INSTITUTE OF PUBLIC ADMINISTRATION AND MANAGEMENT

DEPARTMENT OF ACCOUNTANTCY
BUSINESS ECONOMICS II (MACRO)

LECTURE 6 – MONEY & BANKING

DEFINITION OF MONEY

What is money? Money is any good that is widely used and accepted in transactions involving
the transfer of goods and services from one person to another.

Money can be categorized into three different types: commodity money, fiat money, and bank
money.

 Commodity monies are those items used as money that also have an intrinsic value in
some other use. Gold coins are an example of commodity money. In most countries,
commodity money has been replaced with fiat money.
 Fiat money, sometimes called token money, is money that is intrinsically worthless. The
actual value of a Le5,000 or Le10,000 bill is basically zero.
 Bank money consists of the book credit that banks extend to their depositors.
Transactions made using checks drawn on deposits held at banks involve the use of bank
money.

FUNCTIONS OF MONEY

Money is often defined in terms of the three functions or services that it provides. Money serves
as a medium of exchange, as a store of value, and as a unit of account.
 Medium of exchange. Money's most important function is as a medium of exchange to
facilitate transactions. Without money, all transactions would have to be conducted by
barter, which involves direct exchange of one good or service for another. The difficulty
with a barter system is that in order to obtain a particular good or service from a
supplier, one has to possess a good or service of equal value, which the supplier also
desires. In other words, in a barter system, exchange can take place only if there is a
double coincidence of wants between two transacting parties. The likelihood of a double
coincidence of wants, however, is small and makes the exchange of goods and services
rather difficult. Money effectively eliminates the double coincidence of wants problem by
serving as a medium of exchange that is accepted in all transactions, by all parties,
regardless of whether they desire each others' goods and services.

 Store of value. In order to be a medium of exchange, money must hold its value over
time; that is, it must be a store of value. If money could not be stored for some period of
time and still remain valuable in exchange, it would not solve the double coincidence of
wants problem and therefore would not be adopted as a medium of exchange. As a store
of value, money is not unique; many other stores of value exist, such as land, works of
art, and even stamps.

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 Money may not even be the best store of value because it depreciates with inflation.
However, money is more liquid than most other stores of value because as a medium of
exchange, it is readily accepted everywhere. Furthermore, money is an easily transported
store of value that is available in a number of convenient denominations.

 Unit of account. Money also functions as a unit of account, providing a common

measure of the value of goods and services being exchanged. Knowing the value or price
of a good, in terms of money, enables both the supplier and the purchaser of the good to
make decisions about how much of the good to supply and how much of the good to
purchase.

THE DEMAND FOR MONEY

The demand for money is affected by several factors, including the level of income, interest
rates, and inflation as well as uncertainty about the future. The way in which these factors affect
money demand is usually explained in terms of the three motives for demanding money: the
transactions, the precautionary, and the speculative motives.
 Transactions motive. The transactions motive for demanding money arises from the
fact that most transactions involve an exchange of money. Because it is necessary to have
money available for transactions, money will be demanded. The total number of
transactions made in an economy tends to increase over time as income rises. Hence, as
income or GDP rises, the transactions demand for money also rises.

 Precautionary motive. People often demand money as a precaution against an uncertain

future. Unexpected expenses, such as medical or car repair bills, often require immediate
payment. The need to have money available in such situations is referred to as the
precautionary motive for demanding money.

 Speculative motive. Money, like other stores of value, is an asset. The demand for an
asset depends on both its rate of return and its opportunity cost. Typically, money
holdings provide no rate of return and often depreciate in value due to inflation. The
opportunity cost of holding money is the interest rate that can be earned by lending or
investing one's money holdings. The speculative motive for demanding money arises in
situations where holding money is perceived to be less risky than the alternative of
lending the money or investing it in some other asset. For example, if a stock market
crash seemed imminent, the speculative motive for demanding money would come into
play; those expecting the market to crash would sell their stocks and hold the proceeds as
money. The presence of a speculative motive for demanding money is also affected by
expectations of future interest rates and inflation. If interest rates are expected to rise, the
opportunity cost of holding money will become greater, which in turn diminishes the
speculative motive for demanding money. Similarly, expectations of higher inflation
presage a greater depreciation in the purchasing power of money and therefore lessen the
speculative motive for demanding money.

