Money

Money

Money is any good that is widely used and accepted in transactions involving the transfer of goods and services from one person to another. Economists differentiate among three different types of money commodity money, fiat money, and bank money.

Commodity money is a good whose value serves as the value of money. Gold coins are an example of commodity money. In most countries, commodity money has been replaced with fiat money.

Fiat money is a good, the value of which is less than the value it represents as money. Dollar bills are an example of fiat money because their value as slips of printed paper is less than their value as money.

Bank money consists of the book credit that banks extend to their depositors. Transactions made using checks drawn on deposits held at banks involve the use of bank money.

Function of Money

Medium of exchange

Money also acts as a medium of exchange or as a medium of payments. This function of money is served by anything that facilitates trade by being generally accepted by people in exchange for goods and services.  For example: pay for school fees, food, daily expenses, and insurance. Money will then reduce the time and energy spent in barter. The person who owned a cow can now simply sell it to the person who offers the most money for it and then buy the bullock cart from another person who offers him the best bargain. All trade may be considered barter, one good or services is traded for another good or service either directly, or indirectly with money acting as the intermediary. However, this function can only be performed properly if the value of money remains constant.

Unit of account

Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of good to purchase.

Store of value

Money as a store of value that refers to money as an asset that holder of money used it to transporting purchasing power from one time period to another. Therefore, it serves as a store of wealth over time when it retains purchasing power and hold value over time. They keep money for investment. This function will be performed well as long as money retains a constant purchasing power.

Standard of deferred payment

Money allows existence of credit, possible for contract be agreed involving payment in the future. Examples of situations where future payments are to be made are pensions, principal and interest on debt and salaries.  As long as money maintains a constant value through time, it will overcome the problems associated with making future payments with specific commodities.

Motive of holding Money

Transaction motives:

The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises. 

Precautionary motives:

People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money.  We also hold money in case we need to spend it.

Speculative motives:

Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value due to inflation. 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 asset. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity cost of holding money will become greater.

Money multiplier

The money multiplier is a measure of the extent to which the creation of money in the banking system causes the growth in the money supply to exceed growth in the monetary base. A money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend is a multiple of reserves; this multiple is the reciprocal of the reserve ratio, and it is an economic multiplier.

Function of Central bank

1.     Supervision of the banking system:

Central bank supervises the banking system of the country. Central may be responsible for banking system. They collect information from commercial bank and take necessary decision by two ways:

a.) bank examine

b.) bank regulation

2.     Advising the government on monetary policy:

The decision on monetary policy may be taken by the central bank. Monetary policy refers to interest rates and money supply. The central bank will corporate with the government on economic policy generally and will produce advice on monetary policy and economic matters, including all the statistics.

3.     Issue of banknotes:

The central bank controls the issue of banknotes and coins. Most payment these days does not involve cash but cheques, standing order, direct debit, credit cards and so on. Nevertheless, cash is important as bank’s cash holdings are a constraint on creation of credit, as we have seen.

4.     Acting as banker to government:

Normally a central bank acts as the government’s banker. It receives revenues for Taxes and other income and pay out money for t6he government’s expenditure. Usually, it will not lend to the government but will help the government to borrow money by the sales of its bill and bonds.

How Central Bank control money supply

Required Reserve ratio

Required reserves are the percentages of deposit bank hold in cash or a deposit of Fed. If the reserve ratio decreases, the money supply increases and if the reserve ratio increase, the money supply decrease.  The Fed can lower required reserve rate which raises the multiplier effect of high powered money.

For example, it the required reserves went from 20% to 10%, the bank would only need to hold $10,000 in reserves for the initial injection of $100,000. The other $90,000 would be loaned out so at each stage in the multiplier chain, the banks would be loaning out more funds and the eventual increase in the money supply would be larger.

Discount Rate

The discount rate is the interest rate at which the Fed lends reserves to other banks. The Fed can lower the discount rate and lower the costs for banks holding low excess reserves which will lower the excess reserve rate. If discount rate increases, the supply of money will decrease and if the discount rate decreases, the supply of money will increase.

Open Market operations

Open market operations refer to the buying and selling of government bonds in order to change the supply of money. If the Fed sells bonds, the money supply decrease and if the Fed purchases bonds in the open market, increase the money supply by the price of the bonds. The Fed can buy or sell government securities.

For example, the Fed will contact its broker and announce it wants to buy $100,000 of government securities. The increase of $100,000 cash into the system will result in an increase in the money supply of $500,000.