FUNCTIONS OF MONEY:

Money is any good that is widely accepted in exchange of goods and services, as well as
payment of debts. Most people will confuse the definition of money with other things, like
income, wealth, and credit. Three functions of money are:
1. Medium of exchange: Money can be used for buying and selling goods and services. If there
were no money, goods would have to be exchanged through the process of barter (goods would
be traded for other goods in transactions arranged on the basis of mutual need). For example: If I
raise chickens and want to buy cows, I would have to find a person who is willing to sell his
cows for my chickens. Such arrangements are often difficult. But Money eliminates the need of
the double coincidence of wants.
2. Unit of account: Money is the common standard for measuring relative worth of goods and
service.
3. Store of value: Money is the most liquid asset (Liquidity measures how easily assets can be
spent to buy goods and services). Moneys value can be retained over time. It is a convenient
way to store wealth
MEASURES OF MONEY:
In the real world, money supply has different definitions: M1 and M2. Money is categorized
according to its liquidity. The most liquid items are in M1.
M1: includes currency (coins minted by the U.S. Treasury and paper currency issued by the
Federal Reserve), checkable deposits and travelers checks (issued by the commercial banks and
thrift institutions).
Currency and checkable deposits belonging to the federal government, Federal Reserve, or other
financial institutions are not included in M1.
M1 = Currency + Checkable deposits + Travelers checks
M2: includes all of the components of M1 plus near-moneys which includes items like:
a) Small Time deposits: interest-earning deposits with a value of less than $100,000, and having
a specified maturity.
b) Savings deposits: interest-earning deposits with no specific maturity of maximum value.
c) Money market accounts: savings that invest in short-term financial instruments, pay higher
than savings account interest.

d) Overnight repurchase agreements: agreements by a financial institutions to sell short term

securities to its customers, accompanied by an agreement to repurchase the securities within 24
hours.
e) Overnight Eurodollar deposits: 24-hour dollar-denominated deposits held in financial
institutions outside the United States.
M2 = M1 + all near moneys (Such as Small time deposits, Savings deposits, Money market
accounts, overnight repurchase agreements, overnight Eurodollar deposits).

BANKS AND MONEY CREATION:

The modern banking system was developed from fractional reserve banking of the early days.
Goldsmiths had safes for gold and precious metals, which they often kept for consumers and
merchants for a fee. They issued receipts for these deposits. Later on, the receipts came to be
used as money in place of gold for their convenience, and goldsmiths became aware that much of
the stored gold was never redeemed. Goldsmiths realized they could loan gold by issuing
receipts to borrowers, who agreed to pay back gold plus interest. The actual gold in the vaults
became only a fraction of the receipts held by borrowers and owners of gold. Fractional reserve
banking is significant because banks can create money by lending more than the original reserves
on hand.
Creation of money:
Individual banks are not allowed to print their own money. But, banks may create money by
creating checkable deposits, which are a part of the money supply.
Suppose the Fed prints $100 and decided to deposit it in Bank X. Bank X sets aside a portion of
that $100 that is required reserves (a specific amount that banks must hold as reserves on all
deposits), say 10%. The remaining 90%, $90 becomes excess reserves. Bank X can lend that $90
to Customer A, who deposits into his account in Bank Y. At this step, the original $100 remains
in the system, and we can now add Customer As $90. Bank Y sets aside 10%, and lends out the
rest. This process continues until no new excess reserves can be created.
The money multiplier is the number by which a change in the monetary base is multiplied to find
the resulting change in the quantity of money.
Change in quantity of money = Money multiplier X Change in monetary base.

The money multiplier is determined by the required reserve ratio (r) and by the currency drain
(c). c: an increase in currency held outside the banks, tells us the portion of currency which
people will hold as cash for their expanses after they borrowed from the banks. r is the required
reserve ratio which determined by the Federal Reserve. Banks are required to hold r portion of
their total deposit as their required reserve.
RR: Required Reserve = Total deposit x r
ER: Excess Reserve = Actual reserve - Required Reserve
Maximum new loan amount of the banks is equal to the excess reserve held by the banks.
Money multiplier = 1/ {1- (1-r)(1-c)}
Maximum change in checkable deposits = Money multiplier X Change in reserves from the
initial injection
For example, A deposits $1000 in Bank X. The current required reserve ratio (r) is 10%, c is 25%
Money multiplier = 1 / {1- (1-10%)(1-25%)} = 3
Maximum change in checkable deposits = 3 X $1000 = $3000
Federal deposit Insurance Corporation (FDIC)
Deposits at banks are insured by the FDIC. Such insurance guarantees deposits in amounts of up
to $100,000 per depositor before the 2008 recession. Since then, the amount is increased to
$250,000. This guarantee gives financial institutions the incentive to make risky loans, and gives
depositors confidence for their funds.
FEDERAL RESERVE SYSTEM
The Federal Reserve System, established by Congress in 1913, regulates the money supply and
banking system in the U.S. Its principal components are the following:
1. Board of Governors: controls and coordinates the activities of the Federal Reserve System.
The seven governors are appointed by the president and confirmed by the Senate to staggered
14-year non-renewable terms. The president designates one member of the board as the chair for
a four year, renewable term.
2. Federal Open Market Committee (FOMC): is made up of the seven governors plus five
presidents of Federal Reserve District Banks (the president of the New York district has a

