MONEY AND

BANKING
Chapter 7
DR MOHAMMAD SADIQUNNABI CHOWDHURY
PROFESSOR

Dept. of Economics, SUST

Submitted By:
Group 7B

Registration Number Name

2021331090 MAHDI HASAN QURISHI
2021331042 UMME ZOAYRIA ABEDIN
2021331100 SAGOR CHANDRA PAUL
2021331052 MD. MASUM RABBY
2021331082 MD. KAMRUL HASAN
7.1 – Money
7.1.1 - Understanding Money and Its
Evolution:
Definition of Money:

Money serves as a medium of value that simplifies the exchange of goods

and services within an economy. Unlike barter systems, which require
both parties to have mutually desirable items, money minimizes
transaction costs and streamlines trade.

Initially, money existed in the form of commodities whose inherent

properties made them valuable for trade. In modern economies, money
encompasses government-issued legal tender, fiat currency, money
substitutes, fiduciary media, and digital cryptocurrencies.

Key Characteristics of Money:

• Money acts as a system of value, facilitating trade and economic

transactions.
• It eliminates the inefficiencies of bartering, where both parties must
possess something of equal interest to exchange.
• Historically, early forms of money included agricultural commodities
such as grain and livestock.
• Present-day financial systems operate using standardized currencies
regulated by central banks.
• Digital assets, like cryptocurrencies, exhibit certain properties similar
to traditional money.
Essential Properties of Money:

1. Fungibility – Each unit of money should be interchangeable with

another of equal value, allowing seamless transactions.
2. Durability – It must be resilient enough to withstand multiple
exchanges without losing its value or usability.
3. Portability & Divisibility – Money should be easy to transport and
divisible into smaller units to facilitate transactions of varying sizes.
4. Recognizability – The authenticity and quantity of money should be
easily verifiable to prevent counterfeiting and ensure trust in
exchanges.
5. Stability – The supply of money should remain relatively constant
over time to prevent fluctuations in value due to scarcity or excess
availability.

Functions of Money:

1. Unit of Account – Money serves as a common measure for pricing

goods and services, enabling standardization in trade.
2. Store of Value – It allows individuals to preserve wealth for future
use without significant deterioration in value.
3. Standard of Deferred Payment – Money facilitates transactions over
different time periods, supporting credit and debt systems.
4. Medium of Exchange – It enables smooth trade by retaining value
across various transactions, promoting savings and long-distance
trade.

Evolution of Money:

Money has transformed through various stages over time:

1. Commodity Money – Physical goods such as grains, livestock, and

metals were used as a medium of exchange.
2. Metallic Money – Precious metals like gold and silver were widely
adopted due to their intrinsic value.
3. Paper Money – Banknotes replaced metals, backed by governments
and financial institutions.
4. Credit Money – Transactions began relying on promissory notes,
bank deposits, and financial credit systems.
5. Plastic Money – The advent of debit and credit cards introduced
electronic and digital means of financial transactions.
Summary:

• Key Properties: Fungible, Durable, Portable, Recognizable, Stable.

• Primary Functions: Unit of Account, Store of Value, Standard of
Deferred Payment, Medium of Exchange.
• Stages of Evolution: Commodity Money → Metallic Money → Paper
Money → Credit Money → Plastic Money.
7.2 DEMAND FOR MONEY

The demand for money refers to the desired holding of financial assets in
the form of money, encompassing both cash and bank deposits, as
opposed to other forms of assets such as equities or bonds. This demand
is influenced by several factors, including interest rates, income levels,
and economic stability.

The demand for money is typically categorized into three main types:

1. Transactions Demand
2. Precautionary Demand
3. Speculative Demand

7.2.1 Transaction demand

Transactions demand for money is the need to hold money for the
purpose of conducting everyday transactions.

In the classical quantity theory of money, the demand for money is

influenced by the levels of prices and income, assuming that the velocity
of money remains constant. As income increases, the demand for money
also tends to increase.

