MONEY

AND BANKING

Lecturer: Dr. Nguyen Thu Thuy

Email: nguyenthuthuy279@gmail.com

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 Assessment
Time
Assessment Rate Form of Assessment
allowance
Class participation 10% Oral/ in writing 5’

Mid-term assessment 30%

Mid-term exam 20% 01 multiple-choice writing 50’

exam
Presentation 10% 01 in oral 10-15’/ each
group

Final-term exam 60% Closed book writing exam 60’

MONEY AND BANKING 1

OUTLINE
1. Introduction to Money and Banking
2. The time value of money and Interest rates
3. Financial Markets
4. Financial Intermediaries
5. Commercial Bank
6. Central Bank and Monetary Policy

MONEY AND BANKING 2

Reference
Frederic S. Mishkin, 2004, “The Economics of Money,
Banking and Financial Markets”, 7th ed., Columbia
University.

MONEY AND BANKING 3

Chapter 1:
INTRODUCTION TO MONEY AND BANKING

MONEY AND BANKING 4

Outline
•Financial system: Preliminaries
•Transaction cost and imperfect information
•Introduction to banking
•Introduction to money

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Financial system: Preliminaries
•The financial system channels funds from surplus units to
deficit units
•Vital for saving and investment, consequently for economic
growth
•Well-functioning financial systems promote efficient
resource allocation
•Poorly functioning financial systems can explain low
development and poverty

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Direct and Indirect Finance

Surplus Deficit
units Markets units

Financial Intermediaries

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Financial Markets
Financial Markets: markets on which financial instruments
(securities) are traded.
◦ Bond markets
◦ Stock markets

A security (also called a financial instrument): is a claim on

the borrower’s future income that is sold by the borrower
to the lender.

MONEY AND BANKING 8

Bond market
Bond: is a debt security issued by corporations or
governments that promises to make periodic (coupon)
payments for a specified period of time.
Bond market is especially important:
◦ Enables corporations and governments to borrow to finance their
activities.
◦ Is where interest rate is determined.

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Interest rates on selected U.S. bonds,
1950-2002

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Stock market
Stock: represents a residual claim on the earnings of issuing
corporations.
Common stock represents a share of ownership in a
corporation
The stock market is also an important factor in business
investment decisions.

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Stock prices as Measured by the DJ Industrial
Average, 1950 - 2002

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Foreign Exchange Market
Foreign exchange rate (exchange rate/FX rate/forex rate):
the price of one country’s currency in terms of another’s.
FX market: is the market in which exchange rates are
determined
It is instrumental in moving funds between countries.

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Exchange rate of U.S. Dollar, 1970-2002

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Banking and Financial Institutions
Financial Intermediaries: institutions that borrow funds from
people who have saved and make loans to other people
Banks: institutions that accept deposits and make loans
Other Financial Institutions:
◦ insurance companies, finance companies, pension funds, mutual
funds and investment banks…

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Banking and Financial Institutions
•They transform the characteristics (liquidity, risk) of
acquired funds.
•They have important effects on the performance of the
economy.

MONEY AND BANKING 16

Financial Intermediaries
Depository financial intermediaries
◦ Commercial banks
◦ Savings and Loan Associations (US)
◦ Building Societies (UK)
◦ Credit Unions (credit co-operatives)
Non- depository financial intermediaries
◦ Pension funds
◦ Finance companies
◦ Insurance companies

MONEY AND BANKING 17

Why does FI’s exist?
Positive spread between interest rates on deposits and
loans (net interest margin):
◦ Q: Why don ’ t borrowers and lenders get together and share
intermediation margin?

◦ A: Due to transaction costs and imperfect information.

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Imperfect Information
•Lender is less informed than borrower about his/her
intentions and ability.

•Asymmetric information: unequal distribution of

information between borrower and lender.

à Adverse selection & moral hazard.

