Money

LECTURE No # 4
 Nature &

Functions
Of Money
Terms to know:

Meaning of Barter system

Inconveniences of Barter system

Evolution of Money

Definition of money

Functions of money

Quality of Good Money

 Meaning of Barter:


 There was a time when money did not exist,
people used to exchanges goods for goods.

 Such a system for exchange of goods

without the use of money is called barter.
Or
 The direct exchange of goods for other
goods is called barter.
 Example:

A horse may be exchanged for a cow, or 3

sheep or 4 goats.

 Thus a barter economy is a moneyless

economy. It is also a simple economy
where people produce goods either for
self-consumption or for exchange with
other goods which they want.

 This system found in Primitive

Societies (Simple way living).
 Inconveniences of Barter system

Lack of common measure of values

Lack of double A C Lack of store of

coincidence of values
wants Difficulties
In Barter
system

Indivisibility of E D Payments in
Certain Goods the future
Inconveniences of Barter system:

 Lack of double coincidence of wants:

First difficulty was that… exchange of goods can take place

b/w two persons only if each posses the good which the
other wants.

 Lack of common measure of value:

If incidentally two persons met together who wants each

other goods, they could not find a satisfactory value of their
goods, under such circumstances one party has to suffer.

 Lack of store of value:

Goods cannot be stored for a long time, because their

Value decreases as time passes.
 Inconveniences of Barter system
(continued):

 Payments in the future:

Under the system of barter, it is very inconvenient to lend
goods to other people. With the lapse of time, the value
of the commodities may fall.

 Indivisibility of Certain Goods:

Barter system is based on the exchange of goods with
other goods. It is difficult to fix exchanges rates for
certain goods which are indivisible.
 What is money:

 “Money is the modern medium of exchange

and the standard unit in which prices and
debts are expressed.”
(Prof. Samuelson)
 Money is any material, which is commonly
accepted and generally used as a medium of
exchange for all types of transactions.

 Thus all kinds of currency notes and coins

plus chequing deposits etc. can be regarded
as money
 What is Money

Imagine today’s world without money, how

do you find it?
Don’t you think the ‘Money’ is the greatest
invention of mankind?

 Definitions:
 Descriptive.
 Legal.
 General acceptability.
 Descriptive Definitions:

 Mainly focus on the functions of money and

not what the money is.
 “Anything that is generally acceptable as a
means of exchange and that at the same time
acts as a measure and store of value”.
Crowther, An Outline of Money.
 “Money may be define as a mean valuation and
Payment”.
 “Money is anything that is widely used as mean
of Payments and is generally acceptable in
settlement of debts”.
 Legal Definitions

 Based on “The state theory of money”.

 “Anything which is declared by the state
as money is money”. Professor Knap
 Professor Hartley believes that money
should be legal tender.
- It should be declared by the government of a
country as a mean of payment and people
should be forced to accept it for purpose of
money.
 General Definition

1. Money is anything which is commonly used

and generally accepted as a medium of
exchange or as standard of value. Kent

2. “Doctor Robertson has described money, “as

anything which is widely accepted in payment
for goods or in discharge of other kinds of
business obligations.

3. Money is anything that is generally accepted

in payment for goods and services or in the
repayment of debts. S. Mishkin
 Kinds of money:

Money

Currency Deposit money Near money

OR Credit money (fixed deposits)

Metallic money Paper money

(Coins) (Currency notes)

Full value Token money Convertible Inconvertible

Or Fait money
 Kinds of money (cont’d):

The following is the main classification of money

1. CURRENCY: The money issued by the govt. as
official medium of exchange is called currency.
It is of two types;
I. Metallic money: Metallic money consists of
various kinds of coins.
 In Tanzania, coins of fifty, one, two and five
hundred are the example of metallic money.
II. Paper money: Paper money includes currency
notes issued by the central or state bank of a
country.
 Paper money circulates in the form of notes of
1000, 2000, 5000 and 10000.
 Kinds of money (cont’d):

I. Metallic money is of two types;

a) Full value money: when the face value of a coin is
equal to the value of a metal contained in the coin
(intrinsic value), it is called full-bodied money.
- Non-monetary uses equivalent to monetary value of
the commodity like gold, silver, copper metals,
tobacco, etc
b) Token money (Fait money): when the face value
of a coin is greater than the value of metal it
contains, is called token or fait money.
- Face value> intrincic value.
- Fiat or paper money is made legal tender by the
govt.
 Kinds of money (cont’d):

II. Paper money can be classified into two:

a) Convertible paper money: This type of

money easily converted into the metallic
money or into the gold, if demanded.
b) Inconvertible paper money: Against
such money, the govt. has no promise
to give gold, even if demanded.
 Kinds of money (cont’d):

2) DEPOSIT MONEY or CREDIT MONEY:

 This is the most modern form of money

associated with the development of commercial
banks.
 Demand deposits (current account) in the
banks are called deposit money.

