INTRODUCTION TO MACROECONOMICS

UNIT 4: MONEY AND BANKING

Lecturer: Chilizani Phiri

 Definition of Money

 Functions of Money

 Qualities of Money

 Keynesian Theory on Demand for Money

 Credit Creation by Financial Institutions

 Commercial banks

 Central banks

 Monetary policy
 Money may be defined as any commodity which is

generally accepted in exchange for goods and

services.
 Money gives its holder the ability to purchase

goods and services but it has no direct use.

 It is a means of buying what we want. The demand

for money, therefore, is derived demand.

There are four main functions of money, namely:

 It is a medium of exchange. It allows easy

exchange of goods and services.

 It is a measure of value or Unit of Account

 Value in economics means value-in exchange.

 The value of a commodity means what it can be

exchanged for or what it can buy. It means the

purchasing power of a commodity.

 Similarly, the value of money means its purchasing

power in terms of goods and services in general.
 Prices are used to measure the value of a product

or service.

 For instance, If the price of shirt A is K20, and the

price of shirt B is K50, the value of shirt B is higher

than the value of shirt A.

 It is a store of value. wealth can be stored in

form of money.
 It is a means of making deferred payments.

Money enables people to have immediate

use of goods and services but pay for them
later.
For any commodity to quality to be a medium of

exchange or money, it should have the following

qualities.

 Acceptability: It must be generally acceptable.

 Portability: It must be portable or easy to carry.

 Divisibility: It must be divisible into smaller

units without losing value.

 Durability: It should be durable without losing

value.
 Scarcity: It should be limited in supply for

people to have confidence in it.

There are three components of money supply, namely:
 Bank notes and coins in circulation with public.

 Demand deposits in current accounts. Money in

current accounts do not earn interest. They can be

drawn on demand using a cheque.
 Savings and fixed deposits. These accounts earn

interest but money cannot be withdrawn or

transferred using a cheque.
Measures of money include M1, M2 and M3.
 Money Supply M1 or Narrow Money. This is the

narrow measure of money supply and is

composed of the following items:
 Currency with the public

 Demand deposits with the public in the commercial

and cooperative banks.
 Money Supply M2: M2 is a broader concept of

money supply in India than M1. In addition to

the items of M1, the concept of money supply
M2 includes savings deposits.
 Thus, M 2 = M1 + Savings deposits with the post

office savings banks.

 Money Supply M 3 or Broad Money: M3 is a

broad concept of money supply.

 In addition to the items of money supply

included in measure M1, in money supply M3

time deposits with the banks are also included.
 Thus, M3 = M1 + Time Deposits with the banks.
 Demand for money in economics means the

household’s and companies’ preference to keep

money in homes or at company premises instead
of keeping it in banks.
 Preference by households and firms to hold

money in houses or at company preferences is

called liquidity preference.
Three Motives for Liquidity Preference: Keynes
identified three motives for liquidity preference or for
keeping money at home
 The transaction motive: To hold money at home to

meet current expenditures.

 The precautionary motive: To hold money at home or

company premises to meet unexpected expenditure.

 Speculative motive: People keep liquid cash in

order to jump on any opportunity that may arise.

Speculative demand for money, is influenced by
level of interest rate.
 If interest rate is high, speculative demand for money is
low but if bank interest rate is low, speculative demand
for money is high.
 If each individual liquidity preference is added

together an aggregate liquidity preference curve

can be drawn which represents the total demand

for money as shown in the figure below

 When the interest rate is high like at R1

speculative balances will be zero , that is only

transactions and precautionary balances will
be held.
 If the rate of interest is very low like at R2,

large speculative balances will be held.

 The horizontal portion of the liquidity preference

curve is called s the liquidity trap.

 In this portion of the curve, the demand for

speculative balances is perfectly elastic with respect

to interest rate.
 Reductions in interest rate below the liquidity trap

only increases peoples desire to hold cash at homes.

 Below the liquidity trap an increase in money

supply that is intended to lower the rate of

interest and promote investments in the
economy will not work because people will
keep money in homes instead of putting it in
banks.
Banks have to master to serve, namely:
 The shareholders who want to earn profit by

investing their money or money of depositors.

 The depositors who want confidence and high

liquidity in banks so that they can withdraw

money any time they want.
 Creation of credit is one of the most outstanding

functions of a modern bank.

