3.19 - Money & Commercial Banks
The definition and functions of money
Money serves as a vital tool in modern economies, facilitating trade and economic activities far beyond simple barter systems.
Defining money and its role compared to barter
Money is anything that is widely accepted as a means of payment for goods and services. In contrast, barter economies involve direct exchanges of goods for other goods, which requires a double coincidence of wants—both parties must desire what the other offers. By acting as an intermediary, money allows for specialisation in production, enabling individuals and businesses to focus on specific tasks and thereby expanding overall output possibilities.
The four main functions of money
- Medium of exchange - It is accepted in transactions to buy goods and services, simplifying trade without the need for barter.
- Unit of account - It provides a standard measure for expressing prices and comparing the value of different items.
- Store of value - It retains purchasing power over time, allowing savings, though this function is weakened by high inflation.
- Standard of deferred payment - It facilitates contracts for future payments, such as loans or credit agreements, supporting borrowing and lending activities.
The evolution and components of money supply
The form of money has changed over time, reflecting shifts in economic needs and trust in systems. Today, the money supply includes various elements that contribute to liquidity in the economy.
Historical evolution of money
Early forms of money were commodities with inherent value, such as cattle, shells, salt, gold, or silver. Over time, paper money emerged, initially backed by these commodities like gold or silver. Modern money is known as fiat money, which has no intrinsic value and is accepted solely because of government declaration.
Key components of the money supply
- Cash - Notes and coins in circulation, which are definitively considered money.
- Demand deposits - Funds in current accounts that can be withdrawn immediately, such as cheque or sight deposits.
- Narrow definition of money supply - Includes currency in circulation plus demand deposits.
- Near monies - Assets that can be quickly turned into cash or demand deposits.
The structure and functions of the banking system
The banking system is organised into central and commercial banks, each with distinct roles in managing money, credit, and economic stability.
Structure of the banking system
The system includes a central bank, which oversees the entire framework, and commercial banks, which handle day-to-day financial services for individuals and businesses.
Functions of the central bank
- It holds the exclusive right to issue notes and coins in the country.
- It manages the issuance of government bonds and oversees their repayment.
- It implements monetary policy by adjusting interest rates and influencing commercial bank lending.
- It handles exchange rate policy.
- It supervises and regulates commercial banks.
- It acts as a lender of last resort, providing emergency funds to banks in crisis.
Functions of commercial banks and the fractional reserve system
Commercial banks accept deposits from customers and provide loans, earning profits from the difference in interest rates charged on loans versus paid on deposits. They operate under a fractional reserve system, where only a small portion of deposits is held as reserves (either as cash in vaults or deposits with the central bank). The reserve requirement ratio (rr) specifies the minimum fraction that must be reserved. Any reserves beyond this are excess reserves, which banks can lend out to generate more income.
The money creation process and multiplier
Banks create money through lending, amplifying the initial deposits in the system via a multiplier effect.
How banks create money
When a customer deposits money into a bank, the bank retains only the required reserves and lends out the excess. These loans become new deposits in other banks, which then repeat the process—reserving a fraction and lending the rest. This cycle continues, expanding the total money supply from the original deposit.
Formula for the money multiplier
The money multiplier shows how much the money supply can grow from an initial deposit based on the reserve requirement.
Where:
- rr = Reserve requirement ratio (e.g., 0.2 for 20%)
The change in money supply is then calculated as:
Where:
- ΔMs = Change in money supply
- ΔR = Change in reserves (initial deposit)
Worked example - Calculating the money multiplier and change in money supply
A customer deposits £3,000 into a bank, and the reserve requirement ratio is 20% (0.2). Calculate the money multiplier and the total potential increase in the money supply.
Step 1: Identify the values
- Initial deposit (ΔR) = £3,000
- Reserve requirement ratio (rr) = 0.2
Step 2: Calculate the money multiplier
Step 3: Calculate the change in money supply
Step 4: Interpretation
This means the initial £3,000 deposit could lead to a total money supply increase of £15,000 through repeated lending cycles.
Demand, supply, and determination of interest rates
Interest rates are influenced by the balance between the demand for and supply of money in the economy.
Factors influencing the demand for money
People and businesses hold money for practical reasons, but this comes at a cost. The transactions motive drives the need for cash to cover daily expenses, with demand rising alongside nominal income. However, holding money forgoes interest from alternatives like bonds, creating an opportunity cost. As interest rates increase, the demand for money falls because the cost of not investing rises. Graphically, the money demand curve slopes downwards against the interest rate and shifts rightwards with higher nominal income.
The supply of money
The supply of money is controlled by the central bank and is typically shown as a vertical line on a graph, indicating it does not change with interest rates.
How interest rates are determined
The equilibrium interest rate occurs where the money demand curve intersects the money supply curve. If there is excess demand for money (demand exceeds supply), interest rates rise as individuals sell bonds to obtain more cash. Conversely, if there is excess money supply, interest rates fall as people buy bonds to reduce their cash holdings.