CHAPTER 4

MONEY, BANKING
&
THE FINANCIAL
SYSTEM

1
 Definition
Theory of Money Supply of
Demand Money

MONEY

Functions of
Types of Money
Money
2
Definition of Money
Definition:
Money is any commodity that is generally acceptable
as a payment for goods and services
Or:

Defined as anything that can acts as a

medium of exchange

3
Characteristics of Money
i- Recognizable
ii- Scarcity
iii-Stable in value
iv- Portable
v- Divisible and standardized
vi- Durable
4
Functions of Money
1. A medium of exchange

2. A store of value

3. A unit of account

4. A standard for deferred payment

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1. A Medium of Exchange
i. Money is mostly demanded for transaction
purpose.
ii. Without money, exchanging of goods and
services can only take place through the barter
system, which bears the problem of double
coincidence of wants.
iii. Money is considered as the most liquid form of
wealth since it can be used as a mean of payment
directly.

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2. A Store of Value
i. The ability of money to hold value over time.

ii. The mechanism for transforming present income

into future purchases.

iii. Since money does not suffer from any physical

deterioration, it can be stored and can be turned
into other forms of wealth quickly.

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3. A Unit of Account
i. The function of money to provide a common
measurement of the relative value of goods and
services

ii. In other words , money serves as a standard

measurement of value.

iii. Provide the basis for keeping accounts and

calculating profit and loss

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4. A Standard for Deferred Payment
i. Money can be used as a payment at later date and
not necessarily when the goods and services are
purchased.

ii. In view of the fact that money is stable in value,

durable and always recognized, it can be used as a
payment at future dates.

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Demand for Money
1. Transactionary Motives
People want to hold money to buy goods and services. The amount that
people want to hold for this reason depends on the level of income and it is
not related to interest rate at all. The higher the income received by
individuals, the greater the amount of money that they want to hold for
this purpose. The quantity of money demanded for transaction reason is
positively related with income level.

2. Precautionary motives
For this reason, money is demanded for the emergency or unexpected
circumstances such as accidents, sickness, fire and others. The total money
demanded for this reason is also influenced by the level of income received
and it is not related to interest rate.

3. Speculative Motives
According to Keynes, people also want to hold money to speculate on
securities such as bond and shares. For this reason, the quantity money
depends on interest rate and not influence by the level of income. The
amount of money id held for the purpose of getting profit from the
speculation activities. Generally, speculators will buy more securities when
the prices are low and sell back when the prices are expensive. 10
Types of Money
i. Fiat Money (Coins + Notes)
Both coins and notes are known as ‘fiat money’ as their face value is
greater than their own values.
a. Coins are limited legal tender. It is a limited legal tender as a
certain values of coins can only be used in a limited amount.
b. Coins is also known as ‘token money’ because its face value is
greater than the metallic content of the coins.
c. Paper money is an unlimited legal tender where it can be used
without any limit.

Legal tender means it is made by legal government decree, which

must be accepted as a medium of exchange and in settlements of
debts. Legal tender in Malaysia is Ringgit Malaysia and cent.
This indicates that a Malaysian seller has the right to decline any
payment to him made using other currencies.

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ii. Negotiable Certificate of Deposit (NCD)
It is a receipt for a time deposits places with a commercial bank
or merchant bank. It is negotiable (can be traded). The issuer of
the NCD undertakes to pay principal sum to the bearer on date of
maturity.

iii. Bank Money

It is also known as ‘demand deposit’, ‘bank deposit’, or ‘cheque
deposit’. They are transferable from person to person through the
use of cheques. It is also considered as money since it possess the
functions as a medium of exchange and a store of value.

iv. Near money

This consists of saving deposits and fixed deposits at commercial
banks, Bank Negara Malaysia and other financial institutions.
They are known as near money since they are insufficiently liquid
to be a medium of exchange but it serves the function of store of
value. In order to use it as payment, it has to be converted into
cash (coins and notes ) first.

v. Commodity money
Commodity money is any item that has its own value and is used
as a means of payment. 12
Examples are gold coins, silver coins and cigarettes.
Supply of Money
i) M1 : Narrow money
A narrow definition of money supply is given as M1 and
it comprises of the most liquid assets only. The most
liquid assets are coins, notes and demand deposits
(current account) at commercial banks. They are the
most liquid assets since they can be used as payments
and settlements of debts directly without any
conversion.

