07.

MONEY AND BANKING

[ SUMMARIZED NOTE ]

Money is anything that is generally accepted as a means of payment in the exchange of goods
and services. Following characteristics can be seen in good money.
▪ General acceptance ▪ Divisibility ▪ Legal validity
▪ Durability ▪ Portability ▪ Difficulty to counterfeit
▪ Uniformity ▪ Stability of value ▪ Easy identification

Functions of Money
▪ Act as a medium of exchange
Money serves as a medium of exchange, which means that money acts as an intermediary
between the buyer and the seller. Eg - Instead of exchanging accounting services for shoes,
the accountant now exchanges accounting services for money. This money is then used to
buy shoes.
▪ Act as a store of wealth
A store of value is the function of an asset that can be saved, retrieved and exchanged at a
later time, and be predictably useful when retrieved. More generally, a store of value is
anything that retains purchasing power into the future
▪ Act as a unit of account
Money also functions as a unit of account, providing a common measure of the value of goods
and services being exchanged. Knowing the value or price of a good, in terms of money,
enables both the supplier and the purchaser of the good to make decisions about how much
of the good to supply and how much of the good to purchase.

It has been easier to make financial reports such as business accounts, national accounts,
government budget and balance of payments as money act as a unit of account.
▪ Act as a standard of deferred payment
Ability to settle the past debts at a future date more efficiently is called as a medium of
deferred payment. When business firms sell goods at a debt and when financial institution
provide loans it takes time to resettle these payments. Use of money provides the ability to
resettle these payments without any uncertainty or risk.

Near money - The highly liquid assets Money substitutes - An instrument which
which act as a store of value but which does act as a temporary medium of exchange and
not act as a medium of exchange are known which does not act as a store of value is
as near money. Near money can be easily known as money substitutes. Money
converted to a medium of exchange substitutes can be used for short term
(money). transactions instead of money and cheques.

Examples: Fixed deposits, savings deposits, Examples: credit cards and debit cards
treasury bills, exchange bills, promissory
notes.

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 CREDIT CARDS ARE NOT CONSIDERED AS MONEY.

Money is a financial asset that one may spend—it represents an existing asset that may be
used to purchase goods or services. When calculating the money supply, the Central Bank
includes financial assets like currency and deposits. In contrast, credit card debts are
liabilities. Each credit card transaction creates a new loan from the credit card issuer.
Eventually the loan needs to be repaid with a financial asset—money. To households, the
line of credit associated with a credit card is not a financial asset, only a convenient vehicle
for borrowing to finance a purchase.

CREDIT CARDS ARE TAKEN INTO MONEY SUPPLY.

The loans taken through credit cards are included under “credit to private sector”
according to the M2 definition. A credit card is a mode of granting loans. The amount of
loan that the credit card holder obtains through the card is included in the money supply.

DEBIT CARDS ARE NOT TAKEN INTO MONEY SUPPLY.

Debit cards are issued against already existing bank deposits. Such deposits are already
included in the money supply (M2) even if the debit card is not used. Therefore if debit
cards are included in money supply it would cause a double counting error.

Demand for Money

The preference of people to keep money in the form of money itself at a given period is known
as demand for money or as liquidity preference.

Transaction Motive Since there is a

gap between a
person's income received and
expenditure made holding of money
balances for day to day transactions is
called demand for money on
transactionary motive.

Precautionary motiveHolding money balances to

fulfill the need during
unexpected situations which cannot be planned is
known as demand for money on Precautionary
Motive.

Examples: Holding of money to use at the situations

such as accidents and diseases.

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 Speculative Motive Demand
for money
to gain future benefits by investing
on bonds is called as demand for
money on speculative motive. In
other words keeping of money as an
asset is known as demand for
money on Speculative Motive.

The people intend to keep various assets with them and the selection between bonds and
money depends on the interest rate. Accordingly, there is a negative (inverse) relationship
exists between interest rate and demand for money on assets and bonds.

