Fundamentals of Economics

MONEY (cont.)

(4) Standard for Deferred Payment
 Money functions as a standard benchmark of future

payments for current purchases, i.e. buying now and
paying later.
 Using money as a standard of deferred payments is a
direct result of the store of value and unit of account
functions.

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KEYNESIAN DEMAND FOR MONEY

(1) Transaction Motives
 People use money as a medium of exchange for

conducting everyday transactions, e.g. paying for food
and transport.
 Money held for transaction motive is directly related to
the level of income.
 The higher the income, the higher the transactions that
can be carried out; hence, the higher the amount
money held for transaction motive.

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KEYNESIAN DEMAND FOR MONEY
(cont.)

(2) Precautionary Motives
 Money is held as a precaution against some

unforeseen events, e.g. paying for the repair of the car,
an emergency or medical bills.
 The level of income will determine the amount held of
this purpose.
 The higher the level of income, the higher the amount
held for precautionary motive.

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KEYNESIAN DEMAND FOR MONEY
(cont.)

(3) Speculative Motives
 According to Keynes, people also hold money to buy

financial assets, e.g. bond and shares.
 There is an inverse relationship between the quantity of

money demanded for speculative purpose and the
interest rate.
 When interest rates rise, the opportunity cost of holding
money will increase; hence, people deposit cash into
bank and reduce speculative balances.

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SUPPLY OF MONEY

 The supply of money is controlled by the central bank.

 The central bank issues the currency and decides the
banking policy on credit creation.

(1) M1: Narrow money

 The most narrowest definition of the supply of money and
it comprises of the most liquid assets.

 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.

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SUPPLY OF MONEY (cont.)

(2) M2: M1 + Near Money
 M2 is a broader and less liquid definition of the money supply.
 M2 functions as a store of value and part of our wealth.
 It can be quickly converted into a medium of exchange, but the

liquidity is lesser than Ml because it needs to be turned into cash first.
 M2 consists of M1 and near money. Near money is also called quasi

money.
 Near or quasi-money are highly liquid financial assets, e.g. saving

deposits, fixed deposits, negotiable certificates or deposits (NCD).

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SUPPLY OF MONEY (cont.)

(3) M3: Broad Money
 M3 is the broadest definition of the supply of money with the

lowest liquidity.
 M3 is used by economists to estimate the entire supply of

money within an economy.
 M3 includes M2 plus savings, fixed deposits in other financial

institutions, merchant banks 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
they can be used to make payment or settling debts.

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SUPPLY OF MONEY (cont.)

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SUPPLY OF MONEY (cont.)

 The intersection of the demand for money, MD, and the supply of
money, MS, determines the equilibrium interest rate.

 At the equilibrium interest rate of i0, the quantity of money
demanded is equal to the quantity of money supplied at M0.

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THE CENTRAL BANK AND ITS
MONETARY POLICY

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(i) Central bank

 Owned and controlled by the government.

 The central bank in Malaysia is called Bank Negara
Malaysia.

 Central bank conducts monetary policy, regulates banks
and issues currency to ensure the financial stability of a
country.

(ii) Commercial banks

 Owned by the private sector.

 They are profit-making institutions with a charter from the
government to engage in the business of banking to
accept deposits and provide loans.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(i) Finance Companies

 Provides loans for the purchase of vehicles and
properties.

 Finance companies provide the same services as
banking institutions except that they do not issue
cheques.

(ii) Islamic Banks
 Islamic banking is conducted based on Shari’ah

principles.

 It does not allow the paying and receiving of interest
since Islam prohibits riba and promotes profit sharing.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(iii) Merchant Banks

 Do not accept deposits from the public as they only
provide support services and advice to commercial
banks, in terms of financial management and portfolio
management.

(iv) Discount Houses

 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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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

Non-bank Financial Intermediaries

(i) Development financial 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 farmers.

(ii) Employees Provident Fund (EPF)

 Provides retirement benefits to employees.

