Sample Notes: Money and Banking

A2 Level Economics – Topic 9.4: Money and Banking

9.4.1 Definition, Functions and Characteristics of Money

Definition of Money

• Money is any item that is widely accepted as a medium of exchange for goods and services.
• It is used to settle debts, make purchases, and measure value in an economy.

Functions of Money

1. Medium of Exchange – Facilitates trade by eliminating the need for a double coincidence of wants.
2. Unit of Account – Provides a common measure for valuing goods and services.
3. Store of Value – Maintains value over time and can be used in the future.
4. Standard of Deferred Payment – Enables agreements for future payment.

Characteristics of Money

• Durability – Must withstand physical wear and tear.
• Portability – Easy to carry and transfer.
• Divisibility – Can be divided into smaller units for transactions of varying values.
• Uniformity – Each unit must be the same in terms of value.
• Acceptability – Widely accepted by the public.
• Limited Supply – Must be sufficiently scarce to hold value.

9.4.2 Definition of Money Supply

• The total quantity of money circulating in an economy at a particular time.
• Includes:
  • Narrow money: Physical cash + demand deposits
  • Broad money: Includes savings accounts, term deposits, and other liquid assets

9.4.3 Quantity Theory of Money (MV = PT)

Equation:

• M × V = P × T
  • M = Money Supply
  • V = Velocity of circulation
  • P = Price Level
  • T = Volume of Transactions (or Real Output Y)

Assumptions:

• V and T are constant in the short run
• Any change in M leads to proportional change in P

Implication:

• Increase in money supply → inflation if not matched by output growth

9.4.4 Functions of Commercial Banks

1. Providing Deposit Accounts

• Demand Deposits (Checking Accounts) – Allow withdrawals at any time.
• Savings Accounts – Encourage saving with interest but limited withdrawal frequency.

2. Lending Money

• Overdrafts – Short-term borrowing facility linked to current accounts.
• Loans – Fixed-term lending with interest.

3. Holding and Providing Financial Instruments

• Banks hold:
  • Cash – To meet withdrawal demand.
  • Securities – Investments to earn interest.
  • Loans – Income-generating asset.
  • Deposits – Customer funds.
  • Equity – Shareholders’ capital.

4. Reserve Ratio

• Fraction of deposits banks must hold and not lend.
• Tool for managing liquidity and systemic risk.

5. Capital Ratio

• Bank’s capital as a proportion of its risk-weighted assets.
• Protects against loan defaults and insolvency.

Objectives of Commercial Banks

• Liquidity – Ability to meet short-term obligations.
• Security – Ensuring assets are safe and not overly risky.
• Profitability – Generate return on capital.

9.4.5 Causes of Changes in Money Supply in an Open Economy

1. Credit Creation by Commercial Banks

• Banks lend more → increase money supply
• Credit multiplier effect: 1 / reserve ratio

2. Role of Central Bank

• Controls base interest rates and reserve requirements
• Engages in open market operations (buying/selling government bonds)

3. Government Deficit Financing

• Borrowing from central bank → increases money supply

4. Quantitative Easing (QE)

• Central bank buys financial assets to inject liquidity

5. Balance of Payments

• Capital inflows → increase money supply
• Persistent deficits → reduce reserves and money supply

9.4.6 Policies to Reduce Inflation and Their Effectiveness

Monetary Policy Tools

• Increase Interest Rates – Discourage borrowing and reduce spending
• Open Market Operations – Sell bonds to reduce liquidity
• Increase Reserve Requirements – Limit credit creation

Effectiveness Depends On:

• Magnitude and timing of policy
• Public expectations
• Elasticity of money demand
• Existing inflationary pressures

9.4.7 Demand for Money: Liquidity Preference Theory (Keynes)

Motives for Holding Money:

1. Transaction Motive – For everyday purchases
2. Precautionary Motive – Emergencies and uncertainty
3. Speculative Motive – Anticipate changes in bond prices

Interest Rate Relation:

• As interest rates rise → lower money demand for speculative purposes

9.4.8 Interest Rate Determination

1. Loanable Funds Theory

• Interest rate determined by demand and supply of loanable funds
  • Savings (Supply) vs Investment (Demand)

2. Keynesian Theory

• Interest rates determined by liquidity preference and money supply
• Money supply is fixed by central bank
• Equilibrium at point where money demand = money supply