3) Near money: The deposits of the banks which

are not operated through cheques.
 For example; fixed deposits, the govt.
securities, bonds, and saving certificates.
Evolution of Money
 Evolution of Money

 The word “Money” is derived from the Latin word “Moneta”

which was the Surname of the Roman goddess of Juno
in whose temple at Rome, money was coined.
 The type of money in every age depended on the nature of
its “Livelihood”.
 In a hunting society, the Skins of wild animals were used
as money.
 The Pastoral society used livestock, whereas the
agricultural society used Grains and foodstuffs as money
 The Greeks used Coins as money.
Money throughout the history of the world

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 of money

Some of the major stages through

which money has evolved are as
follows:
i. Commodity Money
ii. Metallic Money
iii. Paper Money
iv. Credit Money
v. Near Money or Plastic Money.
Evolution Stages

1st
2nd
Commodity
Money Metallic
Money
5th

Near
Money 3rd

4th Paper
Money

Credit
Money
Commodity Money

 Various types of commodities have been

used as money from beginning of human
civilization,
 Cow Heads, Goats, Axes, skin, Dried Fishes
etc were used as medium of exchange.
 Difficulties in commodity money

 All commodity were not uniform in quality.

 Difficult to store and prevent loss of value.

 Lacked in portability

 Problem of indivisibility
METALLIC MONEY

The next step in the evolution

was the discovery of precious
metals.
 Cont….

 With spread of civilization and trade

relation by land, sea, metallic money
took the place of commodity money.
 Many nations started using Silver, Gold,
Copper, tin etc.. As Money.
 Metal was made into coins of
predetermined weight.
 This innovation is attributed to King
Midas Of Lydia in the eight (8th)
century.
PAPER MONEY
 Cont….

 Paper currency was introduced as a mode

of payment.
 Originated as a receipt issued by
Goldsmiths.
 These receipts were then later on used
for payments.
 Paper money has no natural (intrinsic value),
hence acceptance is backed by guarantees
from a central authority.
 Cont….

PAPER MONEY
 Refers to the Notes issued by the State
or by the Bank, usually the Central
bank.
 CREDIT MONEY

 Includes Bank money (different instruments

offered by the Banks.
 Cheques, Demand Drafts, are examples.
 Convenient, Safe and easily convertible into
cash.
 The assets which can be easily and quickly
transferred into money without loss in value.
 Cannot be used directly for making payment
and is to be converted in to proper money
as and when needed for spending.
 Near Money

 Near Money or non-monetary liquid

assets mainly consist of time deposit,
treasury bills, government securities,
Bills of Exchange.
 The latest form of money is plastic
money in the form of Credit cards and
Debit cards.
 They aim at removing the need for
carrying cash to make transactions.
Functions of money:

Functions of money

Primary Secondary Contingent

function function function
Primary Functions

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

1. Money as a medium of exchange:

 Money acts as a medium of exchange and
helps in overcoming the difficulty in barter
economy.
 In all market transactions, money is used to
pay for goods and services i.e. the sale or
purchase of goods is done through money.

2. Money as a unit of account:

 Money serves as a common measure of value
i.e. the value of goods and services can be
expressed in terms of unit of money.
 Cont….

3. Money as a standard of deferred payments:

 Money is used to make payments in the future
time.
 Money is the only unit of account which is
easy to borrow and easy to lend.

4. Money as a store of value:

 Money also functions as a store of value.
 Money is the most liquid of all assets,
therefore it is, easier to store value
(resources) in the form of money.
Secondary 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

1. Aid to production and trade:

 The market mechanism, production of
commodities and expansion of trade etc.
have all been facilitated by the use of money.

2. Money specialization to FOP:

 All production takes place for the market and
the factors payments (rent, wages,
interest and profits) are made in money.
 Cont….

3. Money as a tool of monetary

management:
 All the monetary progress is done due to
money. Economic policy for achieving growth,
reduce unemployment, favorable balance of
payment only can be achieved through money

4. Money is an instruments of making loans:

 People save money and deposit it in the
banks. The banks advance these savings to
businessmen and industrialists.
 Thus money is the instruments by which
savings are transferred into investments.
Contingent Functions

The contingent
functions of
Distribution of 1 money are;
National income

Basis of credit
2

3
Liquidity of property
 Contingent Functions

Distribution of National income:

 Money facilitates the distribution of
national income among the various
productive and non-productive purpose.
 In the modern world  people join together
to run a business organization.
 Many people contribute their money,
efforts, skills and space etc. 
 When that business organization make
profits, it should be divided as per the
proportion of efforts or skills or money put
in by all those who are involved.
 Basis of credit system:

The present day money (Coins, currency

notes, cheques, bank drafts etc) is a
promise to pay. 
 The modern economy is based on
promise to pay.
 Banks create credit on the basis of their
cash reserves.
 So money can serve as a basis of credit
system. 
 CHARACTERISTICS OF GOOD MONEY

