MONEY

MONEY DEFINITION:
The medium of exchange and of repayment is known as money.

FUNCTIONS OF MONEY:
1. Medium of Exchange:
In a barer system a goods or service is exchanged for another goods or service. For example a
fisherman want to buy rice and on the other hand, farmer wants to buy fish. In this case the
fisherman buys rice in exchange for fish and on the other hand, the farmer buys fish in exchange
for rice. In the monetary system the fisherman does not have to find out the farmer selling the rice
and on the other hand, the farmer does not have to find out the fisherman selling fish, all they need
is money only as a medium of exchange.
2. Unit of Account:
For example, 1 horse might equal 100 bushels of wheat, or 200 bushels of apples, or 20 pairs of
shoes, or 10 suits, or 55 loaves of bread, and so on. In a money economy, a person doesn’t have to
know the price of an apple in terms of oranges, pizzas, chickens, or potato chips, as in a barter
economy. A person needs only to know the price in terms of money.
3. Store of Value:
The function we call a store of value is related to a good’s ability to maintain its value over time.
This is the least exclusive function of money, because other goods- for example, paintings, houses,
and stamps—can store value too. At times, money has not maintained its value well, such as during
periods of high inflation. For the most part, though, money has served as a satisfactory store of
value. This function allows us to accept payment in money and to keep that money until we decide
how we want to spend it.

TYPES OF MONEY DEMAND/ THE REASONS OF HOLDING MONEY:

1. Transactions Demand for Money:
The demand for money in order to conduct daily transactions is known as transactions demand for
money. If income increases (or decreases), the transactions demand for money increases (or
decrease).
2. Precautionary Demand for Money:
The demand for money in order to secure the future uncertainty is known as precautionary demand
for money. If income increases (or decreases), the precautionary demand for money increases (or
decrease).
3. Speculative Demand for Money:
The demand for money in order to speculate in the bond or securities markets is known as
speculative demand for money. When interest rate decreases, people sell their bonds or securities,
and this is how their speculative demand for money increases. When interest rate increases, people
buy new bonds or securities, and this is how their speculative demand for money decreases.

MONEY DEMAND:
The sum of transactions, precautionary, and speculative demands for money is known as total
demand for money or simply demand for money. Money demand curve is downward slopping. A
money demand curve shows a negative relationship between interest rate and quantity demanded
for money, which shows that when interest rate increases, the money demand decreases or vice
versa. On the other hand, when income increases, the money demand increases where the money
demand curve shifts rightward or vice versa.

Figure: Money Demand Curve

MONEY SUPPLY:
Money supply is the summation of all money circulated (M2) in in the economy, the broad money.
Money supply curve shows no relationship between interest rate and quantity of money. Money
supply curve is vertical.

Figure: Money Supply Curve

THE COMPONENTS OF MONEY SUPPLY/ THE MEASUREMENT OF MONEY

SUPPLY:
1. Narrow Money/ M1:
M1 = Currency held outside banks [Coins and paper money]
+ Checkable deposits [Deposits on which checks can be written. For example- demand
deposits]
+ Traveler’s checks [Checks used by travelers]
2. Broad Money/ M2:
M2 = M1
+ Savings deposits (Including money market deposit accounts)
+ Small-denomination time deposits [it is an interest-earning deposit with a specified
maturity date]
+ Money market mutual funds [it is an interest-earning account at a mutual fund held by
Individuals. For example- bonds]
MONEY MARKET EQUILIBRIUM:
When the supply of money becomes equal to the demand for money, then it is said that the money
market is in equilibrium. i* is the equilibrium level of interest rate and M* is the equilibrium level
of quantity of money.

Figure: Money Market Equilibrium

THE METHODS TO CONTROL MONEY SUPPLY BY THE CENTRAL BANK:

1. Open Market Operation:
When interest rate decreases, the central bank buys bonds or securities and this is how the money
supply increases. On the other hand, when interest rate increases, the central bank sells bonds or
securities and this is how the money supply decreases. Open market operation is a regular
phenomenon to control money supply.
2. Bank Rate:
Bank rate is the interest rate that a commercial bank provides to some other commercial bank for
taking a loan from that bank. If bank rate decreases, the commercial banks take a lot of loans and
create high credits as well and this is how the money supply increases. On the other hand, if bank
rate increases, the commercial banks take fewer loans and create fewer credits and this is how
money supply decreases.
3. Cash Reserve Ratio:
If cash reserve ratio decreases, then money supply increases through high credit creation. On the
other hand, if cash reserve ratio increases, then money supply decreases through fewer credit
creation.
CREDIT CREATION BY COMMERCIAL BANKS:
Commercial Bank Deposit Cash Reserve Ratio (CRR) Cash Reserve Credit
A 100 20% 20 80
B 80 20% 16 64
C 64 20% 12.8 51.2
D …. …. …. ….
…. …. …. …. ….

Credit = 80 + 64 + 51.2 + ….. = First Term/ (1 – Common Ratio) = 80 / (1 – 0.8) = 400 Tk.
Cash Reserve = 20 + 16 + 12.8 + … = First Term/ (1 – Common Ratio) = 20 / (1-0.8) = 100 Tk.
Deposit = 100 + 80 + 64 + … = First Term/ (1 – Common Ratio) = 100 / (1 -0.8) = 500 Tk.
Liabilities = Deposit = 500 Tk.
Assets = Credit + Cash Reserve = 400 Tk + 100 Tk = 500 Tk.