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Supply of Money
The total stock of money that circulates among the general public at a given period is called
money supply. Money supply is also defined as monetary aggregate.

The various definitions presented relating to Sri Lanka's money supply are given below.

▪ Narrow money supply (M1) - M1 = Cp + DDp

▪ Broad money supply (M2) - M2 = M1 + TSDp
▪ Consolidated broad money supply (M2b) - M2b = M2 + 50% of TSDNRFC + RDFCBU
▪ Very broad money supply (M4) | Financial Survey [M4] - M4 = M2b + LSB + RFC

Determinants of Broad Money Supply.

I. Net Foreign Assets of the Banking System

II. Net loans given by the banking system to the government
III. Loans given by Commercial banks to the private sector
IV. Net other assets of the banking system

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High powered money
The direct financial liabilities which supply the basis for the aggregate money supply of a
particular country is known as base money. Base money is also named as high powered
money and reserve money.

Component of high powered money are as follows.

▪ Note and coins of public (Cp)
▪ Currency of public with commercial banks(Ckb)
▪ Deposits of commercial; bank with the central bank (RR)
▪ Deposits of other government institutions maintained at central bank (DOI).
Determinants of High Powered Money.
▪ Loans given by Central banks to commercial banks
▪ Net loans given by the Central bank to the government
▪ Net foreign assets of the Central bank
▪ Net other assets of the Central bank

Money Multiplier
The relationship between total money supply and base money is shown by the money
multiplier. It can be shown by an equation as follows.
M = KH
M = Money supply K = Money multiplier H = Base Money

PRICE LEVELS AND INFLATION

General price level - Price level is the average of current prices across the entire spectrum of
goods and services produced in an economy. They play an important role in the purchasing
power of consumers as well as the sale of goods and services. It also plays an important part
in the supply-demand chain.
Inflation
Inflation is the decline of purchasing power of a given currency over time. A quantitative
estimate of the rate at which the decline in purchasing power occurs can be reflected in the
increase of an average price level of a basket of selected goods and services in an economy
over some period of time. The rise in the general level of prices, often expressed as a
percentage, means that a unit of currency effectively buys less than it did in prior periods.
Inflation can be contrasted with deflation, which occurs when the purchasing power of money
increases and prices decline.

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 Deflation Disinflation
Deflation is the economic term used to Disinflation occurs when price inflation
describe the drop in prices for goods and slows down temporarily. This term is
services. Deflation slows down economic commonly used by the U.S. Federal
growth. It normally takes place during Reserve when it wants to describe a period
times of economic uncertainty when the of slowing inflation. Unlike deflation, this is
demand for goods and services is lower, not harmful to the economy because the
along with higher levels of unemployment. inflation rate is reduced marginally over a
When prices fall, the inflation rate drops short-term period.
below 0%.

INFLATION
Accordingly, there are two main approaches which explain reasons for inflation.

1. Demand pull inflation

2. Costs push inflation

DEMAND PULL INFLATION

Increase in general price level of goods and services due to an increase in demand relative to
supply is meant by demand pull inflation. Which means increase in the general price level due
to the excess aggregate demand. Demand pull inflation is also known as too much money
chasing too few goods.

There are alternative two approaches of demand pull inflation

1. Quantity theory of money
2. Keynesian theory
Quantity Theory of Money
Quantity theory of money is a theory that presents the behavior of price level based on the
equation of exchange. Quantity theory of money states that there is a direct relationship that
exists between change in price level and change in stock of money.

To explain this relationship between money supply and price level, Quantity theory of money
uses the following equation.

MV = PT
MV = value of transactions made with money
(M = money supply, V = Velocity of circulation.)
PT = the total value of transactions of the economy | Nominal GDP
(P – Price level, T- amount of transactions)
Accordingly equation of exchange can be converted to a theory based on the assumptions
related to the behavior of variables in the exchange equation.