 General Acceptability.
 Stability of Value.
 Transportability.
 Storability.
 Divisibility.
 Homogeneity.
 Effects of money in an economy

 Money affects the level of aggregate

economic activity – an increase in money
supply leads to an increase in the level of
income, prices and employment.
 Decrease in money supply leads to a fall in
aggregate level of income, prices and
employment. With less money, demand for
goods will be reduced.
 Money is a prerequisite for establishing a
highly industrialized economy as it frees the
society from time consuming double
coincidence of wants.
 Effects of money in an economy

 Money is a keystone to establishing a

financial system that allows funds to be
transferred from the surplus (savers) to
deficit spending units (borrowers).
Demand for Money

47
 Theories of Demand for money

 The demand for money arises from two

important functions of money:
money acts as a medium of exchange
and
store of value.
 Thus individuals and businesses wish to
hold money partly in cash and partly in
the form of assets.

48
 Determinants of demand for
money
 What determines the changes in demand
for money is a major issue.
 There are two views:
i. The first is the ‘scale’ view which is related to
the impact of the income or wealth levels
upon the demand for money.
- The demand for money is directly related to the
income level.
- The higher the income level, the greater will be
the demand for money.

49
 Determinants of demand for
money

ii. The second is the ‘substitution’ view

which is related to relative
attractiveness of assets that can be
substituted for money.
 According to this view, when alternative
assets like bonds become unattractive
due to fall in interest rates, people
prefer to keep their assets in cash,
and the demand for money increases,
and vice versa.

50
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.

51
 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.

52
 Till recently, there were three approaches
to demand for money, namely:
1. transaction approach of Fisher,
2. cash balance approach of Cambridge
economics, Marshall and Pigou and
3. Keynes theory of demand for money.
 However, in recent years, Baumol, Tobin
and Friedman have put forward new
theories of demand for money.

53
 Fisher has explained his theory in terms
of his equation of exchange:
MV = PT
 Where, M=the quantity of money in
circulation
V = transactions velocity of
circulation
P = average price level.
T = the total number of transactions.

54
 Fisher has explained his theory in terms
of his equation of exchange:
MV = PT
 Where, M=the quantity of money in
circulation
V = transactions velocity of
circulation
P = average price level.
T = the total number of transactions.

55
 According to Fisher, the nominal quantity
of money M is fixed 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.
56
 Since Fisher assumed full-employment of
resources prevailed in the economy, the
volume of transactions T is fixed in the
short run.
 Because the nominal value of
transactions T is difficult to measure, the
quantity theory was formulated in terms
of aggregate output Y.

57
Velocity of Money
and Equation of Exchange

M = the money supply

P = price level
Y = aggregate output (income)
P  Y  aggregate nominal income (nominal GDP)
V = velocity of money (average number of times per year that a dollar is spent)
PY
V
M
Equation of Exchange
M V  P  Y
58
 Important conclusion

 Nominal income is solely determined by

movements in the quantity of money
- When the quantity of money doubles,
M*V doubles and so must P*Y, the value
of nominal income.

59
 Quantity theory of money
demand

Divide both sides by V

1
M =  PY
V
When the money market is in equilibrium
M = Md
1
Let k 
V
M d  k  PY
Because k is constant, the level of tranactions generated by a
fixed level of PY determines the quantity of M d
The demand for money is not affected by interest rates
60
 The equation above tells us that k is a
constant, the level of transactions
generated by a fixed level of nominal
income PY determined the quantity of
money Md that people demand.
 Fisher’s Quantity Theory suggests that
the demand for money is purely a
function of income and interest rates
have no effect on the demand for money.

61
 The Price of Money

 Foregone interest is the opportunity cost

(price) of money people choose to hold.

62
 The Demand for Money

 The demand for money is the

quantities of money people are willing
and able to hold at alternative interest
rates, ceteris paribus.

63
 The Demand for Money

 Although holding money provides little or

no interest, John Maynard Keynes
noted that people hold money for
three reasons:
– Transactions demand.
– Precautionary demand.
– Speculative demand.

64
The transaction motive

 Individuals have day-to-day purchases

for which they pay in cash or by check
 Individuals take care of their rent or
mortgage payment, car payment, monthly
bills and major purchases by check
 Businesses need substantial checking
accounts to pay their bills and meet their
payrolls
 Transaction demand for money is directly
related to the level of income

65
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

66
 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.

67
 Cont...

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.
68
 Cont...

