In-Depth Notes on Functions of Money and Banking Operations

Key Functions of Money

  • Medium of Exchange

    • Facilitates trade by providing an easier method of exchange compared to bartering.
    • Example: Trading a laptop for a phone is complicated; with money, you can find a middle ground easily.

  • Unit of Account

    • Provides a standard numerical unit of measurement that facilitates the valuation of goods and services.
    • Example: Prices in dollars help consumers know how much goods cost in relative terms.

  • Store of Value

    • Retains value over time, allowing individuals to save and spend in the future.
    • Example: Money in a bank account represents accumulated working value and does not diminish quickly over time.
Types of Money

  1. Commodity Money

    • Physical goods that have intrinsic value are used as money.
    • Examples: Gold, silver, and even cigarettes in prisons.
    • Drawbacks:
      • Difficult to transport, especially valuable or heavy items.
      • Problems relating to visibility (e.g., can't trade a fraction of a gold bar easily).
      • Prone to price risks due to fluctuating supply and demand.

  2. Representative Money

    • Paper notes that represent a claim on a commodity (e.g., gold).
    • Example: Gold or silver certificates, such as the US dollar before 1974, were exchangeable for a specific amount of gold.

  3. Fiat Money

    • Money that has no intrinsic value but is established as money by government regulation.
    • Example: US dollar, which has value because the government backs it, but it's not tied to a physical commodity.
    • It allows greater flexibility in monetary policy but can lead to issues like inflation if mishandled.

  4. Cryptocurrency

    • Digital or virtual currency that uses cryptography for security.
    • Still emerging in terms of acceptance as a mainstream form of money.
Measuring Money Supply
  • M2 Money Supply
    • A measure of money supply that includes cash and other liquid deposits.
    • Important to note that deposits also count towards the money supply.
Bank Operations

  • Role of Banks

    • Banks act as intermediaries to lend money and manage deposits.
    • Balance Sheet Components:
      • Assets: Items banks own (reserves, loans, securities).
      • Liabilities: What banks owe to depositors (customer deposits).

  • Money Creation Process:

    • When a bank receives deposits, it can loan out a portion, thus creating new money.
    • Example: If $1000 is deposited and the bank loans out $800, it creates $800 of new money.

  • Reserve Ratio

    • The fraction of deposits that banks are required to keep on reserve.
    • Formula: Reserve Ratio=Total ReservesTotal Deposits\text{Reserve Ratio} = \frac{\text{Total Reserves}}{\text{Total Deposits}}
    • This is pivotal in understanding how much money banks can lend versus how much they must hold in reserve.
Additional Notes
  • Prior monetary systems (like the Bretton Woods system) tied currencies to gold, enabling easier exchange but leading to complications such as inflation when large amounts of gold were discovered.