Okay. So today inshallah we'll continue with uh chapter 32. Uh this is still unit number eight. So let me just quickly recap uh some of the important things that we had discussed in our previous class. In our previous class um I talked about the fractional reserve banking system. And I explain to you the historical background, how it existed um in the first place and then how this fractional reserve banking system uh basically leads to the scenario whereby um you have more money in circulation relative to the actual reserve. Okay. When we talk about actual reserve, of course, if we are talking about the context of the goldmith era, the reserve would be in the forms of gold. But if we are talking about the modern context, uh the reserve basically refers to the depositor's money. So among the important characteristics of fractional reserve banking system that we have today, um banks create money through lending. uh in the first place that money does not belongs to the bank. It basically belongs to the depositors but they are making use of the depositors money as a way how to give out loans to other people in order for them to make profits by charging interest on loans. So in other words, when we talk about fractional reserve banking system, um the total amount of new money uh created is no longer uh equal to the amount of um the actual deposits or the actual reserve. Okay? Because the process of creating money through loans that basically will be made through changing the numbers, okay? In your account. So the numbers going to grow larger and larger and larger but the actual money the physical money basically um remain the same. So meaning that the total amount of money in circulation going to be much much larger than the actual amount of real money or the um currency notes and also coins. So in other words when we talk about fractional reserve banking system uh the commercial banks that we have today they are subjected to bank panics or sometimes we call this as bank runs whereby there will be possibility in which whenever the depositors came together at the same time to withdraw their money from the bank the bank may not have enough uh liquidity okay cash money uh to fulfill the withdrawals of the depositors because some of those money might had been used you know by the borrowers because the bank lend out this money. So I uh shared with you few examples of bank panics. You can read um and you can try to Google more about the scenario of bank panics that really happens in the real world. But today what I want to highlight is um the context where we are today whereby the banking system that operates today is based on the fractional reserve banking system. So what is important for us to understand is that the central bank will then have to play a very important role to make sure that they can manage the amount of money supply. So in other words, if the central bank cannot control the amount of money supply, we are saying that the commercial banks, they will definitely going to lend out more and more and more. So therefore the amount of new money created will be much larger and larger and larger and this eventually may lead to inflation in the system in the economy. So the important role of the central bank we discussed this much much earlier functions of the central bank the main role of the central bank is basically to control the money supply and the way how they control the money supply is by using monetary policy. So in the next chapter or unit number nine we're going to discuss about monetary policy in more detail. So the key highlights uh for today's session we want to understand in what way uh the central bank can limit the ability of the commercial banks in creating money. If you are talking about the commercial banks definitely they want to make more more more and more profit and the best way for them to make more profit would be to loan out. Okay? because that is where they're going to charge interest and then that is where they're going to profit they're going to generate their profit. So in a way central bank will have to control the ability of money creation by the commercial banks. And to do that uh there are several ways but for this particular unit uh when we talk about chapter on money creation chapter 32 they try to highlight one of the important um tools of monetary policy in which for the central bank to control the amount of money creation or to control the amount of lending given out by the commercial banks. So specifically here we are talking about a regulation imposed by the central bank that requires all commercial banks to deposit certain amount of reserve with the central bank. So this is basically what we call as reserve requirement or sometimes we also use the word required reserve. So these two are the same things. Okay. Whether you want to call it reserve requirement or required reserve, it basically refers to the same thing. What it means by reserve requirement or required reserve? This is actually a regulation set by the central bank in which every commercial banks that operate you know in the banking system they will have to put aside certain amount of cash money with the central bank. Okay, that's basically a requirement. So that is why sometimes we also call this as statutory reserve requirement. So it's um a legal requirement in which if the banks does not fulfill