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.
69
The liquidity preference curve (LP)

70
Four Influences on the demand for
money

 Economists have since identified four

factors that influence the three
Keynesian motives for holding
money
 The price level
 Income
 The interest rate
 Credit availability
1) The price level

 As the price level rises, people need to

hold higher money balances to carry out
day-to-day transactions
 As the price level rises, the purchasing
power of the shilling declines, so the
longer you hold money, the less that
money is worth
 Even though people tend to cut down on
their money balances during periods of
inflation, as the price level rises people
will hold larger money balances
72
2) 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

73
3) 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

74
4) 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

75
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

76
Total Demand for Money
20
18
16
14
12
10
Total demand
8 for money
6
4
2

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800

Quantity of money (in $ billions)

This is the sum of the transaction demand, precautionary demand, and

speculative demand for money shown in the previous slide
77
Total Demand for Money and
the Supply of Money
The interest rate of 7.2 20

percent is found at the 18 M

16
intersection of the total 14
demand for money and 12
the supply of money (M) 10
Total demand
8 7.2%
for money
6

Since at any given time the 4

supply of money (M) is fixed 2

it can be represented as a 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800

vertical line Quantity of money (in $ billions)

78
Interest Rate (percent per year)
Money Market Equilibrium

Money supply

The amount of money

9 demanded (held) depends
on interest rates
E1
7
Money
demand

0 g2 g1
Quantity Of Money (billions of dollars)

79
 Liquidity Trap

 The liquidity trap is the portion of the

money-demand curve that is horizontal.
 People are willing to hold unlimited
amounts of money at some (low) interest
rate.
 It can be seen from the above figure that
the liquidity preference curve LP becomes
quite flat, i.e., perfectly elastic at a very
low rate of interest.

80
 It is termed as liquidity trap by
economists because expansion in money
supply gets trapped in this sphere and
therefore cannot affect 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 ineffective.
 People do not bother about the size of
money stock.

81
 Constraints on Monetary
Stimulus

A liquidity trap can stop interest rates from falling

Demand for money

Interest Rate

E1 E2

The liquidity trap

g1 g2
Quantity Of Money
82
Multiple Deposit Creation and the
Money Supply Process

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

 The Supply of Money

 Money supply is the quantity/stock of

money which is in circulation in a particular
country at a particular time. It can be in form
of currency or bank deposits.
 What is important to note is that, the
components of money supply might differ
from one country to another.
 But what is important to remember is that
everything that composes the money supply
is widely accepted for the purpose of
exchange.
 Components of money
supply
 The major components of money supply
are:
i. Currency in circulation (notes and coins)
ii.Demand deposits.
iii.Saving deposits – deposits at banks and
other non-financial institutions that are
not transferable by check and are often
recorded in a separate pass book kept by
the depositors.
 Cont...

iv. Time deposits – interest bearing

deposits with a specific maturity date.
Before that date they can be used only
if a penalty is paid.
v. central bank reserve notes
vi. traveler’s checks (in some countries)
 Alternative Definitions of Money
Supply

 There are three alternative views regarding

the definitions or measures of money
supply.
1) The most common view is associated with the
traditional and Keynesian thinking which
stresses the medium of exchange function of
money.
 According to this view, money supply is
defined as currency with the public and
demand deposits with the commercial
banks.
 Cont...

 Demand deposits are current accounts of

depositors in a commercial bank.
 They are the liquid form of money
because depositors can draw cheques for
any amount lying in their accounts and
the bank has to make immediate
payment on demand.
 Cont...

 Demand deposits with the commercial

bank plus currency with the public i.e
CC+D are together denoted as M1 , the
money supply.
 This is regarded as the narrower
definition of the money supply.
 Cont...

2) The second definition is broader and is

associated with the modern quantity theorists
headed by Friedman.
 Prof. Friedman defines the money supply at
any moment of time as “literally the number
of shillings people are carrying around in
their pockets, the number of shillings they
have to their credit at banks or shillings
they have to their credit at banks in the
form of demand deposits, and also
commercial bank time deposit
 Cont...

 Time deposits are fixed deposits of

customers in a commercial bank.
 Such deposits earn a fixed rate of
interest varying with the time period for
which the amount is deposited.
 Money can be withdrawn before the
expiry of that period by paying a penal
rate of interest to the bank.
 Cont...

 So time deposits posses liquidity and are

included in the money supply by Friedman.

 -Thus the definition includes M1 plus time

deposits of commercial banks in the supply
of money.
M2=M1+SD+TD
 Here money serves as an alternative asset
to physical capital, bonds and other
financial instruments and it stresses the
store of value function of money.
 Cont...

3) The third function is the broadest/extended

definition and is associated with Gurley and
Shaw.
 They include in the money supply, M2
plus foreign currency deposits.
M3=M2+FCD
 The central monetary authority (like
BOT) has the sole power to determine
the money supply.
 Credit/Deposit Creation

 Because deposits at banks are by far the

largest component of the money supply,
understanding how these deposits are
created is the first step in understanding
the money supply process.
 This lecture provides an overview of how
the banking system creates deposits, and
describes the basic principles of the
money supply.
CREDIT CREATION
 Is the process by which a bank is able to lend
out amounts of a greater magnitude than
the amount they originally received in
deposits or
 Is the process through which commercial banks
create extra credit out of the single amount of
money deposited in a given bank.
 Banks create money supply in the process of
their borrowing from and lending to the public.
 While money created by the CB is called High
power Money (MB), money created by the
comm. Banks in called credit money.
 Four Players in the Money
Supply Process

1. The central bank—the government agency that

oversees the banking system and is responsible for the
conduct of monetary policy.
2. Banks (depository Institutions): the financial
intermediaries that accept deposits from individuals
and institutions and make loans like commercial banks,
savings and loan associations, mutual savings banks,
and credit unions.
3. Depositors:individuals and institutions that hold
deposits in banks.
4. Borrowers: individuals and institutions that borrow
from the depository institutions and institutions that
issue bonds that are purchased by the depository
institutions.
 Four Players in the Money
Supply Process

 Of the four players, the central Bank (CB)

is the most important.