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There are two assumptions,
1. Velocity of circulation of money being constant.
2. Volume of transactions being constant. Volume of transactions is constant because,
the economy is in its full employment. (Y also used instead of T)

Assuming V and T remain constant quantity theory of money shows the increase in price level
as proportionate to the stock of money.

Keynesian theory
Keynesian theory uses aggregate income and expenditure analysis to explain demand pull
inflation. After the economy reaches macroeconomic equilibrium, if the aggregate demand
increase the price level will begin to increase.
The Keynesian approach of the inflation is shown by the graph below.

According to the graph

When aggregate demand increases from AD1 to

AD2 the general price level of the economy also
increases from P1 to P2.

Y2 shows the full employment level of output. If

the Aggregate demand increases further the
price levels would increase, however the output
will remain constant
COST PUSH INFLATION
Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost
of wages and raw materials. Higher costs of production can decrease the aggregate supply
(the amount of total production) in the economy. Since the demand for goods hasn't changed,
the price increases from production are passed onto consumers creating cost-push inflation.
Cost push inflation occur with increase in cost of production with an increase in price of inputs
and thus decreases supply. This is shown by the diagram below.
According to the graph at Y1 level of
output price level will be P1.

The aggregate supply curve shifts to

the left from AS1 to AS2 due to
increase in the cost of production.
However, as the aggregate demand
does not change as a result of the
decrease in the aggregate supply
general price level increased from P1
to P2.

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 Headline vs Core Inflation
Headline inflation refers to the change in value of all goods in the basket. Core inflation
excludes food and fuel items from headline inflation. Since the prices of fuel and food items
tend to fluctuate and create ‘noise’ in inflation computation, core inflation is less volatile
than headline inflation. In a developed economy, food & fuel account for 10-15% of the
household consumption basket and in developing economies it forms 30-40% of the
basket. Headline inflation is more relevant for developing economies than developed
economies.

Effects of inflation

Favourable | Advantages Unfavourable | Disadvantages | Costs

▪ Higher profits due to higher prices ▪ Fixed income groups experience a fall in
▪ Better investment returns income.
▪ Increase in production ▪ Inequality in income distribution increases.
▪ More employment opportunities ▪ Upsets the planning process.
▪ Benefits borrowers ▪ Speculative investment increases.
▪ Lenders lose.
▪ Negative impact on exports.

Price Index
The numerical measure which measures the changes of general price level in a certain period
is known as a price index.
NEW BASE YEAR - 2021

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Read More on inflation

[Link]

What are the causes behind the high levels of inflation in Sri Lanka?

▪ The significant increase observed in the general price level in 2022, was largely
attributed to the removal of administered prices, which were maintained at constant
levels over a considerable period as a relief to the general public.
o In addition, foreign exchange shortages, higher transportation costs due to
frequent upward fuel price revisions, and notable electricity and water tariff
revisions made a significant impact on prices.
▪ Further, issues relating to the shortage of fertilizer caused the limited availability of
food commodities elevating their price levels.
▪ Meanwhile, the depreciation of the exchange rate [Sharp depreciation of the Sri Lanka
rupee against the US dollar], rising prices of global commodities and higher freight
charges also resulted in substantial price increases of imported items.
▪ Aggregate demand pressures associated with the lagged impact of monetary
accommodation.
▪ Substantial supply side disruptions both locally and globally

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A financial system is the sum of markets, financial institutions, financial instruments, financial
infrastructure and regulatory bodies.
Financial institutions are the institutions which supply various
Financial Institutions
financial services and which involve in transactions with
various financial instruments.

▪ Banking Sector
o Central Bank
o Licensed Commercial Banks
o Licensed Specialized Banks
▪ Other deposit taking financial institutions
▪ Specialized financial institutions
▪ Contractual savings institutions
o Insurance companies
o EPF
o ETF
The aggregate market where financial instruments are
Financial Markets
purchased and sold to fulfill the need of short term and long
term funds are known as financial market.