permanent seat; the other four places rotate among the remaining 11 district banks). FOMC has
the authority to conduct open market operations, which is the buying and selling of government
securities for the purposes of manipulating the money supply.
3. Federal Reserve District Banks: assist the Board of Governors in overseeing the banking
system and controlling the money supply, the system was divided into 12 geographic districts
and each district is overseen by a Federal Reserve District Bank.
Functions of the Federal Reserve Systems are:
1. Control the money supply
2. Supply the economy with paper money
3. Provide check-clearing services
4. Hold depository institutions Reserves
5. Supervise member banks
6. Serve as the Governments banker
7. Serve as a lender of last resort
8. Serve as a Fiscal Agent for the Treasury.
MONETARY POLICY
Monetary Policy tools:
The Fed can use the following tools to influence the money supply.
1. Open Market Operation: The Fed can affect the money supply by buying or selling U.S.
government securities, using open market operations. When the Fed purchases a government
security from the public, it does so with money that did not exist in the system. Thus, bank
reserves will rise, increasing the money supply.
2. The Required-Reserve Ratio (r): The Fed can influence money supply by changing this ratio.
This ratio specified the amount banks must hold as reserves on all deposits and limits the amount
that banks may lend out. If the Fed increases the reserve ratio, the deposit and money multiplier
will be smaller, thereby further limiting the amount by which banks may expand the money
supply.

3. Discount Rate: Banks will borrow funds when needed. When the banks borrow from the Fed,
they pay an interest rate called the Discount rate. When the discount rate is raised, banks will
have less incentive to borrow, thus lowering the money supply in the system.
When the economy is in an inflationary gap, the Fed will adopt a contractionary monetary policy
to decrease the money supply in the market by selling securities, raising the reserve rate, and/or
increasing the discount rate. When the economy is in recessionary gap, the Fed will adopt
expansionary monetary policy to increase money supply in the market by buying securities,
lowering the reserve rate, and/or decreasing the discount rate.
MONEY MARKET
The demand for money has two components: transactional demand and asset demand.
Transactional demand (Dt) is money kept for purchases and will vary directly with GDP.
Asset demand (Da) is money kept as a store of value for later use. . Asset demand varies
inversely with the interest rate, since that is the price of holding idle money.
Total demand for money will equal quantities of money demanded for assets plus that for
transactions. The demand curve for money illustrates the inverse relationship between the
quantity demanded of money and the interest rate.

The supply of money is a vertical line, suggesting the quantity of money is fixed at a level
largely determined by the Fed.

Equilibrium in the money market exists when the quantity demanded of money equals the
quantity supplied.

In the above graph, it shows an equilibrium of the money market at interest rate of 6%, and
quantity of money at 600 billions. The vertical curve indicates the money supply decided by the
Federal Reserve.
At any interest rate above the equilibrium rate, there is an excess supply of money. At any
interest rate below the equilibrium rate, there is an excess demand of money.
Fed can influence the market interest rate by adjusting the money supply. If the money supply
increases (moving the vertical curve in the above graph towards the right), the interception point
will demonstrate a lower interest rate in the market. If the money supply decreases (moving the
vertical curve in the above graph towards the left), the interception point will demonstrate a
higher interest rate. Therefore, market's interest rate is closely related to the monetary policy of
the Fed.
EQUATION OF EXCHANGE
The Equation of Exchange addresses the relationship between money and price level, and
between money and nominal GDP.
The equation simply states: M x V = P x Y
Where M = the money supply, usually the M1
V = the velocity of money

P = the price level

Y = real output, or real GDP.
Velocity is the number of times the average dollar is spent to buy final goods and services in a
given year. Velocity can be calculated by using V = (P x Y ) / M
The equation tells us that total spending (M x V) is equal to total sales revenue (P x Y). Since (P
x Y) is equal to the nominal GDP, then M x V = nominal GDP.
Velocity (V) and Real GDP (Y) are effectively constant in the short run, therefore any changes in
money supply (M), will cause a proportional change in the price level (P).
Re-writing the equation, we get: P = ( M x V ) / Y
This equation demonstrated a direct relationship between price and money supply. If V and Y are
constant, a certain percentage change in money supply will cause a same amount of change in
the price level.