 Each month, employees and employers have to
contribute a certain percentage of income to the EPF
for their retirement.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

The Central Bank and Its Functions

 Bank Negara Malaysia was established in January 1959
under the Central Bank of Malaya Ordinance and the
Banking ordinance 1958.

 It is owned and controlled by the government to manage the
country’s financial activities and financial bodies, in order to
maintain economic stability and prosperity in the country.

(i) Issue currency and to ensure currency stability

 A central bank is the only financial institution with the
authority to issue and manage currency to ensure currency
uniformity and stability.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(ii) Banker and financial adviser to the government
 A central bank keeps the government’s principal bank

accounts, receives taxes and other revenues, and makes
payments in respect of government expenditure.

 It acts as a source of financing for the federal government.

(iii) Overseeing monetary policy

 A central bank supervises money market operations to
ensure low inflation and full employment.

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

 A central bank manages the country’s foreign exchange
reserves and implements the exchange rate system and
the balance of payments policy.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(v) Banker to the banks
 The central bank keeps cash reserves of commercial

banks and acts as a custodian of the reserves of the
country which supports its credit and banking systems.
(vi) Lender of last resort to commercial banks and the
government
 A central bank acts as a lender of last resort to the
banking sector if banks get into liquidity shortages during
a financial crisis.
 The central bank also acts as lender of last resort to
government.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

 Policy used by the central bank to control the supply of
money as an instrument for achieving the ultimate
objectives of the economic policy of price stability or
low unemployment.

(i) Contractionary or tight monetary policy: aims to
decrease money supply and control inflation.

(ii) Expansionary monetary policy: aims to increase
money supply and control unemployment during
recession.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

Tools of the
Monetary Policy

Quantitative Qualitative Measures
Instruments

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

Quantitative Instruments

(i) Open Market Operation

 The central bank buys or sells government securities
and treasury bills in the open market to influence the
size of bank deposits.

 Contractionary open market operation is used to control
inflation by selling securities and treasury bills to the
public to reduce bank deposits and loans of commercial
bank. Money supply will drop, interest rate will rise,
investment will decrease leading to a decrease in
aggregated demand and price level.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

 In recession, expansionary open market operations is
used. The central bank buys securities from the public,
paying them with cheques resulting in an increase of
credit creation and money supply leading to the fall of
interest rate. This will then result in an increase in
investment, aggregate demand and employment.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(ii) Legal Reserve Requirement
 Required reserve ratio is the minimum amount of cash

that the central bank requires all commercial banks to
keep in the central bank. It is to limit the amount of
loans that banks can make to the domestic economy,
thus limiting the supply of money.
 The higher the central bank sets the reserve
requirement, the higher the commercial banks are
required to keep more funds with the central bank, thus
causing less funds the banks can loan out, leading to
lower aggregate demand and price level.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

 In recession, the authorities reduce the required
reserve ratio to encourage an expansion in lending and
deposits. The economic activity is affected and
investment, output and employment level will increase.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(iii) Bank Rate Policy or Discount Rate
 The bank rate or discount rate is the rate of interest which

a central bank charges on the loans and advances to a
commercial bank.
 Changes in the bank rate or discount rate resulting
changes in the market rate of interest and affect the cost of
loan borrowing.
 During inflation, central bank will force the interest rate up
by raising its own lending rate, loan becomes costly to
borrow and public reduce spending. This will reduce
investment and aggregate demand and control price level.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

 During recession, the central bank will reduce the bank
rate. Borrowing loans from commercial banks will be
easier and cheaper, hence boost up the credit creation,
aggregate demand and employment.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

Qualitative Measures
(i) Fixing Margin Requirements
 Margin requirements refers to the proportion of the loan

amount which is not financed by the bank, i.e. the
borrower has to raise the funds of the margin amount in
order to get financing for his purpose. If margin
requirement is reduced, the loan size will be increased
and vice versa. During inflation, the central bank should
increase the margin requirement to discourage public
borrowing. This will lead to a decrease in aggregate
demand and price levels.

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THE CENTRAL BANK AND ITS
MONETARY POLICY (cont.)