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Adverse selection
•Occurs before transaction takes place
•Refers to the selection of borrowers who are more likely to produce an
adverse outcome for lender
•Gets worse with higher interest rates

Example: r = 8%, 20% loan = £100

- Borrower A has a project with 10% return
with 100% probability of success
- Borrower B has a project with 100% return
with 50% probability of success

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Moral hazard
•Occurs after transaction takes place
•Refers to the incentives of borrowers to act “immorally”
once loan is approved

Example: r = 8%
- Loan approved for Project I: 10% return with
100% probability of success
- New opportunity arises (Project II): 100%
return with 50% probability of success

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 Transaction costs
• Transaction costs: time and cost spent in matching borrowers
and lenders, legal fee…
• Small investors frozen out of financial markets because:
• Commissions and charges are too large compared to the amount invested
• Small amounts do not allow diversification

• Financial intermediaries reduce transaction costs through

• Economies of scale
• Expertise

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Introduction to the Banking
Basic pratical steps in introducing bank management
principles:
◦ The bank balance sheet
◦ Income statement

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Bank’s main business
Accept deposits from customers:
◦ Offer different types of deposit products:
• Demand, savings, time etc
• Cash ISAs (tax- free)

Make loans to customers:

◦ Overdrafts (payable on demand)
◦ Fixed term loans (incl. Mortgages)
These transformations create various risks: liquidity risk,
credit risk, interest rate risk...

MONEY AND BANKING 24

The balance sheet
Assets Liabilities
- Loans and overdrafts - Demand deposits
- Deposits with other banks - Savings deposits
- Items in collection - Time deposits
- Notes and coins - Borrowings
- Treasury bills and other - Other
securities Bank Capital:
- Reserves - Shareholder’s capital
- Other assets (premises and - Loan loss reserves
equipment)

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Income Statement
Income Expenditure

- Interest income - Interest expense

- Fees and commissions receivable - Fees and commissions payable
- Trading income - Employment costs
- Other operating income - Other administrative expenses
(e.g. property)
Total operating income - Depreciation

Total operating expenses

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Bank management principles
Bank’s objective is to maximise profit:
◦ Must manage assets and liabilities in order to achieve
maximum profit
◦ Asset Management: Earn highest possible return from assets at an
acceptable level of risk: diversified portfolio, credit risk and interest
rate risk management…
◦ Liability Management: acquire funds at lowest cost
◦ Liquidity Management: able to meet deposit outflows
◦ Capital Adequacy Management: bank must be able to sustain loan
losses and meet regulator’s demands (implication for loan loss
provisions and shareholders capital)

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Assets
•Money
•Stock
•Bond
•Commodities
•Real estate

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Introduction to Money
•Money (money supply)—anything that is generally accepted
in payment for goods or services or in the repayment of
debts
•Distinguish Money, Wealth and Income:
◦ Bill Gates has a lot of money
◦ He gets a good job that pays a lot of money
◦ I often bring a lot of money when shopping

MONEY AND BANKING 29

Money, Wealth or Income?
•Money and Currency (paper money and coins)?
•Money and Wealth
• Wealth is the total collection of pieces of property that serve
to store value
•Money and Income
• Income is a flow of earnings per unit of time.

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Functions of Money
•Medium of Exchange
•Unit of Account
•Store of Value
•Means of Payment

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Medium of Exchange
•Anything that is used to pay for goods and services.
•Money promotes economic efficiency by minimizing the
time spent in exchanging goods or services.
• Example: a barter economy
•The time spent trying to exchange goods or services is
called a transaction cost.

Q: What if a farmer wants to learn economics?

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Medium of Exchange
Egg Fish Butcher
Seller Seller

BREAD
MONEY

Shoe
Seller Milk Clothing
Seller Seller

MONEY AND BANKING 33

Medium of Exchange
A commodity can function effectively as money if it meets
several below criteria:
◦ Must be easily standardized
◦ Must be widely accepted
◦ Must be divisible
◦ Must be easy to carry
◦ Must not deteriorate quickly

MONEY AND BANKING 34

Unit of Account
•Is used to measure value in the economy
•The monetary unit is the unit in terms of which the value of all
goods and services is measured and expressed in the economy
•Money does not perform this function in a barter economy
•Using money as a unit of account reduces transaction costs in an
economy

Q: How many prices do we need for a market with 100 different goods?
How about 1000 different goods?

MONEY AND BANKING 35

Store of Value
•Is a repository of purchasing power over time
•Any asset other than money may also store wealth. They
yield income and may appreciate in value over time.

Q: Is money a unique as a store of value?

MONEY AND BANKING 36

Store of Value
•Disadvantages of storing assets rather than money:
◦ may involve storage costs
◦ may not be liquid (could not be quickly converted into money
without loss of value)
◦ may depreciate in value

Q: What is the most liquid asset?

