Notesale: Turn your study into money

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1

Medium of exchange
From early days onwards man produces what is more than required
...
Initially commodities was exchanged for one
another
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Initially domestic animals
were used as a medium
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were used
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During 17th and 18th century
paper money became important
...
Today the world entered into electronic
signals and devices for the people to make deposit and purchases
...
Barter is the direct
exchange of goods for other goods without using a medium of exchange
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Simple system
2
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3
...

4
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So no chance for the accumulation of wealth on
some people
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Personal and natural resources are ideally utilized to meet the need of the society
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It leads to division of labour and specialization
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Lack of double co-incidence of want:– it means under barter system the wants of two persons
who desire to exchange must co-inside
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Such double co-incidence involve
great difficulty and wastage of time
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Absence of common measure of value:– value of the commodity in the market cannot be
calculated
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3
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Their value deteriorate
overtime
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4
...
So when a big
indivisible commodity is exchanged for smaller commodity problem arises
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Difficulties in deferred payment:– in barter system there is no common unit which can be
used for future payment
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Problem of transportation: – goods and services cannot be transported from one place to
another easily
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But in modern
economy barter is not relevant
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In such situations direct exchange of goods [barter] created problems
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In order to overcome these difficulties
money was invented
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1
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Different commodities are valued on the basis of number of cattles that they can
command in exchange
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Commodity money:- certain commodities like precious stones, bow, arrow, animal skin
shell, rice, tea etc were accepted as a medium of exchange
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This system was mainly practiced in pastoral age
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Metallic money:- it was common in the commercial stage of the society
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Because of their usefulness and attractiveness
they were considered as natural money
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4
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Due to safety problems of carrying
costly metals, merchants used to carry paper receipts against metallic money
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Credit money:- due to the emergence of banking institutions, bank money emerged as an
important medium of exchange
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So it is
regarded as near money
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6
...
People make deposits and purchases by using electronic equipments
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Definition of money
• Anything accepted as payment for goods and settlement of debts
...

• In general sense money can be defined as, any commodity that is generally accepted as the
medium of exchange and measure of value
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The variations in its stock will have impact on
economic activity
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Money is the most liquid asset – liquidity means the easiness and quickness with which it can
be exchanged for goods and services
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Money pays low return- there is no return of holding the money
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It is the cost of holding money
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Metallic money:-Metallic coins are made of iron, copper, silver, gold, aluminium etc
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C
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Initially it was minted and introduced by private bankers
and gold smiths who certify the purity and weights
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issued coins in uniform value
and shape
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Paper money:-It consist of currency notes printed , authenticated and issued by the govt
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It is the most important form of money supply
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Bank deposits:-Third form of common money is bank deposit
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They are current account deposits, saving bank deposits, and time deposits
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So they are known as demand deposits
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Cheque by itself is not a money
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So credit money is near
money
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Legal tender money:-It is one which is enforced by law
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Eg; Indian currency and coins
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Optional money:-It is the money which may or may not be accepted as means of payment
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Eg
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No one can force
to accept it
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Commodity money and representative money:- Commodity money is made of certain metals
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It serve as a medium of exchange and store of
value
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7
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Eg; paper
currency notes
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Money proper and money of account:- Money proper or actual money is money which is in
circulation in the economy
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Eg
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9
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Eg; general purchasing power,
debt price of goods and services are expressed in terms of money of account
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Eg; Indian rupee
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Eg; after world war first, in Germany, German Mark continued to be the
money proper but Dollar was considered as money on account
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10
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It is
an asset to the individual or firm holding it and it is a liability to someone else
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Example: bank deposits
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Outside Money (Exogenous Money)
Outside money is that part of the money supply which is put into the economic system from
outside by the government
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It is based on public sector debt and is considered as a part
of national wealth
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The
concepts of inside and outside money were developed by Gurley and Shaw
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Medium of exchange; It act as a medium of exchange between two commodities
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Under barter system, double coincidence of wants is
an important problem
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But as
money is acceptable to this entire problem is solved
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• Legal enforceability
2
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All values are measured in
terms of money
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So
computation of individual income and national income is possible
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3
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Storage of value is
important because,
• Storage of surplus production
• Storing value for future use
• Accumulative nature of individual
So if price do not increase overtime value can be stored for long period without any loss of
value
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It provide