(ii) Direct Credit Controls on Bank Lending
 Direct credit controls are used to restrict unhealthy

expansion of some selective credit to control
speculative and hoarding activities within the economy.
During inflation, the central bank restricts unhealthy
expansion of credit through imposing strict regulations.

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COMMERCIAL BANKS AND CREDIT
CREATION

Commercial Bank
A commercial bank is a financial institution which performs
the functions of accepting deposits from the general public
and giving loans for investment with the aim of earning profit.
Banks make their profits by taking small, short-term,
relatively liquid deposits to transform them into larger and
longer maturity loans.

Commercial Banks and Their Functions
(1) Accepting deposits from customers

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COMMERCIAL BANKS AND CREDIT
CREATION (cont.)

(2) Providing loans and advances
 Direct loans, overdraft, discounting of bills

(3) Providing other banking services & facilities
 Facilitating foreign exchange transactions
 Issuing bank drafts, cheques and traveller’s cheques
 Purchasing or selling stock exchange securities
 Providing safe deposit boxes
 Providing credit card facilities and insurance coverage
 Enabling fund transfers from one place another
 Providing advice on financial matters
 Providing Automated Teller Machine (ATM)

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COMMERCIAL BANKS AND CREDIT
CREATION (cont.)

The Credit Creation Process

 Credit creation is the process where a small given
deposit will lead to a greater increase in the money
supply of the economy.

Assumptions:

(i) Cash ratio is fixed by the central bank e.g. at 10%.

(ii) There are many banks in the banking system and
each customer deposits money in different banks.

(iii) Banks only have two types of assets: Cash and loans.

(iv) Commercial banks do not keep excess cash reserves;
all excess reserves are ‘loaned out’ (e.g. 90%).

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COMMERCIAL BANKS AND CREDIT
CREATION (cont.)

(v) All transactions are made by cheques.
(vi) The public must keep their money in the banks and

all deposits are only kept in the form of current
accounts by using only cheques.
(vii) Leakages do not exist as there are no withdrawals
from the banking system.
(viii) Banks have only one liability, that is in the form of
deposits.

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COMMERCIAL BANKS AND CREDIT
CREATION (cont.)

Process of Credit Creation

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COMMERCIAL BANKS AND CREDIT
CREATION (cont.)

Process of Credit Creation

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COMMERCIAL BANKS AND CREDIT
CREATION (cont.)

Limitations of Credit Creation Process
(1) Amount of cash
(2) Cash reserve ratio / legal reserve requirement.
(3) Banking habits of the people
(4) Supply of collateral securities
(5) Availability of borrowers
(6) Excess reserves
(7) Currency drain
(8) Business conditions
(9) Central bank monetary control

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ISLAMIC BANKING PRODUCTS

 Islamic banking is a banking system based on the
principles laid down by Islamic Shari’ah to achieve the
goals and objectives of an Islamic economy.

 The first Islamic bank in Malaysia, Bank Islam Malaysia
Berhad, was established in 1983 under the Islamic
Banking Act, 1983.

 In 1993, commercial banks, merchant banks and
finance companies were allowed to offer Islamic
banking products and services.

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ISLAMIC BANKING PRODUCTS
(cont.)

Islamic Description
Products
Al-Wadiah Wadiah is a trust. Al-Wadiah means goods or deposits which
(Custody and have been deposited with another person or bank as custodian
guarantee) for safekeeping. Bank is the guarantor who guarantees
repayment of the whole amount of the deposits or any
Al outstanding in the account of depositors, when demanded.
Mudharabah Depositors are not entitled to any share of the profits but the
(Profit bank may provide returns to the depositors as a token of
sharing) appreciation.

Contract made between two parties to finance a business
venture, where investor solely provides the capital and bank as
an entrepreneur who solely manages the project. Profit will be
distributed based on a pre‐agreed ratio if the venture is
profitable, however the loss shall be borne solely by the provider
of the capital.

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ISLAMIC BANKING PRODUCTS
(cont.)