this reserve requirement there will be certain penalty imposed. So in modern context when we say about a reserve requirement although we are saying that the commercial banks will have to put aside certain amount of money with the central bank it doesn't really mean that they have to send the cash money you know to the central bank. What it means today really is the central bank requires that the commercial banks to hold that cash money or reserve in their own vault. Okay. So for commercial banks for instance they have to make sure that they have enough cash money in their bank to fulfill the reserve requirement. So the reserve requirement how much really that the commercial banks will have to put aside with the central bank depend on two main factors. Okay. Number one, it depends on the amount of deposits that the commercial banks receive from the depositors. So when we talk about consumer deposits here, uh in your textbook they just specify in terms of checkable deposits. So they are just referring to checkable account. Okay. But in the real context uh essentially it covers all the different deposits that the bank has. Remember bank has different kinds of deposits saving account you know current account fixed account in the real context it covers different types of uh deposit accounts but in your textbook they just put it as checkable deposit to make things much simpler. So what it means by this first factor is that the larger the amount of deposits that a commercial bank has the larger will be the amount of reserve requirement that they have to put aside with the central bank. So if we talk about May Bank for instance, May Bank is the largest bank in Malaysia whereby they have huge amount of depositor base. So if we try to compare with a smaller bank for instance bank Moala okay the total amount of deposits from the depositors will be much much smaller as compared to May Bank. So in other words we are saying that may bank because they have much larger amount of deposits deposited by the depositors so they will have to put aside much larger amount as reserve requirement bankalad on the other hand because the depositors base is very small relative to the may bank and the total amount of deposits that they collected from the depositors is much smaller. So meaning that uh you know the amount of reserve requirement uh for bankala will be much smaller. Okay. So in other words we are saying that reserve requirement depends on the total amount of deposits that the bank has. Larger deposits means larger amount to be um to be spare to the central bank you know as reserve requirement and banks which has smaller deposits total amount of deposits meaning that they will have smaller amount of reserve requirement to be fulfilled. So that's number one. Number two, the amount of reserve requirement also depends on reserve ratio. Reserve ratio, this is actually in terms of percentage. Don't get confused between reserve requirement and reserve ratio. Reserve requirement, we are talking about the total amount of cash money. Let's say 2 million for instance that you have to put aside with the central bank. But when we talk about reserve ratio, this basically corresponds to certain rate of percentage set by the central bank. That basically describe out of the total amount of deposits that the commercial bank has, how much will have to be deposited with the central bank. In other words, the way how we calculate our commercial bank reserve requirement or required reserve will depend on these two factors. Number one is the amount of deposits. Okay, in your textbook they just put it checkable deposits. And then the second factor is basically the reserve ratio. So any changes in the amount of deposits that the bank has or any changes in the reserve ratio set by the central bank will definitely also going to affect the amount of required reserve or the amount of reserve requirement. Central bank they may change the reserve ratio depending on the needs and depending on the goals that they have whether to solve problems of recession or inflation. So I'm just coming up with a simple example here. So suppose that let's say we are talking about Maybang. Okay. and May Bank assuming that they have in total the amount of deposits that they have is 100,000 and let us also suppose that the central bank of Malaysia impose a reserve ratio of 20%. Okay, 20% when I convert to decimal 0.2 okay 20%. So knowing that what's the total amount of deposits that may bank has and also what is the amount of reserve ratio imposed by the central bank I can then calculate what would be the amount of required reserve. So when I calculate this this basically going to give me 20,000. So this 20,000 is actually 20% from the total amount of deposits. So may bankang has to put aside has to be ready in cash. Okay. They have to make sure that they have enough cash to fulfill the reserve requirement. What's the amount of reserve requirement? 