David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 18 Money and banking
Table 18.4 Holdings of M4, 1965-2009
Index of:
Nominal M4
-
Real M4
Real GDP
-
Interest rate (%)
-
-
1965
100
100
100
Sources: Bonk of England; OECD.
6
-
--
2009
10 100
800
285
1-4
-
-
Explaining the rise in money holdings from
1965 to 2009
Why were nominal money holdings 90 times higher in 2009
than in 1965? We have identified three explanations: prices,
real income and nominal interest rates. Table 18.4 shows how
these variables changed over the period.
Although nominal money holdings rose 101-fold, the price
level also rose a lot between 1965 and 2009. Table 18.4 shows
real money rising eight-fold over the period. Real GDP was
almost three times its initial level. Higher real output and
income raised the quantity of real money demanded. Nominal
interest rates fell substantially, which also added to the demand
for money.
Summary
• 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 cost 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 tradeoff
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. Interest-bearing 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 MO 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.
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