The Economics of Money, Banking and Financial Markets


Background to the study

Money is defined as any substance that acts as a medium of exchange (Holdsworth 5). Before the acceptable use of money, it was Barter trade where people exchanged goods for goods. This trade had many shortcomings such as lack of double coincidence of wants that is, if one had a goat and he wanted maize he had to look for a consumer who is willing to exchange maize for a goat. In addition commodities are bulky and hence difficult for one to carry to the market place (some commodities are not portable). Moreover, in barter trade division of commodities into smaller portion was difficult. For example if a customer had a cow and needed two kilograms of beans, it was hard to cut a quantity that was equivalent to two kilograms of beans. Due to these shortcomings of barter trade money was invented.

After barter trade, many commodities were used as money. People used commodities such as shells, furs, grains, tobacco or metal (U.S. Department of State para 16). Money must be readily acceptable within the borders of that country. It should not be in sufficient quantities and should be able to serve many needs so as not to lose its desirability. The commodity should be durable; this means that it should not lose its value easily through decay or deterioration. In addition the commodity should be divisible into smaller parts. Furthermore it should be homogeneous. All its parts or units should look alike and also have uniform value (Holdsworth 7). The other characteristic of money is portability. One should be able to conveniently carry it from place to place. Finally a good medium of exchange should easily recognized by its colour, shape or weight.

Money has functions such as; store of value, standard of deferred payments, medium of exchange, and measure of value (Scott 305). These functions of money lead people to widely use it. The function of money as a store of value contributed to evolution of banking services. This function of money enables people to store their commodities in monetary values. Banking is a process where people keep their money in custody in banks and the banks uses this money to loan it to public so as to create more money. National banking system was established in 1863 after the discovery of banking notes. National banking system helps the country two have a uniform and sound bank currency for the whole country.


The aim of this report is too describe the economics of money, banking and financial markets. The report focuses on interest rates, reserve ratios, money supplies and GDP.


The report entails a description of the economics of money, banking and financial markets. The application of fiscal policies and monetary policies such as reserve ratio, and interest rates, to maintain money supply is also discussed. Factors that influence aggregate demand are discussed and a conclusion is considered.


Interest rates

Interests are rates that the central bank of country charges its financial and non financial institutions when they borrow money. These charges help to control the rate and the amount of money that banks borrow from the central bank. Although banks create money by giving loans to borrowers, sometimes they do not have money to give their customers. When this happens, they borrow from the central bank.

The central bank uses interest rates as a form of controlling the amount of money in circulation in the economy. When there is a lot of money in circulation the prices of goods and services increases. This leads to inflation and it affects the economy of the country. On the other hand, during deflation there is less money in circulation and the prices of goods and services are low. To stabilize the prices of goods and services the central bank uses interest rates as a means. In an event of inflation the central bank increases the interest rates and this helps to discourage banks from borrowing (Scott 307), which trickles to the customers as banks reduce the loans given to the public. This helps to reduce the amount of money in circulation. However during deflation central banks lowers the interest rates and hence banks are able to borrow more money. When the banks have more money they lend to the public hence amount of money in circulation increases.

Reserve ratios

Financial and non financial institutions usually keep a certain percentage of their deposits with the central bank. This percentage is called the reserve ratio (U.S. Department of State para 9). Reserve ratios help to control the stability of the economy. The central banks controls the percentages that the banks have to deposit therefore these reserves are not fixed. When there is a lot of money in circulation (during inflation), the central bank increases the amount of reserve ratio therefore the deposits in the bank decrease and hence few members of public access loans from banks. When the public does not hold a lot of money in liquid form, money in circulation in the economy decreases.

In addition during deflation (less money in circulation in the economy), central bank lowers the amount of reserve ratios. When reserve ratios are decreased banks hold more money in liquid form and hence are able to loan more money to the public. This process helps to increase money circulation in the economy.

Money supply

Money supply is its amount in circulation in an economy. This amount has to be controlled. In most cases, it’s controlled through open market operations or through buying and selling of government securities (U.S. Department of State para 12). To increase the supply of money in the economy, the Federal Reserve buys government securities from banks, public or businesses and pays them with cheques (Scott 307). When these checks are deposited in banks they create more reserves which can be lent to the public or invested. This helps to increase money supply in the economy. On the other hand, to reduce money supply, Federal Reserve sells government securities to banks and the public. This helps to reduce the liquid money in the economy hence lowering money supply. Money supply is also controlled through reserve requirements like deposit ratios or discount rates.

When money supplies increase, interests rate declines and the amount of consumer spending increases because prices of goods and services increase. In addition employment level increases causing the economy to maximize its short term employment. Increase in money supply to high levels may lead to inflation which may also cause the American dollar to have a low value. However decline of money supply causes interest rates to increase, while the spending of consumers and businesses decreases. This leads to deflation and the economy operates below its capacity. When money supply is very low the level of unemployment increases and the value of dollar rises. Therefore the Federal Reserve should control money supply to help maintain economic growth and development.