SUPPLY OF MONEY

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There are several definitions of the supply of money, these are summarized below:
 M1 is narrowest and most commonly used. It includes all currency (notes and coins) in
circulation, all checkable deposits held at banks (bank money), and all traveler's
checks. Therefore M1 or transaction money is defined as:

M1 = currency held outside banks + demand deposits + traveler’s check + other checkable deposits

 M2 is a somewhat broader measure of the supply of money; it includes all of M1 plus

savings and time deposits held at banks. Therefore M2 or broad money is defined as:

M2 = M1 + Savings accounts + Money market accounts + other near monies

 An even broader measure of the money supply is M3, which includes all of M2 plus large
denomination, long‐term time deposits—for example, certificates of deposit (CDs) in
amounts over $100,000.

M3 = M2 + large time deposit (large denomination)

Most discussions of the money supply, however, are in terms of the M1 definition of the money
supply.

BANKING THEORY

In order to understand the factors that determine the supply of money, one must first understand
the role of the banking sector in the money‐creation process. Banks perform two crucial
functions. First, they receive funds from depositors and, in return; provide these depositors with
a checkable source of funds or with interest payments. Second, they use the funds that they
receive from depositors to make loans to borrowers; that is, they serve as intermediaries in the
borrowing and lending process.

When banks receive deposits, they do not keep all of these deposits on hand because they know
that depositors will not demand all of these deposits at once. Instead, banks keep only a fraction
of the deposits that they receive. The deposits that banks keep on hand are known as the banks'
reserves. When depositors withdraw deposits, they are paid out of the banks' reserves. The
reserve requirement is the fraction of deposits set aside for withdrawal purposes. The reserve
requirement is determined by the nation's banking authority, a government agency known as the
central bank. Deposits that banks are not required to set aside as reserves can be lent to
borrowers, in the form of loans. Banks earn profits by borrowing funds from depositors at zero
or low rates of interest and using these funds to make loans at higher rates of interest.

A balance sheet for a typical bank is given in the Table below. The balance sheet summarizes
the bank's assets and liabilities. Assets are valuable items that the bank owns and consist
primarily of the bank's reserves and loans. Liabilities are valuable items that the bank owes to
others and consist primarily of the bank's deposit liabilities to its depositors.

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In the table below, the bank's assets (reserves and loans) total $1 million. The bank's liabilities
(deposits) total $1 million. A banking firm's assets must always equal its liabilities.

You can infer from Table that the reserve requirement in this example is 10%.

How banks create money. Consider what happens when the same bank receives a $100,000
deposit from one of its depositors. The bank is required to set aside 10% of this deposit, or
$10,000, as reserves. It then lends out its excess reserves—in this case, the remaining $90,000 of
the initial deposit. Suppose, for the sake of simplicity, that all borrowers redeposit their loans
into the same bank. The bank thus receives $90,000 in new deposits of which it sets $9,000 aside
as reserves and lends out all of its excess reserves. Suppose again that all borrowers redeposit
their loans in the same bank, that the bank sets aside a portion of these deposits, and that the
bank then lends out the remainder, which is again redeposit in the bank and so on and so on. This
repeated chain of events is summarized in the table below.

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 If one were to follow this multiple deposit expansion process to its completion, the end result
would be that the bank's deposits would increase by $1 million, its loans would increase by
$900,000, and its reserves would increase by $100,000, all due to the initial deposit of $100,000.

Money Multiplier. The amount by which bank deposits expand in response to an increase in
excess reserves is found through the use of the money multiplier, which is given by the formula

In the example of deposit expansion found in the Table above, the reserve requirement is 10%;
so, the money multiplier in this case is (1/.10) = 10. The excess reserves resulting from the initial
deposit of $100,000 are $90,000. Multiplying $90,000 by the money multiplier, 10, yields
$900,000, which is the amount of additional deposits created by the banking system as the result
of the initial $100,000 deposit.

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In reality, loan recipients do not deposit all of their loan funds into a bank. More typically, they
hold a fraction of their loan funds as currency. If some loan funds are held as currency, then there
is a leakage of money out of the banking system. In this case, the money multiplier will still be
greater than 1, but it will be less than the inverse of the reserve requirement.

