Lecture Notes - Topic 4 – Money banking and financial sector

Money, Banking & The Financial System

 Money make the world go around and most people in the world
probably have handled money, many of them on a daily basis.

In short, money can be anything that can serve as a

 store of value, which means people can save it and use it later to
smoothing their purchases over time;

 unit of account, that is, provide a common base for prices; or

 medium of exchange, something that people can use to buy and sell
from one another.

 If there were no money, we would be reduced to a barter economy.

 Every item someone wanted to purchase would have to be exchanged

for something that person could provide.

 For example, a person who specialized in fixing cars and needed to

trade for food would have to find a farmer with a broken car.

Money has three functions:

 Means of transaction. It is used to buy things. There is no need to

barter. The more transactions the more money that is required.

 Unit of account. It allows comparison. If the value of money changes

rapidly, it is difficult to use for comparison.

 Store of value. It is used for savings. If it loses value it is not useful for
saving.

 Households select the amount of cash that they want to hold.

 This will be determined by their desire to purchase goods, repay debts

and buy assets.

 It will also be determined by technology (cash alternatives).

 Banks determine the amount of reserves that they hold by estimating
how much they need for customer requests and for settling balances
with other banks.

 Generally, other assets will yield more than reserves.

 The liquidity ratio is the ratio of reserves to bank deposits.

 Therefore, central bank cash is determined by the liquidity ratio, the

cash demanded by households and the size of bank deposits.

 Subject to the liquidity constraint (liquidity rate), commercial banks

will create money by making loans when it is profitable to do so.

 The commercial bank money is determined by the size of current

accounts.

 Households and firms determine the amount of cash that they will
hold.

 This will be deponent on their income and the level of interest rates.

 As income increases, households will want to conduct more

transactions and will need more money to do that; as interest rates
rise, the return on bonds becomes higher and makes bank deposits less
attractive.

 A financial system is a set of institutions, such as banks, insurance

companies, and stock exchanges, that permit the exchange of funds.

 Financial systems exist on firm, regional, and global levels.

 The firm's financial system is the set of implemented procedures that

track the financial activities of the company.

 Within a firm, the financial system encompasses all aspects of finances,

including accounting measures, revenue and expense schedules,
wages, and balance sheet verification.

 The financial system is the system that enables lenders and borrowers
to exchange funds.
  Regional financial systems include banks and other institutions, such as
securities exchanges and financial clearinghouses.

 The global financial system is basically a broader regional system that

encompasses all financial institutions, borrowers, and lenders within
the global economy.

 In a global view, financial systems include the International Monetary

Fund, central banks, government treasuries and monetary authorities,
the World Bank, and major private international banks.

Definition, characteristics and functions of money

 Money has taken many forms through the ages, but money
consistently has three functions: store of value, unit of account, and
medium of exchange.

 Modern economies use fiat money and money that is neither a

commodity nor represented or "backed" by a commodity.

 Money is something that people use every day. We earn it and spend it
but don't often think much about it.

 Economists define money as any good that is widely accepted as final

payment for goods and services.

 Money is as store value, unit of account and medium of exchange.

 The characteristics of what serves as money depend somewhat on the

degree of complexity in the society.

 A relatively simple economy, with relatively few goods and services,

few producers and consumers, and few transactions, may be able to
function with a form of money that would not work in a more complex
society.

 There are some general characteristics that are usually important for
whatever serves as money in a modern economy.

 To serve as an effective medium of exchange and store of value, money

must be durable.
 Durability is when an item is able to withstand all the hardships and is
still able to maintain to be undamaged and usable after a long term of
usage.

 Durability is crucial for money to be able to perform the following

functions of medium of exchange and store of value.

 Coins and paper bills are made to perform and to act as the currency.

 Nowadays, Money is manufactured with the materials such as paper,

metal and plastics, which results to a long lasting medium.

 Portability, which also serves as a medium of exchange, means that

money can be movable from place to place to be used as monetary
transaction to be exchanged for goods and services.

 Portability also means that consumers are now able to carry money
along with them to be used as transactions for goods and services.

 In modern days, money is carried from one location to another without

needing much effort as all types of money such as cash notes, coins
and cards are carried easily in a wallet.

 Divisibility is a characteristic which means the money can be divided

into small units and that it can be used in exchange for goods and
services.

 As to function as the medium of exchange, as it is divisible, it can be

used to purchase all kinds of goods with different values.

