Money and Banking in Macro and Microeconomics - Coursework Example

Macro & Micro economics Table of Contents L01. 3 1 Characteristics of money 3 2 Functions of Money 3 LO2 4 2 The key motives for holding money 4 2.2 The relationship between the demand for money, interest rates, exchange rates and inflation 5 2.3 The relationship between money supply, output, Retail Price Index and Consumer Price Index 6 LO3 9 3.1 Role of commercial banks in UK 9 3.2 Role of Merchant Banks 11 3.2 Role of Bank of England in UK 12 3.3Role of Pension Funds, and Insurance Companies in the U.K 12 Reference List 13 L01. 1.1 Characteristics of money Money is a medium of exchange that has a value of itself. It is a medium generally accepted in return for payment of goods bought or services rendered (Biz/ed, 2012). Before the advent of money, barter system was used for direct exchange of commodities and services. This barter system had many drawbacks; for instance, desire to exchange goods should coincide with each other. The common measuring value of goods exchanged was absent in the barter system. This means that goods exchanged did not have the equal value. It was simply exchanged for needs and not for value. These drawbacks of barter system gave rise to a uniform medium of exchange – money. Money has many characteristics. These different characteristics of money serve as a unit of account. Money is a medium of exchange. People are paid for their incomes in terms of money, which further acts as a way of spending. This helps to bring in simplicity and coordination to our economy. People are willing to accept money in exchange for the output they have produced. Another characteristic of money is the role of unit of account with a standard value. This means that prices and value of commodities and services can be measured with money. Money has the ability to store value. This means that money that is stored presently can be utilized in the future. A storage of value means that money has the retention power of its value over a period of time. This time of retention covers the time of receipt and disbursement (Serletis, 2007). 1.2 Functions of Money The various functions of money can be broadly classified into three categories – primary, secondary and contingent functions. Medium of exchange and measure of value are primary functions of money. It is chiefly regarded as a medium of exchange for purchase of commodities and services provided. Currency is a measure, which endow commodities and services with value (Funke, 2001). The secondary functions of money comprise storage of value, transfer of value as well as to act as standard of deferred payment. Money has storage of value. This means that it can be stored for future use. Money also has a transferable value. This implies that value of money can be transferred quite easily. Goods can be measured with money because of this transferable value. Contingent functions include distribution of national income, maximization of satisfaction and a basis of credit system. Money helps in distribution of national products through the system of salaries and wages, interest and profit. Hence, money facilitates the division of national income between individuals in a country. Money also allows producers and consumers to maximize their benefits. A producer maximizes profit by equating the marginal productivity of a factor unit to its price. Similarly, a consumer maximizes his satisfaction by equating prices of each commodity with its respective marginal utility. Credit has a vital role in the modern economic system and money constitutes the base of credit. People deposit money in form of saving in banks; and with these savings, banks create credit in the market (Funke, 2001). LO2 2.1 The key motives for holding money John Maynard Keynes, a renowned British economist, had framed theories and ideas that have been able to fundamentally affect modern macroeconomics. He is considered amongst founders of modern macroeconomics as well as the most influential economist of 20th century. His ideas are known as Keynesian economics. John Maynard Keynes in his book, “The general Theory of Employment, Interest and Money”, had stated three reasons for liquidation of money. They are precautionary motive, speculative motive and transaction motive. In the context of precautionary motive, it is the need to hold cash as a safety margin, which acts as a financial reserve. The speculative motive is the need to hold cash in order to take advantage of rise in bargain purchases, attractive rates of interest and favourable exchange rate fluctuations. Transaction motive is the need to hold cash to satisfy normal disbursement and collection activities, which are associated with ongoing operations of an organization. Cash inflows are generated from sales collection, sale of assets and any kind of new financing. Cash outflows are payment of wages and salaries, trade debts, taxes and dividends (Serletis, 2007). 