Money, Banking, and Interest Rates – Comprehensive Study Notes

Definition of Money
  • Anything widely accepted as a medium of exchange for goods and services.
  • Core idea: money’s acceptability—not its physical form—gives it purchasing power.
Four Classic Functions of Money
  • Medium of Exchange
    • Eliminates the double coincidence of wants inherent in barter.
    • Allows specialization and greater economic efficiency.
  • Store of Value
    • Retains purchasing power over time.
    • Prerequisite: reasonable price stability; high inflation erodes this function.
  • Unit of Account
    • Provides a common measure to quote and compare prices (e.g., $10\$10 for bread vs. $25\$25 for a book).
    • Enables bookkeeping, budgeting, and economic calculation.
  • Standard of Deferred Payment
    • Debts, wages, and contracts are denominated in money for future settlement.
    • Creditor and debtor can plan because the monetary unit is commonly understood.
Types of Money
  • Commodity Money
    • Has intrinsic value (e.g., gold, silver, cigarettes in POW camps).
    • Value derives from alternative, non-monetary uses.
  • Fiat Money
    • Lacks intrinsic value; worth arises from government decree and public confidence.
    • Examples: modern paper notes, digital balances.
  • Commercial Bank Money
    • Created when banks issue loans; exists mainly as deposits in checking/savings accounts.
    • Dominant form in contemporary economies.
The Banking System
  • Banks = financial intermediaries that accept deposits and extend loans.
  • Core roles
    • Safeguarding customers’ funds in demand, savings, and term accounts.
    • Providing credit (personal loans, mortgages, business overdrafts).
    • Facilitating payments: cheques, debit cards, credit cards, electronic transfers.
    • Money creation via the fractional reserve process (see below).
Fractional Reserve Banking (FRB)
  • Banks keep only a fraction of customer deposits as reserves; remainder is loaned out.
  • Reserve Ratio example
    • Suppose a bank receives a deposit of $1,000\$1{,}000.
    • With a reserve requirement of 10%10\% (i.e., 0.100.10), it must hold $100\$100 in reserve and may lend $900\$900.
    • The borrower spends the $900\$900; the recipient redeposits it, creating additional deposits and loans.
  • Money Multiplier (simplified): m=1RRm = \frac{1}{RR}
    • If RR=0.10RR = 0.10, then m=10m = 10 → potential total deposit expansion up to $10,000\$10{,}000 from the original $1,000\$1{,}000.
  • Significance
    • FRB expands the money supply beyond the stock of physical currency.
    • Central Banks supervise reserve rules to maintain stability.
Interest Rates (as of 02 July 202502\,July\,2025)
  • Definition: Price of money—the cost for borrowers or the reward for savers.
  • Expressed as a yearly percentage of the principal (e.g., an annual rate of 5%5\% means $5\$5 per year on each $100\$100 borrowed/saved).
  • Central Banks (e.g., Bank of Mauritius) set a key policy rate—the Repo/Base Rate—that guides commercial banks’ lending and deposit rates.
How Interest Rates Influence the Economy
  • High Interest Rates
    • Borrowing becomes expensive → households & firms reduce loans → spending and investment fall.
    • Saving becomes more attractive → greater deposits.
    • Lower demand may ease inflationary pressure.
  • Low Interest Rates
    • Cheaper credit → borrowing rises → consumption and investment increase.
    • Saving less attractive → funds shift toward spending.
    • Stimulates GDP growth, though risk of higher inflation.
Central Bank & Monetary Policy
  • Objectives: price stability, full employment, sustainable growth, financial system soundness.
  • Monetary Policy Tools
    1. Policy (Repo) Rate adjustments—primary focus of this transcript.
    2. Open-market operations (buying/selling government securities).
    3. Reserve requirement changes (altering FRB leverage).
  • Policy Stances
    • Expansionary (a.k.a. accommodative): Lower rates → boost economic activity, combat unemployment.
    • Contractionary (a.k.a. restrictive): Raise rates → cool demand, restrain inflation.
Key Definitions Recap
  • Money Supply: Aggregate quantity of money (notes, coins, bank deposits) in the economy.
  • Fractional Reserve Banking: System wherein banks hold only a slice of deposits as liquid reserves.
  • Base Rate / Repo Rate: Benchmark interest rate set by the Central Bank for short-term lending to commercial banks.
  • Liquidity: Ease and speed with which an asset can be converted to cash without significant loss of value.
Practical & Ethical Considerations
  • Financial Stability: Excessive lending in FRB can fuel bubbles; regulators impose capital & liquidity ratios.
  • Inflation vs. Growth Trade-off: Policymakers continually balance low inflation against the benefits of robust employment.
  • Social Equity: Interest rate changes impact borrowers (often lower-income) and savers (often retirees) differently.
  • Trust & Confidence: Fiat money and commercial-bank money rely fundamentally on public belief in institutions.
Connections to Wider Curriculum / Real-World Relevance
  • Links to prior lectures on inflation measurement (CPI, GDP deflator) and macro-equilibrium models (AD-AS).
  • Real-world example: 2008 Global Financial Crisis highlighted dangers of lax regulation in FRB and the pivotal role of Central Banks lowering rates to near 0%0\%.
  • Contemporary issue: debates over Central Bank Digital Currencies (CBDCs) could reshape money’s forms and the banking system itself.