S5 Economics Chapter 7 – Money & Banking

Barter Economy

• Definition: direct exchange of goods for goods; requires $ext{double coincidence of wants}$.

• Key drawbacks:

  • Double coincidence of wants ⇒ high transaction cost.

  • No common measure of value – many relative prices (with $n$ goods: $\frac{n(n-1)}{2}$ prices).

  • Difficult wealth storage (bulky/perishable goods).

  • Indivisibility of many goods.

  • Transport inconvenience.

  • Inflation concept absent: price rises in one good imply falls in another ⇒ no general price level change.

Money

• Definition: anything generally accepted as a $ext{medium of exchange}$ (≠ cash only).

• Monetary economy: Goods → Money → Goods (indirect exchange).

Functions (4)

1. Medium of exchange: accepted for goods/services, avoids double coincidence.

2. Unit of account: common measure of value for pricing.

3. Store of value: holds purchasing power over time.

4. Standard of deferred payment: allows for debt and future transactions.

Money solves barter problems

• Removes need for double coincidence.

• Provides single price expression.

• Durable & portable wealth storage.

• Divisible denominations enable any transaction size.

Properties of Good Money (7)

Generally acceptable (everyone trusts it), divisible (for small/large transactions), durable (withstands wear), portable (easy to carry), homogeneous (all units identical), scarce (limited supply maintains value), stable in value (quantity manageable).

Value of Money

• Nominal (face) value.

• Real value (purchasing power) ∝ $\frac{1}{\text{price level}}$.

• Intrinsic value (commodity value).

Types of Money (Historical)

• Commodity money (gold, salt).

• Representative/convertible money (gold certificates).

• Fiat money: Value is by government decree; legal tender means it must be accepted for debts.

  • Legal tender (notes & coins).

  • Demand deposits (chequable).

• Electronic money: virtual currency (e.g. Bitcoin) is a digital form; electronic payment tools (Octopus, FPS) are mechanisms to transfer existing money, not money themselves, as they represent a claim on money.

Hong Kong Currency & Note Issue

• Coins & $\$10$ notes: issued by HKMA.

• Other notes: HSBC, SCB, BOC under HKMA supervision.

• Linked exchange rate system (since 1983):

  • Banks obtain Certificates of Indebtedness from Exchange Fund at fixed rate US$\$1 = \text{HK}$\$7.8 before issuing notes.

  • Redeemable in reverse at same rate.

  • Market HK$/US$ rate floats; arbitrage possible if gap vs 7.8 emerges (e.g., if market HK$ strengthens to 7.75, banks can buy HK$ in market at 7.75$and sell to HKMA at$7.80$, profiting and pushing market rate back towards$7.80; reverse for weakening HK$).

Banking Overview

• Bank = financial intermediary: accepts deposits, makes loans; earns spread between lending and deposit rates.

Types of Banks

Central bank, commercial (licensed) banks, merchant (investment) banks.

Central Bank Functions (HK context)

1. Supervise banks – HKMA rules & monitoring.

2. Lender of last resort – HKMA liquidity support.

3. Conduct monetary policy – maintain linked rate.

4. Manage official reserves (Exchange Fund).

5. Government’s banker/adviser (HSBC banking services; HKMA advice).

6. Issue currency (coins, $10 notes).

7. Hold cash reserves (not applicable in HK; liquidity ratio instead).

8. Administer clearing house (HK Interbank Clearing Ltd.).

Commercial Banks (Licensed) – Key Functions

• Accept demand/savings/time deposits.

• Provide loans (mortgage, overdraft).

• Other services: remittance, FX, credit cards, insurance, etc.

Three-tier Deposit-taking System (HK)