Money has four functions: a medium of exchange or means
of payment, a store of value, a unit of account
and a standard of deferred payment. Its use as a medium of
exchange distinguishes money from other assets.
In a barter economy, trading is costly because there must
be a double coincidence of wants. Using a medium of exchange reduces the costs
of matching buyers and sellers, letting society devote scarce resources to
other things. A token money has a higher value as a medium
of exchange than in any other use. Because its monetary value greatly exceeds
its production cost, token money economizes a lot on the resources needed
for transacting.
Token money is accepted either because people believe it can subsequently
be used to make payments or because the government makes it legal tender.
The government controls the supply of token money.
Banks create money by making loans and creating deposits
that are not fully backed by cash reserves. These deposits add to the medium
of exchange. Deciding how many reserves to hold involves a trade-off between
interest earnings and the danger of insolvency.
Modern banks attract deposits by acting as financial intermediaries.
A national system of clearing cheques, a convenient form of payment, attracts
funds into sight deposits. Interestbearing time deposits attract further funds.
In turn, banks lend out money as short-term liquid loans, as longer-term less
liquid advances, or by purchasing securities.
Sophisticated financial markets for short-term liquid lending allow modern
banks to operate with very low cash reserves relative to deposits. The
money supply is currency in circulation plus deposits. Most is the
latter.
The monetary base M0 is currency in circulation plus banks’
cash reserves. The money multiplier, the ratio of the money
supply to the monetary base, is big. The money multiplier is larger (a) the
smaller is the desired cash ratio of the banks and (b) the smaller is the
private sector’s desired ratio of cash in circulation to deposits.
Financial deregulation has allowed building societies
into the banking business. M4 is a broad measure of money
and includes deposits at both banks and building societies.
The demand for money is a demand for real money, for its
subsequent purchasing power over goods. The demand for narrow money
balances the transactions and precautionary benefits of holding another
pound with the interest sacrificed by not holding interest-bearing assets
instead. The quantity of real money demanded falls as the interest rate rises.
Higher real income raises real money demand at each interest rate.
For wide money such as M4, the asset motive for holding
money also matters. When other interest-bearing assets are risky, people diversify
by holding some safe money. With no immediate need to transact, this leads
to an asset demand for holding interest-bearing bank deposits. This demand
is larger the larger the total wealth to be invested and the lower the interest
differential between deposits and risky assets.
