Money takes the form of either commodity money (with intrinsic value like gold) or fiat money (without intrinsic value established by government decree). Money serves three functions as a medium of exchange, unit of account, and store of value. The money supply includes M1 (currency and checkable deposits) and broader M2 (M1 plus savings deposits and money market funds). When the central bank increases reserves, the banking system can expand deposits by making loans, multiplying the initial change in reserves through the deposit multiplier.

1. MONEY &
BANKING

2. DEFINITION OF MONEY
To the layperson, the words income, credit, and
wealth are synonyms for money. In economics, the
words money, income, credit, and wealth are not
synonyms.
Economists, use the word in a more specific sense:
Money is the set of assets in the economy that people
regularly use to buy goods and services from each
other. According to Prof. Walker, “Money is what money
does”.
“Anything that is generally acceptable as a means of
exchange (i.e., as a means of settling debts) and that at
the same time, acts as a measure and as a store of

3. THE KINDS OF MONEY
When money takes the form of a commodity with
intrinsic value, it is called commodity money. The term
intrinsic value means that the item would have value
even if it were not used as money. One example of
commodity money is gold. Another example of
commodity money is cigarettes (used in prisoner-of-
war camps during World War II and in Soviet Union after
the breaking up in the late 1980s).
Money without intrinsic value is called fiat money. A
fiat is an order or decree, and fiat money is established
as money by government decree. The acceptance of
fiat money depends as much on expectations and
social convention as on government decree.

4. THE FUNCTIONS OF MONEY
Money has three functions in the economy; It is a: 1.
Medium of exchange 2. Unit of account 3. Store of
value.
A medium of exchange is an item that buyers give to
sellers when they purchase goods and services.
A unit of account is the yardstick people use to post
prices and record debts. When we want to measure and
record economic value, we use money as the unit of
account.
A store of value is an item that people can use to
transfer purchasing power from the present to the
future. The term wealth is used to refer to the total of
all stores of value, including both money and
nonmonetary assets. Money is the most liquid asset,

5. COMPONENTS OF MONEY SUPPLY
Two frequently used definitions of the money supply
are M1 and M2.
M1 is sometimes referred to as the narrow definition
of the money supply or as transactions money.
M1= Currency held outside banks + Checkable deposits
+ Traveler’s checks
Money Is More Than Currency?
“Your money or your life,”
Though people often equate money and currency. To an
economist, though, money is more than just currency.

6. M2 is commonly referred to as the broad definition of
the money supply.
M2= M1 + Savings deposits (including money market
deposit accounts) + Small denomination time deposits
+ Money market mutual funds (retail)
A savings deposit, sometimes called a regular savings
deposit, is an interest-earning account at a commercial
bank or thrift institution.
A time deposit is an interest-earning deposit with a
specified maturity date.
A money market mutual fund (MMMF) is an interest-
earning account at a mutual fund company. MMMFs
held by individuals are referred to as retail MMMFs.
Only retail MMMFs are part of M2.

7. THE DEMAND FOR MONEY
Three motives for demanding money:
the transactions, the precautionary, and
the speculative motives.
The transactions motive for demanding money
arises from the fact that most transactions involve
an exchange of money.
The need to have money available in unexpected
situations is referred to as the precautionary
motive for demanding money.
The speculative motive for demanding money
arises in situations where holding money is
perceived to be less risky than the alternative of
lending the money or investing it in some other

8. THE MONETARY BASE
The monetary base (also called high-
powered money) equals currency in
circulation C plus the total reserves in
banking system R. The monetary base MB can
be expressed as
MB = C + R
Central Bank exercises control over the
monetary base through its purchases or sales
of securities in the open market, called open
market operations, and through its extension
of discount loans to banks.

9. MULTIPLE DEPOSIT CREATION
When the Central Bank supplies the banking
system with $1 of additional reserves, deposits
increase by a multiple of this amount—a
process called multiple deposit creation.
 Suppose that Central Bank has bought $100
million in bonds from the First National Bank,
the bank finds that it has an increase in
reserves of $100 million.
To analyze what the bank will do with these
additional reserves, we begin the analysis with

10. MULTIPLE DEPOSIT CREATION: A
SIMPLE MODEL

11. Because the bank has no increase in its
checkable deposits, required reserves
remain the same, now the bank has $100
million of excess reserve.
Let’s say that the bank decides to make a
loan equal in amount to the $100 million
rise in excess reserves. When the bank
makes the loan, it sets up a checking
account for the borrower and the bank
alters its balance sheet by increasing its
liabilities with $100 million of checkable
deposits and at the same time increasing its
assets with the $100 million loan. The