Central banking and the supply of money. A portion of each nation's money supply (M1) is
controlled by a government agency known as the central bank (Bank of Sierra Leone). The
central bank is unique in that it is the only bank that can issue currency. The central bank issues
Leone bills, known as notes. Thus, the central bank has control over the supply of the currency.
The central bank also has control over the commercial bank reserves that banks entrust to the
central bank. Banks hold a portion of their required reserves with the central bank because the
central bank acts as a clearing house for all sorts of transactions between banks—for example,
the processing of all checks.

The Central Bank’s liabilities therefore consist of all notes in circulation plus all commercial
bank deposits held at the central bank as reserves on the asset side, the central bank owns a large
amount of government debt in the form of government bonds. These bonds have been issued by
the central bank on behalf of the government to pay for current and past government deficits. A
simplified example of the central bank's balance sheet is provided in the table below. Note that
the central bank's total liabilities are equal to its total assets.

The central bank's control over the money supply stems from its ability to change the
composition of its balance sheet. For example, the central bank may decide to purchase
additional government bonds on the open market from bondholders or commercial banks. This
type of action is referred to as an open market operation by the central bank. In exchange for
these government bonds, the central bank increases the reserves of commercial banks by the
amount of the purchase. Banks, in turn, lend out their excess reserves and initiate the multiple
deposit expansion process discussed above. Thus, when the central bank buys government bonds
on the open market, it increases the supply of money by increasing bank reserves and inducing
an expansion in the amount of deposits. Similarly, when the central bank sells some of its stock
of government bonds to bondholders or commercial banks, the central bank compensates itself
for the sale by reducing the reserves of commercial banks.

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The sale of government bonds by the central bank reduces the supply of money by reducing the
reserves available to commercial banks and thereby decreasing the amount of deposit expansion
that is possible.

The central bank can also control the supply of money by its choice of the reserve requirement.
Recall that the money multiplier is the reciprocal of the reserve requirement. If the central bank
increases the reserve requirement, the money multiplier decreases, implying that deposit
creation and the money supply are reduced. If the central bank decreases the reserve
requirement, the money multiplier increases, causing both the creation of deposits and the
money supply to expand further.

MONETARY POLICY

Monetary policy is conducted by a nation's central bank. The central bank has three main
instruments that it uses to conduct monetary policy: open market operations, changes in
reserve requirements, and changes in the discount rate.

 Open Market Operations: Open market operations involve the purchases and sales of
government bonds. When the central bank purchases government bonds, it increases the
reserves of the banking sector, and by the multiple deposit expansion process, the supply
of money increases. When the central bank sells some of its stock of government bonds,
the end result is a decrease in the supply of money.

 Reserve requirement: If the central bank increases bank reserve requirements, the
banking sector's excess reserves are reduced, leading to a reduction in the supply of
money; a decrease in reserve requirements induces an increase in the supply of money.

 Discount Rate: The discount rate is the interest rate the central bank charges commercial
banks that need to borrow reserves in order to meet reserve requirements. From time to
time, unanticipated withdrawals leave banks with insufficient reserves. Banks can make
up for deficiencies in their required reserves by borrowing from the Fed at the discount
rate. If the Fed sets the discount rate high relative to market interest rates, it becomes
more costly for banks to fall below reserve requirements. Accordingly, banks will hold
more excess reserves, which tend to reduce the multiple expansions of deposits and the
supply of money. Similarly, when the discount rate is low relative to market interest
rates, banks tend to hold fewer excess reserves, allowing for greater deposit expansion
and an increase in the supply of money.

Expansionary and contractionary monetary policy: The central bank is engaging in

expansionary monetary policy when it uses any of its instruments of monetary policy in such a
way as to cause an increase in the supply of money. The central bank is said to engage in
contractionary monetary policy when it uses its instruments to effect a reduction in the supply of
money.

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CLASSICAL VIEW OF MONETARY POLICY.

The classical economists' view of monetary policy is based on the quantity theory of money.
According to this theory, an increase (decrease) in the quantity of money leads to a proportional
increase (decrease) in the price level.

