Lesson 4-MGT411-Banking

Money & Banking – MGT411

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Lesson 4

OTHER FORMS OF PAYMENTS

Debit Card

The money in your account is used for payments

Works like a cheque and there is usually a fee for the transaction

Credit card

It is a promise by a bank to lend the cardholder money with which to make purchases.

When the card is used to buy merchandise the seller receives payment immediately

The money that is used for payment does not belong to the buyer

Rather, the bank makes the payment, creating a loan that the buyer must repay.

So, they do not represent money; rather, they represent access to someone else’s money

Electronic Funds Transfer

Move funds directly from one account to another.

Banks use these transfers to handle transactions among themselves

Individuals may be familiar with such transfers through direct deposit of their paycheques and the

payment of their utility bills, etc

E-money

Used for purchases on the Internet.

You open an account by transferring funds to the issuer of the e-money

When shopping online, instruct the issuer to send your e-money to the merchant

It is really a form of private money.

Stored-value card

Retail businesses are experimenting with new forms of electronic payment

Prepaid cellular cards, Internet scratch cards, calling cards etc

The Future of  Money

The  time  is rapidly approaching  when  safe and  secure  systems for  payment  will  use  virtually  no

money at all

We will also likely see

Fewer “varieties” of currency, (a sort of standardization of money) and

A dramatic reduction in the number of units of account

Money as  a store  of  value  is  clearly  on  the  way  out as many financial instruments  have  become

highly liquid.

Measuring Money

Different  Definitions  of  money   based  upon  degree  of  liquidity.  Federal  Reserve  System  defines

monetary aggregates.

Changes in the amount of money in the economy are related to changes in interest rates, economic

growth, and most important, inflation.

Inflation is a sustained rise in the general price level

With inflation you need more money to buy the same basket of goods because it costs more.

Inflation makes money less valuable

The primary cause of inflation is the issuance of too much money

Because  money growth is related to inflation we  need to be  able to measure  how much money is

circulating

Money as a means of payments

We  measure the  quantity of  money  as the  quantity  of  currency in  circulation  –  an  unrealistically

limited measure, since there are other ways of payments

Alternatively, broadly categorize financial assets and sort them by the degree of liquidity

Sort them by the ease with which they can be converted into a means of payments

Arrange them from most liquid to least liquid

Draw a line and include everything on one side of the line in the measure of the money

Money & Banking – MGT411

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Where to draw the line?

In  reality,  we   draw  line  at  different  places  and  compute   several  measures  of  money  called  the

monetary aggregates

M1, M2, and M3

M1  is  the narrowest definition  of money  and  includes only currency and various deposit  accounts

on which people can write Cheques.

Currency in the hands of the public,

Traveler’s Cheques,

Demand deposits and

Other chequeable deposits

M2 includes everything that is in M1 plus assets that cannot be used directly as a means of payment

and are difficult to turn into currency quickly,

Small-denomination time deposits,

Money market deposit accounts,

Money market mutual fund shares

M2 is the most commonly quoted monetary aggregate since its movements are most closely related

to interest rate and economic growth.

M3 adds to M2 other assets that are important to large institutions

Large-denomination time deposits,

Institutional money market mutual fund shares,

Repurchase agreements and

Eurodollars

_Symbol

Assets included

C                      Currency

M1                       C + demand deposits, travelers’ Cheques,

other chequeable deposits

M2                      M1 + small time deposits, savings deposits,

money market mutual funds, money market deposit accounts

M3                       M2 + large time deposits, repurchase agreements, institutional money market

mutual fund balances

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Money & Banking – MGT411

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Monetar y Aggregates                                          Figures in millions as of  March 2005

1.

Currency issued                           711,997

2.

Currency held by SBP                             3,188

3.

Currency in tills of Scheduled Banks                                 43,914

4.

Currency in circulation (1 – 2 – 3) 664,895

5.

Scheduled Banks demand deposits    93,272

6.

Other Deposits with SBP                   4,826

7.

M1 (4+5+6)            1,602,423

8.

Scheduled Banks Time Deposits            1,037,678

9.

Resident Foreign Currency Deposits                     172,074

10.

Total Monetary Assets (M2)            2,812,175

11.