2.2 The relationship between the demand for money, interest rates, exchange rates and inflation Nobel Laureate Robert Mundell (1963) had proposed the idea that demand for money depends on exchange rate, interest rate and income rate. He asserted that “The demand for money could depend on the exchange rate in addition to income and the interest rate,” (Mundell, 1963, p. 175). The exchange rate is volatile and in turn gives rise to uncertainty of wealth and associated effects. Instead, exchange rate can have direct impact on money and its demand. Hence, it can be analyzed that exchange rate volatility should be introduced as the other determinant of demand and function of money (Serletis, 2007). The demand for money can be stated as economic theory of the positive relationship between changes in money supply and price of goods. It also states that increase in the amount of money will eventually lead to an equal percentage rise in prices of products and services in an economy. The calculation behind the quantity theory of money is– M*V = P*T Where, M = represents supply of money in the economy V= represents velocity of money P= represents average price-level T= volume of transactions in the economy. Figure 1: Demand of money (Source: Croke, n.d.) There are three major factors that determine demand for money. These factors are interest rates, price levels and real national income. The rate of interest plays a vital role in determining demand for money. With higher interest rate, demand for savings increases. This in turn lowers liquid money available in the market as well as demand of money. Similarly, with a fall in interest rates, demand for money rises (Croke, n.d.). 2.3 The relationship between money supply, output, Retail Price Index and Consumer Price Index The long-run relationship between money supply and price is strong and their correlation is almost equal. Lucas (1995 cited in Ross, Westerfield and Jorda, 2008) in his Nobel Prize Lecture had emphasized on the long-term relationship between money and price. Short-term relationship between money growth and inflation is weak and unclear. As a result, it is difficult to establish a straight relationship between these two variables in short-term. Retail price index (RPI) is the measure of the change in the cost of a basket of retail goods and services. It is a factor which determines inflation. In United Kingdom it is a measure of inflation published by Office for National Statistics (Ross, Westerfield and Jorda, 2008). Figure 2: RPI (Source: Carstensen, et al., 2008) Consumer price index (CPI) is officially used to measure inflation of consumer prices of the United Kingdom. It is also known as Harmonised Index of Consumer Prices (HICP). Figure 3: CPI (Source: Carstensen, et al., 2008) Retail price index and Consumer price index are different in many ways. Though RPI and CPI is used to measure inflation, yet CPI does not consider the household costs. So, there is a rise in mortgage payments, rents, and council tax. Then again, RPI takes these costs into account. There is a mathematical difference as well. RPI is the ‘proportional difference’, which is calculated using arithmetical mean between old and new price; whereas, CPI employs the geometric mean. The concluding result is that RPI always gives a bigger figure for inflation compared to CPI (Ross, Westerfield and Jorda, 2008). The circular flow model of income illustrates interdependencies of different factors in economy, which helps in flow of money. This model describes reciprocal circulation of income between producers and their consumers. In this model, inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively, which facilitate the flow of income. Firms provide consumers with goods and service in return to the factors of production received from households. Figure 4: Circular flow of money (Source: Carstensen, et al., 2008) Monetary policy defined as the process by which monetary authority of any country controls supply of money in the economy, considering the rate of interest for strengthening and promoting economic growth and stability. To calculate the monetary policy, the government considers factors such as, short and long term interest rates, velocity of money in economy, rates of exchange, credit quality, bonds and equities of corporate ownership and their debts, comparison between the government and private sectors’ earnings and expenditure, flow of international currency in economy and financial derivatives like, options, swaps and future contacts (ECB, 2001). LO3 3.1 Role of commercial banks in UK The banking sector in UK has gone through various changes in last decades. Traditionally, the sector was dominated by major banks, namely Barclays, HSBC (formerly Midlands) and Lloyds. There were several mutually owned societies, which demutualised and became banks. Recently, many foreign banks have set up with target upon the savings accounts. In earlier years, banking was solely the rights of Bank of England. This had led to fall in interest rates, especially for the wholesale money markets. Multiple Scottish, foreign and demutualised building societies were established, which brought down the interest rate, facilitated lending of short-term money and offered mortgage loans. This stopped with the credit crunch in 2007. Consumers faced problems while lending from the money market. Banks like, Northern Rocks and Lehmann Brothers, had frozen and required emergency funding from the government. The British government learnt about their bankruptcy and funded their operations by merging Lloyds with Halifax Bank of Scotland group. Currently, banks in UK are the same, but with different owners and