20,000. So if they do not fulfill this reserve requirement amounting to 20,000 meaning that they will have to be they will they will uh they will be imposed penalty. Okay. Central bank will impose penalty to May Bank. And we also need to understand for a particular commercial banks this amount of deposits here will keep changing every single seconds, every single minutes, every single day because there will be people who going to withdraw their money. Okay, you uh make use of your debit card to purchase something. So the amount of deposits basically decrease. Some other people basically transfer from one account to another account. So um this value basically going to keep changing over the day and therefore the reserve requirement also going to change okay over time. Okay. every single minute, every single day. For the case of reserve ratio, like what I said earlier, uh it depends a lot in terms of uh the policy of the central bank, the goals that they want to achieve. In the context of Malaysia, I mentioned to you earlier, the current rate of the reserve ratio is 2%. Okay, in this my example earlier, I talk about 20%. Where do I get this 20%. 20% because this is coming from your textbook. Okay. But in the context of Malaysia, we are talking about 2%. And that 2% um was the rate imposed effective of uh 2020 year 2020 and it remains at 2% up until today. Prior to 2020, it was set at 3%. Okay. So um it depends on the policy objective of the central bank. This reserve ratio may change um from time to time. So whenever reserve ratio change uh definitely the reserve requirement also going to change and sometimes it's also very important for you to be able to manipulate the formula. So this is the original formula how you calculate the reserve requirement which depends on these two factors. Okay, the reserve ratio and also the amount of deposits. You know sometimes they're just going to give you uh the reserve requirement and then they also going to give you the value of deposits. They're going to ask you to calculate reserve ratio. So you can also calculate what is the reserve ratio if you just rearrange the original formula. So this is the original formula. The one that I have below here is just um rearranging you know the formula so that I can solve for reserve ratio if I know what's the value of required reserve and also checkable deposits. I just want to explain a little bit more in terms of you know how the changes in deposits and also reserve ratio may affect the reserve requirement. So in my example here I'm talking about the effect of changes in the deposits. Okay. In my earlier example I said that the reserve ratio is 20%. And then the total amount of deposits that this particular bank okay a specific bank has is 100,000. So we can calculate the required reserve. When we calculated the required reserve earlier the value is 20,000. So 20,000 or 20% of the total deposits that they have they have to put aside as the reserve requirement with the central bank and if let's say there is an increase in checkable deposits. So if you look at the row above what really happens here I try to describe that the amount of deposits increases and assuming that the reserve ratio remain the same. So what's going to happen to your required reserve? Your required reserve going to increase. Why? Because you are talking about now 20% out of 150,000. So if you multiply 20% with 150,000 that basically going to give you a new required reserve. So meaning that the higher the amount of deposits, the higher the amount of reserve requirement or required reserve. On the other hand, when the amount of deposits hold by a commercial banks become smaller, so what happens to the required reserve or reserve requirement? Reserve requirement basically going to fall assuming that the reserve ratio remain the same. Okay. And then we also described earlier that the second factor that may affect reserve requirement is the reserve ratio. changes in the reserve ratio. So here I give you another example. So this is the original value whereby we have 20% of reserve ratio checkable deposits or the amount of deposits is 100,000. So when we calculate the required reserve it's going to give us 20,000. But if let's say the central bank decided to increase the reserve ratio from 20% to 30%. and assuming that the amount of checkable deposit remain the same. Okay. So if we try to calculate what would be the required reserve, the required reserve will be 30,000 because this 30,000 is basically 30% from the amount of deposits. Okay. So when we want to um analyze the effect of one particular factor normally we just consider setus paribus. So that is why when we want to analyze the impact of changes of the reserve ratio, we just assume that checkable deposit remain the same. Okay. So that we would know really in terms of what's the relationship between reserve ratio and also required reserve. So higher reserve ratio means higher required reserve because the percentage that you have to multiply with your deposits is now much higher than before. On the other hand, if the reserve ratio or if the central bank decided to reduce the reserve ratio from 20% to 10% and when you multiply with the amount of deposits based on this formula here reserve ratio 10% and then you multiply with the 100,000 of deposits that basically going to give you 10,000 which is much lesser than before. So the lower the reserve ratio the lower will be the reserve requirement or required reserve. Another important concept um that we also need to understand earlier we talked about reserve requirement. Okay. So what is reserve requirement? Reserve requirement is the amount of money that you have to put aside with the central bank. And how do you calculate the reserve requirement? Based on the previous