Money

Money:

Money was not used in the early history Exchange were very few as family's were self-sufficient Exchanges were done by BARTER ( i.e exchange of goods for another goods) But there were many difficulties with it.

Definition of Money

Anything which is widely accepted in payments for goods or in discharge of other kinds of business obligations.

Or

Anything that is generally acceptable as a means of exchange and that at the same time acts as a measure and a store of value.

Function of Money
Money serves as a :

Medium of Exchange Unit of Account Deferred payments Store value

Supply of Money

Money Supply

Definition of Money Supply: It refers to the amount of money which is in circulation in an economy at any given time. Money supply plays a crucial role in the determination of price level and interest rates. Growth of money supply helps in acceleration of Economic development and price stability. There must be a controlled expansion of money supply i.e No inflation or Deflation in the Economy.

Concept

It is the total stock of money held by the people ( household, firms and institutions) It the total sum of money available to the public in the economy at a point of time It includes money held by the public and in circulation but it does not include money held by Central Bank or Commercial Bank as they are money creating agencies. The separation of producers of money from the users of money is important from the viewpoint of both Monetary theory and policy

Concept

It composed of two elements Currency with the Public (High Powered Money) Currency notes in circulation issued by Reserve Bank of India The number of rupee notes and coins in circulation Small coins in circulation Demand Deposits with Public (Secondary Money) Deposit of the public with the banks Bank Money

Demand Deposits Time Deposits

Constituents of Money Supply

Money Supply

Traditional Approach (Narrow Money)

Coins, currency, Demand Deposits

Modern Approach (Broad Money)

Money
Coins, Currency, Demand Deposits

Near Money

Traditional Approach (M1)

It includes those items which can be spent immediately or readily accepted as a medium of Exchange. Money that be spent directly, such as cash and current accounts in banks. M1= C +D + OD C= Currency with the Public D = Demand Deposits with the public in the commercial and co-operative banks OD = Other deposits held by the public with RBI

Time deposits are excluded from it as its not possible to draw a cheque against them.

Modern Approach

Coins Currency with the Public (High Powered Money) Demand Deposits with Public (Secondary Money) Time Deposits with banks Financial assets deposits non-banking financial intermediaries Bills Treasury and Exchange bills Bonds and equities

Modern view extends the phenomenon of money to the whole spectrum of liquidity in the assets portfolio of individuals in modern economy.

Measurement

Money Supply is classified into various measures On the basis of its functions is that effective predictions can be made about the likely affects on the economy of changes in different components of Money Supply. RBI has adopted 4 concepts of Money Supply

Measurement
M0 : Currency in circulation and in bank vaults. Its called as the monetary base- the base from which other forms of money are created.

A measure of the money supply which combines any liquid or cash assets held within a central bank and the amount of physical currency circulating in the economy
M1 / Narrow Money M1= C +D + OD C= Currency with the Public D = Demand Deposits with the public in the commercial and co-operative banks OD = Other deposits held by the public with RBI

Measurement
Money Supply M2 M2= M1 + Saving deposit with the post office saving banks The small saving deposits are not as liquid as demand deposits but are more liquid than the time deposits. M3 / Broad Money M3 = M1 + Time Deposits with the banks Time deposits are nit as liquid however loans from the banks can be obtained against them and they can also be withdrawn any time by forgoing interest earned on them.

Measurement
Money Supply M4 M4 = M3 + Total post office deposits (TPOD) TPOD = Includes saving and time deposits of the public with the post offices

Monetary Aggregates: New Series

Under the Working group on Money supply(WGMS), the RBI has revised monetary data since April 1992, and since 1999, has started publishing the new monetary aggregates, namely M0(monetary base), NM1(narrow money), NM2 (intermediate monetary aggregate) and NM3 (broad money) based on the residency concept. The new series clearly distinguishes between monetary aggregates and liquidity aggregates.