The quantity theory of money is usually discussed in terms of the equation of exchange, which
is given by the expression

In this expression, P denotes the price level, and Y denotes the level of current real GDP. Hence,
PY represents current nominal GDP; M denotes the supply of money over which the central
bank has some control; and V denotes the velocity of circulation, which is the average number
of times a Leone bill is spent on final goods and services over the course of a year.

The equation of exchange is an identity which states that the current market value of all final
goods and services—nominal GDP—must equal the supply of money multiplied by the average
number of times a Leone bill is used in transactions in a given year. The quantity theory of
money requires two assumptions, which transform the equation of exchange from an identity to a
theory of money and monetary policy.

Recall that the classical economists believe that the economy is always at or near the natural
level of real GDP. Accordingly, classical economists assume that Y in the equation of exchange
is fixed, at least in the short‐run. Furthermore, classical economists argue that the velocity of
circulation of money tends to remain constant so that V can also be regarded as fixed. Assuming
that both Y and V are fixed, it follows that if the central bank were to engage in expansionary (or
contractionary) monetary policy, leading to an increase (or decrease) in M, the only effect would
be to increase (or decrease) the price level, P, in direct proportion to the change in M. In other
words, expansionary monetary policy can only lead to inflation, and contractionary monetary
policy can only lead to deflation of the price level.

KEYNESIAN VIEW OF MONETARY POLICY.

Keynesians do not believe in the direct link between the supply of money and the price level that
emerges from the classical quantity theory of money. They reject the notion that the economy is
always at or near the natural level of real GDP so that Y in the equation of exchange can be
regarded as fixed. They also reject the proposition that the velocity of circulation of money is
constant and can cite evidence to support their case.

Keynesians do believe in an indirect link between the money supply and real GDP. They believe
that expansionary monetary policy increases the supply of loanable funds available through the
banking system, causing interest rates to fall.

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With lower interest rates, aggregate expenditures on investment and interest‐sensitive
consumption goods usually increase, causing real GDP to rise. Hence, monetary policy can
affect real GDP indirectly.

Keynesians, however, remain skeptical about the effectiveness of monetary policy. They point
out that expansionary monetary policy that increase the reserves of the banking system need not
lead to a multiple expansion of the money supply because banks can simply refuse to lend out
their excess reserves. Furthermore, the lower interest rates that result from an expansionary
monetary policy need not induce an increase in aggregate investment and consumption
expenditures because firms' and households' demands for investment and consumption goods
may not be sensitive to the lower interest rates. For these reasons, Keynesians tend to place less
emphasis on the effectiveness of monetary policy and more emphasis on the effectiveness of
fiscal policy, which they regard as having a more direct effect on real GDP.

MONETARIST VIEW OF MONETARY POLICY.

Since the 1950s, a new view of monetary policy, called monetarism, has emerged that disputes
the Keynesian view that monetary policy is relatively ineffective. Adherents of monetarism,
called monetarists, argue that the demand for money is stable and is not very sensitive to
changes in the rate of interest. Hence, expansionary monetary policies only serve to create a
surplus of money that households will quickly spend, thereby increasing aggregate demand.
Unlike classical economists, monetarists acknowledge that the economy may not always be
operating at the full employment level of real GDP. Thus, in the short‐run, monetarists argue that
expansionary monetary policies may increase the level of real GDP by increasing aggregate
demand. However, in the long‐run, when the economy is operating at the full employment level,
monetarists argue that the classical quantity theory remains a good approximation of the link
between the supply of money, the price level, and the real GDP—that is, in the long‐run,
expansionary monetary policies only lead to inflation and do not affect the level of real GDP.

Monetarists are particularly concerned with the potential for abuse of monetary policy and
destabilization of the price level. They often cite the contractionary monetary policies of the Fed
during the Great Depression, policies that they blame for the tremendous deflation of that period.
Monetarists believe that persistent inflations (or deflations) are purely monetary phenomena
brought about by persistent expansionary (or contractionary) monetary policies. As a means of
combating persistent periods of inflation or deflation, monetarists argue in favor of a fixed
money supply rule.

They believe that the Central Bank should conduct monetary policy so as to keep the growth rate
of the money supply fixed at a rate that is equal to the real growth rate of the economy over time.
Thus, monetarists believe that monetary policy should serve to accommodate increases in real
GDP without causing either inflation or deflation.