 The CB conduct of monetary policy

involves actions that affect its balance
sheet (holdings of assets and liabilities),
to which we turn now.
CB’s Balance Sheet

Central Bank’s Balance Sheet

Assets Liabilities
Government securities Currency in circulation

Discount loans Reserves

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

 2. Reserves. All banks have an account at the CB in

which they hold deposits.
 Reserves consist of deposits at the CB plus currency
that is physically held by banks (vault cash).
 Reserves are assets for the banks but liabilities for
the CB.
 An increase in reserves leads to an increase in the
level of deposits and hence in the money supply.
 Total reserves can be divided into two categories:
reserves that the CB requires banks to hold (required
reserves) and any additional reserves the banks
choose to hold (excess reserves).
 CB’s Balance Sheet

 For example, the CB might require that

for every shilling of deposits at a
depository institution, a certain fraction
(say, 10 cents) must be held as reserves.
 This fraction (10%) is called the
required reserve ratio.
 In Tanzania the required reserve
ratio is 6%
 Currently, the CB pays no interest on
reserves.
 CB’s Balance Sheet

 The two assets on the CB’s balance sheet

are important for two reasons:
1) changes in the asset items lead to changes in
reserves and consequently to changes in the
money supply.
2) because these assets (government securities
and discount loans) earn interest while the
liabilities (currency in circulation and reserves)
do not, the CB makes billions of money every
year—its assets earn income, and its liabilities
cost nothing.
 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

 The monetary base (high-powered

money) equals currency in circulation C
plus the total reserves in banking system
R.
 The monetary base MB can be expressed
as:
MB = C + R
 The CB exercises control over the
monetary base through open market
operations, and its extension of discount
loans to banks.
Open Market Purchase from a Bank
 Suppose that the CB purchases $100 of bonds from
a bank and pays for them with a $100 cheque.
 The bank will either deposit the cheque in its
account with the CB or cash it in for currency, which
will be counted as vault cash.
1. Net result is that reserves have increased by $100
2. No change in currency
3. Monetary base has risen by $100

Commercial Bank’s Balance Sheet Central Bank’s Balance Sheet

Assets Liabilities Assets Liabilities
Securities -$100 Securities +$100 Reserves +$100
Reserves +$100
Open Market Purchase from
Nonbank Public I
We must look at two cases:
First, let’s assume that the person or corporation sells
$100 of bonds to the CB deposits the check in a local bank.
1. Net result is that reserves have increased by $100
2. No change in currency
3. Monetary base has risen by $100

Commercial Bank’s Balance Sheet Central Bank’s Balance Sheet

Assets Liabilities Assets Liabilities
Reserves +$100 Checkable +$100 Securities +$100 Reserves +$100
deposits
Open Market Purchase from
Nonbank Public II
 Second, the person selling the bonds cashes the CB
check either at a local bank or at the CB for currency
1. Reserves are unchanged
2. Currency in circulation increases by the $100
3. Monetary base increases by the amount of the $100

Nonbank Public Central Bank’s Balance Sheet

Assets Liabilities Assets Liabilities
Securities -$100 Securities +$100 Currency in +$100
circulation
Currency +$100
 Open Market Purchase:
Summary

 If the proceeds from the sale are kept in

currency, the OMO purchase has no effect on
reserves;
 if the proceeds are kept as deposits, reserves
increase by the amount of the OMO purchase.
 The effect of an OMO purchase on the MB,
however, is always the same (the MB increases
by the amount of the purchase) whether the
seller of the bonds keeps the proceeds in
deposits or in currency.
 The impact of an OMO purchase on reserves is
much more uncertain than its impact on the MB.
Open Market Sale
 if the CB sells $100 bonds to an individual who pays
for them with currency,
1. Reduces the monetary base by the amount of the sale
2. Reserves remain unchanged
3. The effect of open market operations on the monetary
base is much more certain than the effect on reserves

Nonbank Public Central Bank’s Balance Sheet

Assets Liabilities Assets Liabilities
Securities +$100 Securities -$100 Currency in -$100
circulation
Currency -$100
 Shifts from Deposits into Currency

