Chapter 3
Money and Banking
Money is the commonly accepted medium of exchange. In an
economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for
money. Even if there are more than one individual but they do
not take part in market transactions, such as a family living on
an isolated island, money has no function for them. However, as
soon as there are more than one economic agent who engage
themselves in transactions through the market, money becomes
an important instrument for facilitating these exchanges.
Economic exchanges without the mediation of money are referred
to as barter exchanges. However, they presume the rather
improbable double coincidence of wants. Consider, for example,
an individual who has a surplus of rice which she wishes to
exchange for clothing. If she is not lucky enough she may not be
able to find another person who has the diametrically opposite
demand for rice with a surplus of clothing to offer in exchange.
The search costs may become prohibitive as the number of
individuals increases. Thus, to smoothen the transaction, an
intermediate good is necessary which is acceptable to both
parties. Such a good is called money. The individuals can then
sell their produces for money and use this money to purchase
the commodities they need. Though facilitation of exchanges is
considered to be the principal role of money, it serves other
purposes as well. Following are the main functions of money in a
modern economy.
3.1 FUNCTIONS OF MONEY
As explained above, the first and foremost role of money is that
it acts as a medium of exchange. Barter exchanges become
extremely difficult in a large economy because of the high costs
people would have to incur looking for suitable persons to
exchange their surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. When
we say that the value of a certain wristwatch is Rs 500 we mean
that the wristwatch can be exchanged for 500 units of money,
where a unit of money is rupee in this case. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth
, 10 ÷ 2 = 5 pencils. The same notion can be used to calculate the value of
money itself with respect to other commodities. In the above example, a rupee
is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen. Thus if prices of all commodities
increase in terms of money which, in other words, can be regarded as a general
increase in the price level, the value of money in terms of any commodity must
have decreased – in the sense that a unit of money can now purchase less of
any commodity. We call it a deterioration in the purchasing power of money.
A barter system has other deficiencies. It is difficult to carry forward one’s
wealth under the barter system. Suppose you have an endowment of rice which
you do not wish to consume today entirely. You may regard this stock of
surplus rice as an asset which you may wish to consume, or even sell off, for
acquiring other commodities at some future date. But rice is a perishable item
and cannot be stored beyond a certain period. Also, holding the stock of rice
requires a lot of space. You may have to spend considerable time and resources
looking for people with a demand for rice when you wish to exchange your
stock for buying other commodities. This problem can be solved if you sell
your rice for money. Money is not perishable and its storage costs are also
considerably lower. It is also acceptable to anyone at any point of time. Thus
money can act as a store of value for individuals. Wealth can be stored in the
form of money for future use. However, to perform this function well, the value
of money must be sufficiently stable. A rising price level may erode the
purchasing power of money. It may be noted that any asset other than money
can also act as a store of value, e.g. gold, landed property, houses or even
bonds (to be introduced shortly). However, they may not be easily convertible
to other commodities and do not have universal acceptability.
3.2 DEMAND FOR MONEY
Money is the most liquid of all assets in the sense that it is universally acceptable
and hence can be exchanged for other commodities very easily. On the other
hand, it has an opportunity cost. If, instead of holding on to a certain cash
34 balance, you put the money in a fixed deposits in some bank you can earn
interest on that money. While deciding on how much money to hold at a certain
Introductory Macroeconomics
point of time one has to consider the trade off between the advantage of liquidity
and the disadvantage of the foregone interest. Demand for money balance is
thus often referred to as liquidity preference. People desire to hold money balance
broadly from two motives.
3.2.1 The Transaction Motive
The principal motive for holding money is to carry out transactions. If you
receive your income weekly and pay your bills on the first day of every week,
you need not hold any cash balance throughout the rest of the week; you may
as well ask your employer to deduct your expenses directly from your weekly
salary and deposit the balance in your bank account. But our expenditure
patterns do not normally match our receipts. People earn incomes at discrete
points in time and spend it continuously throughout the interval. Suppose
you earn Rs 100 on the first day of every month and run down this balance
evenly over the rest of the month. Thus your cash balance at the beginning
and end of the month are Rs 100 and 0, respectively. Your average cash holding
can then be calculated as (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are
making transactions worth Rs 100 per month. Hence your average transaction
demand for money is equal to half your monthly income, or, in other words,
half the value of your monthly transactions.
