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Lecture - Money Banking and Financial Institutions 1
Lecture - Money Banking and Financial Institutions 1
LECTURE No # 4
Nature &
Functions
Of Money
Terms to know:
Evolution of Money
Definition of money
Functions of money
There was a time when money did not exist,
people used to exchanges goods for goods.
Indivisibility of E D Payments in
Certain Goods the future
Inconveniences of Barter system:
Money
Shells
Live stock
Precious stones
Skulls
Pearls
Wheat
Feathers
Brass
Silver
Gold
Paper money
Stages in the
Evolution of Money
5 stages of Money Evolutions
Evolution Stages
1st
2nd
Commodity
Money Metallic
Money
5th
Near
Money 3rd
4th Paper
Money
Credit
Money
Commodity Money
Lacked in portability
Problem of indivisibility
METALLIC MONEY
PAPER MONEY
Refers to the Notes issued by the State
or by the Bank, usually the Central
bank.
CREDIT MONEY
Defnitions:
Descriptive.
Legal.
General acceptability.
Descriptive Defnitions:
Functions
Functions of
of money
money
The primary
functions of
Medium of exchange
1 money are;
Unit of account
2
Standard of deferred 3
payments
4
Store of values
Primary Functions
The secondary
functions of
1 money are;
Aid to production
Money facilitates 2
to FOP
Money as a tool of 3
monetary management
Money as a instrument 4
of making loan
Secondary Functions
The contingent
functions of
Distribution of 1 money are;
National income
Basis of credit
2
3
Liquidity of property
Contingent Functions
3. Liquidity of property:
Money is convenient form for holding the
wealth. As money can buy any asset at any
time. As well as any assets can be converted
in to money. So money is the most liquid form
of asset.
Money gives a liquid form to wealth. A
property can be converted into liquid form with
the use of money.
CHARACTERISTICS OF GOOD MONEY
General Acceptability.
Stability of Value.
Transportability.
Storability.
Divisibility.
Homogeneity.
Liquid Asset
Assets Liabilities
Government securities Currency in circulation
LIABILITIES
The sum of the CB monetary liabilities; currency in
circulation (C) and reserves (R) is called the
monetary base (MB).
1. Currency in circulation is the amount of currency
in the hands of the (non-bank) public. Currency
held by depository institutions is also a liability of
the CB, but is counted as part of the reserves.
CB’s Balance Sheet
ASSETS
1. Government securities. The CB provides
reserves to the banking system by purchasing
securities. An increase in government securities
(buying) held by the CB leads to an increase in
the money supply.
2. Discount loans. The CB can provide reserves
to the banking system by making discount loans
to banks. An increase in discount loans can also
be the source of an increase in the money
supply. The interest rate charged banks for
these loans is called the discount rate.
Control of the Monetary Base
Reserves -$100
Making a Discount Loan to a Bank
Loans +$90
Bank B Bank B
Loans +$81
Table 1 Creation of Deposits (assuming
10% reserve requirement and a $100
increase in reserves)
Deposit Creation: the banking system
Assumptions:
assume that the desired level of currency
C and excess reserves ER grows
proportionally with checkable deposits D;
in other words, we assume that the ratios
of these items to checkable deposits are
constants in equilibrium:
c = {C/D} = currency ratio
e = {ER/D} = excess reserves ratio
Deriving the Money Multiplier
117
Theories of Demand for money
118
Determinants of demand for
money
119
Determinants of demand for
money
120
The scale and substitution view combined
together have been used to explain the
nature of the demand for money which
has been split into:
1. the transactions demand,
2.the precautionary demand and
3.the speculative demand.
121
The demand for money has been a
subject of lively debate in economics
because of the fact that demand for
money plays an important role in the
determination of the price level, interest
and income.
122
Till recently, there were three approaches
to demand for money, namely,
transaction approach of Fisher, cash
balance approach of Cambridge
economics, Marshall and Pigou and
Keynes theory of demand for money.
However, in recent years, Baumol, Tobin
and Friedman have put forward new
theories of demand for money.