Financial market consists two types,

1. Money market
2. Capital market

Money Market - The market which exchange short term assets with a maturity of less than
one year which earns an interest such as treasury bills, Commercial papers, and certificate of
deposits is known as money market. Sub markets → Interbank call credit money market,
Treasury bill market, Commercial paper market and interbank foreign exchange market.

Capital Market - The market which exchange financial instruments of more than one year of
maturity is known as the capital market. Sub markets → Treasury bond marks, corporate bond
market, share market.

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CENTRAL BANK OF SRI LANKA
The objectives of the CBSL are:
▪ Maintaining economic and price stability
▪ Maintaining financial system stability
Economic and Price Stability
Price stability safeguards the value of the currency in terms of what it will purchase at
home and in terms of other currencies. Price stability is interpreted to mean low and stable
inflation. Experience has shown that the economy performs well when inflation is low and
is expected to remain low. Interest rates are also low in these conditions. Such an
environment allows the economy to achieve its growth potential and fosters high
employment. Free from the disruptive effects of high and variable inflation, both
consumers and producers make economic decisions with confidence. Low inflation or price
stability fosters sustainable long-term economic growth and employment. The CBSL uses
monetary policy measures to control inflation.
Financial System Stability
A stable financial system is able to function smoothly, helping carry out economic activity
in an uninterrupted manner. Furthermore, a stable financial system generates a conducive
environment for savers and investors that encourages efficient financial intermediation
and promotes investment and economic growth. Financial system stability can be defined
as the ability of the financial system to perform its main functions of resource mobilization
and allocation, risk management and the settlement of payments, effectively at all times,
even under stressful circumstances. Therefore a stable financial system is typically
characterized by the effective functioning of financial institutions, markets and
infrastructure. Financial system stability is founded on the confidence of the public in the
financial system and largely depends on the soundness and resilience of its principal
components i.e. financial institutions, financial markets and financial infrastructure to
collectively withstand risks.

Functions of the Central Bank ▪ Management of official foreign

▪ Controlling of monetary policy reserves
▪ Controlling of exchange rate policy ▪ Providing of license to primary dealers
▪ Issuing of currency ▪ Act as a banker and financial agent to
the government
Agency functions
▪ Management of public debt
▪ Control of foreign exchange
▪ Management and administration of employee provident fund
▪ Implementing of small scale financial programs and management of rural debt
schemes

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Monetary Policy
Monetary policy is the process by which a Central Bank manages the supply and the cost of
money in an economy mainly with a view to achieve the macroeconomic objective of price
stability.
Central Bank of Sri Lanka is responsible for conducting monetary policy in Sri Lanka, which
mainly involves setting the policy interest rates and managing the liquidity in the economy.
The monetary operations of the Central Bank influences interest rates in the economy,
affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate
of inflation. Therefore, the Central Bank uses monetary policy to control inflation and keep it
within a desired path.
Monetary Policy Framework
At present, the Central Bank conducts monetary policy in line with a flexible inflation targeting (FIT)
framework, aimed at stabilising inflation at mid-single digit levels over the medium term while
supporting economic growth to reach its potential. In terms of operational aspects of this framework,
the Central Bank uses its policy instruments to guide short term interest rates, particularly the average
weighted call money rate (AWCMR) as the operating target.

Prior to this transition, the Central Bank conducted monetary policy within an enhanced monetary
policy framework with features of both monetary targeting and flexible inflation targeting (FIT). Under
this enhanced monetary policy framework, the Central Bank attempted to stabilise inflation in mid-
single digits over the medium term, while supporting the growth momentum of the economy and
flexibility in exchange rate management. Similar to the current practice, the AWCMR was used as the
operating target.