, Consider, next, a two-person economy consisting of two entities – a firm (owned
by one person) and a worker. The firm pays the worker a salary of Rs 100 at the
beginning of every month. The worker, in turn, spends this income over the
month on the output produced by the firm – the only good available in this
economy! Thus, at the beginning of each month the worker has a money balance
of Rs 100 and the firm a balance of Rs 0. On the last day of the month the
picture is reversed – the firm has gathered a balance of Rs 100 through its sales
to the worker. The average money holding of the firm as well as the worker is
equal to Rs 50 each. Thus the total transaction demand for money in this
economy is equal to Rs 100. The total volume of monthly transactions in this
economy is Rs 200 – the firm has sold its output worth Rs 100 to the worker
and the latter has sold her services worth Rs 100 to the firm. The transaction
demand for money of the economy is again a fraction of the total volume of
transactions in the economy over the unit period of time.
d
In general, therefore, the transaction demand for money in an economy, M T ,
can be written in the following form
d
M T = k.T (3.1)
where T is the total value of (nominal) transactions in the economy over unit
period and k is a positive fraction.
The two-person economy described above can be looked at from another
angle. You may perhaps find it surprising that the economy uses money balance
worth only Rs 100 for making transactions worth Rs 200 per month. The answer
to this riddle is simple – each rupee is changing hands twice a month. On the
first day, it is being transferred from the employer’s pocket to that of the worker
and sometime during the month, it is passing from the worker’s hand to the
employer’s. The number of times a unit of money changes hands during the
unit period is called the velocity of circulation of money. In the above example
it is 2, inverse of half – the ratio of money balance and the value of transactions.
Thus, in general, we may rewrite equation (3.1) in the following form
1 d d
35
.M T = T, or, v.M T = T (3.2)
k
Money and Banking
where, v = 1/k is the velocity of circulation. Note that the term on the right
hand side of the above equation, T, is a flow variable whereas money demand,
d
M T , is a stock concept – it refers to the stock of money people are willing to hold
at a particular point of time. The velocity of money, v, however, has a time
dimension. It refers to the number of times every unit of stock changes hand
during a unit period of time, say, a month or a year. Thus, the left hand side,
d
v.M T , measures the total value of monetary transactions that has been made
with this stock in the unit period of time. This is a flow variable and is, therefore,
equal to the right hand side.
We are ultimately interested in learning the relationship between the aggregate
transaction demand for money of an economy and the (nominal) GDP in a given
year. The total value of annual transactions in an economy includes transactions
in all intermediate goods and services and is clearly much greater than the
nominal GDP. However, normally, there exists a stable, positive relationship
between value of transactions and the nominal GDP. An increase in nominal
GDP implies an increase in the total value of transactions and hence a greater
transaction demand for money from equation (3.1). Thus, in general, equation
(3.1) can be modified in the following way
d
M T = kPY (3.3)
Money and Banking
Money is the commonly accepted medium of exchange. In an
economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for
money. Even if there are more than one individual but they do
not take part in market transactions, such as a family living on
an isolated island, money has no function for them. However, as
soon as there are more than one economic agent who engage
themselves in transactions through the market, money becomes
an important instrument for facilitating these exchanges.
Economic exchanges without the mediation of money are referred
to as barter exchanges. However, they presume the rather
improbable double coincidence of wants. Consider, for example,
an individual who has a surplus of rice which she wishes to
exchange for clothing. If she is not lucky enough she may not be
able to find another person who has the diametrically opposite
demand for rice with a surplus of clothing to offer in exchange.
The search costs may become prohibitive as the number of
individuals increases. Thus, to smoothen the transaction, an
intermediate good is necessary which is acceptable to both
parties. Such a good is called money. The individuals can then
sell their produces for money and use this money to purchase
the commodities they need. Though facilitation of exchanges is
considered to be the principal role of money, it serves other
purposes as well. Following are the main functions of money in a
modern economy.
3.1 FUNCTIONS OF MONEY
As explained above, the first and foremost role of money is that
it acts as a medium of exchange. Barter exchanges become
extremely difficult in a large economy because of the high costs
people would have to incur looking for suitable persons to
exchange their surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. When
we say that the value of a certain wristwatch is Rs 500 we mean
that the wristwatch can be exchanged for 500 units of money,
where a unit of money is rupee in this case. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth
, 10 ÷ 2 = 5 pencils. The same notion can be used to calculate the value of
money itself with respect to other commodities. In the above example, a rupee
is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen. Thus if prices of all commodities
increase in terms of money which, in other words, can be regarded as a general
increase in the price level, the value of money in terms of any commodity must
have decreased – in the sense that a unit of money can now purchase less of
any commodity. We call it a deterioration in the purchasing power of money.
