Notes on the Theory of Money & Banking

THE DEMAND FOR MONEY

  • The demand for money is influenced by several factors:
    • Level of income
    • Interest rates
    • Inflation
    • Uncertainty about the future
  • It is explained through three main motives:
    • Transactions motive
    • Precautionary motive
    • Speculative motive

LIQUIDITY PREFERENCE

  • Keynes described the demand for money as liquidity preference.
  • Cash balances can be classified into two categories:
    • Active Cash Balances: used for transactions and precautionary needs.
    • Idle Cash Balances: held for speculation.

ACTIVE CASH BALANCES

TRANSACTIONS DEMAND
  • People keep cash to cover day-to-day expenses during the time between income receipt and expenditure.
  • Income Motive Factors:
    • Level of income
    • Price level
    • Spending habits
    • Time-interval between receipts and expenditures
  • Business Application:
    • Businesses require money to meet expenses, such as:
    • Materials
    • Wages
    • Current expenditures.
PRECAUTIONARY MOTIVE
  • Individuals keep money to prepare for unforeseen events or contingencies.
  • It acts as a store of value against unexpected expenses.
SPECULATIVE MOTIVE
  • People hold money in anticipation of future events, aiming to profit from fluctuating interest rates.
  • If interest rates are expected to rise, individuals keep cash available to invest later.

DEMAND CURVE FOR MONEY

  • Shows the quantity of money demanded at a given interest rate.
  • Characteristic: The demand curve is downward sloping, indicating:
    • Higher interest rates lead to less demand for money.

SUPPLY OF MONEY

  • Defined as the total quantity of money circulating in the economy at a specific time.
  • Includes:
    • Cash
    • Demand deposits
    • Near money (liquid assets)
  • Common measures of money supply: M1, M2, M3.

SUPPLY CURVE FOR MONEY

  • Controlled by policies such as open market operations by the central bank (e.g., Fed, Bank of Jamaica).

SIGNIFICANCE OF MONEY SUPPLY

  • Money supply variations reflect economic conditions and can be used as an economic performance indicator (per Milton Friedman).

STRUCTURE OF MONEY SUPPLY IN AN OPEN ECONOMY

  • Total effective money supply includes:
    • Currency (coins and paper money)
    • Demand deposits
  • Near money such as savings deposits may also be included in the money supply.

MODERN BANKING SYSTEM

  • Balance Sheet Equation:
    • Assets - Liabilities = Net Worth
    • Assets = Liabilities + Net Worth
  • Key Assets: Loans, cash on hand, deposits with central bank.
  • Liabilities: Debts owed (deposits are liabilities).

BANK RESERVES

  • Comprise deposits held at the Fed and cash on hand.
  • Required Reserve Ratio (RRR): Percentage of deposits banks must maintain as reserves.

T-ACCOUNT EXAMPLE

  • Illustrates assets and liabilities of a bank with a balanced equation:
    • Assets: Reserves, Loans
    • Liabilities: Deposits, Net Worth.

CREATION OF MONEY

  • Banks can issue loans based on their reserves while adhering to reserve requirements.
  • Example:
    • Deposit of $100 leads to potential loans and deposits amounting to $500, depending on the RRR (e.g., 20%).

MONEY MULTIPLIER

  • The money multiplier indicates how many times deposits can increase based on reserves.
  • With a 20% RRR, each dollar in reserves can generate a total of $5 in additional deposits.

QUANTITY THEORY OF MONEY

  • Suggests a direct relationship between money supply changes and price levels.
  • Calculated using the formula: MsimesV=PimesTM_s imes V = P imes T
    • Where:
    • MsM_s = money supply
    • VV = velocity of money
    • PP = average price level
    • TT = volume of transactions.

MONEY AND INFLATION

  • Changes in money supply directly impact price levels and purchasing power.
  • An increase in money supply typically results in rising inflation and decreasing the money's value.

CENTRAL BANK FUNCTIONS

  • Reference material on the functions of the Central Bank (Bank of Jamaica) is suggested for further reading.