Money and Banking (Copy)

9.4.1 Definition, Functions, and Characteristics of Money

• Definition of Money:
  • Any widely accepted medium of exchange used to facilitate transactions.
• Functions of Money:
  1. Medium of Exchange: Facilitates buying and selling, eliminating barter inefficiencies.
  2. Unit of Account: Provides a common measure for valuing goods and services.
  3. Store of Value: Retains purchasing power over time for future use.
  4. Standard of Deferred Payment: Used to settle debts in future payments.
• Characteristics of Money:
  • Durability: Should withstand repeated use.
  • Portability: Easy to carry and transfer.
  • Divisibility: Can be divided into smaller units.
  • Uniformity: Units are identical.
  • Acceptability: Widely accepted.
  • Limited Supply: Scarcity maintains value.
  • Stability of Value: Maintains purchasing power over time.

9.4.2 Definition of Money Supply

• Money Supply:
  • Total stock of money available in an economy at a given time.
  • Includes cash in circulation, demand deposits, and other liquid assets.
• Money Supply Measures:
  • M0: Physical currency and reserves.
  • M1: M0 + demand deposits.
  • M2: M1 + savings deposits and time deposits.

9.4.3 Quantity Theory of Money (MV = PT)

• Equation:
  • M × V = P × T
    where:
  • M = money supply
  • V = velocity of circulation (number of times money changes hands)
  • P = price level
  • T = volume of transactions or output
• Explanation:
  • Assumes velocity and output are constant in the short run, so changes in money supply directly affect price level (inflation).

9.4.4 Functions of Commercial Banks

• Providing Deposit Accounts:
  • Demand Deposit Accounts: Allow deposits and withdrawals on demand (checking accounts).
  • Savings Accounts: Pay interest, limited withdrawal flexibility.
• Lending Money:
  • Overdrafts: Allow temporary spending beyond account balance.
  • Loans: Fixed amounts lent for a period, repaid with interest.
• Holding or Providing:
  • Cash reserves, securities, loans, deposits, and equity investments.
• Reserve Ratio:
  • Portion of deposits banks must hold as reserves, limiting amount available for lending.
• Capital Ratio:
  • Regulatory requirement for capital buffer relative to risk-weighted assets to ensure solvency.
• Objectives of Commercial Banks:
  1. Liquidity: Maintain sufficient cash to meet withdrawals.
  2. Security: Avoid insolvency and protect depositor funds.
  3. Profitability: Maximise returns on loans and investments.

9.4.5 Causes of Changes in Money Supply in an Open Economy

• Commercial Banks as Credit Creators:
  • Through fractional reserve banking, banks create credit by lending more than reserves held.
• Bank Credit Multiplier:
  • The multiple by which deposits can increase based on reserve ratio.
  • Formula: Money Multiplier = 1 ÷ Reserve Ratio
• Role of Central Bank:
  • Controls money supply via monetary policy instruments: open market operations, reserve requirements, interest rates.
• Government Deficit Financing:
  • When government borrows from central bank or commercial banks, increases money supply.
• Quantitative Easing (QE):
  • Central bank buys financial assets to inject liquidity directly into economy.
• Changes in Balance of Payments:
  • Surpluses increase money supply; deficits reduce it due to foreign exchange flows.

9.4.6 Policies to Reduce Inflation and Their Effectiveness

• Monetary Policy:
  • Raising interest rates to reduce spending and borrowing.
  • Effective in demand-pull inflation but less so for cost-push inflation.
• Fiscal Policy:
  • Reducing government spending or increasing taxes to reduce aggregate demand.
  • Politically difficult but effective short term.
• Supply-Side Policies:
  • Increase productive capacity to reduce cost-push inflation.
  • Long term, slow to implement.

9.4.7 Demand for Money: Liquidity Preference Theory

• Proposed by Keynes, money demand depends on:

• Relationship with Interest Rates:
  • Higher interest rates reduce money demand (incentive to invest).
  • Money demand curve slopes downward with respect to interest rate.

9.4.8 Interest Rate Determination

• Loanable Funds Theory:
  • Interest rate determined by supply and demand of funds in financial markets.
  • Supply comes from savings; demand comes from investment.
• Keynesian Theory:
  • Interest rate balances money demand and money supply.
  • Central bank controls money supply influencing interest rates.

Diagrams

Diagram 1: Quantity Theory of Money

M × V = P × T

- If V and T are constant, increase in M causes proportional increase in P.

Diagram 2: Money Supply and Credit Creation

Deposits
↑
|   Deposits created via lending > Reserves held
|   Money Multiplier = 1 ÷ Reserve Ratio
|__________________________→ Time

Diagram 3: Liquidity Preference and Interest Rate

Interest Rate
↑
|
| 
|  
|   
|     Money Demand (Md)
|________________________→ Quantity of Money

Diagram 4: Loanable Funds Market

Interest Rate
↑
|   Savings (Supply of Funds)
|    /
|   /
|  /
| / 
|/______________________ Demand for Investment Funds
|                       
|                        
|__________________________→ Quantity of Loanable Funds

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Economics Full Scale Course