During the early 1980s, the Central Bank adopted monetary targeting as its monetary policy
framework, and monetary aggregates became the key nominal anchor in the conduct of monetary
policy. Under a monetary targeting framework, the changes in money supply are considered as
primary causal factors affecting price stability. In general, two major definitions of monetary
aggregates are considered in analysing monetary developments in Sri Lanka. The first is 'reserve
money' consisting of currency issued by the Central Bank and commercial banks' deposits with the
Central Bank. This is also called base money or high-powered money, as commercial banks can create
deposits based on reserve money which are components of a broader definition of money supply,
through their process of creating credit and deposits. The second is broad money defined as the sum
of currency held by the public and all deposits held by the public with commercial banks. Studies have
shown that the most appropriate monetary variable to analyse the relationship between the money
supply and the general price level is the broad money supply. However, given the rising volatility in
money multiplier and velocity amid a weakening relationship between money supply and inflation,
the role of monetary targets as a nominal anchor became uncertain and also complicated the Central
Bank’s communication strategy, causing the Central Bank to upgrade its monetary policy framework.

The Central Bank conducts its Open Market Operations (OMO) within the corridor of interest rates
formed by its policy rates i.e. the standing deposit facility rate (formerly the repurchase rate) and the
standing lending facility rate (formerly the reverse repurchase rate), to achieve the intended inflation
path. Policy rates are periodically reviewed and adjusted appropriately, if necessary, to guide the
interest rate structure of the economy with a view to achieve the desired path of inflation.

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Monetary Policy Instruments

1. Quantitative Monetary Policy Instruments

Approaches commonly followed to reduce or to control debt are known as quantitative
monetary policy instruments.

There are three quantitative monetary policy instruments.

1. Policy Interest rates
2. Statuary reserve ratio
3. Open market operations

1. Policy Interest Rates

Bank Rate
The interest rate charged by the central bank as lender of the last resort from the commercial
banks which face difficulties in liquidity is called the bank rate. When bank rate increases
money supply decreases due to reduction in bank borrowings along with reduction of
reserves. Money supply expands with decrease in bank rate.

Standing Deposit Facility Rate (SDFR) Standing Lending Facility Rate (SLFR)
SDFR provides the floor rate for absorption SLFR is the interest rate applicable on
of overnight excess liquidity from the reverse repurchase transactions of the
banking system by the Central Bank. The Central bank with commercial banks on an
standing deposit system of the central overnight basis under the Standing Facility,
bank is uncollateralized. providing the ceiling rate for the overnight
liquidity by the banking system by the
central bank.

The main instruments to achieve the intended inflation path are the standing deposit
facility rate (formerly the repurchase rate) and the standing lending facility rate (formerly
the reverse repurchase rate) of the Central Bank which form the lower and upper bounds
for the overnight interest rates in money markets. These rates, which are the Bank's
signaling mechanism on its monetary policy stance, are reviewed on a regular basis, usually
eight times per year, and revised if necessary.
Standing facilities are available for those participating institutions which were unable to
obtain their liquidity requirements at the daily auction. That is, even after an auction, if a
participant has excess money he could deposit such funds under the standing deposit
facility. Similarly, if a participant needs liquidity to cover a shortage, he could borrow funds
on reverse repurchase basis under the standing lending facility. Accordingly, these facilities
help containing wide fluctuations in interest rates.

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2. Statutory Reserve Ratio

The statutory reserve ratio (SRR) is the proportion of the deposit liabilities that commercial
banks are required to keep as a cash deposit with the Central Bank.

At the situations where central bank wants a monetary expansion it will reduce statutory
reserve ratio and as a result commercial banks’ ability to provide credit increases along with
increase in commercial banks reserves.

Similarly, when central bank wants a monetary contraction it will increases statutory reserve
ratio. As a result, commercial bank reserves decrease causing a reduction in the ability of
providing credit.

3. Open Market Operations

Purchasing and selling securities of the central bank at the open market is called open market
activities. When central bank purchases securities at the open market central bank’s money
will flow to the money market. When central bank sells securities at the open market money
will flow from money market to the central bank.