 Even if the CB does not conduct OMO, a shift

from deposits to currency will affect reserves in
the banking system.
 Suppose that a person decides to close her
account by withdrawing her $100 balance in
cash and vows never to deposit it in a bank
again.
 The banking system loses $100 of deposits and
hence $100 of reserves.
 the monetary base is unaffected by the person’s
disgust/behaviour at the banking system.
 Shifts from Deposits into Currency

Nonbank Public Banking System

Assets Liabilities Assets Liabilities
Checkable -$100 Reserves -$100 Checkable -$100
deposits deposits
Currency +$100

Central Bank’s Balance Sheet

Assets Liabilities

Currency in circulation +$100

Reserves -$100
Making a Discount Loan to a Bank

 When the CB makes a $100 discount loan to the

First National Bank, the bank is credited with $100
of reserves from the proceeds of the loan.
1. Monetary liabilities of the CB have increased by $100
2. Monetary base also increases by this amount

Banking System Central Bank’s Balance Sheet

Assets Liabilities Assets Liabilities
Reserves +$100 Discount +$100 Discount +$100 Reserves +$100
loans loan
(borrowing from CB) (borrowing from CB)
 Paying Off a Discount Loan from the CB

 if the bank pays off the loan from the CB, thereby
reducing its borrowings from the CB by $100,
 Net effect on monetary base is a reduction
 Monetary base changes one-for-one with a change in the
borrowings from the CB

Banking System Central Bank

Assets Liabilities Assets Liabilities
Reserves -$100 Discount -$100 Discount -$100 Reserves -$100
loans loans
(borrowing from CB) (borrowing from CB)
Deposit Creation: Single Bank

 Suppose that the First National Banks gives a $100 loan

to a borrower who deposited the loan in Bank A.
 If the RRR=10%, the bank can only give loans of the
excess reserves $90.
 If the borrower puts the loan in Bank B, this bank will only
be able to give loans of the excess reserves $81, which
will be deposited in another bank, and so on.
 The checkable deposits would increase so far by the
total amount of $271 ($100 + $90 + $81).
 If all banks make loans for the full amount of their excess
reserves, further increments in checkable deposits will
continue as depicted in Table.
Deposit Creation: The Banking System

Bank A Bank A

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable +$100 Reserves +$10 Checkable +$100
deposits deposits

Loans +$90

Bank B Bank B

Assets Liabilities Assets Liabilities

Reserves +$90 Checkable +$90 Reserves +$9 Checkable +$90
deposits deposits

Loans +$81
Table 1 Creation of Deposits (assuming 10%
reserve requirement and a $100 increase in
reserves)
Deposit Creation: the banking system

 The multiple increase in deposits generated from

an increase in the banking system’s reserves is
called the simple deposit multiplier.
 More generally, the simple deposit multiplier
equals the reciprocal of the required reserve
ratio, so the formula for the multiple expansion
of deposits can be written as:
∆D = (1 / r) × ∆R
 where ∆D = change in total checkable deposits in the banking
system
 r = required reserve ratio (0.10 in the example)
 ∆R = change in reserves for the banking system ($100 in the
example)
 Critique of the Simple Model
 The actual creation of deposits is much less
mechanical than the simple model indicates.
Holding cash stops the process i.e the proceeds
from Bank A’s $90 loan are not deposited but are
kept in cash, nothing is deposited in bank B and the
process on credit creation stops.
 Currency has no multiple deposit expansion
 Another situation ignored is the one in which banks do
not make loans or buy securities in the full amount of
their excess reserves.
 If banks choose to hold all or some of their excess
reserves, the full expansion of deposits predicted by the
simple model of multiple deposit creation does not
occur.
 Critique of the Simple Model

 The CB is not the only player whose behavior

influences the level of deposits and therefore
the money supply.
 Depositors’ decisions (how much currency to
hold) and bank’s decisions (amount of excess
reserves to hold), and borrowers decisions on
how much to borrow also cause the money
supply to change.
 The Money Multiplier

 Because the CB can control the monetary base

(currency in circulation plus total reserves in the
banking system) better than it can control
reserves alone, it makes sense to link the
money supply M to the monetary base MB
through a relationship such as the following:
M = m × MB (1)
 The variable m is the money multiplier, which
tells us how much the money supply changes
for a given change in the monetary base MB.
 The Money Multiplier

 The money multiplier reflects the effect on

the money supply of other factors besides
the monetary base.
 Depositors’ decisions about their holdings
of currency and checkable deposits are one
set of factors affecting the money
multiplier.
 It also involves the reserve requirements
imposed by the CB on the banking system.
 Banks’ decisions about excess reserves also
affect the money multiplier
 Deriving the Money Multiplier

 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

 We begin the derivation of the model of the

money supply with the equation:
R = RR + ER
Where RR=required reserves and ER=excess
reserves.
 The total amount of required reserves equals
the required reserve ratio r times the amount
of checkable deposits D:
RR = r × D
 Deriving the Money Multiplier