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opportunities to make attractive future buying
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Standard of differed payment; Differed payment means borrow today and repay tomorrow or
buy today and pay later
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Barter system is very difficult while compared to this
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But money perform
this function because, its value remains more or less same
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Transfer of value; through money, value can be transformed from one place to another
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6
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Money is helpful for distributing this
national income through wage, rent, profit etc
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Basis of credit system; credit play an important role in modern economy
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So bank create credit
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Liquidity to wealth; Money gives liquidity to various forms of wealth
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Near Money
They are less than perfectly liquid asset which are close substitute for money
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Near money refers to all assets
which posses many characteristics of money which have high degree of liquidity and which can
inexpensively converted into money
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They must be converted into money for making transactions
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Nearness of near money depends upon degree of liquidity
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Difference between money and near money
Money

Near Money

Notes and coins in circulation and demand Financial assets which are close substitutes of
deposits of banks
money
Perfectly liquid assets

Less than perfectly liquid asset

Not an income earning asset

Income earning asset

Medium of exchange

Not a medium of exchange

Used for direct transactions

Cannot be used for direct transactions

Store of value

Stores of value
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Money market is comprised of those who
demand and supply money
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So the study of demand for money is important
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Financial asset can be in the form of money earning interest and interest
bearing securities
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Important factors that influence demand for money is price level, real income and interest rate
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It raises demand for money
...

The demand for money function can be written as
Md = P L [Y,I]
Md = aggregate dd for money
P= price level
Y= real income
I= interest rate earned by non-monetary assets
L= function
Theories of demand for money
1
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It was initially conceived by Jean Bodin in 1568 to
explain the price rise in France
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commented and contributed to the development of theory
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Cash transaction approach – Irving Fisher
Fisher’s version of quantity theory of money analyze the relation between quantity of money and
price level
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In his approach
the role of money is the medium of exchange
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So it is determined by
Total quantity of goods and services to be transacted during a given period
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MV=PT
M= total qty of money supplied
V=velocity of circulation of money
P=general price level
T=total volume of goods and services exchanged for money
As per equation, demand for money depends upon value of transaction to be undertaken in the
economy
...
So in the
equation, PT represent demand for money
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It was determined by level of
aggregate income
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Another factor which determines the demand for money is the velocity of circulation of
circulation of money
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Fischer modified his early version by including the money supply created by bank through credit
creation based on their demand deposit
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Theory of price level
The theory says that qty of money determines the general price level of price
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b
...
It is equal to constant fraction of those
transactions
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The demand for money
function in Fischer’s quantity theory of money function,
MV=PT [here, V and T are constant]
M=1/V PT
In equilibrium, we have Md =Ms
In equation, M= 1/V PT
M=money in circulation= Ms and then 1/V PT will be Md
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PT=Y
So Md = k PT
Md= K Y
Aggregate demand for money is K proportion of national income
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Developed by Marshall and Pigou
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That is,
demand for money implies demand for cash balances
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Md=KPY
Md= dd for money
P= price level
Y = real income
K= fraction of money income held in the form of cash balances
...
Md is a
proportional function of money income
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[1/V]

k=1/V
Y
Md=kPY
Price level

P2

P1
Demand for Money
0

M1

M2

X

Demand for money is represented by Md=kPY curve
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As nominal income rises, community want to hold
proportionately more in money balance
...
Because, to make the same transaction at a doubled price double amount
of money is needed
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It is unrealistic
The influence of rate of interest was not considered
Ignored the speculative demand for money
Theory assumes k as constant
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Keynes challenged the direct relationship b/n qty of money and price level
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2
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4
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An increase in rate of interest leads to a
decrease in the price of bonds
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Par Value: The initial value of the bond and what is repaid to the holder when the bond matures
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It is fixed
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Market Price of the Bond: The present value of the bond
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Capital gain or loss Net change in the value of the bond
In the table when a Rs
...
If the market rate of interest is 4 per cent, the market value of the bond will be
Rs
...
40/
...
1000)
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If the market rate of interest has risen to 5 % after 3 years, the market price of the
bond falls to Rs
...
(R/i = Rs
...
05 = Rs
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The original buyer holds a bond worth only Rs
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Selling it leads to a capital loss of Rs
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A further rise in the rate of interest to 6 %, leads
to a fall in the price of the bond to Rs
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If the original buyer is selling the bond then, he will
incur a capital loss of Rs
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Date