formula. Another important concept that we also need to understand is the excess reserve. Excess reserve. When we say excess reserve, it basically refers to the difference between actual reserve and the required reserve. Okay. What it means by actual reserve? This actual reserve basically um describe about the total amount of cash money that the bank has. So this is where um in your textbook they try to explain in the context of balance sheet of a commercial bank. So I have drawn here a simple balance sheet and this balance sheet basically corresponds to a commercial bank. Okay, we are talking about commercial bank. So there are uh assets and also liabilities. For a commercial banks whatever deposits that they receive these are considered to be liability to them because this does not belongs to the commercial bank. the the deposits basically belongs to the depositors. Okay. So bank is liable to pay back whenever the depositors would like to withdraw their money they have to be able to give back that money which have been deposited by depositors. So that is why we consider whatever amounts of deposits received by the commercial banks it will be recorded under liabilities. And then on the asset side okay we have reserve. See this is basically refers to the total amount of cash money that the bank has that the commercial bank has. So for [Music] instance if let's say this particular commercial bank receive an receive an additional deposits amounting to 10,000. Whenever there is an increase in the liability side when we talk about balance sheet it has to be balanced. So meaning that on the asset side it will have to match what you have on the liability side. So when the bank receive 10,000 ringit deposits it will then be recorded under the reserve side uh under the asset side under the reserve amounting to 10,000. So this is the additional amount of cash that the bank receive in the forms of deposits. Okay, in the forms of deposits. So when we talk about actual reserve here, okay, it's basically refers to this value here. Okay, in the balance sheet, in the balance sheet, if you refer to your textbook or if you refer to questions, when they just put here reserve, that basically refers to the actual reserve. This actual reserve refers to cash money. Okay, that the bank has. Where does this cash money comes from? From the deposits, okay, deposited by the depositors. So whenever there is an increase in deposits by 10,000 so this asset side also going to increase by 10,000 meaning that the banks receive cash money amounting to 10,000. So this 10,000 is what we considered as actual reserve. So meaning that if we want to know what is the excess reserve excess reserve is the actual reserve minus the required reserve. Okay. Minus the required reserve. So in your textbook they try to um give uh one example um especially when we want to calculate the required reserve. We had discussed this much earlier. Checkable deposits multiply by the reserve ratio. So in your textbook they give an example of reserve ratio 20% and then deposits is 100,000. So this is actually the same example that we had earlier. Okay, 20% of reserve ratio 100,000 of deposits. So we can calculate the required reserve. Required reserve is 20,000. Okay, required reserve is 20,000. So if we know what is our required reserve, this would be very useful because in order for us to calculate excess reserve, we need to know what is our required reserve first. And what about our actual reserve? The actual reserve because it refers to the amount of deposits that the bank has. So we're just going to assume that whatever the amount of deposits that the bank received okay that remains as a cash money. So therefore it will be recorded under actual reserve or reserve in the balance sheet. So the difference between actual reserve and also the reserve requirement that basically going to give me 80,000. So this 80,000 is what we call as excess reserve. So excess reserve is actually the amount after you put aside the reserve [Music] requirement you have 100,000 of reserve you put aside 20% which corresponds to 20,000 so the remaining 80,000 that is basically what we call as excess reserve. So we are interested to know in terms of how um changes in deposits going to affect our excess reserve as well. Earlier we just tried to describe changes in deposits going to affect our required reserve. Okay, positive relationship. Higher deposits means higher required reserve. But whenever there is an increase in deposits, it also going to affect our excess reserve. Okay? Because why? Because you have to minus 150,000 which is your actual reserve minus the required reserve which is 30,000. that basically going to give you excess reserve 120,000 and this 120,000 is basically much larger than our initial example when your checkable deposit is 100,000. So here what is important we are trying to basically uh describe um that uh changes in deposits the higher the amount of deposits. Okay, the higher the amount of deposits, the higher will be the amount of um required reserve and at the same time that also going to means that your excess reserve also going to increase because now [Music] um you have additional deposits. Okay. So, uh that basically going to explain what happens to your excess reserve. And then if you try to also explain in terms of reserve ratio. Okay. So this is