Financial System Essentials and Monetary Policy Explained

Functions of the Financial System

• Facilitating Savings and Investments: The financial system connects savers and investors by providing platforms like banks and stock markets.
• Efficient Resource Allocation: It directs funds toward productive projects, fostering economic growth.

Understanding Time Deposits

• A time deposit is a bank account where money is deposited for a fixed period. In return, the depositor earns higher interest than a regular savings account. Withdrawals before maturity may incur penalties, ensuring the bank can use the funds for longer-term loans.

Demand for Money: Transaction Motive

• The transaction motive refers to holding money for everyday purchases and payments. It depends on income levels and the frequency of transactions. As income increases, individuals hold more money to meet their consumption needs.

Defining M1 Money Supply

• M1 money includes the most liquid forms of money, such as cash, coins, and demand deposits (checking accounts). It represents money readily available for spending without restrictions, forming the narrowest definition of the money supply.

Expansionary Monetary Policy Tools

• Expansionary monetary policy lowers interest rates to stimulate borrowing and spending. Tools include reducing the reserve ratio, lowering the central bank’s policy rate, or purchasing government bonds (open-market operations). These measures increase money supply and boost economic activity.

Open Market Operations: Selling Bonds

• When central banks sell bonds, they withdraw money from circulation as buyers pay for the bonds. This reduces the money supply, aiming to control inflation. It also raises interest rates, discouraging borrowing and reducing overall demand in the economy.

Financial Instrument: Pension Funds

• Pension funds are collective investment schemes designed to provide retirement income. Employees and employers contribute to these funds, which are invested in long-term assets like stocks and bonds to generate returns for future payouts.

Monetary Policy: Bank Reserve Ratio

• The reserve ratio is the fraction of deposits that banks are required to keep as reserves. By adjusting this ratio, central banks influence the money supply. Lowering the ratio increases money available for loans, while raising it restricts lending capacity.