M1 = FIAT MONEY + CHECKABLE DEPOSITS

*Fiat money also known as currency in circulation

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Supply of Money cont..
ii) M2 : Near Money + M1
This is slightly broad definition of money supply as it includes some
less liquid assets. It comprise of M1 and also savings and fixed
accounts at commercial banks and Bank Negara Malaysia,
negotiable bills and Bank Negara Malaysia’s certificates. These
assets serve the function as a store value and part of our wealth but
they are said to be less liquid as they need to turn into cash first
before can be used as medium of exchange. They can be converted
easily and do not take long to do it. That is why they are also
labeled as ‘narrow near money’ because this is just a narrow
measurement of near money.
M2 = M1 + NARROW NEAR MONEY
OR
M2 = M1 + (SAVINGS & DEPOSITS IN COMMERCIAL BANKS + NCD
+REPO + BNM CERTIFICATES)
NEAR MONEY (Quasi Money) = M2 – M1
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Supply of Money cont..
iii) M3 : Broad Money
This is a broad definition of money. M3 includes all the
M2 money supply plus saving and fixed deposits at
other financial institutions, merchant bank and
discount houses. These savings and fixed deposits at
other institutions are part of near money, as they need
to be converted into cash too, before it can be used to
make payment or settling debts.

M3 = M2 + (SAVINGS & DEPOSITS IN OTHER

BANKING INSTITUTIONS)

BROAD NEAR MONEY = M3 – M1

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Supply of Money cont..
RM Million

M3

M2
Deposits
M1 Narrow Quasi Money Placed in
other
Banking
Currency In Demand Saving Fixed Foreign Institution
Circulation Deposits Deposits Deposits NIDs Repos Currency s
Deposits

44,931.8 158,064.0 102,914.4 438,151.5 22,141.5 1,885.5 54,284.0 29,196.0

Sources: Monthly Statistical Bulletin January 2010

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Monetary Theory
Money Supply and
Price Level (Fisher’s Equation)
Any changes in the total money supply in an economy
will produce the same rate of changes in general price
level
Assumption:
I. Money is demanded for transaction purpose only,
II. The economy is always at the full-employment level
III. The volume of goods and services produced/exchanged and
the velocity of circulation of money are constant

17 17
Money Supply and
Price Level (Fisher’s Equation)

 Produce by American Economist named Irving

Fisher
The speed with which
Called as Fisher’s equation MONEY whizzes
around the economy, or
MV = PT the number of times it
changes hands.
 M = Total money supply in economy
 V = velocity of circulation of each money in economy
 P = general price level that also reflect the rate of
inflation in economy
 T = volume of goods and services produced / exchange/
purchased @GDP@ the number of transaction in
economy

18 18
Money Supply and
Price Level (Fisher’s Equation)
 Total money supply, M is presumed to be
controlled by the Central Bank
 If V is 5 times, means average every money is
used for 5 times or transaction during that year
 V & T Fisher assume constant because
economy have achieved full-employment level
MV means total expenditure in the economy
PT means total value of national output
Therefore, MV = PT means

Total expenditure in economy = Total value of national output

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Money Supply and
Price Level (Fisher’s Equation)

Lets go through the following example:

 Suppose:
Money supply = RM 80 million
Price level = RM 5.00
Velocity of circulation = 4 times
 Determine the quantity of output, T
 If there is an increase in the money supply by 6%,
determine the new amount of money supply
 What happen to the price level? Determine the new
price level.
 Determine the rate of changes in the price level
above. What is your conclusion?
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The Financial System
The Financial System

Banking Non-Bank Financial Non-Bank Financial

Institutions Institutions Intermediaries

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Banking Institutions
i) Central bank
Owned and controlled by the government. The
central bank in Malaysia called the Bank Negara
Malaysia.

ii) Commercial banks

Is a firm ( a profit making institutions) with a
charter from the government to engaged in the
business of banking

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Non-Bank Financial Institutions
i. Finance Companies
Provides loans for the purchase of vehicle and also the purchase of
properties. The services provide by banking institutions and finance
companies are similar except finance companies do not issue cheques.
ii. Islamic Banks
Banking system that is based on Syariah principles. It does not allow
the paying and receiving of interest since Islam prohibits Riba’and
promotes profit sharing.
iii. Merchant Banks
Do not accept deposits from the public. They provide support services
and advice to firms, financial management and portfolio management.
iv. Discount Houses
the function is to provide short-term loans in the financial market.
Discount houses receive loans with lower rates of interest from
financial institutions and supply loans to the public at a higher rate of
interest and obtain profits.

