Money: Characteristics, Supply, and Demand

Money and Banking

Introduction to Money

• Money is an item used to buy and sell goods and services.
• Bank notes and coins (cash) are for small purchases.
• Money in bank deposits is the main form of money and can be transferred via direct debit, credit cards, and smartphones.
• Cryptocurrencies, like Bitcoin, allow online payments without commercial banks, unregulated by central banks, acquired through payment acceptance, purchase, or mining.
• Cryptocurrency value is determined by demand and supply and fluctuates considerably, making its status as true money debatable due to its lack of general acceptance.

The Functions of Money

• The primary function of money is to facilitate the buying and selling of goods and services, coupled with three additional functions.
• Each function possesses a technical designation.
• Money serves as a medium of exchange; goods and services are sold for money, which is then used to purchase other goods and services.
• Money acts as a store of value, enabling people to save for future use.
• Money functions as a unit of account, also known as a measure of value, allowing the value of different items to be compared through prices.
• Money serves as a standard of deferred payment, enabling borrowing, lending, buying, and selling in the future.

The Characteristics of Money

• Money must be generally acceptable.
• This is its most important characteristic.
• The item must be recognisable as money.
• Central banks distinguish their country's notes and coins.
• Money must be portable for easy carrying.
• Money must be divisible into different values.
• Each unit of money must be homogeneous or identical.
• Money must be limited in supply; an unlimited supply would render it valueless.
• Money must not be easy to counterfeit.
• Central banks incorporate special features in banknotes to prevent counterfeiting.

The Money Supply

• The money supply is the total amount of money in an economy, calculated as currency in circulation plus relevant deposits.
• Governments measure the money supply to gain insights into trends in aggregate demand, the state of financial markets, and to guide monetary policy.
• Measuring the money supply is complex due to difficulties in determining what to include.
• Economists define items as money based on their fulfillment of money's functions.
• Governments employ various measures of the money supply because the extent to which items fulfill these functions can vary.
• Narrow money is used as a medium of exchange, including notes in circulation, cash in banks, and balances held by commercial banks at the central bank; this is sometimes referred to as the monetary base.
• Broad money includes items in narrow money along with items that function as a store of value, such as money in savings accounts.

The Quantity Theory of Money

• Aggregate demand influences the money supply, which in turn affects the money supply.
• The quantity theory of money explains how changes in the money supply impact the economy.
• It is based on the Fisher equation: MV = PT (or MV = PY), where:
  • M = money supply
  • V = velocity of circulation
  • P = price level
  • T/Y = transactions or output of the economy
• Both sides of the equation must be equal, representing total expenditure in the economy.
• Monetarists assume V and T are constant, leading to the conclusion that a change in the money supply causes an equal percentage change in the price level.
• Keynesians assert that the equation cannot become a theory because V and T can change with the money supply.

Keynesian and Monetarist Theoretical Approaches

• Keynesians prioritize avoiding unemployment and advocate for government intervention to influence economic activity.
• If left to market forces, there is no assurance an economy will achieve full employment GDP.
• GDP can deviate from full employment levels for extensive periods.
• If high unemployment is present the government can use a budget deficit to increase aggregate demand.
• Governments can assess the needed stimulus to inject into the economy.
• Monetarists prioritize controlling inflation for a government.
• The main role of government is to control the money supply, as inflation is a result of excessive money supply growth.

Functions of Commercial Banks

• Commercial banks, also called high street and retail banks, conduct multiple functions.
• These banks provide deposit accounts for customers:
  • Demand deposit accounts allow easy and quick access, mainly for receiving and making payments.
  • Savings deposit accounts are mainly for saving.
• Commercial banks hold assets like cash, securities, and equities, earning profits primarily through lending.
• Customers may overdraw their deposit accounts within a certain limit.
• Overdrafts can be requested to spend beyond deposit balances, with interest charged.
• Banks provide loans for specific purposes over fixed terms with interest, usually at a higher rate compared to overdrafts.

The Objectives of a Commercial Bank

• Banks have three main objectives to achieve high profits from lending.
  • Profitability
  • An adequate amount of liquid assets to meet customer requests for cash withdrawals are needed to maintain bank liquidity.
  • Liquid assets can be quickly converted into cash.
  • Liquid assets are not very profitable.
• They are secure to ensure they do not go out of business along with convincing customers they are sound
  • Keeping sufficient financial capital to cover riskier loans contributes to the bank's security.
  • Holding a mix of liquid, less profitable assets and profitable, less liquid assets to balance security and profitability is a bank's security.