Par
value

Coupon rate Coupon
payment

Rate
interest

of Price
bond

of Capital
gain/loss

When issued

1000

4%

40

4%

1000

0

3 year later

1000

4%

40

5%

800

-200

5 years later

1000

4%

40

6%

667

-333

7 years later

1000

4%

40

3%

1333

+333

10 years later

1000

4%

40

2%

2000

+1000

If the market rate of interest has fallen to 3 %, price of the bond increases to Rs
...
The
original buyer holds a bond worth of Rs
...
Selling it leads to a capital gain of Rs
...
A
further fall in the market rate of interest to 2 % after 10 years, leads to a further rise in the market
price of the bond to Rs
...
If the original buyer of the bond is selling it then, his capital gain
will be Rs
...

Keynes theory of demand for money or liquidity preference theory
Explained in his famous work “The General Theory Of Employment Interest And Money”
[1936]
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Liquidity means
convertibility of an asset into cash
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According to Keynes, the demand for money is the desire for holding money balances or desire
for liquidity
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Keyns explained three important motives for
liquidity preference
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Transaction motive;
Money is the medium of exchange
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Everybody hold some amount of money to carryout day today transactions
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Generally income is received monthly or weekly
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So certain amount of money is needed by the people to
carry out their frequent transactions smoothly
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Transaction motive are two types
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It implies that transaction demand depends upon two factors
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Higher the money income, greater will be the money demand to make transactions
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It is interest inelastic
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2
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households -unexpected
economic situations affect their decision to hold money for precautionary motive
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The amount of money demanded for precautionary purpose change directly with income
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Keyns combined transactionary and precautionary demand for money because, they are function
of income interest inelastic
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Speculative motive arises from the expectations about the
behavior of prices in the bond market
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It is related with rate of interest and bond prices
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According to Keynes there is an inverse relationship
between bond prices and the market rate of interest
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A decrease in the market rate of interest (future)leads to an increase in the price of a bond
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Then the
corresponding speculative demand for money is very low
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Thus it is not safe to
invest in bonds at a low rate of interest(today)
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That is the
speculative demand for money will be high at low rate of interest
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The speculative
demand for money function can be represented as,
Ms = f (r)
Supply of Money
Determined by the central bank of a country
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EquilibriumRate of Interest
Given the supply of money and the income level, at some particular interest rate demand for
money(the sum of the transactions, precautionary and the speculative demand) will just equal
the supply of money
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In diagram, the vertical line represents the supply of money
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The corresponding rate of interest r represents the equilibrium rate of interest
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It implies that the speculative demand for money becomes infinitely large or infinitely interest
elastic below a 'critical' minimum level of interest
-a level below which people prefer to hold idle cash balance and banks stops working
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The phenomenon of liquidity trap can be explained with reference to stock market players
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Theyoperate also in the money market
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Therefore, they convert their idle cash balances into bonds
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They sell off
their bonds and accumulate idle cash balance
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They too
start believing that the interest rate would not go any further down as it has reached its 'critical'
minimum level
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Therefore, they too start selling their bonds and
accumulating cash balance
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Under this condition, even if monetary authority increases money supply to lower the rate of
interest, the entire extra money supply gets trapped in liquidity as extra idle cash balance
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R

Ms

Ms1

Ms2

Liquidity trap
r1

In the liquidity trap, asset holders will absorb unlimited quantities of money into idle balances
without using any of it to buy bonds
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Rate of interest will never be equal to zero
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The rate of interest cannot be pushed down below the level set by the liquidity trap
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If the economy is in the liquidity trap, monetary policy is ineffective
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4
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Criticisms
1
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it is not considered by Keyns
2
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Keynes never explained the factors that determine the normal rate of interest
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The same unit of money can perform different motives
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for money

4
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5
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6
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7
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8
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14

MONEY AND PRICES
Classical theory- relation between changes in the money supply and changes in the price level is
direct and proportional
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Keynes- relation between changes in the money supply and
changes in the price level is indirect
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Because prices are determined primarily by costs of production
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A reduction in the rate of interest leads to an increase in investment
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Together with this there is an increase in the level of employment and output
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In the analysis of Keynes, employment and prices rise with an increase in the quantity of money
till the point of full employment
...

