Unit 1

Money and Banking

-Nature, function, and significance of money
-Demand and supply of money
-Quantitative theory of money
-Inflation and its control
-The impact of money on inflation and
unemployment
 History
The system of commodity money eventually evolved
into a system of representative money after barter
system.
This occurred because gold and silver merchants or
banks would issue receipts to their depositors
redeemable for the commodity money deposited.
Eventually, these receipts became generally accepted
as a means of payment and were used as money. Paper
money or banknotes were first used in China during
the Song Dynasty.
These banknotes, known as "jiaozi", evolved from
promissory notes that had been used since the 7th
century. However, they did not displace commodity
money, and were used alongside coins.
 History
Banknotes were first issued in Europe by Stockholms
Banco in 1661, and were again also used alongside
coins.
The gold standard, a monetary system where the
medium of exchange are paper notes that are
convertible into pre-set, fixed quantities of gold,
replaced the use of gold coins as currency in the 17th-
19th centuries in Europe.
These gold standard notes were made legal tender, and
redemption into gold coins was discouraged.
By the beginning of the 20th century almost all
countries had adopted the gold standard, backing their
legal tender notes with fixed amounts of gold.
 History
After World War II, at the Bretton Woods
Conference, most countries adopted fiat
currencies that were fixed to the US dollar.
The US dollar was in turn fixed to gold. In 1971
the US government suspended the convertibility
of the US dollar to gold.
After this many countries de-pegged their
currencies from the US dollar, and most of the
world's currencies became unbacked by anything
except the governments' fiat of legal tender and
the ability to convert the money into goods via
payment.
 Nature
Barter versus Monetary Exchange
-A barter system (with no money) would be
awkward and extremely inefficient.
-Money greases the wheels of exchange and,
thus, makes the whole economy more
productive.
 Nature

What Serves as Money?

Societies have gradually moved from the use
of commodity monies to the use of money
that has no commodity backing at all.
 Definition

The Conceptual Definition of Money

The functions of money:
-Medium of exchange
-Unit of account
-Store of value
Money = whatever serves as the medium of
exchange
 Functions

Money is often defined in terms of the three

functions or services that it provides.
-Money serves as a medium of exchange,
-As a store of value,
-As a unit of account.
 Medium of exchange
Medium of exchange. Money's most important
function is as a medium of exchange to facilitate
transactions. Without money, all transactions would
have to be conducted by barter, which involves direct
exchange of one good or service for another.
The difficulty with a barter system is that in order to
obtain a particular good or service from a supplier, one
has to possess a good or service of equal value, which
the supplier also desires. In other words, in a barter
system, exchange can take place only if there is a
double coincidence of wants between two transacting
parties.
 Medium of exchange

The likelihood of a double coincidence of wants,

however, is small and makes the exchange of goods
and services rather difficult.
Money effectively eliminates the double coincidence
of wants problem by serving as a medium of
exchange that is accepted in all transactions, by all
parties, regardless of whether they desire each
others' goods and services
 Store of value
Store of value. In order to be a medium of
exchange, money must hold its value over time;
that is, it must be a store of value. If money could
not be stored for some period of time and still
remain valuable in exchange, it would not solve
the double coincidence of wants problem and
therefore would not be adopted as a medium of
exchange.
As a store of value, money is not unique; many
other stores of value exist, such as land, works of
art, and even baseball cards and stamps.
 Store of Value

Money may not even be the best store of value

because it depreciates with inflation. However,
money is more liquid than most other stores of value
because as a medium of exchange, it is readily
accepted everywhere.
Furthermore, money is an easily transported store of
value that is available in a number of convenient
denominations.
 Unit of account
Unit of account. Money also functions as a
unit of account, providing a common measure
of the value of goods and services being
exchanged.
Knowing the value or price of a good, in terms
of money, enables both the supplier and the
purchaser of the good to make decisions
about how much of the good to supply and
how much of the good to purchase.
 Forms of Money
1.Commodity Money: Money that is inherently
valuable, e.g., Gold & Silver
2.Paper Money: Initially paper money used to be
convertible into an equivalent amount in precious
metals. More recently, no such convertibility : fiat
money.
3.Checkable Deposits: Convenient, Safe & Useful for
Large Transactions
4.Electronic Money: Debit Cards, Wire Transfers
(FedWire, Clearing House Interbank Payments
System)
Efficient
Concerns about Safety & Security
 How Do We Measure Money

