Introduction and It’s

Rationale
Money, Banking, and Finance

Symbiosis International (Deemed University)

Session Objectives
By the end of this session, you will be able to:
• Describe the functions and types of money.
• Explain Banking System and It’s uses.
• Differentiate between Banks and Credit Unions.
• Explain how banks create money.
• Explain what is M1 and M2 money.
Chapter Outline
1. Why Money?
2. What is Money?
3. The Banking System.
4. Money and Finance.
 Why Money?
Imagine there is no money:
• You would need to barter and
for that you need to find
someone who wants just the
opposite exchange
• Sometimes, goods are not easily
divisible (imagine you want to
get some eggs, but only have a
cow)
 What is Money?
• Medium of exchange -
I. Must be widely accepted
II. Must be divisible
III. Must be easy to carry
IV. Must not deteriorate quickly

• Store of value - something that serves as a way of preserving economic value

that one can spend or consume in the future.

• Unit of account - the common way in which we measure market values in an

economy.

• Standard of deferred payment - money must also be acceptable to make

purchases today that will be paid in the future.
Cowrie Shell or Money?
● Is this an image of a
cowrie shell or money?

The answer is: Both.

For centuries, people used the

extremely durable cowrie shell
as a medium of exchange in
various parts of the world.
 Commodity money
Something that contains intrinsic value and can
be used easily in exchange
• Coins made of gold or silver;
• Sometimes cigarettes developed into a
medium of exchange in hard times

To be used as money, a commodity must be

generally acceptable, standardized, durable,
portable, scarce, and, preferably, easily divisible
A Silver Certificate and a Modern U.S. Bill

● Until 1958, silver certificates were

commodity-backed money - backed by
silver, as indicated by the words “Silver
Certificate” printed on the bill, pictured
at bottom.

● Today, The Federal Reserve backs U.S.

bills, but as fiat money (inconvertible
paper money made legal tender by a
government decree).
Bank Deposits and Money
• Dank deposits fulfill the criteria for money
• Store of value
• Widely accepted in payment
• Unit of account
• But: deposits have a different degree of
liquidity; not all can be used for payment
• What do we count as money?
• Pragmatic solution: different monetary
aggregates which include bank deposits with
different kinds of maturities
 What is Not Money?
A lot of things you might in everyday life call
“money” is NOT money in the eyes of
economists
• If someone has a high income (“he earns a
lot of money”), you would call this income,
not money

• If someone has a lot of stocks or bonds, he

does not have money in the economic
meaning of the term
Que:

Do You Use Money if You Use a Credit Card to Make

a Purchase?

Ans : No!
The Liquidity Continuum
Liquidity Continuum
More Less
Liquid Liquid

Currency Share of Stock Real Estate

Checking Account Precious Metal

The Banking System
Que: When you put your
money into the bank do
they safely store it in the
vault for you until you
need it? “
 Credit union ?
• The Federal Deposit Insurance Corporation (FDIC) is
backed by the government and provides protection for
accounts held at banks.

• The National Credit Union Share Insurance Fund is

backed by the government and provide the insurance
for credit unions.
Banks and Credit Unions
Banks Credit Unions

• For profit • Not-for-profit

• Operate to serve shareholders • Operate to serve members
• Pay taxes • No Taxes
• May have more branches • May have more competitive
• May have more products to interest rates
offer as larger institution • May have lower fees
• Easy Accessibility ATM, Online • Limited Accessibility
Services etc
Why use a bank or credit union?
• It keeps your money safe.
• It can provide proof that you paid your bill.
• It makes it easier to track and manage your
money.
• It allows you to build a relationship with a
financial institution. (Credit Score)
• It can save you money on check cashing or
money orders.
• It gives you financial assistance. Eg Loan,
credit etc
Bank Types
Chief Functions
Retail banks Safekeeping of money, checking accounts, loans
Savings banks Similar to retail bank but specializing in loans, particularly mortgages and loans to
small and medium sized businesses
Cooperative banks Same as a retail bank, but cooperatively owned by customers
Private banks Caters almost exclusively to high net worth individuals; functions extend beyond
traditional banking into variety of financial services
Investment banks No traditional banking functions; involved in underwriting and issuing securities,
assistance with company mergers and acquisitions, market making, and general
advice to corporations
Universal banks Covering both investment and retail banking services
Central banks Overseeing the monetary stability of the national economy by setting interest rates
and providing liquidity to commercial banks
Simplified Balance Sheet of a Commercial
Bank
Assets Liabilities

Reserves €10 million Deposits €100 million

Government bonds €20 million

Loans €70 million

Reserves: Funds kept as vault cash or as deposits at the central

bank.

