The demand for money tells us what makes people desire a certain amount of money. Since money is required to conduct transactions, the value of transactions will determine the money people will want to keep: the larger is the quantum of transactions to be made, the larger is the quantity of money demanded. Since the quantum of transactions to be made depends on income, it should be clear that a rise in income will lead to a rise in demand for money. Also, when people keep their savings in the form of money rather than putting it in a bank which gives them interest, how much money people keep also depends on rate of interest. Specifically, when interest rates go up, people become less interested in holding money since holding money amounts to holding less of interest-earning deposits, and thus less interest received. Therefore, at higher interest rates, money demand comes down.
Supply of Money In a modern economy, money comprises cash and bank deposits. Depending on what types of bank deposits are being included, there are many measures of money. These are created by a system comprising two types of institutions: The state bank of the economy and the commercial banking system. The state Bank is a very important institution in a modern economy system. Almost every country has one central bank. The State Bank has several important functions. It issues the currency of the country. It controls the money supply of the country through various methods, like bank rates, open market operations, and variations in reserve ratios. It acts as a banker to the government. It is the custodian of the foreign exchange reserves of the economy. It also acts as a bank to the banking system, which is discussed in detail later. From the point of view of money supply, we need to focus on its function of issuing currency. This currency issued by the central bank can be held by the public or by commercial banks and is called the ‘high-powered money’ or ‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation. Commercial Banks Commercial banks are the other type of institutions that are a part of the money-creating system of the economy. In the following section, we look at the commercial banking system in detail.
They accept deposits from the public and lend out part of these funds to those who want to borrow. The interest rate paid by the banks to depositors is lower than the rate charged by the borrowers. This difference between these two types of interest rates, called the ‘spread’ is the profit appropriated by the bank. The process of deposit and loan creation by banks is explained below. In order to understand this process, let us discuss a story. Once there was a goldsmith named Mike in a village. In this village, people used gold and other precious metals in order to buy goods and services. In other words, these metals were acting as money. People in the village started keeping their gold with Mike for safekeeping. In return for keeping their gold, Mike issued paper receipts to the people of the village and charged a small fee from them. Slowly, over time, the paper receipts issued by Mike began to circulate as money. This means that instead of giving gold for purchasing wheat, someone would pay for wheat or shoes or any other good by giving the paper receipts issued by Mike. Thus, the paper receipts started acting as money since everyone in the village accepted these as a medium of exchange.