Fiscal Policies

Fiscal policies are policies imposed by the government to control economic stability. These policies are used to stabilize economy during inflation or deflation. Some of the fiscal policies used in America are taxes and government spending. For example when the demand rate is high the government should raise tax rates. Increase in taxes lower the ability of consumers to buy goods or services because it reduces their financial level. Likewise when there is excess demand the government should reduce its spending leading to reduction in the consumers’ rate of consumption. Therefore during inflation the government should increase taxes and reduce its spending (U.S. Department of State para 9)

During deflation the demand is low because the public holds little money in liquid form. To increase the amount of money in circulation, the government should lower its taxes and hence money supply will increase. Government spending as a way of increasing money supply and it involves the government reducing its spending. This will cause consumer demand to reduce, because prices will not be affordable. Therefore when money supply is low, to increase it using fiscal policies, the government should reduce its spending or increase taxes.

C + I + G + NX = Yad

  • C= consumption
  • I= investment
  • G= government expenditure
  • Nx= net export
  • Yad=aggregate demand

According to this equation, the summation of consumption, investment, government expenditure and net exports (imports minus exports) is equal to aggregate demand.


According to economists, consumption level of an individual affects the economy therefore it is included in the economic equation above. Consumption level depends on the rate of consumption for both goods and services. There are some factors which determine consumption level (Holdsworth 19). These factors include; technological level, disposable income, and prices of goods and services. Disposable income is the major factor that determines consumption level of an individual. The amount of spending is influenced by employment level because through employment one earns income. Taxes also influence disposable income, for example when tax rate increases disposable income decreases and vice versa.

Price of commodities influences an individual’s level of consumption. When prices are high consumption rate reduces and consumption rate increases when prices are low. This because low prices are affordable hence increase demand and when prices are high demand is low. Technological level influences consumption in that high level of technology simplifies most things for example many people travel because the means of travelling are available and sufficient and therefore there is high demand. Government spending also influences the level of consumption.


Investments are means used to earn more money or get a profit. In the economy investments are influenced mostly by the rates of interests. This can be done in businesses, banks, or in shares (Holdsworth 19). When one deposits money in banks, the deposits earns interest. In businesses one earns profits while in shares there are dividends that one gets according to the number of shares.

When interest rates are high, the level of investment increases at an increasing rate because many people invest. On the other hand, decrease in interest rate leads to a decline on level of investments. When the level of investment is high the economy grows and also the consumption level rises. Decline in economic growth and development is led by decline in level of investment.

Government expenditure

Government expenditure is the total amount of money that government uses in various sectors such as health, security, transport, and education. These expenses cannot be left in the hands of private sectors to prevent consumer exploitation. Government expenditures are influenced by government revenue (Daniells 9). The main source of government revenue is the income tax on individuals. Other sources of includes payroll taxes, fees, fines, money from renting of government premises and facilities and also foreign exchange (U.S. Department of State, para 17).When taxes are increased the government revenues increases and it is able to meet its expenditures. Therefore the government should increase its sources of revenues and also manage its funds efficiently so that it meets its expenses on the public.

Net exports

Net exports are earned when the exports are more than imports in the countries budget (Holdsworth 17). It shows that the economy is growing because the country is importing less compared to the exports. Net exports are influenced by the country’s domestic production. Increase in domestic production leads to increase in export and a decrease in imports. Domestic production is mostly influenced by the level of technology. Development in technology facilitates growth in many economic sectors such as transport, manufacturing and processing sector, and agricultural sector. Expansion of these sectors leads to economic growth and development.

In addition growth of these sectors increases domestic production which leads to increase in export. Availability of labour also influences productivity of an economy. therefore factors such as basic education and training influences productivity. Decrease in net exports leads to government borrowing which leads to raise of the government debts. In addition borrowing affects the balance of payments.

Aggregate demand

According to the equation above aggregate demand is influenced by investment, consumption, government expenditure and the net exports. Aggregate demand is the ability of a consumer to consume a product or a service (Daniells 12). Increase in investments leads to an increase in the consumers’ income which increases the aggregate demand. In addition increase in government expenditure determines the aggregate demand. Net exports also determine consumers’ aggregate demand. For example if domestic production of agricultural products is high the prices will be low and hence increase the aggregate demand. Therefore according to economist aggregate demand of goods and services is determined by all the economic factors.


According to economists, fiscal and monetary policies are used to maintain stability of the economy. Inflation or deflation has effects on the economy. For example inflation leads to an increase in prices of goods as well as influencing the economy to operate at its full capacity. High inflation leads to a currency’s value declining compared to those of other countries. Growth and development of an economy is determined by investments, government spending and net exports. These factors according to the equation above also influence an individual’s aggregate demand.


In every economy sometimes there is instability and therefore the government should control the economy. Inflation affects the economy and should be controlled. For an economy to grow and reduce its balance of payments, it should increase its net exports and increase investments.

Works Cited

Daniells, Lorna. Business and information. California: University of California press. 2003. Print

Holdsworth, John. Money and banking. Vancouver. 2010. Print.

Williams, Scott. Money and banking. Vancouver. 2007. Print.

U.S.DepartmentofState.Monetaryandfiscalpolicy. 2010. Web.

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BusinessEssay. "The Economics of Money, Banking and Financial Markets." November 2, 2022.