In most countries, banks are required to keep some share of

their deposits as reserves – this is called required reserves
How Commercial Banks Earn Profits
• Interest from government bonds
• Earn interest by lending money to national governments
• Relatively safe and liquid. Less risk of NPA
• Interest from portfolio of loans
• Funds that are owed to the bank by businesses, households, nonprofits, or
nonfederal levels of government
• Less liquid than government bonds
• Major asset and major way to make earnings
• High Risk of NPA
How Banks Create Money - 1
The banking system can create money through the process of making loans

Singelton Bank Balance Sheet, Example 1

• Just keeping money with themselves (Storing)

• This bank will have loss as a result because they are paying more than they are
earning.
How Banks Create Money - 2
Singelton Bank Balance Sheet, Example 2

• Giving loan

• This bank will have Profit as a result because they are earning more than they
are paying.
How Banks Create Money - 3
First National Balance Sheet, Example 3
How Banks Create Money - 4
First National Balance Sheet, Example 4

● Now, First National Bank must hold some required reserves ($900,000) but can lend out the other amount
($8.1 million) in a loan to Jack’s Chevy Dealership.
How Banks Create Money - 5
First National Balance Sheet, Example 5

• This money creation is possible because there are multiple banks in the financial
system.
• They are required to hold only a fraction of their deposits,
• loans end up deposited in other banks,
• which increases deposits and the money supply.
• This money creation is possible because :

1. They are required to hold only a fraction of their

deposits,
2. There are multiple banks in the financial system.
3. Loans should end up deposited in other banks,
4. Repetition of the cycle

This money creation increases deposits and the

money supply.
M1 Money
● M1 money supply includes:

• Coins and currency in circulation - the coins and bills that circulate in
an economy that are not held by the U.S Treasury, at the Federal
Reserve Bank, or in bank vaults.

• Checkable (demand) deposits - checkable deposit in banks that is

available by making a cash withdrawal or writing a check.

• Traveler’s checks – lesser extent (if more liquid)

M2 Money
• All M1 types

• Savings deposits - bank account where you cannot withdraw money by

writing a check, but can withdraw the money at a bank - or can transfer it
easily to a checking account.

• Money market fund - the deposits of many investors are pooled together
and invested in a safe way like short-term government bonds.

• Certificates of Deposit (CD’s) and other time deposits - account that the
depositor has committed to leaving in the bank for a certain period of time,
in exchange for a higher rate of interest.
M2 Money
M1 Money
• All M1 Money • coins and currency
• savings deposits in circulation
• money market • checkable
funds (demand) deposit
• certificates of • traveler's checks
deposit
• other time
deposits.
Birth and Dominance
US Dollar ($)

Symbiosis International (Deemed University)

Quiz
Q.1. Money creation is possible when?
a. Bank Prints more money
b. Loan more money
c. More bank in the system

Q.2. M1 money includes:

a) checkable (demand) deposit
b) certificates of deposit
c) savings deposits
Session Outcomes
In this session, you learned about:
1. Functions and types of money.
2. Banking System and It’s uses.
3. Banks and Credit Unions.
4. How banks create money.
5. M1 and M2 money.
Quantity Theory of
Money and Demand
Money, Banking and Finance

Symbiosis International (Deemed University)

Session Objective
1. Value of Money
• Concept
• Types
• Standard
2. Quantity Theory of Money and Demand
• Fischer’s Theory
• Cambridge Approach
• Keynesian Approach
Value of Money
• The term value of money means the purchasing power
of money. It refers to the quantity of goods and services
that can be bought by a unit of money.
• According to D. H. Robertson, “ The value of money
means the amount of things in general which will be
given in exchange for a unit of money”
Value of Money- A relative concept
• The value of money is a relative concept. The value of
money or purchasing power of money depends upon
the price level of goods and services to be purchased
with money.
• Thus, the value of money is inversely related to the
price level. The money buys more when prices of goods
and services are low and money buys less when prices
are high.
Eg – 1 Sale (Offer)
Eg – 2 (Price Comparison)
Eg – 3 (Price Comparison in Value)
Standards of value of money
1. Wholesale Standard:
According to this standard, the value of money is expressed in terms of
prices of all those commodities whish are traded in the wholesale market.
It includes raw materials, semi-finished and finished goods which are
traded in large quantities
2. Retail standard:
According to this standard, the value of money express in terms of those
goods and services which are purchased by average family for
consumption purpose. There are purchased in small quantities.
3. Labour Standard:
According to this, the value of money is calculated from the average wage
rate payable to the labour for a day’s work.
Types of value of money
1. Internal value of money:
It refers to the purchasing power of money within a country. It
is the value of national currency over domestic goods and
services. It is based on the internal price level.
2. External Value of money:
It refers to the value of money over foreign goods and
services. It is the purchasing power of the national currency
outside the currency. It is based on the ‘exchange rate’
between two currencies.
 The Quantity theory of money
This theory try to explain the determination of the value of money and
variations in its value over a period of time.
This theory was made by writers like Locke and David Hume in 18th century,
Irving Fisher, Alfred Marshall, A.C. Pigou and Friedman in the 20th century.
It states that, other things remaining the same, the general price level varies
directly and proportionately with the quantity of money.
Generally the value of money or the price level does not remain constant but
fluctuates often. When the price level rises, the value of money declines and
when the price level declines, the value of money rises.
There are two approaches to the traditional quantity theory of money,
The American version or cash transaction version, and
The Cambridge version or cash balance version.
 Theory of Money Demand/Value
Quantity Keynesian Post- Keynesian Friedman and
Theory Theory Theory Tobin’s Theory