 Substituting r × D for RR in the first equation yields

an equation that links reserves in the banking
system to the amount of checkable deposits and
excess reserves they can support:
R = (r × D) + ER
 Because the monetary base MB equals C plus R, we
can generate an equation that links the amount of
monetary base to the levels of checkable deposits
and currency by adding currency to both sides of the
equation:
MB = R + C = (r × D) + ER + C
 Deriving the Money Multiplier

 To derive the money multiplier formula in terms of

the currency ratio c = {C/D} and the excess
reserves ratio e = {ER/D}, we rewrite the last
equation, specifying C as c × D and ER as e × D:
MB = (r × D) + (e × D) + (c × D)
= (r + e + c) × D
 We next divide both sides by the term inside the
parentheses to get an expression linking checkable
deposits D to the monetary base MB:
D = (1 / r + e + c) × MB (2)
 Deriving the Money Multiplier

 Using the definition of the money supply as currency

plus checkable deposits (M = D + C) and again
specifying C as c × D,
 M = D + (c × D) = (1 + c) × D
 Substituting in this equation the expression for D
from Equation 2, we have:
M = ((1 + c) / (r + e + c)) × MB (3)
The money multiplier m is thus:
m = (1 + c) / (r + e + c) (4)
 The ratio that relates the change in the money supply
to a given change in the monetary base is what is
called money multiplier (m).
 Deriving the Money Multiplier

 As you can see, the ratio that multiplies

MB is the money multiplier that tells how
much the money supply changes in
response to a given change in the
monetary base (high-powered money)
 Intuition Behind the Money
Multiplier

 Given the following information

 r = required reserve ratio = 0.10
 C = currency in circulation = $400 billion
 D = checkable deposits = $800 billion
 ER = excess reserves = $0.8 billion
 M = money supply (M1) = C + D = $1,200 billion

 From these numbers we can calculate the values for

the currency ratio c and the excess reserves ratio e:
 Intuition Behind the Money
Multiplier
 c = $400 billion / $800 billion = 0.5
 e = $0.8 billion / $800 billion = 0.001
 The resulting value of the money multiplier is:
m = (1 + 0.5)/(0.1 + 0.001 + 0.5)
= 1.5 / 0.601 = 2.5
 The money multiplier of 2.5 tells us that, a $1
increase in the monetary base leads to a $2.50
increase in the money supply (M1).

 Note that although there is multiple expansion of

deposits, there is no such expansion for currency.
 Money Supply Responses to
Changes in the Factors

 Changes is r. If r increases banks must contract

their loans, causing a decline in deposits and hence
in the money supply.
 The reduced money supply relative to MB, indicates
that the money multiplier has declined as well.
 when r increases from 10% to 15%, m becomes:
 m = (1 + 0.5)/(0.15 + 0.001 + 0.5) = 2.3
 The money multiplier and the money supply are
negatively related to the required reserve ratio r.
 Money Supply Responses to
Changes in the Factors

 Changes in c.
 what happens to m when depositor behavior causes
c to increase?
 When checkable deposits are being converted into
currency, there is a switch from a component of the
money supply that undergoes multiple expansion to
one that does not.
 Suppose that c rises from 0.50 to 0.75. The money
multiplier then falls from 2.5 to:
 m = (1 + 0.75)/(0.1 + 0.001 + 0.75) = 2.06
 The money multiplier and the money supply are
negatively related to the currency ratio c.
 Money Supply Responses to
Changes in the Factors

 Changes in e.
 When banks increase their holdings of excess
reserves relative to checkable deposits, banks will
contract their loans, causing a decline in the level of
checkable deposits and a decline in the money
supply, and the money multiplier will fall.
 Suppose that e rises from 0.001 to 0.005.
 m = (1 + 0.5)/(0.1 + 0.005 + 0.5) = 2.48
 The money multiplier and the money supply are
negatively related to the excess reserves ratio e.
 The M2 Money Multiplier

 The derivation of a money multiplier for the M2

definition of money requires only slight modifications
to the analysis in the chapter. The definition of M2
is:
 M2 = C + D + T
 where
 T = time and savings deposits (t.D)
 We assume that t = T/D,
 M2 = D + (c × D) + (t × D)
= (1 + c + t) × D
 Money Supply Responses to
Changes in the Factors

 Substituting in the expression for D from Equation 2

in the chapter,1 we have
 M2 = ((1 + c + t)/(r + e + c)) × MB
 Suppose that t = 3
 m2 = (1 + 0.5 + 3)/(0.10 + 0.001 + 0.5) = 7.5
 Limitations of Credit Creation

 There may be leakages of cash outside

the banking system eg some money lent
out may not be re-deposited into the banking
system.
 Nature of customers demand for loans ie
customers may not be willing to borrow at
the interest rates that the banks would
charge.
- If the interest rates on borrowing are
excessively high, the demand for loans may
be low and hence the ability of banks to
create credit is limited.
 Limitations of Credit Creation