What are the functions of Central Bank?

The central bank generally performs the following functions:
1. Bank of Note Issue:
The central bank has the sole monopoly of note issue in almost every country. The currency
notes printed and issued by the central bank become unlimited legal tender throughout the
country.
In the words of De Kock, "The privilege of note-issue was almost everywhere associated with
the origin and development of central banks."
However, the monopoly of central bank to issue the currency notes may be partial in certain
countries. For example, in India, one rupee notes are issued by the Ministry of Finance and all
other notes are issued by the Reserve Bank of India.
The main advantages of giving the monopoly right of note issue to the central bank are given
below:

(i) It brings uniformity in the monetary system of note issue and note circulation.
(ii) The central bank can exercise better control over the money supply in the country. It
increases public confidence in the monetary system of the country.
(iii) Monetary management of the paper currency becomes easier. Being the supreme bank of the
country, the central bank has full information about the monetary requirements of the economy
and, therefore, can change the quantity of currency accordingly.
(iv) It enables the central bank to exercise control over the creation of credit by the commercial
banks.
(v) The central bank also earns profit from the issue of paper currency.
(vi) Granting of monopoly right of note issue to the central bank avoids the political interference
in the matter of note issue.
2. Banker, Agent and Adviser to the Government:
The central bank functions as a banker, agent and financial adviser to the government,
(a) As a banker to government, the central bank performs the same functions for the government
as a commercial bank performs for its customers. It maintains the accounts of the central as well
as state government; it receives deposits from government; it makes short-term advances to the
government; it collects cheques and drafts deposited in the government account; it provides
foreign exchange resources to the government for repaying external debt or purchasing foreign
goods or making other payments,
(b) As an Agent to the government, the central bank collects taxes and other payments on behalf
of the government. It raises loans from the public and thus manages public debt. It also
represents the government in the international financial institutions and conferences,
(c) As a financial adviser to the lent, the central bank gives advise to the government on
economic, monetary, financial and fiscal ^natters such as deficit financing, devaluation, trade
policy, foreign exchange policy, etc.

3. Bankers' Bank:
The central bank acts as the bankers' bank in three capacities:
(a) custodian of the cash preserves of the commercial banks;
(b) as the lender of the last resort; and (c) as clearing agent. In this way, the central bank acts as a
friend, philosopher and guide to the commercial banks
As a custodian of the cash reserves of the commercial banks the central bank maintains the cash
reserves of the commercial banks. Every commercial bank has to keep a certain percentage of its
cash balances as deposits with the central banks. These cash reserves can be utilised by the
commercial banks in times of emergency.
The centralization of cash reserves in the central bank has the following advantages:
(i) Centralised cash reserves inspire confidence of the public in the banking system of the
country.
(ii) Centralised cash reserves provide the basis of a larger and more elastic credit structure than if
these amounts were scattered among the individual banks.
(iii) Centralised reserves can be used to the fullest possible extent and in the most effective
manner during the periods of seasonal strains and financial emergencies.
(iv) Centralised reserves enable the central bank to provide financial accommodation to the
commercial banks which are in temporary difficulties. In fact the central bank functions as the
lender of the last resort on the basis of the centralised cash reserves.
(v) The system of contralised cash reserves enables the central bank to influence the creation of
credit by the commercial banks by increasing or decreasing the cash reserves through the
technique of variable cash-reserve ratio.
(vi) The cash reserves with the central bank can be used to promote national welfare.
4. Lender of Last Resort:
As the supreme bank of the country and the bankers' bank, the central bank acts as the lender of
the last resort. In other words, in case the commercial banks are not able to meet their financial

requirements from other sources, they can, as a last resort, approach the central bank for financial
accommodation. The central bank provides financial accommodation to the commercial banks by
rediscounting their eligible securities and exchange bills.
The main advantages of the central bank's functioning as the lender of the last resort are :
(i) It increases the elasticity and liquidity of the whole credit structure of the economy.
(ii) It enables the commercial banks to carry on their activities even with their limited cash
reserves.
(iii) It provides financial help to the commercial banks in times of emergency.
(iv) It enables the central bank to exercise its control over banking system of the country.
5. Clearing Agent:
As the custodian of the cash reserves of the commercial banks, the central bank acts as the
clearing house for these banks. Since all banks have their accounts with the central bank, the
central bank can easily settle the claims of various banks against each other with least use of
cash. The clearing house function of the central bank has the following advantages:
(i) It economies the use of cash by banks while settling their claims and counter-claims.
(i) It reduces the withdrawals of cash and these enable the commercial banks to create credit on a
large scale.
(ii) It keeps the central bank fully informed about the liquidity position of the commercial banks.

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