Sample Term Paper on: Understanding Money & Banking

     The interest rate on M is less than that on other assets. As interest rates rise, the family might put the half of their money in the checking account at the beginning of the month, and put the other half in a saving account earning 9% per annum. Then on the 15th day of the month, they take the money out of the saving account to pay the next two weeks bill. (Munn, 2003) This shows that as the interest rates rise and the family decided to put half of its earnings in a savings account, the average money balance of the family fell to half, showing that the money holdings are sensitive to interest rates. Thus, other things being equal, as interest rates rises, the quantity of money demanded declines.

     Another factor that contributes for the relationship for the demand for money and the changes in the interest rates is the asset demand for the money. In general, a well-constructed portfolio may want to contain low risk investments as well as riskier ventures. But it is not in general advisable to hold M1 (currency or checking deposits). The reason is that the other assets, such as the government securities or safe money market mutual funds are just as safe asM1 and have higher interest rates. Thus the transaction money is dominated asset as other assets are equally safe but have higher yields. (Klebaner, 2003)

Precautionary Balance

     Presume that a person is paid a monthly stipend of $4000 and paid twice a month. On the 1st and 15th of each month, this person is paid $2000 which is held as cash or as a deposit in a checking or current account. Over the days that come next these cash balances are run-down as this person buys goods and services or pays his monthly bills such that towards the end of a pay period, his cash balances are close to $0. Nonetheless, at the start of the following pay period $2000 is received and his cash balances are reinstated. Consequently at the start of a pay period this person is holding (demanding) $2000 and by the end of the pay period he is holding certain amount close to $0. On average this person has cash balances of about $1000 [($2000-0)/2].

     This symbolizes part of his specific demand for cash balances or money. By collocating over all individuals and institutions in the economy we can conclude the aggregate demand for money as the sum of individual demands. With a growth in income, either for an individual or in the aggregate, we would anticipate that more is held such that the average sum held over time grows. (Goodwin, 2003)

MdT = f [+] (Y) where 'Y' = Nominal GDP in the aggregate

     One might ask the concept that at the end of a pay period, cash balances are equal to $0. Cash balances that not utilized for transaction stand for a source for savings, that is surplus of funds. The individual might select to keep these "savings" in the form of currency of on deposit in a checking account. However by making this selection, the individual is giving up the chance to earn some form of return (or yield) on these funds in the form of interest, profits, or rents. As yields rise, the opportunity cost of holding cash balances in addition to increases generating the individual to lower his cash holdings. The individual can do this by buying an alternative financial asset in the form of a time deposit, share of stock, or a bond. When one of these assets is bought, or demand deposit balances are transformed to time deposit balances, the individual's cash balances are reduced. Thus, the money demand becomes:

Md = f (Y[+], i[-])

     We can consequently state that money demand is directly proportional to Nominal GDP, and conversely related to market interest rates and yields on unlike financial assets. Consequently economic performance in the real sector, that is the changes in income, or activity in financial markets, that is buying and selling of stocks, bonds, and related financial instruments, can affect the demand for money or cash balances.

Measure Of Income

     Gross domestic product or GDP is the broadest measure of the health of the economy. Real GDP is described as the output of goods and services produced by labor and property located in a country.' GDP is a measure of production within the national income and product accounts. There are three alternative ways of measuring GDP:

• sum of expenditures
• sum of incomes
• sum of value added

     In theory, GDP as measured by all three methods should be the same. But, in actual practice, of the two methods primarily followed by the financial markets, it is easier to get reliable estimates for expenditures than for income components. Fundamentally, expenditures are measured more directly than income. The expenditure components for GDP are also most firmly followed by markets. This is to some extent due to most expenditure data being more readily obtainable than some of the income data. While quarterly personal income data are emancipated with the advance GDP release, corporate profits are not available until the succeeding month. Thus, the expenditure approach to estimating GDP clearly is the method most intimately followed by the financial markets. The important expenditure components are personal consumption (C), gross private domestic investment (I), government purchases (G), and net exports (X-M); they form the familiar identity of:

GDP = C + I + G + X - M.

     Goodwin, J., (2003) Greenback: The Almighty Dollar and the
Invention of America , Journal of Banking.

     Klebaner, B.J, (2003), American Commercial Banking. New Age
Publishers, New York .

     Munn, G.G., (2003), Encyclopedia of Banking and Finance
(10th rev. ed.), Finlay Books.