Different Measures of Money Depending Upon

What is Included and What is Not.
Usual Criterion for Qualifying as Money:
Acceptability as Medium of Exchange
 M1

Also known as Narrow Money

Includes
Currency
Travelers Checks
Demand Deposits
Other Checkable Deposits
 M2
Also known as Broad Money
Includes
M1
Small Denomination Time Deposits
Savings & Money Market Deposits
Non-Institutional Shares in Money Market
Mutual Funds
Overnight Repos
Overnight Eurodollar Deposits
 M3
Includes
M2
Large Denomination Time Deposits
Institutional Shares in Money Market Mutual
Funds
Term Repos
Term Eurodollar Deposits
 L
Includes
M3
Short Term Treasury Securities
Commercial Paper
Savings Bonds
Bankers Acceptances
 Significance of Money in modern
economic life
Money occupies a central position in our modern
economy. Money is everywhere and for everything in
the modern economic life.
Money has become the religion of the day in the
ordinary business of life. Every branch of economic
activity in a money economy is basically different from
what it would have been in a barter economy.
Money has created a far reaching effect on all facets of
economic activities; consumption, production,
exchange and distribution, as also on public finance
and economic welfare.
 Significance of Money
Money and Consumption
Money enables a consumer to generalize his purchasing
power. It gives him command over a wide variety of goods.
It enables him to canalize his purchasing power and get
what he wants.
In fact, it is money through its immense purchasing power
that makes a consumer sovereign in a capitalist economy.
The consumers sovereignty can be expressed through
money spending.
Money provides freedom of choice of consumption.
Money and the price mechanism help a consumer to
allocate his income over goods in such a way so that he
derives maximum satisfaction from his consumption.
 Significance of Money
Money and Production
The introduction of money has made present day mass
production possible. Without money, production on a large
scale would be impossible. The benefits of money in
production are as follows
Money has made extreme division of labour possible.
Intensive specialization is necessary for large scale production.
Money is the very essential for modern enterprise.
Entrepreneurs are concerned, while planning their production
activities, with the cost of production and selling prices
together with the resulting profit, all calculated in terms of
money.
 Significance of Money
Money and production-
The use of money enables a producer to concentrate on the
organization of the production process. Money provides a basis for
supporting more complex methods of organizing production.
Money has facilitated borrowing and lending and these are
essential in present day production. Credit is the main pillar of
modern business.
Money is the most liquid and general form of capital which is highly
mobile between different regions and industries.
Money helps the producer to discover through the price
mechanism what buyers want and how much they want, so that he
can produce and supply accordingly. In fact, money has changed the
basic characteristics of production.
 Significance of Money
Money and Exchange.
Money overcomes the difficulties of a barter system of exchange. In a
money economy; it is simple matter to ascertain the market price in terms
of monetary units. Money facilitates trade by serving as a medium of
exchange. Thus, rapid exchange in a modern economic system is possible
because of money. Money is the basis of the pricing mechanism through
which economic activities are adjusted.
Money and Distribution.
Money eases the process of distribution of factors rewards like wages,
interests and profits which are all measured and distributed in terms of
money. It is with the help of money that the shares of different factors of
production are properly adjusted. Accounting, receiving and storing of its
share of income by any factor-unit in kind is most inconvenient. Here
money comes to the rescue.
 Significance of Money
Money and Public Finance
In a modern economy, government plays a very important role.
Government receives income in the form of taxes, fees, prices of public
utility services, etc and uses this income for administrative and
developmental purposes.
But the great magnitude of public revenues and public expenditure in a
modern state would become impossible without money.
Further, fiscal devices like public borrowing and deficit financing for
economic development can be adopted only in a monetary economy.
In recent times, the fiscal policy of a government acquired very great
importance in economic life, since economic activities can be regulated
through budgetary operations that are facilitated by the institutions of
money.
 Significance of Money in Economy
Money, thus, plays an important role in the shaping of
the economic life of a country. The growth of money
economy has made the growth of economic liberalism
and, hence, of the present day free enterprise or
capitalists system possible. In fact the pattern of
economic life has changed in accordance with the
changes in the economic progress.
For better performance of an economy, a countrys
monetary system should be operated in such a manner
as to maintain high levels of employment and
avoidance of business fluctuations.
 Demand, Supply, and Equilibrium in
the Money Market
The Demand for Money

The demand for money is the relationship between the quantity of money
people want to hold and the factors that determine that quantity.