 Prudent management of lending

operations by the banks themselves eg
the banks may demand substantial security
in order to lend especially where the risk of
default is substantially high.
- Many banks in developing countries have a
considerable proportion of non-performing loans
and therefore tend to be cautious in lending.
 A change in the legal requirement
regarding the cash ratio which in turn
influences the value of credit multiplier
 Commercial Bank and its
Functions

 An institution which accepts deposits,

makes business loans, and offers related
services.
 Commercial banks also allow for a variety
of deposit accounts, such as checking,
savings, and time deposit.
 These institutions are run to make a
profit and owned by a group of
individuals, yet some may be members
of the CB.
 Commercial Bank and its
Functions

 While commercial banks offer services to

individuals, they are primarily concerned
with receiving deposits and lending to
businesses.
 Functions of Commercial banks

1. It accepts deposits from the public. These deposits

can be withdrawn by cheque and are repayable on
demand.
2. A commercial bank uses the deposited money for
lending and for investment in securities i.e lend
the money to individuals, firms and government.
Loans may be in different forms like cash credit,
overdraft facilities, short-term loans.
3. Commercial banks supply medium of exchange by
facilitating payment system. It also facilitate
money supply process through the so called credit
creation. Money created by commercial banks is
known as deposit money.
 Functions of Commercial banks

4. Facilitates foreign exchange transaction

through buying and selling foreign
currency
5. It is a unique financial institution that
creates demand deposits which serves
as the medium of exchange.
6. Transfer of funds locally and
internationally through various
instruments like bank drafts, cheques,
etc.
 Central Bank and Monetary
Policy

 CB is a government agency that oversees

the banking system and is responsible for
the conduct of monetary policy in the
country eg. BOT
 Functions of CB

Traditionally, a central bank performs

three main functions:
1) managing the nation’s monetary system,
2) serving as a banker to commercial
banks, and
3) acting as a financial agent for the
national government.
 Functions of CB

1) The most important function of a central

bank is its control over the monetary
system.
- In pursuance of this objective, the central
bank regulates the supply, cost and
availability of credit.
- The ability of the central bank to control the
monetary system is enhanced by the central
bank’s ability to create and destroy monetary
reserves by its lending and investigating
activities.
 Functions of CB

2) A central bank acts as banker to

commercial banks by providing services to
the banking system similar to those which
the commercial banking system performs
for individuals and business enterprise.
- Some of the services rendered by the central
bank lend support to its role as the manager of
the monetary system.
- Such services include the holding of legal
reserves and acting as a lender of the last
resort.
 Functions of CB

3) It also provides services that promote

the smooth working of the monetary
system.
- Among such services may be the
clearing and collection of cheques,
distribution of coins and paper currency
to commercial banks and supervising
and regulating the activities of
commercial banks.
 Cont...

4) In its role as the financial agent, the

central bank acts as the banker to the
government. It receives, holds, transfers
and disburses the fund of the
government.
5) It provides technical services related to
the public debt and financial advice to
government.
6) The CB is responsible for supervising and
regulating banking institutions in the
country.
 Monetary Policy

MP consists of actions that affect the

amount of money and the cost of
credit available in the economy using
the following instruments:
a) Open Market Operations (OMO)
b) Discount Rate
c) Reserve Requirement
d) Selective Credit Control
e) Special deposits
 Open Market Operations (OMO)

 Buying and selling of government securities in

the open market to influence the level of
reserves.
 When prices are rising and there is need to
control them, the central bank sells securities.
The reserves of commercial banks are reduced
and they are not in a position to lend more to
the business community.
 Contrariwise, when recessionary forces start in
the economy, the central bank buys securities.
The reserves of commercial banks are raised.
They lend more.
 Discount/Bank Rate Policy

 The process of setting the interest/bank rate

called discount rate at which commercial banks
and other depository institutions can borrow
reserves from central bank.
 When the central bank finds that inflationary
pressures have started emerging within the
economy, it raises the bank rate. Borrowing
from the central bank becomes costly and
commercial banks borrow less from it.
 The commercial banks, in turn, raise their lending
rates to the business community and borrowers
borrow less from the commercial banks.
 Reserve Requirement policy

 Every bank is required by law to keep a

certain percentage of its total deposits in
the form of a reserve fund in its vaults and
also a certain percentage with the central
bank.
 When prices are rising, the central bank
raises the reserve ratio. Banks are required
to keep more with the central bank.
 Their reserves are reduced and they lend
less. The volume of investment, output and
employment are adversely affected.
 Selective Credit Controls

 Selective credit controls are used to

influence specific types of credit for
particular purposes.
 The financial institutions are advised by
the CB to offer more credit to
specific/essential sectors like agriculture,
SMEs than to non essential sectors of the
economy.
 Special deposits

 The CB has the power to require banks to

lodge “special deposits” with it, which
usually earn a rate of interest.
 Since commercial deposits are
compulsory, they ensure reduction in
commercial bank’s liquid assets and
reduce the banks’ ability to increase
credit and hence money supply.