A barter system has other deficiencies. It is difficult to carry forward one’s
wealth under the barter system. Suppose you have an endowment of rice which
you do not wish to consume today entirely. You may regard this stock of
surplus rice as an asset which you may wish to consume, or even sell off, for
acquiring other commodities at some future date. But rice is a perishable item
and cannot be stored beyond a certain period. Also, holding the stock of rice
requires a lot of space. You may have to spend considerable time and resources
looking for people with a demand for rice when you wish to exchange your
stock for buying other commodities. This problem can be solved if you sell
your rice for money. Money is not perishable and its storage costs are also
considerably lower. It is also acceptable to anyone at any point of time. Thus
money can act as a store of value for individuals. Wealth can be stored in the
form of money for future use. However, to perform this function well, the value
of money must be sufficiently stable. A rising price level may erode the
purchasing power of money. It may be noted that any asset other than money
can also act as a store of value, e.g. gold, landed property, houses or even
bonds (to be introduced shortly). However, they may not be easily convertible
to other commodities and do not have universal acceptability.
3.2 DEMAND FOR MONEY
Money is the most liquid of all assets in the sense that it is universally acceptable
and hence can be exchanged for other commodities very easily. On the other
hand, it has an opportunity cost. If, instead of holding on to a certain cash
34 balance, you put the money in a fixed deposits in some bank you can earn
interest on that money. While deciding on how much money to hold at a certain
Introductory Macroeconomics
point of time one has to consider the trade off between the advantage of liquidity
and the disadvantage of the foregone interest. Demand for money balance is
thus often referred to as liquidity preference. People desire to hold money balance
broadly from two motives.
3.2.1 The Transaction Motive
The principal motive for holding money is to carry out transactions. If you
receive your income weekly and pay your bills on the first day of every week,
you need not hold any cash balance throughout the rest of the week; you may
as well ask your employer to deduct your expenses directly from your weekly
salary and deposit the balance in your bank account. But our expenditure
patterns do not normally match our receipts. People earn incomes at discrete
points in time and spend it continuously throughout the interval. Suppose
you earn Rs 100 on the first day of every month and run down this balance
evenly over the rest of the month. Thus your cash balance at the beginning
and end of the month are Rs 100 and 0, respectively. Your average cash holding
can then be calculated as (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are
making transactions worth Rs 100 per month. Hence your average transaction
demand for money is equal to half your monthly income, or, in other words,
half the value of your monthly transactions.
, Consider, next, a two-person economy consisting of two entities – a firm (owned
by one person) and a worker. The firm pays the worker a salary of Rs 100 at the
beginning of every month. The worker, in turn, spends this income over the
month on the output produced by the firm – the only good available in this
economy! Thus, at the beginning of each month the worker has a money balance
of Rs 100 and the firm a balance of Rs 0. On the last day of the month the
picture is reversed – the firm has gathered a balance of Rs 100 through its sales
to the worker. The average money holding of the firm as well as the worker is
equal to Rs 50 each. Thus the total transaction demand for money in this
economy is equal to Rs 100. The total volume of monthly transactions in this
economy is Rs 200 – the firm has sold its output worth Rs 100 to the worker
and the latter has sold her services worth Rs 100 to the firm. The transaction
demand for money of the economy is again a fraction of the total volume of
transactions in the economy over the unit period of time.
d
In general, therefore, the transaction demand for money in an economy, M T ,
can be written in the following form
d
M T = k.T (3.1)
where T is the total value of (nominal) transactions in the economy over unit
period and k is a positive fraction.
The two-person economy described above can be looked at from another
angle. You may perhaps find it surprising that the economy uses money balance
worth only Rs 100 for making transactions worth Rs 200 per month. The answer
to this riddle is simple – each rupee is changing hands twice a month. On the
first day, it is being transferred from the employer’s pocket to that of the worker
and sometime during the month, it is passing from the worker’s hand to the
employer’s. The number of times a unit of money changes hands during the
unit period is called the velocity of circulation of money. In the above example
it is 2, inverse of half – the ratio of money balance and the value of transactions.
Thus, in general, we may rewrite equation (3.1) in the following form
1 d d
35
.M T = T, or, v.M T = T (3.2)
k
Money and Banking
where, v = 1/k is the velocity of circulation. Note that the term on the right
hand side of the above equation, T, is a flow variable whereas money demand,
d
M T , is a stock concept – it refers to the stock of money people are willing to hold
at a particular point of time. The velocity of money, v, however, has a time
dimension. It refers to the number of times every unit of stock changes hand
during a unit period of time, say, a month or a year. Thus, the left hand side,
d
v.M T , measures the total value of monetary transactions that has been made
with this stock in the unit period of time. This is a flow variable and is, therefore,
equal to the right hand side.
We are ultimately interested in learning the relationship between the aggregate
transaction demand for money of an economy and the (nominal) GDP in a given
year. The total value of annual transactions in an economy includes transactions
in all intermediate goods and services and is clearly much greater than the
nominal GDP. However, normally, there exists a stable, positive relationship
between value of transactions and the nominal GDP. An increase in nominal
GDP implies an increase in the total value of transactions and hence a greater
transaction demand for money from equation (3.1). Thus, in general, equation
(3.1) can be modified in the following way
d
M T = kPY (3.3)