Motives for Holding Money

The transactions demand for money is money people hold to pay for goods
and services they anticipate buying.

The precautionary demand for money is the money people hold for
contingencies.

The speculative demand for money, according to John Maynard Keynes, is the
money held in response to concern that bond prices and the prices of other
financial assets might change.
 Interest Rates and the Demand for
Money
Interest Rates and the Demand for Money

The quantity of money people hold for all the motives is

likely to vary with the interest rates they can earn from
alternative assets such as bonds.

When interest rates rise, the quantity of money held falls.

When interest rates fall, the quantity of money held rises.

People can satisfy their transactions and precautionary

demands for money with various combinations of money
and bond funds (or liquid investments).
 Implications of the bond fund
approach
Implications of the bond fund approach are as follows:
A household is more likely to adopt a bond fund
strategy when the interest rate is higher.
People are more likely to use a bond fund strategy
when the cost of transferring funds is lower.
Speculative demand for money depends upon the
expected future price of bonds.
The lower the interest rates, the higher bond prices
and the greater the likelihood that investors will
expect bond prices to fall.
 The Demand Curve for Money

The demand curve for money shows the

quantity of money demanded at each interest
rate, all other things unchanged.
A rise in the interest rate lowers the quantity
of money demanded. A fall in the interest rate
raises the quantity of money demanded.
Other Determinants of the Demand
for Money
Real GDP
The price level
Expectations
Transfer costs
Preferences
Household attitudes toward risk affect money
demand.
Household attitudes toward the importance of
cash balances on hand affect money demand.
 The Supply of Money
The supply curve of money shows the relationship
between the quantity of money supplied and the
market interest rate, all other determinants of supply
unchanged.
The Fed is able to control the total quantity of
reserves in the banking system through open-market
operations.
We assume that the money supply is a fixed multiple
of reserves.
The supply curve of money as a function of the
interest rate is therefore a vertical line.
 Equilibrium in the Market for
Money
The money market is the interaction among
institutions through which money is sup-plied to
individuals, firms, and other institutions that
demand money.
Money market equilibrium occurs at the interest
rate at which the quantity of money demanded is
equal to the quantity of money supplied.
Money market equilibrium can be illustrated
graphically.
 Changes in Money Demand

A decrease in money demand, all other things unchanged,

shifts the money demand curve to the left and results in a
new money market equilibrium with a lower interest rate.
A decrease in money demand means that people want
more bonds and less money thereby driving up the price of
bonds and lowering the interest rate.
An increase in money demand means that people want to
hold more money and fewer bonds thereby driving down
the price of bonds and raising the interest rate.
An increase in money demand causes the money demand
curve to shift to the right resulting in a new equilibrium
with a higher interest rate.
 Changes in the Money Supply
An increase in the money supply shifts the money supply curve to the right
resulting in a new equilibrium with a lower interest rate.

An increase in the money supply gives people more money than they want
and causes them to buy bonds which drives the price of bonds up and the
interest rate down.

A decrease in the money supply shifts the money supply curve to the left
resulting in a new equilibrium with a higher interest rate.

A decrease in the money supply gives people less money than they want and
causes them to sell bonds which drives the price of bonds down and the
interest rate up.

The Fed sells bonds to reduce the money supply and buys bonds to increase
the money supply.
 Quantity theory of money
An economic theory which proposes a positive relationship between changes in
the money supply and the long-term price of goods. It states that increasing the
amount of money in the economy will eventually lead to an equal percentage rise
in the prices of products and services.
The calculation behind the quantity theory of money is based upon Fisher
Equation:

Calculated as:

M .V = P.T
Where:
M represents the money supply.
V represents the velocity of money.
P represents the average price level.
T represents the volume of transactions in the economy.
 QTM
The Theorys Calculations
In its simplest form, the theory is expressed as:

MV = PT (the Fisher Equation)