in the context of reserve ratio. Whenever there is a change in reserve ratio from 20% to 30% for instance what happens to your required reserve? your required reserve basically going to increase because you have to put aside 30% much larger than before which was 20%. But in the context of excess reserve your excess reserve going to fall. Why? Because we assuming that checkable deposit remain the same here. Okay. When we change or when we want to analyze the impact of changes in reserve ratio we're just going to assume that deposits remain the same. So meaning that required reserve going to increase from 20,000 to 30,000 but the excess reserve basically going to fall because you are talking from the same amount of actual reserve here. So actual reserve is 100 you minus the required reserve now is 30,000. So basically that means your excess reserve will become 70,000. So the relationship whenever there is a change in required reserve that basically going to leads to a much smaller excess reserve. So far we are yet to explain why this excess reserve is very important. Okay, we'll come to that after this and but so far we try to understand what it means by excess reserve and what would be the impact you know whenever there is a change in the amount of deposits hold by uh each commercial banks and how it going to affect the reserve requirement and also excess reserve and secondly we also try to understand whenever there is a change in reserve ratio how that basically going to affect the reserve require requirement or uh required reserve and also how it going to affect the excess reserve. Okay. So that's relationship is very important. So this slide try to summarize what we had discussed so far. So higher reserve ratio means higher amount of uh required reserve to be deposited with the central bank and higher amount of required reserve means less amount of cash within the commercial banks. Why do you mean less amount of cash within the commercial banks? Because they have to put aside more okay due to much higher reserve ratio. So they have to uh make sure that they fulfill the reserve requirements. So what left for them will be much smaller and what left for the commercial bank is what we call as excess reserve. So the important part here is that when they have much lesser amount of cash okay we are referring to the excess reserve here. When excess reserve falls meaning that the bank will have much lesser amount of cash because some portion will have to be deposited with the central bank. So meaning that they will have much lesser amount of cash to be loan out. Okay. Why this is very important? Because we are saying that the way how commercial banks create money is by giving out loans. The process of money creation under the fractional reserve banking system. How money is being created? By issuing new receipts. Okay. Under the modern context when the banks give out loans which originates from the depositor's money. Okay. It's not belong to them. they are basically just making use of the depositor's money because they know that the depositors may not withdraw at the same time. Okay. So, might as well use the depositor's money to give out loans. So, in the case that people want to uh borrow. So, I'll just make use a portion of what being deposited by uh brother Nafi for instance to be given to um sister Aisha for instance. So when the central bank impose the reserve requirement or when the central bank increase the reserve ratio that means reserve requirement will increase and that also means that the excess reserve left with the commercial banks will become smaller. And this excess reserve is very important because this excess reserve going to explain how much the commercial banks can give out loans. They can't give out more than what they have in terms of excess reserve because if they give out more than their excess reserve meaning that they will not fulfill their reserve requirement. So the maximum amount that they can give out you know as a loans will depend on the amount of excess reserve that they have. So the higher the bank has the excess reserve the more that they can give out loans meaning that the greater um you know for them to uh for them to generate profit by charging interest. Okay. So the more that they loan out the more that they uh will get returns in terms of interest charges and that is where the banks can generate much larger profit. Okay. In the context of conventional banks. So when we say excess reserve become smaller and banks can loan out lesser amount of money. So that basically going to corresponds to much smaller amount of money supply. So in other words, we are saying that the central bank try to control the amount of money supply by changing the reserve ratio or by changing the reserve requirement. Okay, by changing the reserve ratio, it going to affect the reserve requirement. And then changes in uh reserve requirement also going to affect the excess reserve. And whenever there is a change in excess reserve, it's going to affect the ability of the banks to loan out and therefore it also going to affect in terms of the new money that can be created. Okay. So it's very important for you to understand that the process of money creation depends on how much uh the banks can loan out and how much the banks can loan out will depend on the amount of excess reserve that they have.