Money and Banking (Copy)

9.4 Money and Banking

9.4.1 Definition, Functions and Characteristics of Money

Definition: Anything generally accepted as a medium of exchange.

Functions:

• Medium of exchange.
• Unit of account.
• Store of value.
• Standard of deferred payment.

Characteristics:

• Acceptability.
• Durability.
• Divisibility.
• Portability.
• Stability of value.
• Uniformity.

9.4.2 Definition of Money Supply

• Total quantity of money in circulation at a point in time.
• Includes currency in circulation + deposits in banks (varies with measure: M1, M2, M3).

9.4.3 Quantity Theory of Money (MV = PT)

Formula:
M × V = P × T

• M = Money supply.
• V = Velocity of circulation.
• P = Price level.
• T = Volume of transactions.

Implication: If V and T constant → changes in M cause proportional changes in P.

9.4.4 Functions of Commercial Banks

• Providing deposit accounts:
  • Demand deposit account (current account).
  • Savings account.
• Lending money:
  • Overdrafts, personal loans, business loans.
• Holding/providing:
  • Cash, securities, loans, deposits, equity.
• Reserve ratio: Proportion of deposits kept as reserves.
• Capital ratio: Bank’s capital ÷ risk-weighted assets.
• Objectives:
  • Liquidity (ability to meet withdrawals).
  • Security (low default risk).
  • Profitability (earning from loans and investments).

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

9.4.5 Causes of Changes in the Money Supply in an Open Economy

• Commercial banks – credit creation: Banks lend more → deposits multiply via bank credit multiplier:
  k = 1 ÷ reserve ratio.
• Central bank: Controls base money via interest rates, reserve requirements, open market operations.
• Government deficit financing: Borrowing from banks or central bank increases money supply.
• Quantitative easing (QE): Central bank buys financial assets → increases bank reserves.
• Balance of payments changes: Surplus → inflow of foreign currency → higher money supply; deficit → opposite.

9.4.6 Policies to Reduce Inflation and Their Effectiveness

9.4.7 Demand for Money – Liquidity Preference Theory

• Transactions motive: Money for everyday spending.
• Precautionary motive: Money for unexpected expenses.
• Speculative motive: Holding cash to avoid losses when bond prices fall.

Demand for money inversely related to interest rate (higher rates → lower speculative demand).

9.4.8 Interest Rate Determination

Loanable Funds Theory:

• Interest rate determined by demand and supply for loanable funds.
• Demand: Investment, government borrowing.
• Supply: Savings.

Keynesian Theory:

• Interest rate determined by money demand and supply.
• Money supply fixed by central bank; intersection with liquidity preference curve sets rate.

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