9.4 Money and banking

Money performs four functions: medium of exchange, unit of account, store of value and standard of deferred payment. Good money is durable, portable, divisible, recognisable and scarce enough to retain confidence.

Using money avoids the double coincidence of wants required by barter and provides a common way to compare prices. Inflation weakens its store-of-value function; instability weakens willingness to accept it.

A phone payment lets a seller accept value without wanting the buyer’s particular goods, and the price label provides a unit of account for comparing alternatives.

Money is not identical to income or wealth, and an asset is not automatically money unless it is readily accepted for transactions.

The money supply is the quantity of money in circulation or in relevant bank accounts, depending on the measure used. Narrow measures contain highly liquid cash and deposits; broader measures include less liquid assets.

Credit creation, bank lending, central-bank operations, government balances and public preferences can change the measured supply. The definition and boundary of the monetary aggregate must be stated.

A bank loan credits a borrower’s deposit, increasing spendable bank money, while a repayment can destroy that deposit money. The central bank’s reserve balance is not identical to household money.

The money supply is not just notes and coins, and a larger monetary aggregate does not mechanically create the same increase in real output.

The quantity equation is MV = PY: money supply times velocity equals the price level times real output. It becomes a theory of inflation only when assumptions about velocity and real output are made.

If velocity is stable and real output is determined by real factors in the long run, a sustained increase in money can raise the price level. In the short run, velocity, spare capacity and expectations may change.

If M rises 5%, V and Y are unchanged, the equation implies P rises about 5%. If banks hoard liquidity or output responds, the price effect is different.

MV=PY is an identity in measured data; the causal claim that money causes proportional inflation needs the additional assumptions.

Commercial banks accept deposits, make loans, facilitate payments and provide other financial services. They transform short-term liquid liabilities into longer-term, less liquid assets and earn income from the spread and fees.

Banks face credit, liquidity, interest-rate and operational risks. Capital requirements, reserves, collateral and confidence constrain lending; a bank cannot safely lend every deposited dollar indefinitely.

A bank may fund a five-year business loan with a mixture of deposits and longer-term finance, but must still meet withdrawals and absorb defaults.

Banks are not simply passive intermediaries transferring pre-existing savings, and a loan creates a deposit but also creates a liability for the borrower.

The money supply can expand when banks create new deposits through lending or when central-bank and government operations add liquidity; it can contract through repayment, asset sales, tighter lending or withdrawal of deposits.

The simple money-multiplier story is conditional: banks may hold excess reserves, borrowers may not want loans, and households may change cash preferences. Capital regulation and risk appetite matter as much as reserve availability.

A central-bank asset purchase may increase bank reserves, but if firms are pessimistic and banks tighten standards, deposit creation and spending may rise little.

A reserve injection is not the same as a guaranteed multiple increase in broad money, and money growth need not translate one-for-one into real GDP.

Demand-pull inflation can be restrained by contractionary fiscal or monetary policy; cost-push inflation may require supply-side action, targeted support or acceptance of a temporary price rise.

Policies work through different lags and side effects. Higher rates can reduce demand but increase debt-service costs; taxes can reduce spending but affect incentives; supply improvements take time and may not lower prices immediately.

If inflation follows an overheated demand boom, rate rises may be appropriate. If it follows a one-off energy shock, aggressive demand reduction may cut output while leaving the initial energy price unchanged.

No anti-inflation policy is costless or guaranteed, and a lower inflation rate is not the same as falling prices.

The demand for money is the amount of money people wish to hold rather than spend or invest. Transaction and precautionary motives generally rise with income; speculative demand depends on expected interest rates and asset prices.

Holding money has a liquidity benefit but an opportunity cost: the interest that could have been earned on bonds or other assets. Uncertainty, payment technology and confidence also affect the demand.

A household may hold more cash before a large bill, while an investor may hold liquid funds when expecting bond prices to fall and interest rates to rise.

Money demand is not the same as demand for goods, and a higher income does not necessarily raise every component by the same amount.

An interest rate is the price of borrowing or the return to saving. In a money-market model it is determined where money demand meets the available money supply; in a loanable-funds model it balances saving and borrowing demand.

State the model before explaining a shift. A larger money supply can lower the equilibrium rate in a simple liquidity model, while higher investment demand or lower saving can raise the rate in a loanable-funds model.

If the central bank supplies more liquid balances and money demand is unchanged, the market rate may fall, encouraging borrowing; if confidence simultaneously raises investment demand, the net movement is less clear.

“The interest rate” is not one universal number, and the policy rate, market yields and loan rates can differ.