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Non-Bank Financial Intermediaries
i. Development financial institutions
Institutions set up by the government to promote
investments in the industrial and agricultural sectors.
Its main function is to provide loans and financial
assistance to firms and also farmers.

ii. Employees Provident Fund (EPF)

Design for the benefit of employees. The employees and
employers contributes a certain percentage of the
income to EPF each month.

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Central Bank
Established on January 1959 under the Central
Bank of Malaya Ordinance and the Banking
ordinance 1958.
It is owned and controlled by the government .

Responsible to manage the country’s financial

activities and financial bodies in order to
maintain economic stability and prosperity in the
country.

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Functions of Central Bank
i) To issue currency and to safeguard the external value of the
currency
The central bank has been issuing currency since 1967. it also helps to safeguard
the value of the currency.

ii) Banker to the government

The central bank keep the governments principle’s bank account, receive tax and
other revenue and makes payments with respect to government expenditures. Act
as source of financing for the federal government.

iii) Banker to the banks

The central bank performs several function as to keep cash reserves of commercial
banks in the economy and thus acts as a custodian of the reserves of the country
which supports its credit and banking system.

iv) Promotes monetary stability of the country

Responsible in achieving monetary stability, control of credit and hence money
supply as an essential condition for continued growth. The central bank uses
quantitative and qualitative measures to ensure monetary stability.

v) Holder of the country’s stock of gold and foreign currency reserves

The central bank manages the nation’s foreign exchanges reserves, implements the 26
government exchange rate and balance of payment policy .
Commercial Banks
A commercial bank is an institutions that is owned by
the private sector and it is profit-making institutions.

Banks earns their income from providing banking

services such as opening current account and savings
account. A commercial earns the most profits from
loans and investment.

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List of Commercial Banks in Malaysia
1. ABN Amro Bank Berhad 18. OCBC Bank (Malaysia) Berhad
2. Bank of America Malaysia Berhad 19. Public Bank Berhad
3. Affin Bank Berhad 20. RHB Bank Berhad
4. Alliance Bank Malaysia Berhad 21. Southern Bank Berhad
5. AmBank (M) Berhad 22. Standard Chartered Bank Malaysia
Berhad
6. Aseambankers Malaysia Berhad
23. The Bank of Nova Scotia Berhad
7. Bangkok Bank Berhad
24. United Overseas Bank (Malaysia)
8. Bumiputra-Commerce Bank Berhad Berhad
9. Bank of China (Malaysia) Berhad 25. Bank Islam Malaysia Berhad
10. Bank of Tokyo-Mitsubishi UFJ 26. Bank Muamalat Malaysia Berhad
(Malaysia) Berhad
27. RHB ISLAMIC Bank Berhad
11. Citibank Berhad 28. Commerce TIJARI Bank Berhad
12. Deutsche Bank (Malaysia) Berhad 29. Hong Leong Islamic Bank Berhad
13. EON Bank Berhad 30. Kuwait Finance House (Malaysia)
14. Hong Leong Bank Berhad Berhad
15. HSBC Bank Malaysia Berhad 31. Affin Islamic Bank Berhad
16. J.P. Morgan Chase Bank Berhad 32. EONCAP Islamic Bank Berhad
17. Malayan Banking Berhad 33. AmIslamic Bank Berhad 28
Functions ( Roles ) of
Commercial Bank
1. Accepting deposits from customer
2. Providing loans and advances
Direct loans, overdraft, discounting of bills
3. Providing other banking services & facilities
Facilitating foreign exchange transaction
Issuing bank drafts, cheques and traveller’s cheque
Purchasing or selling stock exchange securities
Enabling fund transfers from one place another
Providing advice on financial matters
Providing Automated Teller Machine (ATM)

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Credit Creation
 Credit creation is the process where a small given deposit
will lead to a greater increase in the money supply of the
economy.
Assumption:
i) Cash ratio is fixed by the central bank and its value is
constant
ii) Banks do not keep excess cash reserves
iii) The public must keep their money in the bank
iv) Leakages does not exist
v) Bank’s asset are only in the form of cash and loans
vi) Bank has only one liability (deposits)
vii) Deposits are only in the form of current deposites (only
cheque)
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Process of Credit Creation
Assume a customer, deposits RM1,000 in Bank XYZ