12. MULTIPLE DEPOSIT CREATION: A
SIMPLE MODEL

13. The bank has created checkable deposits by its act
of lending. Because checkable deposits are part of
the money supply, the bank’s act of lending has, in
fact, created money. When the borrowers make
purchases by writing checks, the checks will be
deposited at other banks, and the $100 million of
reserves will leave the First National Bank. As a
result, a bank cannot safely make a loan for an
amount greater than the excess reserves it has
before it makes the loan.
The increase in reserves of $100 million has been
converted into additional loans of $100 at the First
National Bank, plus an additional $100 million of

14. MULTIPLE DEPOSIT CREATION: A
SIMPLE MODEL

15. To simplify the analysis, let’s assume that the $100
million of deposits created by First National Bank’s
loan is deposited at Bank A and that this bank and
all other banks hold no excess reserves. Bank A’s
T-account becomes

16. If the required reserve ratio is 10%, this bank will
now find itself with a $10 million increase in
required reserves, leaving it $90 million of excess
reserves. Because Bank A (like the First National
Bank) does not want to hold on to excess reserves,
it will make loans for the entire amount. The net
result is that Bank A’s T-account will look like this:

17. If the money spent by the borrowers to whom Bank A lent
the $90 million is deposited in another bank, such as Bank B,
the T-account for Bank B will be
The checkable deposits in the banking system have risen by
another $90 million, for a total increase of $190 million
($100 million at Bank A plus $90 million at Bank B). Bank B
will want to modify its balance sheet further. It must keep
10% of $90 million ($9 million) as required reserves and has
90% of $90 million ($81 million) in excess reserves and so
can make loans of this amount. Bank B will make loans

19. The $81 million spent by the borrowers from Bank
B will be deposited in another bank (Bank C).
Consequently, from the initial $100 million
increase of reserves in the banking system, the
total increase of checkable deposits in the system
so far is $271 million (=$100 m + $90 m + $81
m).
Following the same reasoning, if all banks make
loans for the full amount of their excess reserves,
further increments in checkable deposits will
continue (at Banks C, D, E, and so on). Therefore,
the total increase in deposits from the initial $100
increase in reserves will be $1,000 million: The

20. The multiple increase in deposits generated from an
increase in the banking system’s reserves is called
the simple deposit multiplier. In our example with a
10% required reserve ratio, the simple deposit
multiplier is 10.
More generally, the simple deposit multiplier equals
the reciprocal of the required reserve ratio,
expressed as a fraction (for example, 10 = 1/0.10),
so the formula for the multiple expansion of deposits
can be written as follows.
∆𝑫 =
𝟏
𝒓𝒓
× ∆𝑹

21. Where,
∆𝑫 = change in total checkable deposits in the
banking system
rr =required reserve ratio (0.10 in the example)
∆𝑹 =change in reserves for the banking system
($100 million in the example)
The procedure of eliminating excess reserves by
loaning them out means that the banking system
(First National Bank and Banks A, B, C, D, and so
on) continues to make loans up to the $1,000
million amount until deposits have reached the
$1,000 million level. In this way, $100 million of
reserves supports $1,000 million (ten times the

22. FUNCTIONS OF CENTRAL BANK
Central Bank has eight major responsibilities or
functions:
1. Controlling the Money Supply.
2. Supplying the Economy with Paper Money (Bank
Notes). Central Banks have Bank notes on hand to
meet the demands of the banks and the public.
3. Providing Check-Clearing Services. When a bank
receives a check (from a depositor) drawn on
another bank, it may send the check for collection
and clearing directly to the other bank, deliver the
check to the other bank through a local

23. FUNCTIONS OF CENTRAL BANK
4. Holding Depository Institutions’ Reserves. Banks
are required to keep reserves against customer
deposits either in their vaults or in reserve
accounts at the Central Bank.
5. Supervising Member Banks. Without warning,
Central Banks can examine the books of member
commercial banks to assess the nature of the loans
the banks have made, monitor compliance with
bank regulations, check the accuracy of bank
records, and so on.
6. Serving as the Government’s Banker. The
government collects and spends large sums of
money. As a result, it needs a checking account for
many of the same reasons an individual does. Its

24. FUNCTIONS OF CENTRAL BANK
7. Serving as the Lender of Last Resort. A
traditional function of a central bank is to
serve as the lender of last resort for banks
suffering cash management, or liquidity,
problems.
8. Handling the Sale of Government Securities
(Auctions). Government securities (bills,
notes, and bonds) are sold to raise funds to
pay the government’s bills.