MONEY AND BANKING 37

Store of Value
•Money is the most liquid asset of all because it is the
medium of exchange
•How good a store of value money is depends on the price
level (related to the term “inflation”)

Q: When people do not want to hold their wealth in form of money?

MONEY AND BANKING 38

Means of Payment
•Is used in the repayment of debts à facilitate the exchange
of goods and services
•In terms of medium of exchange, money and goods move
together and in different ways.
•In terms of means of payment, money and goods move
separately.

MONEY AND BANKING 39

Evolution of the Payments System
•Commodity Money
•Fiat Money
•Checks
•Electronic Payment
•E-Money

MONEY AND BANKING 40

 Evolution of the Payments System

Commodity Money

Fiat Money

Checks

Electronic Payment

E-Money

TIỀN TỆ - NGÂN HÀNG 41

Commodity Money
For any object to function as money, it must be universally
acceptable and it clearly has value to everyone à a natural
choice is a precious metal such as gold or silver
Money made up of precious metals or another valuable
commodity is called commodity money.
Problem: Money is very heavy and is hard to transport from
one place to another.

MONEY AND BANKING 42

Commodity Money

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Fiat Money
Initially, paper currency carried a guarantee that it was
convertible into coins or into a quantity of precious metal.
However, currency has evolved into fiat currency, paper
currency then decreed by governments as legal tender but
not convertible into coins or precious metal.
Problem: paper currency and coins are easily stolen and can
be expensive to transport in large amounts

MONEY AND BANKING 44

Fiat Money

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Checks
•A check is an instruction from you to your bank to transfer
money from your account to someone else’s account when
he deposits the check.
•Checks allow transactions to take place without the need to
carry around large amounts of currency.

MONEY AND BANKING 46

Checks
Advantages:
◦ Using checks reduces transaction costs
◦ Checks can be written for any amount up to the balance
in the account
◦ Loss from theft is greatly reduced
Disadvantages:
◦ It takes time to get checks from one place to another
◦ All the paper shuffling required to process checks is costly

MONEY AND BANKING 47

A Sample Check

MONEY AND BANKING 48

Electronic Payment
•Can be used to transmit your payments electronically
instead of mailing a check to pay your bills
àSave time and money
•Electronic payment system is provided by banks

Q: Distinguish checking account and savings account?

MONEY AND BANKING 49

Generic Electronic Payment Protocol

MONEY AND BANKING 50

E-Money
•Debit cards: enable customers to purchase goods and
services by electronically transferring funds directly from
their bank accounts to a merchant’s account.
•Stored-value card (like a prepaid phone card)
•E-cash: a customer gets e-cash by setting up an account
with a bank that has links to the Internet and then e-cash
transferred to her PC

MONEY AND BANKING 51

Example: International Card Organizations

MONEY AND BANKING 52

Example: Gift Card Process

MONEY AND BANKING 53

Example: A Model E-cash system

MONEY AND BANKING 54

Measuring Money (the Fed)

MONEY AND BANKING 55

Money and Business Cycles
•Evidence suggests that money plays an important role in
generating business cycles
•Recessions (unemployment) and booms (inflation) affect all
of us
•Monetary Theory ties changes in the money supply to
changes in aggregate economic activity and the price level

MONEY AND BANKING 56

MONEY AND BANKING 57
Money and Inflation
•The aggregate price level is the average price of goods and
services in an economy
•A continual rise in the price level (inflation) affects all
economic players
•Data shows a connection between the money supply and
the price level

MONEY AND BANKING 58

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Money and Interest Rates
•Interest rates are the price of money
•Prior to 1980, the rate of money growth and the interest
rate on long-term Treasure bonds were closely tied
•Since then, the relationship is less clear but still an
important determinant of interest rates

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MONEY AND BANKING
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MONEY AND BANKING
Monetary and Fiscal Policy
•Monetary policy is the management of the money supply
and interest rates
◦ Conducted in the U.S. by the Federal Reserve Bank (Fed)
•Fiscal policy is government spending and taxation
◦ Budget deficit is the excess of expenditures over revenues for a
particular year
◦ Budget surplus is the excess of revenues over expenditures for
a particular year
◦ Any deficit must be financed by borrowing

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