Each variable denotes the following:
M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services
The original theory was considered orthodox among 17th century
classical economists and was overhauled by 20th-century
economists Irving Fisher, who formulated the above equation, and
It is built on the principle of "equation of exchange":
 QTM (Continue)
The quantity theory of money states that there is a direct relationship
between the quantity of money in an economy and the level of prices of
goods and services sold.
According to QTM, if the amount of money in an economy doubles, price
levels also double, causing inflation (the percentage rate at which the level
of prices is rising in an economy).
The consumer therefore pays twice as much for the same amount of the
good or service.
Another way to understand this theory is to recognize that money is like
any other commodity: increases in its supply decrease marginal value (the
buying capacity of one unit of currency).
So an increase in money supply causes prices to rise (inflation) as they
compensate for the decrease in moneys marginal value.
 Inflation & Control Measures
Inflation -
The overall general upward price movement of goods and services
in an economy (often caused by a increase in the supply of money),
usually as measured by the Consumer Price Index and the Producer
Price Index.
Over time, as the cost of goods and services increase, the value of a
rupee is going to fall because a person won't be able to purchase as
much with that dollar as he/she previously could.
While the annual rate of inflation has fluctuated greatly over the
last half century, ranging from nearly zero inflation to 23% inflation,
the Fed actively tries to maintain a specific rate of inflation, which is
usually 2-3% but can vary depending on circumstances. opposite of
deflation.
 Deflation
Deflation
A situation in which a currency gains value, often
resulting from a decrease in prices.
Many economists believe that deflation is the
result a fall in demand for goods and services,
which causes producers to reduce prices.
This reduces their profits and causes a reduction
in investment, which contributes to a further drop
in demand. Because of this deflationary spiral,
deflation is often associated
with recessions and depressions and has been
known to cause unemployment. It is also called
negative inflation.
 Inflation Control Measures

There are broadly two ways of controlling

inflation in an economy
Monetary measures and
fiscal measures.
 1.Monetary Measures
Monetary measures used to control
inflation include:
(i) bank rate policy
(ii) cash reserve ratio and
(iii) open market operations.
 Monetary Measures (Continue)

Bank rate policy is used as the main instrument

of monetary control during the period of
inflation.
When the central bank raises the bank rate, it is
said to have adopted a dear money policy. The
increase in bank rate increases the cost of
borrowing which reduces commercial banks
borrowing from the central bank.
Consequently, the flow of money from the
commercial banks to the public gets reduced.
Therefore, inflation is controlled to the extent it
is caused by the bank credit.
 Monetary Measures(Continue)
Cash Reserve Ratio (CRR) :
To control inflation, the central bank raises the
CRR which reduces the lending capacity of the
commercial banks.
Consequently, flow of money from commercial
banks to public decreases. In the process, it halts
the rise in prices to the extent it is caused by
banks credits to the public.
 Monetary Measures (Continue)

Open Market Operations: Open market

operations refer to sale and purchase of
government securities and bonds by the central
bank.
To control inflation, central bank sells the
government securities to the public through the
banks.
This results in transfer of a part of bank deposits
to central bank account and reduces credit
creation capacity of the commercial banks.
 2.Fiscal Measures
Fiscal Measures
Fiscal measures to control inflation include
taxation, government expenditure and public
borrowings.
The government can also take some
protectionist measures (such as banning the
export of essential items such as pulses,
cereals and oils to support the domestic
consumption, encourage imports by lowering
duties on import items etc.).
 Money supply impact on inflation
Money supply affects inflation in the longer term, often
with one and two years delay.
There is a strong correlation between monetary growth
and inflation.
Positive correlation, which means that if money supply
increases as inflation is expected to increase, and vice
versa for the reduction.
Central banks are closely watching the growth and size
of the money supply to keep inflation under control.
Central banks buy or sell fixed-income securities
(bonds / treasury bills) in order to influence the money
supply, leading to an increase or decrease in available
cash that can be used for consumption.
 Money supply and Unemployment
Unemployment
Keynesians would advocate an increase in the money
supply (expansionary monetary policy), which would
decrease interest rates, increase spending, increase AD,
increase prices and output, and decrease unemployment.
But monetarists believe that an increase in the money
supply will affect mostly prices, not output. This would raise
inflationary expectations and actually INCREASE nominal
interest rates.
In general, Monetarists believe in fixed money supply
targets, or a "rule" for how much to change the money
supply. Keynesians disagree, and believe in more flexibility
or "discretion", with the Fed adjusting money supply to
respond to economic conditions.
This debate is known as "rules vs. discretion."