets on the left and liabilities plus net worth on the right.

Example of Credit Creation

Suppose a total deposit of RM1000 is made, with a cash reserve ratio of 10%. The process of credit creation is as follows:

Additional info: This process continues, with each subsequent bank holding 10% in reserve and lending out the remainder, leading to a multiplied effect on total deposits.

The Working of the Money Multiplier

The money multiplier demonstrates how an initial deposit can lead to a greater total increase in the money supply.

• Formula:

• Example: If RM1000 is deposited and the reserve ratio is 10% (0.1):

Key Money Supply Formulas

• Cash Ratio:

• Money Multiplier:

• Total Money Supply:

• Total Reserve:

• Total Credit Creation:

How the Central Bank Controls Money Supply

The central bank uses several tools to influence the money supply:

• Required Reserve Ratio: The fraction of deposits banks must hold as reserves. Increasing the ratio reduces the money supply; decreasing it increases the money supply.

• Discount Rate: The interest rate charged by the central bank on loans to commercial banks. Raising the rate discourages borrowing and reduces the money supply; lowering it encourages borrowing and increases the money supply.

• Open Market Operations: The buying and selling of government securities in the open market. Buying securities increases the money supply; selling securities decreases it.

The Supply Curve for Money

The money supply curve (Ms) is typically shown as vertical, indicating that the quantity of money supplied is fixed at a given point in time, regardless of the interest rate.

• Shifts in the Curve: When the central bank increases the money supply, the Ms curve shifts right; when it decreases the money supply, the curve shifts left.

Additional info: The vertical nature of the Ms curve reflects the central bank's control over the money supply in the short run.