Thus Keynes accepts the direct relationship between changes in the money supply and changes
in the price level only after the economy reaches full employment
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prices
...

prices
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15

Based on full employment
...

So long as there is unemployment, employment and
output will change in the same proportion as the
quantity of money
When there is full employment prices will change in
the same proportion as the quantity of money
...


Neglect the influence of rate of Keynes analyzed the influence of rate of interest on the
interest

because

of

the

direct level of investment and thus on the volume of output

relationship between the quantity of and employment
...

Monetary sector of the economy is Keynes integrated the monetary sector and real sector
not related to the real sector of the of an economy through his theory of employment and
economy
...

Changes in the quantity of money affect the rate of
interest and hence the level of investment, employment
and output
...

According to Keynes, expansion of money supply is not harmful to the economy so long as
there is unemployment
...


15

Based on full employment
...

So long as there is unemployment, employment and
output will change in the same proportion as the
quantity of money
When there is full employment prices will change in
the same proportion as the quantity of money
...


Neglect the influence of rate of Keynes analyzed the influence of rate of interest on the
interest

because

of

the

direct level of investment and thus on the volume of output

relationship between the quantity of and employment
...

Monetary sector of the economy is Keynes integrated the monetary sector and real sector
not related to the real sector of the of an economy through his theory of employment and
economy
...

Changes in the quantity of money affect the rate of
interest and hence the level of investment, employment
and output
...

According to Keynes, expansion of money supply is not harmful to the economy so long as
there is unemployment
...


16

FRIEDMAN'S RESTATEMENT OF THE QUANTITY THEORY OF MONEY (NEW QUANTITY THEORY
OF MONEY)
Classical quantity theory of money explained the direct relationship between the supply of
money and the price level
...

The Chicago version is known as the New Quantity Theory of Money or the Restatement of the
Quantity Theory of Money
...

There are two types of demand for money
...

The demand for money depends on three factors
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The total wealth to be held in various forms
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The price of and return on various forms of wealth and

3
...

I
...

a) money
b) bonds1
c) equities
d) physical nonhuman goods and
e) human capital,
Total wealth includes all sources of income
(Money includes currency, demand deposits and time deposits)
1

Stocks and bonds represent two different ways for an entity to raise money to fund or expand their operations
...
When an entity issues a bond, it is issuing debt with the
agreement to pay interest for the use of the money
...
(Y)
When the price level falls, value of money increases, so the rate of return on money is positive
...

Thus the price level P is an important variable in the demand for money function
...

Bonds are a form of long-term debt in which the issuing corporation promises to pay the
principal amount at a specific date
...

The return from a bond is represented as rb
...

Equities pay dividends to the owners, but only if the corporation declares a dividend
...
(re)
Physical non human goods are durable goods like consumer durables, land and houses
...
(rd)
Human capital refers to the productive capacity of human beings
...

The ratio of nonhuman to human wealth is represented by W
...
(U)
Friedman's demand for money function can be represented as follows
...

The amount of money demanded depends on wealth, interest rate on bonds, the return on
equities, the expected rate of inflation, the ratio of nonhuman to human wealth and the
variables affecting the tastes and preferences of wealth holders
...

If the rate of interest on bonds rises or returns on equities increase, less money is demanded
...

The ratio of nonhuman to human wealth and variables which affect tastes and preferences are
assumed constant in the short run
...
He underestimated the influence of the rate of interest on the demand for money
...
He assumes that a rise in M results rise in the price level and fall in real income and thus
leads to change in output and income
...

3
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The concept of permanent

income cannot be measured accurately
...


Friedman's concept of wealth is too broad and concepts like human capital are difficult to

quantify
...

