Basics of Money and Banking

Modern business is impossible without money and banks. A Business Economics student needs the essentials of both.

Money is anything generally accepted as a medium of exchange and a measure of value. It emerged to overcome the drawbacks of barter — chiefly the lack of a double coincidence of wants (a person with rice wanting cloth had to find someone with cloth wanting rice), the absence of a common measure of value, and the difficulty of storing value in perishable goods.

Functions of money:

• Medium of exchange — money is accepted in payment for goods and services, so buying and selling no longer require a double coincidence of wants.
• Measure (unit) of value — prices of all goods are expressed in a common money unit, making comparison and accounting possible.
• Store of value — purchasing power can be held over time in the form of money, allowing saving.
• Standard of deferred payment — debts and future contracts (loans, instalments, salaries) can be stated in money terms.

These functions matter directly to business: a firm quotes prices, keeps accounts, holds working capital, and enters credit contracts — all of which depend on money performing these roles reliably. When money loses value quickly (high inflation), each of these functions is impaired.

Commercial banks accept deposits from the public and lend to households and firms. Their most economically important activity is credit creation. A bank keeps only a fraction of its deposits as reserves (the Legal Reserve Ratio, LRR) and lends the rest; the borrowed money is spent and returns to the banking system as fresh deposits, part of which is again lent out. Through this chain the banking system as a whole creates deposits several times the original amount. The total deposits the system can create from an initial deposit are:

where $1/LRR$ is the money (credit) multiplier. This credit is the lifeblood of business investment. …