Islamic Description
Products
Contract on sale and purchase transaction for the financing of
Al-Bai assets on deferred and installment basis at a pre-agreed payment
Bithaman Ajil period. The sale price includes a profit margin.
(Deferred
payment sale)

Al-Bai Partnership arrangement between two parties or more to finance a
Bithaman Ajil business venture. All parties contribute capital in the form of cash
(Deferred or in kind for the purpose of financing the business venture. Profit
payment sale) will be distributed based on a pre‐agreed profit sharing ratio and
loss will be shared on the basis of equity participation.

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ISLAMIC BANKING PRODUCTS
(cont.)

Islamic Description
Products
Leasing contract whereby a lessor or owner leases out an asset
Al-Ijarah or equipment to his client at an agreed rental fee for a
(Lease or pre‐determined lease period. Lessor is the owner of the leased
rental) equipment.

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13

CHAPTER

PUBLIC FINANCE

LEARNING OUTCOMES

At the end of this chapter, you should be able to:

 Discuss the concepts of public finance

 Discuss the sources of conventional government revenue and
expenditure

 Differentiate between the two types of government expenditures:
operating and development expenditures

 Distinguish between the three types of tax structures: progressive,
proportional and regressive taxes

 Differentiate between the types of government budgets: deficit,
surplus and balanced budgets

 Discuss the types and roles of fiscal policy

 Discuss public finance in Islam

 Describe the sources of Islamic government revenue and
expenditure

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CONCEPTS OF PUBLIC FINANCE

 Public finance is the field of economics that studies the
government actions and the various ways of financing
government expenditure.

Taxes  Subsidies

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CONCEPTS OF PUBLIC FINANCE
(cont.)

Major Functions of Public Finance

(1) Allocation function

 It is the responsibility of the government to provide for public
goods. Public goods, such as national defence, government
administration, judiciary law enforcement, public healthcare
and public infrastructures such as roads, and so on are
different from private goods.

 Public goods are not provided through market mechanism,
but are essential for consumers and are, therefore, provided
by the government. As such, the government has to allocate
its resources between private goods and public goods.

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CONCEPTS OF PUBLIC FINANCE
(cont.)

(2) Distribution function
 Through its tax and expenditure policy, the government

affects distribution of personal income of households in
a manner which is just and fair. As such, it taxes the
rich and spends on schemes which will greatly benefit
the poor.

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CONCEPTS OF PUBLIC FINANCE
(cont.)

(3) Stabilization function

 The economy of a country is affected by economic
fluctuations, such as conditions of boom and
depression. Such changes will benefit some and harm
others.

 In such a situation, appropriate policy measures are
required by the government to affect the levels of
aggregate demand. These measures are called
stabilization measures and are aimed at countering
situations of inflation and unemployment.

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CONVENTIONAL GOVERNMENT
REVENUES

(1) Tax revenue

 A compulsory contribution imposed by the government on
private individuals and organizations to raise revenue to
finance the expenditure on public goods and services. It is
the most important source of government revenue.

(2) Non-tax revenue

 Non-tax revenues are revenues which arise from other
sources besides tax. It includes receipts from licences,
regulation fees and permits, services fees, sales of goods,
interest and returns on investment and fines.

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CONVENTIONAL GOVERNMENT
REVENUES (cont.)

(3) Non-revenue receipts
 Refunds of expenditure, interdepartmental credit,

refunds of overpayment, erroneous payment,
reimbursement and contribution from government
departments, statutory bodies and government-owned
enterprise.

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TYPES OF GOVERNMENT
EXPENDITURES

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TYPES OF TAX STRUCTURES

(1) Progressive Tax All Rights Reserved

 Tax is imposed, so that the 1–11
effective tax rate increases as the
amount to which the rate is
applied increases. This is where
the rate of tax increases as
income increases.

 It imposes a greater portion of tax
on higher income group than the
lower income group. This is the
most effective way of
redistributing income among the
population. This structure is
practised in personal income tax.

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TYPES OF TAX STRUCTURES (cont.)

(2) Proportion Tax
 The rate of tax remains constant as income changes. An

example is the corporation tax.

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