The document discusses several key topics related to money and banking: 1) It outlines the functions of money as a medium of exchange, unit of account, and store of value. 2) It describes how the banking system works, including the roles of central banks, high-powered money, reserve ratios, and how the money multiplier determines money supply. 3) It presents models for the demand for money based on transactions, precautionary, and asset motives as well as the relationship between money demand and interest rates.

1. Money and the banking system
• Functions of money
• Key aspects of the banking system
• Money supply / money base and multiplier
• Equilibrium in financial markets

2. The functions of money
1. Medium of exchange: it facilitates efficient
trading
2. Unit of account
3. Store of value: it can be used to make purchases
in the future

3. The banking system
• In earlier times precious metals like gold or silver
were used as a medium of exchange
• Later paper currency issued. Only central banks
were allowed to issue paper currency that was
convertible into gold
• Abandonment of the gold standard: currencies
were no longer convertible by law into anything
valuable
• Today almost all currency is fiat money. Fiat
money is widely accepted because it is declared by
government to be legal tender

4. • Central banks are the providers of high-powered
money
• High powered money = currency (bank notes and
coins) in private circulation plus the quantity held by
the banking system in deposits held with the Central
Bank . Also referred to as the monetary base or M0
• High powered money is an asset to anyone in the
private sector who holds it but is a liability of the
Central Bank
• Monetary conditions in an economy can be influenced
by altering the stock of high powered money

5. • The Central Bank can increase the amount of high
powered money in the economy through open-
market operations
– This involves the purchase of securities (usually
government bonds) undertaken with newly issued high-
powered money
– The government guarantees to pay a fixed interest per
year and repay the principal at some future date
– Government bonds considered to carry less risk than
private sector bonds

6. The ratios approach to
the creation of deposit money
• Two ratios are important in the determination of
the level of deposit creation:
– Commercial banks’ reserve ratio
– Ratio of currency to deposits held by the public
• Define R as the cash held in bank reserves
• Define C the cash held by the non-bank public
• Define H the level of high-powered money in the
economy
• then: C + R = H

7. C+R=H
• Desired reserve ratio (i.e. reserves as a proportion of deposits, D) of
banks is given by r
R = rD
• The public hold a fraction c of its bank deposits in cash
C = cD
• Hence:
cD + rD = H
• Solving for D yields
D = H/(c+r)
• if c=0, and r = 0.1, then deposits would be 10x the cash in the
economy
D = H/0.1 ⇒ 10D = H
• as c ⇑, the value of deposits becomes smaller. E.g suppose c=0.2, then,
D = H/(0.1+0.1) ⇒ D = H/(0.2) ⇒ 5D = H

8. • An expression for money supply (M) and H can be
obtained by noting that the total supply of money is
the sum of deposits (D) and currency (C). Thus:
M=C+D
M = cD + H/(c+r)
M = cH/(c+r) + H/(c+r)
M = H(c+1)/(c+r)
• (c+1)/(c+r) is know as the money multiplier
• It tells us how much bigger is the money supply to the
cash base of the system
• Money supply = money multiplier x monetary base
• In the UK banking system the reserve ratio is 0.005 and the
cash ratio is 0.033 therefore the value of the money multiplier
is just over 27

9. Narrow and Broad Money in the UK
(£’s billion)
Wide Monetary Base (M0) 24.4
- Banks Cash &Balance at Central Bank 3.1
= Notes and Coins in Circulation 21.3
+ Banks’ Retail Deposits 228.2
+ Building Society’s Deposits & Shares 205.0
+ Wholesale Deposits 211.6
= Money Supply (M4) 661.1

10. Changing the money supply
• If the central bank wants to raise money supply, it
can use the following instruments:
a) it can lower the required reserve ratio
b) it can lower its discount rate
(a) and (b) affect the money multiplier
c) it can engage in open market operations
This affects the monetary base

11. The demand for money
•Individuals can only hold two assets: money or bonds
•Money does not pay any interest whereas bonds are interest-
bearing assets
•There are benefits to holding money, but there are also costs
– the interest foregone by not holding an interest bearing
asset
• Three motives for holding money:
– Transactions motive (related to income)
– Precautionary motive (related to income)
– Asset motive (risk aversion)

12. Marginal cost, For a given level of real
marginal benefits income, The marginal
benefit of holding
money falls as money
holdings increase
E** MC’
MC
E E*
MB’
MB
L
Real money holdings

13. Is the opportunity cost of holding money the real or
nominal interest rate on bonds ?
– Real interest rates measure the real return on lending in
terms of the increase in purchasing power over goods
as a result of postponing spending
– If the rate of inflation is given by π and the return on
bonds is r, then the real return on bonds is r - π
– Since money is non interest bearing asset, the real
return on money is 0 - π
• The opportunity cost of holding money is the
differential between the real return on bonds and
the real return on money
• This is (r - π) - (0- π) = r (the nominal rate of
interest)

14. We could thus write an expression for demand for
real money balances as follows:
M/P = f(Y/P, r)
where, M is nominal money demand, p is the price
level, Y is nominal income, and r is the nominal
rate of interest

15. Money market equilibrium
Interest Rate
Supply of real balances
At r0 there is excess demand for
money, ∴individuals sell bonds,
this lowers the price of bonds,
r* which thus raises the interest rate
E
r0 A B
LL= demand for real
balances
L*
Real money holdings