Due to these two types of policies there can be a monetary expansion or monetary
contraction within the economy.

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Policy interest rates and interest rate corridor

An interest rate corridor was constructed related

to call money market interest rates. Lower limit
of interest rate corridor is the standing deposit
facility rate and upper limit of interest rate
corridor is standing lending facility rate.

The aim of constructing this interest rate corridor

by the central bank is to prevent large
fluctuations of short term interest rates.

2. Qualitative monetary policy instruments Approaches followed by the central bank to

control the volume, or the direction of
credit are known as qualitative monetary policy instruments.

There are several qualitative monetary instruments.

▪ Imposing of maximum limit over credit

▪ Moral suasion
▪ Change of collateral requirements for loans
▪ Control of bank credit

Commercial Banks
Financial intermediaries or the strong and prominent financial institutions which accept
deposits from public with an intension of earning profits with a promise of repaying when
asked are known as commercial banks.

There are two main objectives of a commercial bank.

▪ Protecting of liquidity
▪ Increasing of profitability

THE CONFLICTING OBJECTIVES OF COMMERCIAL BANKS

Liquidity means ability of transferring assets into cash without having a loss. Commercial
banks have to maintain liquidity in order to protect publics' belief of the ability to withdraw
money at any time they want.
Net interest income obtained after deducting interest rate paid for deposits from the
revenue gained by all sorts of lending is called profitability.
When commercial banks try to achieve the above motioned objectives there can be a
controversy between the two objectives. When commercial banks try to secure liquidity,
profitability will decrease. On the other hand when it tries to secure profitability liquidity
will decrease. Due to this controversy between two objectives. Commercial bank have to
maintain a balance between these two objectives.

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CREDIT CREATION
Commercial bank credit creation refers to the process where each commercial bank operating
within the banking system shall retain a part of the deposits accepted by them and extend
the balance as loans. When such loans are transacted through demand deposits, the banking
system is able to create transactions of much higher value than the value of initial deposits
which entered the banking system.

Basic assumptions of the credit creation process

▪ A given statutory reserve ratio
▪ There will not be any inflow or outflow of funds from the banking system after the
initial deposit.
▪ All borrowers will deposit the loan funds fully in a different commercial bank within
the commercial banking system.
▪ All banks will not maintain excess reserves.

Deposit Multiplier
The number of times the value of demand deposits of the banking system can be expanded
in total or aggregate terms, based on a given initial deposit value. The consolidated balance
sheet of the banking system will also be derived using the deposit multiplier.
1
Deposit Multiplier =
SRR
Illustration
SRR = 10% SRR = 20%
Deposit Multiplier = 1 /0.1 Deposit Multiplier = 1 /0.2
= 10 times = 5 times
The total deposits in the banking system can be calculated using the deposit multiplier.
Total deposits = Initial deposit x Deposit Multiplier

Initial deposit = Total reserves

Total deposits = Total reserves x Deposit multiplier
Δ Total deposits = Δ Reserves / Δ Initial deposit x Δ Deposit Multiplier

Why is the credit created in reality less than the amount denoted by the deposit multiplier?
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CREDIT CREATION PRACTICE
QUESTION 01
The following is a simplified balance sheet for one of the banks in a commercial banking
system in a country.

Liabilities Assets
Deposits 200,000 Required Reserves 20,000
Shareholder equity 50,000 Excess Reserves 10,000
Securities 60,000
Loans 160,000
Total Liabilities 250,000 Total Assets 250,000

(i) What is the required reserve ratio?

(ii) Assume that a customer withdraws Rs.4000 million from his current account at this
bank. By how much will this bank’s reserve change based on this cash withdrawal?
(iii) Assuming that the required reserve ratio remains unchanged, what is the maximum
amount of new loans that this bank could make after the withdrawal of Rs.4000 million
deposits?

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