9.4 Money and Banking
Money serves as a medium of exchange, unit of account, store of value, and standard of deferred payment. Its supply is categorized into narrow and broad money. The Quantity Theory of Money (MV=PY) links money supply to price levels. Commercial banks provide vital services like lending and holding deposits, regulated by capital and reserve ratios. They influence money supply through credit creation. Central banks and government policies, such as quantitative easing and deficit financing, also affect money supply. Inflation control policies include monetary and fiscal tools. The demand for money follows Keynes’ liquidity preference theory and is shaped by interest rate theories like the loanable funds model.
9.4 Money and Banking – Long Revision Notes
9.4.1 Definition, Functions and Characteristics of Money
Definition of Money:
Money is anything that is generally accepted as a medium of exchange for goods and services. It serves as the cornerstone of all economic transactions in a modern economy.
Functions of Money:
1. Medium of Exchange – Eliminates the inefficiencies of barter by facilitating buying and selling.
2. Unit of Account – Provides a common measure to value goods and services.
3. Store of Value – Preserves value over time for future use, assuming stable prices.
4. Standard of Deferred Payment – Used for borrowing and lending, allowing contracts in terms of money.
Characteristics of Money:
- Durable: Must withstand physical wear.
- Portable: Easy to carry and transfer.
- Divisible: Can be broken into smaller units.
- Uniform: Identical units have the same value.
- Acceptable: Widely accepted by people and institutions.
- Limited Supply: Not too abundant, which helps maintain value.
9.4.2 Definition of Money Supply
The money supply refers to the total amount of monetary assets available in an economy at a specific time.
Classifications of Money Supply:
- Narrow Money (M1): Includes cash in circulation and demand deposits (checking/current accounts).
- Broad Money (M2/M3): Includes M1 plus savings deposits, time deposits, and other near-money assets.
The central bank controls the money supply through tools such as interest rates, reserve requirements, and open market operations.
9.4.3 Quantity Theory of Money (MV = PT)
This theory explains the relationship between the money supply and the price level in an economy.
Equation: MV = PT (or MV = PY)
- M = Money supply
- V = Velocity of circulation (how often money is spent)
- P = Price level
- T (or Y) = Volume of transactions or real output
If velocity and output are constant, any increase in the money supply leads to a proportional increase in price levels (inflation). This theory is associated with monetarist economists like Milton Friedman.
9.4.4 Functions of Commercial Banks
Key Functions:
1. Accepting Deposits: Offer demand deposit accounts (current), savings accounts, and fixed deposits.
2. Lending Money: Provide overdrafts, personal loans, business loans, mortgages.
3. Investment Services: Hold and manage securities, bonds, and other financial assets.
4. Cash Management: Maintain cash reserves for withdrawals and regulatory compliance.
5. Intermediation: Connect savers with borrowers to promote economic activity.
Key Ratios:
- Reserve Ratio: The percentage of deposits that banks are required to hold in reserve (not lent out).
- Capital Ratio: The ratio of a bank’s capital to its risk-weighted assets, ensuring financial stability.
Objectives of Commercial Banks:
- Liquidity: Maintain enough liquid assets to meet obligations.
- Security: Ensure investments are safe and minimize risk.
- Profitability: Generate income from interest and service fees.
9.4.5 Causes of Changes in the Money Supply in an Open Economy
The money supply can expand or contract due to several internal and external factors:
1. Credit Creation by Commercial Banks: Banks lend more money than they hold due to the fractional reserve system, creating new money.
2. Bank Credit Multiplier: The ratio 1 / reserve ratio shows how much the initial deposit can expand the money supply through lending.
3. Role of Central Bank: Controls the base money through interest rates, reserve requirements, and open market operations.
4. Deficit Financing: When governments borrow from central or commercial banks, money supply increases.
5. Quantitative Easing (QE): Central bank purchases financial assets to inject liquidity into the economy.
6. Balance of Payments Effects: A trade surplus brings foreign currency inflows, increasing money supply; a deficit may reduce it.
9.4.6 Policies to Reduce Inflation and Their Effectiveness
To manage inflation, especially when it’s demand-driven, various policies are used:
- Monetary Policy:
- Increasing interest rates to reduce borrowing and spending.
- Selling government bonds to reduce liquidity in the economy.
- Fiscal Policy:
- Reducing government spending.
- Increasing taxation to lower consumer demand.
- Supply-side Policies:
- Improve productivity and reduce production costs, helping control cost-push inflation.
Effectiveness Depends On:
- The cause of inflation (demand-pull vs cost-push)
- Time lags in policy implementation
- Public expectations
- Coordination between monetary and fiscal authorities
9.4.7 Demand for Money: Liquidity Preference Theory
Proposed by John Maynard Keynes, this theory explains why people hold money instead of investing it.
Three Motives for Holding Money:
- Transaction Motive: Need for money to make everyday purchases.
- Precautionary Motive: Holding money for unexpected expenses or emergencies.
- Speculative Motive: Holding money to take advantage of future investment opportunities or avoid losses in bonds when interest rates rise.
When interest rates are low, people prefer to hold money (liquidity trap), making monetary policy less effective.
9.4.8 Interest Rate Determination: Loanable Funds vs Keynesian Theory
Loanable Funds Theory (Classical):
- Interest rates are determined by the supply of savings and the demand for investment.
- When savings increase, interest rates fall; when investment demand increases, rates rise.
Keynesian Theory:
- Interest rate is determined by the interaction between the demand for and supply of money.
- At lower interest rates, people hold more money (speculative motive); hence, central banks influence rates by changing money supply.
Key Difference:
- Loanable Funds = Real view based on saving/investment
- Keynesian = Monetary view based on money supply/liquidity preference
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