Money and Banking

Functions of money

Function	Meaning
Medium of exchange	Generally accepted in exchange, so the double coincidence of wants of barter is not needed
Unit of account	Values of goods are expressed in money, so they can be compared
Store of value	Holds purchasing power over time
Standard of deferred payment	Debts are stated in money for future repayment

Hong Kong's money supply

• M1 = legal tender notes and coins held by the public + customers' demand deposits with licensed banks
• M2 = M1 + customers' savings and time deposits with licensed banks + negotiable certificates of deposit (NCDs) issued by licensed banks and held by the public
• M3 = M2 + customers' deposits with restricted licence banks and deposit-taking companies + NCDs issued by them and held by the public

Monetary base = currency in circulation + balances of the banking system with the HKMA + Exchange Fund Bills and Notes.

The banking system

Hong Kong has a three-tier system: licensed banks, restricted licence banks and deposit-taking companies. The Hong Kong Monetary Authority (HKMA) maintains currency stability under the Linked Exchange Rate System, supervises banks and promotes the stability of the financial system.

Deposit creation

Banks keep a fraction of deposits as reserves and lend out the excess reserves; loans are redeposited and lent again.

$\text{Maximum banking multiplier} = \frac{1}{\text{required reserve ratio}}$

$\text{Maximum change in deposits} = \text{initial excess reserves} \times \text{banking multiplier}$

The actual multiplier is smaller because of cash leakage (the public holds cash), banks keeping excess reserves, and insufficient demand for loans.

Quantity theory of money

$MV \equiv PY$

$M$ = money supply, $V$ = velocity of circulation, $P$ = general price level, $Y$ = real output. If $V$ and $Y$ are constant, a change in $M$ causes an equal percentage change in $P$.

The Linked Exchange Rate System

Since 1983 the Hong Kong dollar has been linked to the US dollar at about HK$7.80 = US$1. Because capital moves freely, Hong Kong interest rates closely follow US interest rates.

Nominal and real interest rates (Fisher equation)

$\text{Nominal interest rate} = \text{real interest rate} + \text{inflation rate}$

If actual inflation is higher than expected, the real interest rate is lower than planned: borrowers gain and lenders lose.

Common mistake: savings deposits are part of M2, not M1. Only demand deposits are in M1.