Transaction Cambridge/
Cash balance

• Marshall’s Equation
• Robertson’s Equation
• Pigou’s Equation
Fisher’s Quantity Theory of Money or Cash
Transaction Approach. M = Qty of money
V = Velocity of money
MV = PY P = Price Level
Y = Qty of goods/services
consumed
Fisher’s Quantity Theory of Money or Cash
Transaction Approach.
Fisher’s Quantity Theory of Money or Cash
Transaction Approach.
Fisher’s Quantity Theory of Money or Cash
Transaction Approach.
The Cash transaction approach of the quantity theory of money was provided by the
American economist Irving Fisher in his book- The Purchasing Power of Money (1911).
According to Fisher, “Other things remaining unchanged, as the quantity of money in
circulation increases, the price level also increases in direct proportion and the value of
money decreases and vice versa”.
Fisher’s quantity theory is explained with the help of his famous equation of exchange:
MV = PY or P = MV/Y
Where, M – the total quantity of money of all types.
V – is the velocity of circulation of money. The product MV is the total supply of
money in a year.
Y – is the total amount of goods and services exchanged for money.
p – is the price per unit, Hence the product PY is the total value of all the
transactions for which money is used.
Money supply and Price level Diagram

Price level

P0

M0

Money Supply
Money supply and Value of money Diagram

V0

Value of
Money

M0

Money Supply
Assumptions of Fisher’s Quantity Theory:
1. Constant Velocity of Money
According to Fisher, the velocity of money (V) is constant
and is not influenced by the changes in the quantity of money.
2. Constant Volume of Trade or Transactions
Total volume of trade or transactions (T) is also assumed to
be constant and is not affected by changes in the quantity of
money.
3. Price Level is a Passive Factor
According to Fisher the price level (P) is a passive factor
which means that the price level is affected by other factors of
equation, but it does not affect them
Assumptions of Fisher’s Quantity Theory:
4. Money is a Medium of Exchange:
The quantity theory of money assumed money only as a medium of
exchange. Money facilitates the transactions.
5. Constant Relation between M and M’:
Fisher assumes a proportional relationship between currency
money (M) and bank money (M’).
6. Long Period:
The theory is based on the assumption of long period. Over a long
period of time, V and T are considered constant.
7. Full Employment:
There exist 100% employment rate in the economy.
Fisher’s equation - Extended
MV+𝑀𝑀1 𝑉𝑉 1 = 𝑃𝑃𝑃𝑃
The Cash-balance Approach or Cambridge
equation of exchange
The Cash–balance approach was provided by some of the economists of Cambridge University such
as Alfred Marshall, A C Pigou, D H Robertson, and J M Keynes. The equation is based on the store-
of-value function of money and cash balance held by the people to make day-to-day expenditures.
According to Cambridge economists, the value of money is determined in terms of supply and
demand.
Features:
1. According to this approach, the price level depends upon the demand for and supply of money.
Hence, the changes in the value of money are caused by either a change in the demand for or
supply of money.
2. According to the theory, the supply of money is a stock rather than a flow. It comprises of all
the cash and bank deposits.
3. The demand for money implies a demand for cash balance. Cash balance is that proportion of
the real income which the people to hold in the form of money.
4. Given the supply of money at a point of time, the value of money is determined by the demand
for cash balances.
Marshall’s Equation
M = Qty of money
k = Proportion of income people
want to hold as cash balance
P = Price Level
Y = Real Income
M = P*k*Y
 M = Qty of money

Robertson’s Equation k = Proportion of income people

want to hold as cash balance
P = Price Level
M = P*k*T T = Qty of Goods/services purchased
 M = Qty of money

Pigou’s Equation k = Proportion of income people want to

hold as cash balance
P = Value of Money / Purchasing Power
Y = Real Income
M = k*R P = k*R
P M
Value of Money and Price level Diagram

Value of money

P0

M0

Money Supply and Demand

Pigou’s Diagram
According to Pigou, the demand curve for money has a
uniform unitary* elasticity. This is explained in the diagram as
above.