Causes of Changes in the Money Supply

• The money supply in an open economy can increase through:
  • Increased commercial bank lending
  • Increased government spending financed by borrowing from commercial banks
  • Increased government spending financed by borrowing from the central bank
  • Quantitative easing is the sale of government bonds to private sector financial institutions
  • More money entering than leaving the country

Commercial Banks and Credit Creation

• Commercial banks create money when they lend. Due to bank loans being credited to the borrower's account
• Banks have realized that they only cash a proportion of their deposits.
• People use credit/debit cards and online transfers more when they make payments which involves transferring money using banks records of deposits
• Banks create more deposits then liquid assets.
• Banks must be careful when calculating liquidity ratios to keep
• Keep liquidity ratios must be observed to set by a central bank called a reserve ratio
• The lower the proportion of liquid assets, the more banks can lend however, there is a system risk if they miscalculate.
• Banking relies on customer confidence as customers must believe that their deposits can be paid out even though it is not going to happen.

The Bank Credit Multiplier

• Banks can calculate a bank credit multiplier by estimating what reserve ratio to keep.
• Commercial banks will take reserve ratios into account.
• Advance calculation of bank credit multiplier is possible.

Reserve Ratio

• The bank credit multiplier is 20 where a bank keeps a bank reserve ratio of 5% (100 / 5 = 20).
• Banks can figure out how much it can lend with this knowledge.
• They can determine the possible increase it its total liabilities.
• Multiply the change in the liquid assets with the bank credit multiplier.
• Total deposits can rise by $800 million if the credit multiplier is 20 and has risen by $40 million ($40 million * 20= $800 million)
• Deduct he change in assets from the change in liabilities to calculate the change in the loans.
• This is because the change in liabilities will include deposits to those putting in liquid assets.
• The change in loans can be $760 million since $800 million - $40 million= $760 million in the provided example.
• A bank may not lend as much as the bank credit multiplier suggests.
• This can be due to a credit worthy borrower or from a lack of household and firms who want to borrow.
• There is consequences on a banks liquidity when banks lend to borrowers with poor credit ratings.
• Banks can alter the following when a bank needs to change its reserve ratio.
• People altering proportion of their deposits they require cash
• Other banks altering their lending policies
• The country central bank requires banks to enforce a set reserve ratio.
• A central bank can influence commercial banks to lend.
• Open market operations can be used.
• To reduce bank loans, a central bank will sell government securities.
• Purchasers use commercial banks deposits to pay causing a fall in the banks liquid assets

The Capital Ratio

• The capital ration is a commercial banks capital available expressed as a percentage of its riskier assets.
• Available capital includes retained and newly issued shared.
• 8% of its riskier assets are readily available of accessible capital with a capital ratio of 8%-
• The more a bank has with its capital ratio, the less unexpected losses can occur from going out of business.
• The bank's customers are protected with capital ratios during crises and discourage excessive risk taking for a stable banking sector..

The Role of a Central Bank

• The central bank of a country carries out a range of functions.
  • Issues bank notes and authorises the minting of coins.
• They are commercial banks.
• It also keeps deposits in the central bank.
• It lends to banks that get in financial difficulty ( lender of last resort)
  • The central bank provides financial support to the government.
• Implements monetary policy of government

Government Deficit Financing

• The government has to borrow if spending is more from taxation so the central bank organizes this.
• If the central bank borrows selling securities to non-bank firms and using existing money since purchasers draw from bank deposits.
• Liquid assets resulting from increased government spending = the falling assets as money is withdrawn
• A budget deficit that borrows from commercial banks or the central bank will increase the money supply.

Quantitative Easing

• Central banks purchasing government and private securities to increase the money supply thus stimulating the economy is quantitative easing
• Banks can lend more with liquid assets increasing both the money supply and the short-term as well as long term interest rates.
• Investment and consumer expenditure is increased for economic activity and so also is aggregate demand

Changes in the Balance of Payments

• The total currency flow is regarding total outflow or inflow, coming from international transactions as its recorded in balance of payment sections.
• Trade balance is possible and where export revenue exceeds and where money flows in.
• Multiple increase in the money supply is possible from traders depositing in commecial banks

The Effectiveness of Policies to Reduce Inflation

• Contractionary policies such as fiscal and monetary policy can be used to reduce inflation.
• When cost-push inflation is present, a supply side policy can be used.
• Policies are affected by the following. correct identification of inflation
  • When fiscal and monitary policy are introduced but are less then full employment, the aggregate demand will also fall potentially increasing unemployment but not impact price levels too much.
  • It is often hard to determine whether there is cost-push and demand-pull infaltion Inflation is a mix of both cost-push and demand-pull when under way

Some policy tools help reduce both types of inflation whether short or long run

Explore the key characteristics of money, including acceptability, divisibility, and limited supply. Understand the roles of narrow and broad money, and the impact of income frequency on transactional money demand. Learn about active vs. idle balances and speculative demand related to bond prices and interest rates.