Understanding Money: Fiat, Banking, and Demand
Understanding the Current Monetary System
The Current Monetary System: We operate under a fiduciary system where paper money isn’t backed by precious metals. It’s supported by institutions and used for payments, but it has no intrinsic commodity value.
Evolution of Money
Kinds of Money: Money has evolved from commodity money to paper money backed by gold, and now to fiat money, which is based on trust and the institutions that support it.
Current Money: Includes physical currency plus legal deposit money.
The total money in an economy is known as the money supply.
Lawful Money and Bank Deposits
Lawful Money: Issued by a central institution, it takes the form of coins and banknotes. Fiduciary money in bank deposits is also generally accepted as a means of payment.
Types of Deposits:
- Given (Checking): The owner can immediately access the money using checks.
- Savings: Similar to checking but does not support checks, typically using passbooks.
- Term (Time Deposit): The owner agrees to keep the money for a fixed period and cannot withdraw it without penalty before the term ends.
Quasi-money: Financial assets that are not money but can be converted into cash within a specified time (e.g., bonds, debentures).
Functions of Money
2 Functions of Money:
- Means of Payment: Used for transactions and paying debts.
- Unit of Account: Used to set prices and establish the value of goods and services.
- Store of Value: A way to keep wealth as a financial asset.
Banks and Money Creation
Banks and Money Creation: Banks accept deposits and grant credits. They are required to maintain a portion of deposits as reserves.
Reserves consist of cash in banks and deposits with the central bank.
Banks maintain cash reserves to handle customer withdrawals.
Money Supply and Monetary Base
Magnitude of Money: The money supply and monetary base.
Monetary Base: The base for creating the money supply, formed by central bank money.
Monetary Base = Central Bank Money + Liquid Assets of the Banking System
Liquid Bank Reserves = Cash in Bank Deposits + Bank Deposits in the Central Bank
Money Supply: The total amount of money in an economy, defined as the sum of cash in the public’s hands plus bank deposits.
Demand for Money
Demand for Money: There are three types:
- Transaction Motive: Demand for money for shopping, directly related to income (Y). Higher income leads to more consumption.
- Precautionary Motive: Demand for cash to meet unexpected expenses.
- Speculative Motive: Demand for money to obtain a benefit or value. Indirectly depends on interest rates. High interest rates increase demand for financial assets and lower demand for money.
The demand for money is influenced by the interest rate, which is considered the price of money.