*a situation in which a change in one variable results in an equally proportional change in another variable.

Also known as Rectangular Hyperbola Effect / Curve

Pigou’s Equation - Extended
According to Pigou, the demand for money consists not only of legal tender
money, but also bank deposits. Hence, the equation has modified as.
𝐾𝐾𝐾𝐾
P=
𝑀𝑀 [𝑐𝑐+ℎ 1−𝑐𝑐 ]
Where:
C= denotes the ready cash with the public
(1-c)= represents the portion of ready cash kept in the form of bank deposits
h =is the percentage of cash reserves against bank deposits held by the bank.
So, [𝑐𝑐 + ℎ 1 − 𝑐𝑐 ] represents the total amount of cash in the community at any particular
time.
According to Pigou, the purchasing power of money is influenced by both
supply of money (M) and the demand for money (K). He considers K as more
significant than M in influencing the changes in the value of money.
Keynes Equation
Keynes gave his Real balance quantity equation as an
improvement over other cash balance equations. According
to him, people always want to have some purchasing power to
finance their day to day transactions.
Keynes Equation
The amount of purchasing power depends partly on their taste and habits and partly on their
wealth. This demand for money is measured by consumption units.

N= PK +R𝐾𝐾 1
Where,
N –represents quantity of money in circulation.
P – the price level of consumption goods.
K – is the amount of the consumption goods which the people desire to hold.
𝐾𝐾 1 - is the amount of the consumption goods which the people hold in the form
of bank deposits.
R – is the cash reserve ratio of the banks.
In the above equation, if K is constant, a proportionate increase in N (amount of money) will
lead to a proportionate increase in price level ( P )
According to Keynes, in the short period, K 𝐾𝐾 1 and remain constant. So a change in N will cause
a direct proportionate change in P. In the long run K 𝐾𝐾 1 and R may not remain constant. So a
change in N may influence K,𝐾𝐾 1 and R.
Criticisms
Simple Truism:
The Marshall equation establishes proportionate relationship between the quantity of
money and the price level M=KPM, assuming all other factors to be constant. It does not
tell anything new.
Role of rate of interest ignored:
The cash balance theory excludes the role of rate of interest in explaining the changes in
the price level which is very important in determining the demand for money.
Ignored the speculative motive:
This approach has not properly analysed various motives for holding money. It ignored the
speculative motive for holding money which causes changes in the demand for money.
K and T assumed constant:
Fisher also assume that K and T remain constant. This is possible in a static situation. But in
dynamic conditions. So the theory is inadequate to explain the dynamic price behavior in
the economy.
Criticisms
The cash balance approach is narrow:
This approach fail to explain the purchasing power of money in terms of
capital goods. But it considered only consumption goods.
Neglects other factors:
This theory is narrow because K is also determined by factors other than
real income, such as, the price level, the monetary and business habits
and political conditions in the country.
Unitary elasticity of demand:
The Cambridge equation assumes that the elasticity demand for money is
unity. This is unrealistic assumption because the elasticity of demand
cannot be unity in the modern day in the progressive and dynamic society.
Criticisms of Quantity Theory of Money
1. Unrealistic Assumption of factors being constant:
The assumption that P is passive, V and T are constant, is highly
unrealistic. P is not passive, it affect the other elements in the equation.
Similarly V is not independent, it changes with a change in M
2. Unrealistic Assumption of Long Period:
The quantity theory of money has been criticized on the grounds that, it
provides a long-term analysis of the value of money. It throws no light on the
short-run problems. Keynes has aptly remarked that “in the long-run we are
all dead”. Actual problems are short-run problems.
3. Unrealistic Assumption of full Employment:
Keynes’ fundamental criticism of the quantity theory of money was based
upon its unrealistic assumption of full employment. Full employment is a
rare phenomenon in the actual world.
 Criticisms of Quantity Theory of Money
4. Simple Truism:
The equation of exchange (MV = PT) is a mere truism and proves nothing. The equation
does not tell anything about the causal relationship between money and prices; it does not
indicate which is the cause is and which is the effect.
5. Fails to Explain Trade Cycles:
The quantity theory does not explain the cyclical fluctuations in prices. It does not tell why
during the depression the prices fall even with the increase in the quantity of money and
during the boom period the prices continue to rise at a faster rate in spite of the adoption
of tight money and credit policy.
6. One-Sided Theory:
Fisher’s transactions approach is one-sided. It takes into consideration only the supply of
money and its effects and assumes the demand for money to be constant.
7. Non Monetary Factors are excluded : Fashion / Trend / Expectations
8. Rate of Interest is Ignored: Impact of ROI on money supply