Keyns

Friedman

demand for money unstable, shifting with changes in demand for money function as
function
the public confidence in the stable
economy
Components
money demand

of Segmented the demand for money does not compartmentalize the
function into transactions demand, demand for money based on the
precautionary
demand
and uses of money
speculative demand
...

Narrow Definition defined as the sum of all constituent assets of money
...

Broader Definition Based on the liquidity of assets as stores of value
...

RBI called the broader measure of money as Aggregate Monetary Resources (AMR)
...

It includes currency in the hands of the public and demand deposits at the banks
...

bj-bamacro economics 19-20

20

It includes the currency notes and coins issued by the central bank of a country
Bank money
It is the demand deposit held by the public in commercial banks
...

Velocity of money
It refers to the average number of times a unit of money changes hands or is transferred from
one person to another during a given period of time
...

Total supply of money over a period of time is equal to the total amount of money in circulation
multiplied by its velocity of circulation
...

1
...

An increase in the CRR will result in a reduction in the excess reserves of the commercial banks
used for credit creation
...
Conversely, a reduction in the CRR will result
in an increase in the excess reserves of commercial banks and hence an increase in the supply of
money
...
5%, Bank rate 6
...
Excess Reserves of Banks
...

Excess reserves are used for credit creation
...

3
...

The demand to hold bank deposits arises from their convenience and safety in transferring large
sums of money
...

Conversely, if people exhibit a preference for currency, bank reserves will decrease, leading to a
reduction in money supply
...
Monetary Base
...

Monetary base changes due to the policy of the government and is also influenced by the value
of money
...
Money Multiplier
...

Money multiplier (m) has positive influence upon the money supply
...
Confidence in Bank Money
...
Time-Deposit Ratio
...
A rise in t reduces m and thereby the supply of money decreases
...
Value of Money
...

9
...
Real income (Y) has a positive influence on the money multiplier and hence on
the money supply
...

MEASURES OF MONEY SUPPLY IN INDIA
From 1977 onwards, the RBI started publishing 4 alternate measures of money supply
...

M1 =C+ DD + OD
Where
C = Currency (currency notes and coins)
...

OD = Other deposits of RBI
...

M2 =M1 + Post office savings deposits
M3 =M2 + Time deposits of banks
...

M3 is called money supply by RBI
...

STATUTORY LIQUIDITY RATIO (SLR)
Minimum portion of the daily total demand and time deposits that each bank is statutorily
required to maintain in the form of designated liquid assets
...

CB
=Current account balances with other banks
L
=Total demand and time deposits
Unencumbered securities are those securities against which loans have not been taken from the
RBI
...

These securities enjoy government guarantee in respect of payment of principal and interest
...

SLR operates indirectly to control the supply of money
...
The present SLR is 20
...

HIGH POWERED MONEY
High powered money is money provided by the RBI and the government and held by the public
and the banks
...

HPM is also called the base money or monetary base
...

HPM = C + RR + ER
C = Currency
RR = Required Reserves
ER = Excess Reserves

MONET MULTIPLIER
Degree to which money supply expanded as a result of the increase in high-powered
money
...

If we know the value of money multiplier we can predict how much money will change when
there is a change in the amount of high-powered money
...

Cash or currency reserve ratio of the banks and currency-deposit ratio of the public which
determines the size of multiplier
...

M = C+DD
High powered money is the sum of currency held by the public, required reserve and commercial
bank reserves
...

=

+

+

The relationship between money supply and high powered money is given as
D-total bank deposit, DD is demand deposit, TD is time deposit(D=DD+TD)
+
=

+

+

Dividing the numerator and denominator of the right hand side of the equation by D we get,
+
=
+
By substituting Cr for , RRr for

and Err for

+
we get

1+
=

+

+

This is the money multiplier
...
The lower these
ratios the larger is the money multiplier
...
High powered money, known as the central bank money, is
the sum of currency held by the public and commercial bank reserves
...

Thus HPM is equal to the sum of currency held by the public, required reserves and excess
reserves of banks
...

Money supply can be derived from the following money multiplier equation
...

For example, if the money multiplier is four, then the overall money supply is equal to four times
the supply of central bank money

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