In an inventory model, the demand for holding money is determined by

how often individuals receive their pay and the costs associated with
depositing money into a bank. When people receive their salaries, they
retain some money for purchasing goods. If they are paid monthly, they
might deposit a portion to earn interest and then withdraw funds as
needed over the following months. However, with the advent of electronic
transfers and debit cards, this model has become less significant.

7.2.2 Precautionary demand

A need for money resulting from an unforeseen situation is called

precautionary demand for money. Example: Walking through the road
and rain come, one must take Rickshaw. This demand of money often
referred as to "Rainy day money" or "Safety money". Individuals and
businesses keep a reserve of funds or assets to cover unforeseen
circumstances, such as medical emergencies, sudden repairs, or other
unexpected financial needs. This type of demand is influenced by the
level of uncertainty in the economy and individual risk preferences. These
assets can take the form of cash, securities and bullion, although
precautionary demand is an expression usually applied to money. This is
because precautionary demand is understood to remove money from
circulation, thus dampening economic activity.

The three main reasons to hold money, as opposed to bonds, equity, or

other financial asset classes, are as follows:

1. A transactions-related reason – People need money on a regular basis

to pay bills and finance their discretionary consumption.
2. A precautionary reason, as an unexpected need, can often arise; and
3. A speculative reason if they expect the value of such money to
increase versus other asset classes.

7.2.3 Speculative demand

A need for money for investment purposes is called speculative demand

for money. This demand is related to the desire to hold money as a store
of value, particularly when people expect changes in interest rates or
asset prices. If individuals anticipate that interest rates will rise, they might
hold onto money instead of investing in bonds or other assets, expecting
to invest later at a higher return. Conversely, if they expect interest rates
to fall, they might prefer to hold money to avoid potential losses in asset
values.
7.3 — Supply of Money
7.3.3 — Components of Money Supply
Components
• Currency
o Currency outside bank
o Cash in public demand
• Deposits
o Checkable deposits (C/A)
o Savings deposits
• Large Deposits
o Time deposits

Types of Money:
1. Narrow Money: Currency + Deposits
2. Broad Money: Narrow Money + Time Deposit

7.3.2 - Balance Sheet of CoB & CB

Terminologies
BALANCE SHEETS:

A balance sheet is a financial statement that provides a

snapshot of a company's financial position at a specific
point in time. It shows the company's assets, liabilities, and
shareholders' equity and helps investors, creditors, and
other stakeholders assess its financial health.
 • ASSETS
• LIABILITIES

ASSET:

Assets = Liabilities + Shareholders' Equity

An asset is anything of value or resource owned by a

business or individual that is expected to provide future
economic benefits.

LIABILITIES:

What the company owes, which are also divided into two
categories:

• Current liabilities: Obligations due within one year,

such as short-term loans, accounts payable, and
accrued expenses.
• Non-current liabilities: Long-term debts or
obligations, like long-term loans or bonds payable.

COB BALANCE SHEET:

 ASSETS LIABILITIES
(i) Reserve (i) Checkable Deposits
(ii) Loans (ii) Savings and Time Deposits
(iii) Investment and Securities (iii) Other liabilities
(iv) Others (iv) Net Worth

Total Assets = Total Liabilities

Net worth = Asset – Liabilities

CB BALANCE SHEET:

ASSETS LIABILITIES

(i). Govt securities and [Link] (i). Currency

(iI). Loans ,Repo (ii). Deposit of COB

(iii). Other Assets (iii). Other liabilies

(Iv). Domestic Assets (iv). Equity Capital

7.3.3 Creation of money

The creation of money refers to the process by which new money enters
circulation in an economy. It occurs primarily through central banks
issuing currency and commercial banks creating money via loans and
credit. This process expands the money supply, influencing economic
activity and inflation.

The process starts with Central Bank.

Let’s see an example.

Imagine CB prints $100 and gives it to a man.

