9.4 Money and banking

Hyperinflation first damages store of value and deferred payment, then unit of account and finally medium of exchange if sellers reject the currency. A local currency can still be money within its acceptance network if it performs all functions; a cheque is normally a payment instruction transferring bank-deposit money, not money itself because acceptance is limited.

Demonetising widely used notes immediately reduces narrow money if invalid notes cease to count. M1 can later recover when replacement cash is issued or people deposit valid money into qualifying bank accounts. Always report units and the aggregate definition before interpreting the change.

Modern money includes bank deposits, not only currency. Cheques, cards and payment apps are instruments that instruct transfers of deposit money; the instrument is not an extra stock of money. Central-bank reserve balances are different from household deposits and enter aggregates only under their stated definition.

If M rises 3%, V is unchanged and T rises 3%, P is unchanged. If M rises 5% while V and full-employment T are fixed, P rises about 5%. If V falls 5% while M rises 5% and T is unchanged, the price effects approximately offset.

Velocity can change with payment frequency, technology, interest rates and desired balances. Monthly rather than weekly pay tends to make people hold larger average balances, reducing V; easier card/ATM access can reduce balances and raise V. A fall in V can therefore absorb an increase in M without a price rise.

Liquidity means an asset can be converted into cash quickly with little loss; security means limiting default/market/operational risk; profitability comes from interest spread, fees and asset returns. More liquid/secure assets usually yield less, while high-return lending can be illiquid/risky, so banks diversify, screen borrowers, require security/collateral and hold reserves/capital.

If customers withdraw extra cash, bank reserves fall and lending ability tightens. Requiring a higher liquidity ratio similarly reduces potential lending. Weak collateral checks and excessive risk can raise profit temporarily but increase defaults and threaten capital and confidence.

With a 10% required cash ratio and a new $50 million reserve base, the simple maximum deposit stock is$50m ÷ 0.10 = $500m. If deposits were$600m backed by $50m cash, raising the ratio to 10$500m unless cash rises.

A higher public cash-to-deposit or idle-balance preference restricts repeated bank lending and spending; easier bank/ATM access can lower the cash ratio. Higher liquidity/reserve requirements restrict lending. A reserve/QE injection may be absorbed as excess reserves or idle balances, especially in recession, so the full multiplier is not guaranteed.

QE is least destabilising in a deep recession with unemployment and weak inflation. Near full employment it is more likely to raise asset prices, exchange-rate pressure and inflation. It differs from ordinary bank lending and from a government spending decision, even if transactions interact.

Demand-pull inflation from excess AD is directly reduced by contractionary demand policy. Cost-push inflation shifts AS left: aggressive demand restraint may lower second-round pressure but deepens the output/unemployment loss without removing the original cost. Mixed inflation often needs credible demand control plus source-specific supply action.

High rates are stronger against an interest-sensitive credit boom than against a one-off imported energy shock. If consumers expect faster future inflation, they may bring spending forward and weaken rate rises. Inaccurate inflation measurement can cause under- or over-tightening. Monetarist rules target stable money growth, but broad money is difficult to define/control and V/output can move.

Bond prices and yields move inversely. At a very low current interest rate, investors may expect rates to rise and bond prices to fall, so they hold money to avoid a capital loss. At high rates/low bond prices, they are more willing to buy bonds, reducing speculative money balances.

In a liquidity trap at a very low interest rate, speculative money demand becomes highly/perfectly interest-elastic: people absorb extra money into idle balances because they expect bond losses. Increasing MS then barely lowers the interest rate, so investment, AD and output may not rise. Fiscal policy or measures changing expectations/bank balance sheets may be more effective.

In the Keynesian liquidity trap, LP is nearly horizontal at a very low rate. A larger MS is absorbed into idle balances and may leave the rate, investment and output unchanged. To hold a rate down after LP shifts right, the central bank can buy bonds/increase MS; outside the trap this shifts MS right and offsets the rise.

Even when the policy/market rate changes, investment and output respond only if bank lending and investment demand are interest-sensitive. Different maturities, risk and bank margins mean policy rates, government-bond yields and household/business loan rates need not move equally.