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Money and banking: Class 12 Economics
The functions of money, the problems of barter, the central bank and commercial banks, credit creation and the quantity theory of money.
Key points
Before money, people exchanged goods by barter. Barter needs a double coincidence of wants, which means that each person must have what the other wants. It has no common measure of value, and it is hard to divide goods or to store wealth. Money solved these problems.
Money has four functions:
- A medium of exchange: it is accepted in payment for goods and services.
- A unit of account: it measures the value of goods, so that prices can be compared.
- A store of value: it can be saved and used later.
- A standard of deferred payment: debts can be written in money and paid in the future.
Money has taken many forms: commodity money, metal coins, paper notes, and now bank deposits, cards and mobile wallets. Good money is acceptable, durable, portable, divisible and stable in value. Legal tender is money that must be accepted by law in payment of debts.
A central bank is the main bank of a country. In Pakistan it is the State Bank of Pakistan. Its functions are to issue notes, to act as banker to the government and as banker to the commercial banks, to manage the foreign exchange reserves and to control the supply of credit in the economy.
The central bank controls credit with instruments of monetary policy. It can change the policy rate, which affects the cost of borrowing. It can change the cash reserve requirement, which is the share of deposits that banks must hold as reserves. It can buy or sell government securities in the open market to add or take away money. To reduce inflation it tightens policy, and to encourage growth it eases policy.
Commercial banks accept deposits, lend money and provide services such as payments and transfers. They earn profit from the difference between the interest on loans and the cost of deposits. They also create credit: a bank lends part of its deposits, the borrower spends it, and it returns to the banking system as new deposits.
The credit multiplier shows how much total deposits can grow from an initial deposit: multiplier = 1 / reserve ratio. With a reserve ratio of 10 per cent, the multiplier is 10, so a new deposit of Rs. 1,000 can support total deposits of Rs. 10,000. In practice the amount is lower because people hold some cash and banks hold extra reserves.
The quantity theory of money is shown by the equation MV = PT, where M is the money supply, V is the velocity of circulation, P is the price level and T is the volume of transactions. If V and T are fixed, a rise in the money supply raises the price level. This is why too much money causes inflation.
Study tip: Remember that the multiplier is the upside down of the reserve ratio. Write one example with 10 per cent and one with 20 per cent.
Definitions and flashcards
Say the meaning first, then open the card to check.
Barter
Direct exchange of goods for goods.
Legal tender
Money that must be accepted by law.
Central bank
The bank that controls the money supply and the banking system.
Reserve ratio
The share of deposits that banks must keep as reserves.
Policy rate
The interest rate set by the central bank to guide other rates.
Credit multiplier
The number of times that deposits can grow from an initial deposit, equal to 1 divided by the reserve ratio.
Velocity of circulation
The number of times that a unit of money is used in a given period.
Formula sheet
| Name | Formula | What it means |
|---|---|---|
| Credit multiplier | 1 / reserve ratio | The maximum growth of deposits. |
| Quantity equation | MV = PT | The relation of money, velocity, prices and transactions. |
Short questions with model answers
These are the kind of questions asked for 2, 3 and 5 marks. Try each one before opening the answer.
What are the problems of barter? (3 marks)
Barter needs a double coincidence of wants, there is no common measure of value, goods are difficult to divide and wealth is difficult to store.
State the functions of money. (4 marks)
It is a medium of exchange, a unit of account, a store of value and a standard of deferred payment.
What is the role of the State Bank of Pakistan? (4 marks)
It issues notes, acts as banker to the government and to the banks, holds foreign exchange reserves and controls the supply of credit with monetary policy.
Explain how commercial banks create credit. (5 marks)
A bank keeps a fraction of its deposits as a reserve and lends the rest. The borrower spends the money, and the receiver deposits it in a bank. That bank keeps a part and lends the rest. The process continues, so deposits grow by a multiple of the first deposit.
What is the quantity theory of money? (3 marks)
It says that the price level depends on the amount of money. In the equation MV = PT, if V and T are constant, a rise in M raises P in the same proportion.
Numericals with worked steps
The reserve ratio is 10 per cent. Find the credit multiplier and the total deposits created by a new deposit of Rs. 1,000.
- Credit multiplier = 1 / 0.10 = 10.
- Total deposits = 1,000 x 10 = 10,000.
Answer: Multiplier = 10 and total deposits = Rs. 10,000, of which Rs. 9,000 is new credit.
In an economy M = 100, V = 4 and T = 200. Find the price level using MV = PT.
- MV = 100 x 4 = 400.
- P = MV / T = 400 / 200 = 2.
Answer: P = 2.
Common mistakes
- Confusing a medium of exchange with a store of value.
- Writing the credit multiplier as the reserve ratio instead of one divided by the reserve ratio.
- Saying that the central bank gives loans to the public. It is the banker of the government and the banks.
- Forgetting that a higher reserve ratio lowers the credit multiplier.