123
FISHER’S QUANTITY THEORY OF
MONEY: THE CASH TRANSACTIONS
APPROACH
124
According to Fisher, “other things remaining the
same, as the quantity of money in circulation
increases, the price level also increases in direct
proportion and the value of money decreases and
vice versa”.
126
According to Fisher, the nominal quantity
of money M is fxed by the Central Bank
of the country and is therefore treated as
an exogenous variable which is assumed
to be given quantity in a particular period
of time.
Further, the number of transactions in a
period is a function of national income;
the greater the national income, the
larger the number of transactions
required to be made.
127
Since Fisher assumed full-employment of
resources prevailed in the economy, the
volume of transactions T is fxed in the
short run.
Because the nominal value of
transactions T is difcult to measure, the
quantity theory was formulated in terms
of aggregate output Y.
128
Velocity of Money
and Equation of Exchange
130
Quantity theory of money
demand
132
The Price of Money
133
The Demand for Money
134
The Demand for Money
– Transactions demand.
– Precautionary demand.
– Speculative demand.
135
Why Hold Money
136
Why Hold money
137
The Keynesian Motives for
Holding Money
138
The Keynesian Motives for
Holding Money
The precautionary motive
People will keep money on hand just in case
some unforeseen emergency arises
• They do not actually expect to spend this
money, but they want to be ready if the need
arises
• Unforeseen contingencies include theft, fire,
accidents, etc
• Precautionary demand for money is a
function of income
139
The Keynesian Motives for Holding
Money
The speculative motive
People relate this motive to the desire to
hold one’s resources in liquid form in
order to take advantage of market
movements regarding the future
changes in the rate of interest (or bond
prices).
This motive is based on the belief that better
opportunities for investment will come along
and that, in particular, interest rates will rise.
140
Money held under speculative motive
serves as a store of value.
Speculative demand for money is
inversely related to the interest rate.
As the interest rate increases, the
opportunity cost of holding cash balances
increases, the incentive will be to move
into securities.
141
If bonds prices are expected to rise
which, in other words, means that the
rate of interest is expected to fall,
businessmen will buy bonds to sell when
their prices actually rise.
If, however, the bond prices are expected
to fall, ie., the rate of interest is expected
to rise, businessmen will sell bonds to
avoid capital losses.
142
The liquidity preference curve
LP
143
Four Infuences on the Demand
for Money
144
Four Infuences on the
Demand for Money
Income
The more you make, the more you
spend
The more you spend, the more money
you need to hold as cash or in your
checking account
Therefore as income rises, so does the
demand for money balances
145
Four Infuences on the
Demand for Money
Interest rates
The quantity of money demanded (held)
goes down as interest rates rise
• The alternative to holding your assets in the
form of money is to hold them in some type
of interest bearing paper
• As interest rates rise, these assets become
more attractive than money balances
146
Four Infuences on the
Demand for Money
Credit availability
If you can get credit, you don’t need to
hold so much money
• The last three decades have seen a unusual
explosion in consumer credit in the form of
credit cards and bank loans
• Over this period, increasing credit
availability has been exerting a downward
pressure on the demand for money
147
Four Infuences on the
Demand for Money
Four generalizations
As interest rates rise, people tend to
hold less money
As the rate of inflation rises, people
tend to hold more money
As the level of income rises, people
tend to hold more money
As credit availability increases, people
tend to hold less money
148
Total Demand for Money
20
18
16
14
12
10
Total demand
8 for money
6
4
2
it can be represented as a 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800
150
Interest Rate (percent per year)
Money Market Equilibrium
Money supply
0 g2 g1
Quantity Of Money (billions of dollars)
151
Liquidity Trap
152
It is termed as liquidity trap by
economists because expansion in money
supply gets trapped in this sphere and
therefore cannot afect rate of interest
and therefore the level of investment.
According to Keynes it is because of the
existence of liquidity trap that monetary
policy becomes inefective.
People do not bother about the size of
money stock.
153
Constraints on Monetary
Stimulus
E1 E2
g1 g2
Quantity Of Money
154