M3

3,833,686

Source: State Bank of Pakistan

Table : The Monetary Aggregates

Monetary Aggregates Value as of August 2004 (U.S.$ billion)

M1

= Currency in the hands of the public

686.2

+ Traveler’s checks

7.6

+ Demand deposits

315.3

+ Other checkable deposits

328.5

Total M1

1,337.6

M2

=M1

+ Small-denomination time deposits

794.7

+ Savings deposits including money market deposit

accounts

3415.3

+ Retail money market mutual fund shares

735.5

Total M2

6,283.1

M3

=M2

+ Large-denomination time deposits

1,036.3

+ Institutional money market mutual fund shares

1,104.7

+ Repurchase agreements

516.6

+ Eurodollars

344.5

Total M3

9,285.2

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Money & Banking – MGT411

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Figure: Growth Rates in Monetary Aggregates

40

35

30

25

M1

20

M2

15

M3

10

5

0

-5

Figure: Money Growth and Inflation

%

30

25

20

15

10

5

0

Years

Measures of  Inflation

Fixed-weight Index - CPI

Deflator – GDP or Personal Consumption Expenditure Deflator

Consumer Price Index (CPI)

Measure of  the overall level of  prices used to

Track chang es in the typical household’s cost of  living

Allow comparisons of  dollar figures from different years

Survey consumers to determine composition of the typical consumer’s “basket” of goods.

Every month, collect data on prices of all items in the basket; compute cost of basket

CPI in any month equals

Cost of basket in that month

100 Cost of basket in base period

×

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Example:

The basket contains 20 pizzas and 10 compact discs.

Prices

Years Pizza CDs

2002 $10 $15

2003 $11 $15

2004 $12 $16

2005 $13 $15

From this table, we can calculate the inflation rate as:

Years Cost of Basket CPI Inflation rate

2002 $350 100.0 n.a.

2003 370 105.7 5.7%

2004 400 114.3 8.1%

2005 410 117.1 2.5%

GDP Deflator

The GDP deflator, also called the implicit price deflator for GDP, measures the price of  output relative to

its price in the base year. It reflects what’s happening to the overall level of  prices in the economy

GDP Deflator = (Nominal GDP / Real GDP) ×100

Years Nom. GDP Real GDP GDP Deflator Inflation Rate

2001 Rs46, 200 Rs46, 200 100.0 n.a.

2002 51,400 50,000 102.8 2.8%

2003 58,300 52,000 112.1 9.1%

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Lecture No. 5 (MGT411)Banking

Financial Intermediaries

The informal arrangements that were the mainstay of the financial system centuries ago have since given way to the formal financial instruments of the modern world Today, the international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics. We obtain the financial resources we need from this system in two ways: Directly from lenders and Indirectly from financial institutions called financial intermediaries  Indirect Finance   A financial institution (like a bank) borrows from the lender and then provides funds to the borrower. If someone borrows money to buy a car, the car becomes his or her asset and the loan a liability. Direct Finance   Borrowers sell securities directly to lenders in the financial markets. Governments and corporations finance their activities this way The securities become assets to the lenders who buy them and liabilities to the borrower who sells them Financial and Economic Development   Financial development is inextricably linked to economic growth There aren’t any rich countries that have very low levels of financial development. Figure: Financial and Economic Development    Financial Development is measured by the commonly used ratio of broadly defined money to GDP. Economic development is measured by the real GDP per capita. Financial Instruments   A financial instrument is the written legal obligation of one party to transfer something of value – usually money – to another party at some future date, under certain conditions, such as stocks, loans, or insurance. Written legal obligation means that it is subject to government enforcement; The enforceability of the obligation is an important feature of a financial instrument. The “party” referred to can be a person, company, or government The future date can be specified or can be when some event occurs Financial instruments generally specify a number of possible contingencies under which one party is required to make a payment to another Stocks, loans, and insurance are all examples of financial instruments Uses of Financial Instruments     Means of Payment Purchase of Goods or Services Store of Value Transfer of Purchasing Power into the future Transfer of Risk Transfer of risk from one person or company to another   Characteristics of Financial Instruments     Standardization Standardized agreements are used in order to overcome the potential costs of complexity Because of standardization, most of the financial instruments that we encounter on a day-to-day basis are very homogeneous Communicate Information Summarize certain essential information about the issuer Designed to handle the problem of “asymmetric information”, Borrowers have some information that they don’t disclose to lenders Classes of Financial Instruments   Underlying Instruments (Primary or Primitive Securities) E.g. Stocks and bonds Derivative Instruments Value and payoffs are “derived from” the behavior of the underlying instruments Futures and options Value of Financial Instruments   Size of the promised payment People will pay more for an instrument that obligates the issuer to pay the holder a greater sum. The bigger the size of the promised payment, the more valuable the financial instrument When the payment will be received The sooner the payment is made the more valuable is the promise to make it The likelihood the payment will be made (risk). The more likely it is that the payment will be made, the more valuable the financial instrument The conditions under which the payment will be made Payments that are made when we need them most are more valuable than other payments Value of Financial Instruments Size Payments that are larger are more valuable Timing Payments that are made sooner are more valuable Likelihood Payments that are more likely to be made are more valuable Circumstances Payments that are made when we need them most are more valuable