If the man deposits the money in the bank, the balance sheet of the bank
becomes:

Assets Liabilities
Reserve Checkable
$100 deposit + $100

Let, Reserve Requirement = 10%

Assets Liabilities
Reserve Checkable
$10 deposit + $100

Now the bank has $90 extra. So it gives it away as a loan.

Assets Liabilities
RR $10 $100
Loan $90

Then the man spends this money in the market. Imagine he buys
something from a shop, and the shop owner puts the money in his own
bank. His bank balance looks like:

Assets Liabilities

RR $9 Deposit $90
Loan $81

In equilibrium:

D=1/r×R
where 1/r is the deposit multiplier…
7.3.4 – Money Multiplier
The money multiplier in economics refers to the ratio that quantifies how
much the money supply increases in response to an increase in the
monetary base. It shows the maximum amount of money that banks can
create through the process of fractional reserve banking.

M=C+D

= C + DD + TD

CB’s money is called High powered money.

H=C+R

M=mH

For 1 unit change in High powered money, the unit change in money is
called Money Multiplier.
Money Multiplier Formula:

Where:

• Reserve Ratio (RR) is the fraction of total deposits that banks are
required to keep as reserves.

If the reserve ratio is 10% (0.10), the money multiplier is:

This means that for every $1 increase in the monetary base, the total
money supply can expand up to $10.

Money Market

The money market is a segment of the financial market where short-term borrowing and lending
of funds occur. It deals with highly liquid and short-term financial instruments, typically with a
maturity of one year or less.
7.4.1 Quantity theory of money

MV = PQ

Here,
P = Price level
Q= Real GDP or Output
PQ= Nominal GDP
M = Nominal Money Supply
M/P= Real Money Supply
V = Velocity of money
This is the equation which is controlled by CB.

Frequency of transaction:
Average rate at which money supply has an effective transaction.
Money Interchange or turnover
This is all about the classical quantity theory of money.
Cambridge Quantity Theory of Money:
M =( 1/v)P y
M=kPy
Where ,
M → money supply
kpy → Money demand
kPy = TD + PD
Hence,
Md = kPy – ih
Interest and money demand has an inverse relationship . If,

i ↑ then Md ↓
i ↓ then Md ↑

Money market equilibrium

Ms = Md
M = kPy - ih

7.4.2 functions of the Central Bank:

Goals of CB:Price stability

Price stability maintain economic stability

[Link] GDP Growth

[Link] Unemployment

✓ Supervise Bank
✓ Control currency

✓ Formulating monitory policy

✓ Banker to Govt.

✓ Banker to COB

✓ Lender to Last resort

Two major functions:

➢ Formulation of Monitory policy.

[Link] Exchange rate ->Exchange rate targeting

[Link] targeting

[Link] rate targeting

[Link] rate

➢ Supervision of Bank (CoB) and other non-Bank Financial institutes.

[Link] Bank and financial supervision

[Link] the systemic risk->Lender of the last resort
[Link] financial services to Banks and services

Tools for Monitory Policy:

1. OPEN MARKET OPERATION DURING,
▪ Surplus → withdraw money
▪ Shortage → Inject money

2. DISCOUNT RATE
# Signal to commercial Bank (COB)
{ Lending rate → 90%
Spread →4%
Deposit rate → 5%.

[Link] RESERVE RATIO(RRR):

100 Crore deposite
[Link] 80 crore on cash invault
2. 20 crore deposit with CB

7.4.3 The Relationship between Money and

output
Equilibrium between money market: Money supply and interest rates have
an inverse relationship. A larger money supply lowers market interest rates, making it less
expensive for consumers to borrow.

Conversely, smaller money supplies tend to raise market interest rates, making it pricier for
consumers to take out a loan.
If Money M ↑ Interest i ↓

Again, I= I0 - hi
From here we can say that the
relation between interest and
investment is inversely proportional.
For increasing money, aggregate demand will shift upward. And as a result, output y
also will be increased. So, the relation between money and output is
proportional.