Money is a generally accepted medium of exchange. It facilitates indirect exchange of goods and services. Since all goods and services are measured in units of money the consumer knows exactly how much of a good he is giving up in order to consume another. It also serves as a store of value as money received now can be saved for buying goods and services in the future. It is printed and supplied by the central bank. Money is generally classified into narrow money (M1) and broad money (M2)
Narrow money is the most liquid form of money in the hands of the public that is immediately available for spending. It is the amount of currency notes and coins circulating in the economy as well as money available in the form of demand deposits or any other deposits against which checks can be written. Narrow money is also called as M1.
Broad money includes everything in narrow money plus money locked in time deposits and liquid mutual funds like money market mutual funds. Broad money is also called M2.
Fractional reserve banking
A bank makes money by lending out the deposits it receives at an interest rate higher than the interest it pays on the deposits. At any point in time a bank lends out only a portion of the deposits kept with it. The remaining deposits are held in reserve as buffer against potential losses. This is called fractional reserve banking as banks lend only a fraction of its deposits.
Money creation process
The money that the bank lends a customer may be used by the customer to buy some goods and services. The seller of the goods and services may then deposit the money received from the sale with another or same bank. The bank will then again lend a portion of the new deposit to another customer who may further use it to purchase goods and services. In this way the process of lending, spending and depositing continues and the same money that was lent out of the bank originally multiplies and grows itself thus expanding the money supply in the economy.
The total amount of money that can be created in this way can be calculated with the following formula;
If the original deposit was 1000 and the percentage of deposit to be held in reserve is 25%, then money created will be 1000/0.25 = 4000.
Therefore we can say the money multiplied 4 times or the money multiplier is 4.
Money multiplier can be directly computed as,
If the reserve requirement decreases, more money can be lent and therefore money created increases. Reverse is true when reserve requirement increases. Therefore supply of money can be controlled through the reserve requirement.
Quantity of money in the economy is some proportion of the total spending in the economy. The equation is given as ;
Velocity is the number of times the same unit of money has been used to buy goods and services. It is believed that real output and velocity change very slowly. Assuming velocity and real output are held constant, an increase in the money supply will lead to increase in prices. Therefore it is believed that monetary policy can be used to control the level of prices in the economy by controlling the money supply.
The belief that changes in money supply and prices have little or no effect on the velocity and real output (as they are believed to change very slowly) is called as money neutrality.
Demand and Supply of Money
Money is demanded for various reasons. Money is demanded for entering into transactions. Money is also demanded to be held to meet unforeseen contingencies. Money is demanded for speculation as and when investment opportunities arise. If perceived risk in holding financial instruments is higher, people will move out of them into cash. If perceived risk is lower people will move from cash to financial instruments.
Demand for money is directly proportional to the level of short term interest rates. When interest rates are low demand for holding money is higher. When interest rates are higher people prefer to hold less money and invest more in interest bearing financial instruments.
Central banks can affect the short term interest rates by controlling the money supply in the economy, which it does through the administration of the monetary policy. If money supply is increased, more money is chasing less demand and this puts downward pressure on the interest rates in the market. When the central bank decreases the money supply excess demand is chasing less supply and this puts upward pressure on interest rates.
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For solved examples please refer to the CFA Institute Books or any other books that provide them and you may want to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.