in a more concentrated form (Ross, Westerfield and Jorda, 2008). The Bank of England analyses inflationary trends in the economy taking into consideration various economic variables such as, unemployment, exchange rate of interest and economic growth. With these considerations, the bank decides rise and fall of inflation. If the inflation is high, then interest rates are increased and vice versa. Figure 5: Base Rate and inflation in UK (Source: Carstensen, et al., 2008) During the credit crunch of 2007, Bank of England used Quantitative Erasing as part of the monetary policy. It involved creation of money electronically in order to purchase assets like, government bonds from banks. It was anticipated that by buying debentures and bonds, money supply would increase and deflationary pressures would be reduced (De Soto, 2006). Figure 6: GDP growth of UK (Source: Carstensen, et al., 2008) The UK monetary policy is set up by Monetary Policy Committee (MPC) under the Bank of England. They are an independent body setting the interest rates considering targets set up by the government. UK monetary policy uses interest rates and other monetary tools for determining the level of Consumer Spending and Aggregate Demand (AD). The monetary policy in UK targets the CPI 2% +/-1 in respect to inflation. Other macroeconomics value, such as, growth and unemployment, is also considered (de Grauwe and Senegas, 2003). 3.2 Role of Merchant Banks Merchant banks are combinations of banking and consultancy services. Consultancy implies providing advice, guidance and service provided for a certain fee. It constitutes services concerning financial, marketing managerial and legal matters. In short, merchant bankers are the financial engineers in business. Figure 7: Merchant Banking (Source: Champkin, n.d.) Merchant banking performs important functions like, raising finance for clients, act as a broker in stock exchange, involve in project management, provide advice on expansion and modernization to clients, manage public issues of companies, facilitate government consent for industrial projects, provide special assistance to small companies and entrepreneurs, offer services to public sector units, revive sick industrial units, portfolio management, corporate reconstructing, oversee money market operations, lease services as well as helps in management of interest and dividend (Champkin, n.d.). 3.2 Role of Bank of England in UK Bank of England performs all functions of a central bank. The most important functions are maintaining price stability and supporting economic policies of the government. This further promotes economic growth. The bank provides monetary and financial stability to the economy. The bank is the sole authority for issuing currency notes. So, Bank of England helps in maintaining integrity and value of the nation’s currency. It also ensures stability and promotes efficiency and competitiveness of the financial system. 3.3 Role of Pension Funds, and Insurance Companies in the U.K Pension funds ensure monetary benefits for individuals and their families’, after their retirement. There are several pension schemes available to employees for making a choice. Similarly, insurance companies assume the risk of their clients in return for premium. There are several insurance plans available. The premiums are monetary payments made by insurer against the object insured (Trichet, 2009). UK institutional investors play a major role in economic affairs and are highly concentrated. Their wealth accounts for two-thirds of the equity in public listed companies. The major investor associations in UK are Investment Management Association, Association of British Insurers, National Association of Pension Funds and The Association of Investment Trust Companies. Reference List Biz/ed, 2012. Worksheet on Money (Beginners). [online] Available at: [Accessed 8 May 2014]. Carstensen, K., Hagen, J., Hossfeld, O. and Salazar Neaves, A., 2008. Money demand stability and inflation prediction in the four largest EMU countries. Working Paper No. 61. Champkin, J., no date. RPI Versus CPI: What’s The Difference? Why Does It Matter? Will It Make You Poorer Or Richer? [online] Available at: [Accessed 8 May 2014]. Croke, P., no date. John Maynard Keynes. [pdf] Wordpress. Available at: [Accessed 8 May 2014]. de Grauwe, P. and Senegas, M.A., 2003. Common monetary policy with transmission asymmetry and uncertainty: Is there a case for using national data in EMU? Leuven: Katholieke Universiteit Leuven. De Soto, J. H. 2006. Money, bank credit, and economic cycles. Alabama: Ludwig von Mises Institute. ECB, 2001. Monetary policy-making under Uncertainty. Monthly Bulletin, pp. 43–55. Funke, M., 2001. Money demand in Euroland. Journal of International Money and Finance, 20, pp. 701–713. Mundell, A. R., 1963. Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates. Canadian Journal of Economics and Political Science, 29(4), pp. 475-85. Ross, S., Westerfield, R. and Jorda, B., 2008. Fundamentals of corporate finance. New York: Tata McGraw- Hill Companies Inc. Serletis, A., 2007. The demand for money: Theoretical and empirical approaches.  New York: Springer. Trichet, J., 2009. Insurance Companies, Pension Funds And The New EU Supervisory Architecture. [online] Available at: [Accessed 8 May 2014]. Read More