 As money functions as the medium of exchange it must have

denominations to be traded for all goods and services, and everything
in between.

 Uniformity means that all types of the same denomination of money

must consist of purchasing power.

 It is a characteristic to perform the function of standard of deferred

payments
  Limited supply is a characteristic which helps in storing the value of
money, meaning that constraints on the amount of money in the
monetary circulation ensure that values remain constant for the
currency.

 Currently most of the respective country’s government has the

responsibility to control an adequate money supply based on market
with their monetary policies, such as expansionary monetary policy
and contractionary monetary policy.

 Acceptability supports the function of medium of exchange.

 The essential quality of money is that it must act as an item being

acceptable to all, without having any hesitation in the exchange for
goods and services.

 Acceptability means that everyone must be able to accept the money

for transactions.

 Money is universally accepted around the world as a universal mean

for transaction.

 Lastly, the characteristic of non-counterfeitability which functions as

the store of value means that money cannot be easily duplicated.

 As money cannot be easily duplicated, it prevents the unrestricted and

illegal creating of duplication of money.

 Besides, preventing the duplication of money to happen is one of the

main reasons of government existence.

Supply of money

 The total stock of money circulating in an economy is the money

supply.

 The circulating money involves the currency, printed notes, money in

the deposit accounts and in the form of other liquid assets.

 The money supply is the sum total of all of the currency and other
liquid assets in a country's economy on the date measured.
  The money supply includes all cash in circulation and all bank deposits
that the account holder can easily convert to cash.

 Governments issue paper currency and coins through their central

banks or treasuries, or a combination of both.

 In order to keep the economy stable, banking regulators increase or

reduce the available money supply through policy changes and
regulatory decisions.

Keynesian Demand for money (transaction, precautionary, and speculative

motives

 Keynes distinguishes between three motives for holding cash '(i) the
transactions-motive, i.e. the need of cash for the current transaction of
personal and business exchanges;

 (ii) the precautionary-motive, i.e. the desire for security as to the

future cash equivalent of a certain proportion of ...

 Keynesian’s theory, How much of his income or resources will a person

hold in form of ready money and how much will he lend depends upon
his liquidity preference.

 Demand for money is also called Liquidity Preference which means

demand for money to hold or the desire of the public to hold money in
form of cash.

According to Keynes, the desire to hold money arises because of three

motives,

 Transaction motive

 Precautionary motive

 Speculative motive

The Transaction Demand for Money –

 Under the transaction motive, people hold money in form of cash

balances for transaction purposes, because receipt of money and
payments do not coincide.
  Most of the people receive their pay cheque weekly or monthly while
the expenditure goes on everyday.

 So, a certain amount of cash is kept in hand to make current payments.

 This amount will depend on the size of the individual’s income, the
interval at which income is received and methods of payments
prevailing in the society.

 The businessmen and the entrepreneurs also have to keep a

proportion of their resources in liquid form to meet daily needs.

 They need money all the time to pay for raw material, to pay salaries
and to meet all other current expanses.

 The amount of money held by businessmen and entrepreneurs

depends mostly on the turnover.

 The larger the turnover, larger will be the amount of money needed to
cover current expanses.

 Demand for transaction motive arises primarily because of the use of

money as a medium of exchange.

 The demand for money is a demand for real cash balances for the
purpose of buying goods and services.

 The higher the price level, the more money in form of cash a person
has to hold in order to purchase a given quantity of goods.

 According to Keynes, the transactions demand for money depends only

on the real income and not influenced by the rate of interest.

Precautionary Demand for Money –

 Under precautionary motive people holds money in cash form or liquid

form for unforeseen contingencies such as sickness, accidents, danger
of unemployment and other uncertain perils.

 The amount of money demanded for precautionary motive will depend

on the psychology of the individual and the conditions in which he
lives.
Speculative Demand for Money –

 The speculative motive is related to the desire of the people to hold

money in liquid form to take advantage of market movements
regarding the future changes in the rate of interest.

 The cash held under this motive is used to make speculative gains by
dealing in bonds and shares, whose prices fluctuates.

 If bond or share prices are expected to rise (means that the rate of
interest is expected to fall), businessmen will buy bonds or shares to
sell when their prices actually rise.

 In the other case, if the bond or share prices are expected to fall
(means that the rate of interest is expected to rise), businessmen will
sell bonds or shares to avoid capital losses.

 If the rate of interest is higher than the less money will be held under
the speculative motive and vice versa.

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