Balance Sheet: Bank XYZ

Asset Liability

Cash (10%) RM100 Deposits RM1000

Loans (90%) RM900

Total RM1000 Total RM1000

*Assume Bank’s Legal Cash Requirement is 10% 31

Process of Credit Creation
Then, Bank XYZ will loan RM900 to another person

Balance Sheet: Bank XYZ

Asset Liability

Cash (10%) RM90 Deposits RM900

Loans (90%) RM810

Total RM900 Total RM900

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32
Process of Credit Creation
Again, the bank will loan out RM810 to another customer

Balance Sheet: Bank XYZ

Asset Liability

Cash (10%) RM81 Deposits RM810

Loans (90%) RM729

Total RM810 Total RM810

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Process of Credit Creation
Formula:
Cash Ratio = Cash Reserve x 100%
Initial Deposits
Money Multiplier = 1
Cash Ratio
Total Money Supply = Money Multiplier x Initial Deposits

Total Reserves = Money Multiplier x Initial Reserves

Total Credit Creation = Money Multiplier x Initial Loan

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34
 Monetary Policy
 Is a government policy on money supply and
credit creation and aimed at achieving higher
economic growth, stability in prices and full
employment
Types of monetary policy:
i) Contractionary or tight monetary policy
ii) Expansionary monetary policy

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Tools of The Monetary Policy
Tools of The Monetary Policy
Quantitative Qualitative
Instruments Measures

36
Quantitative Instruments
i) Discount rate (Interest on Loan/Cost of Borrowing)
This refers to interest rate that the central bank charges on
loans of reserves to banks. If the central bank increase its bank
rate, the interest rate on borrowing becomes more expensive
and this will lead to decrease in demand for loan. Thus, it will
lead to decrease in money supply in the economy.

ii) Open market operation

Buying and selling government securities by the central bank
to influence cash reserves in commercial bank. To increase the
money supply in the economy, the central will buying the
securities from the commercial bank and other financial
institutions. This will raise the commercial reserves and will
push the interest rate to fall. When interest rate fall, it will
encourage demand for loan from the public . Hence, will
increase money supply in the economy.
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iii) Legal reserve requirement
This refers to reserve ratio set by the central bank. Minimum legal
cash ratio requirements affects the total amount of the reserves of
commercial banks. To increase money supply, the government
should reduce the ratio so that commercial bank does not have to
keep a lot of deposit. This is also to increase the amount of money
being lend out to the public.
iv) Interest rate (Interest on saving)
This is refers to interest rate on saving. The central bank will
persuade the commercial bank to decrease their interest rate for
saving during recession which will discourage public from keeping
their money in the bank and increase consumption on goods and
services. This is done to influence money supply in the economy.
v) Funding
This is refers to conversion of short term loan to long-term loans.
The objectives is to lengthen the payment of the principle sum so
that the bank cannot create multiple credit. This is to reduce cash
reserve in the commercial bank and hence will reduce demand for
loan from the public. This will lead to decrease in the money supply 38
in the economy.
Qualitative Measures
i) Selective Credit Control
This measures enable central bank to restrict unhealthy expansion
of credit for specific purposes. During inflation, the banking system
can control through hire purchase restriction.

ii) Special Directives

This is to reduce the volumes of loans given to the public. Central
bank also influence commercial bank to restrict their lending policy
such as the need for collateral security, guarantors which will lead to
decrease in the demand for loan. Thus will decrease money supply
in the economy. This measures is used to curb inflation problem.

iii) Moral Suasion

Usually the central bank will persuade the commercial bank to
restrict their lending policies in times of inflation.
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Islamic Bank
 Bank Islam Malaysia Berhad (known as Bank Islam)
is a new milestone in the evolution of the banking
system in Malaysia which coming into effect under
the Islamic Banking Act, 1983 on March 11, 1983 to
provide for the establishment of the Islamic Banks in
the country.

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Islamic Financial Products:
i) Al-Mudharabah
ii) Al-Murabahah
iii) Al-Musyarakah
iv) Al- Bai Bithaman Ajil
v) Al-Ijarah
vi) Al-Takjiri
vii) Al-Qardhul Hassan
viii) Al-Wakalah
ix) Al-Kafalah
x) Al-Wadiah

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