 A bank has sometimes been called a factory for

the manufacture of credit. How credit is created?

 It is generally understood that money received by

the bank is meant to be advanced to others.

 A depositor has to be content simply with the bank’s

promise or undertaking to pay him whenever he

makes a demand.
 Thus, the banks are able to do with a very small

reserve, because all the depositors do not come to

withdraw money simultaneously;
 some withdraw, while others deposit at the same

time.
 The bank is thus enabled to create much more

credit on the basis of a small cash reserve.

 The bank is able to lend money and charge

interest without parting with cash, as the bank

loan creates simply a deposit or it creates a credit
for the borrower.
 This is what is meant by creation of credit.
 The creation of bank deposits in excess of the

currency reserves with them has become

possible because of the fractional reserve
system.
 The fraction of banks’ total deposits that are

held in currency reserves (at the central bank) is

called reserve ratio.
 The money multiplier is a concept which measures

the amount of money created by banks with the

help of deposits after (excluding the amount set
for reserves from the deposits).
 It tells the maximum number of times the amount

will be increased with respect to the given change

in the deposits.
 1
𝑀𝑜𝑛𝑒𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = , Where r is the reserve ratio.
𝑟
Example: If the cash reserve ration is 5%, the money
1 1
multiplier = = = 20.
5% 0.05
 Thus, with 5% as cash reserve ratio banks would use the
initial deposit to create credit 10 times than the initial
deposit.
 Thus, the fractional reserve system enables the banking
system as a whole to create much more demand deposits
than the amount of the original deposit of currency.
 Suppose a bank with a minimum cash reserve
ratio of 10% receives K1,000 deposits. How will
this affect the balance sheet of the bank?
Solution : The Balance Sheet of The Bank
 The bank has increased the amount of money

available for spending in the economy by

K900. How?
 The original depositors can still spend thei

K1,000 and the people who received the

loans can also spend K900.
 We have only considered one step of credit

creation.
 In reality the process of creating deposits or loans

is a continuous one.
 The initial deposit of K1,000 would be used to

create credit 10 times than the initial deposit.

 The process of creating credits can go on and on.
 If the original depositors want to withdraw their

money at once, this will not be possible because

the bank has K100 only.
 In such a situation the bank has three options.

 To borrow money from other sources.

 To borrow money from the Central Bank.

 To go into liquidation
The process of creating bank deposits or credits,
requires a number of conditions which include the
following:
 The bank must receive additional deposits
 The public must deposit their money with banks
instead of keeping it in homes.
 A bigger percentage of deposits must be used to
make loans or to go into new investments.
 People must be willing to borrow from banks.
 Commercial banks are financial institutions which

receive deposits and lend them out to individuals and

companies.
 Functions of commercial banks include the following:

 They safe guard people’s deposits.

 They finance the business community.

 They give advice to customers.

 They receive payments on behalf of customers.

 They buy and sell shares at stock exchange on behalf

of customers.

 They provide foreign exchange to traders engaged in

foreign trade.

 They provide safe custody for wills and other

important documents.
 It is the major financial institution in a country and

acts as a regulator of the banking system.

 Functions of a Central Bank include the following:

 Controlling and supervising the banking system.

 To issue currency (bank notes and coins).

 To provide banking services to the government. All the

money raised by GRZ are deposited at BOZ.
 To provide banking services to other financial

institutions.

 It works with other central banks, the IMF and the

World Bank.

 It manages the government debt.

 It is the custodian of the country’s stocks of gold and

foreign currency reserves.

 It implements balance of payments policy.

 It implements government’s monetary policy.

 It is a lender of last resort.

 Monetary policy deals with the regulation
and monitoring of money supply, liquidity
creation, distribution of credit and control of
interest rates in the economy.
Objectives of monetary policy include the
following:
 To promote financial and monetary stability.

 To achieve economic growth with minimum

inflation.
 To promote investment in the economy.

 To maintain a relatively stable exchange rate.

 Bank of Zambia Monetary Policy Rate (MPR).

 BOZ regulates interest rates depending on whether

the country is pursuing an expansionary or
contractionary policy.
 Reserve ratio (Required Reserve Ratio)

 Commercial banks are required to keep with the

Central Bank a minimum reserve balance.

 Open Market Operation (OMO) to control

money supply, the Central Bank can sell and

buy government securities such as
government bonds.
 Devaluation: It is a sudden reduction in the

value of the local currency.