Monetary Aggregates: New Series

NM1 = Currency with + Demand liabilities portion of savings deposits with the banking system NM2 = NM1+ time liabilities portion of savings deposits with the banking system+ certificates of deposits issued by banks + term deposits of residents with a contractual; maturity upto and including one year with the banking system (excluding CDS) NM3 = NM2+ Long-term deposits of residents + Call/Term funding from financial institutions = Nm2 + term deposits of residents with a contractual maturity of over one year with the banking system+ Call/Term borrowings from nondepository financial corporations by the banking system.

Monetary Aggregates: New Series

NM1includes only non-interest bearing assets monetary liabilities of the banking sector, NM3, on the other hand, is an all encompassing measure that includes long-term deposits. NM2 is an intermediate monetary aggregate that stands in between narrow money NM1 and Broad money NM3. M4 is abolished in the new series

Liquidity Indicators

Along with the above monetary aggregates for the proper assessment of the liquidity the RBI also complies and evaluates three different liquidity indicators L1, L2 andL3. L1= NM3+All deposits with the post office savings banks (excluding National Savings Certificate) L2= L1+ Term deposits with term lending institutions and refinancing institutions (FIs) + Term borrowing by FIs +Certificate of deposits issued by FIs L3= L2+ Public deposits of non-banking financial companies.

Determinants of Money Supply

M= Cp + D The two important determinant of Money supply are

Reserve Money or Amount of High Powered Money Size of Money Multiplier

High Powered Money - H

It denotes currency and coins issued by the Government and Reserve bank of India.

H= Cp +R
Cp = Currency held by the public R= Cash reserve s of currency with the banks

RBI and Government are producers of high- powered money and Banks are producers of demand deposits. For producing demand deposits or credit, banks have to keep with themselves cash reserves of currency. As cash reserves leads to multiple creation of DD and larger expansion of money supply.

Money Multiplier -m

It is the degree to which money supply is expanded as a result of the increase in high powered money.

M= H.m Money supply will increase:

1. When the supply of high powered money H increases 2. When currency- deposit ratio of public decreases 3. CRR ratio falls

Factors Determining Money Supply

Monetary Base

Monetary Gold Stock Reserve assets- Govt securities, bond , foreign exchange Central bank outstanding

Bank credit to the Government Bank credit to the Commercial or Private Sector Community Choice (Cash / Cheque) Changes in Net Foreign Exchange Assets. Government currency liabilities to the public Velocity of Circulation of Money

Velocity of Circulation of Money

To find out supply of money over a period of time, we have to consider the velocity of circulation of money

It is the average number of time money circulates from one hand to another i.E

Ms = MV
Supply of money during a given period is the total amount of money circulation multiplied by the average number of times it has changed hands during that period

Factors Affecting Velocity of Circulation

Time unit of Income receipts (per day/ per week/ per month) Method and habit of payment Degree of regularity of Income receipt Distribution of national Income Business Conditions Development of the Banking sector Speed in transportation of Money Liquidity preference Function

Demand of Money

Demand of Money

Money is demanded because money serve some purpose Medium of Exchange Store of Value

Distinct approach
Demand of Money

The Classical Apporach

Keynesian Approach

Fisher

Marshall/ Pigou

Liquidity Preference

Transaction balance

Cash Balance

The Classical Approach

Classical economist considered money as simply a means of payment or medium of exchange. People are interested in the purchasing power of their money holdings

Fisher Transactions Approach

Money as a means of buying goods and services. Amount of money people have to hold to undertake a given volume of transaction over a period of time Demand of money is determined by:

The volume of Transaction Average price level per unit of transaction Velocity of circulation of money

MV= PT Md= PT/V

Cambridge Cash Balance Approach

The approach stressed on money as store of value or wealth rather than a medium of exchange. Demand for money is according to the choice- determined behaviour of the people ( current interest rate, wealth owned by the individual, expectation of future prices and future rate of interest) Individual demand for cash balance is proportional to the nominal income

Md = kPY Y = Real national income P= Average price level of currently produced goods K = proportion of nominal income that people want to hold as cash balances.

Keynes theory Liquidity Preference

Liquidity preference means the demand for money to hold desire of the public to hold cash

Or

Or Demand for money does not mean the actual money balances held by the people, but what amount of money balances they want to hold.

The desire for liquidity arises because of three motives

Transaction motive Precautionary motive Speculative motive

a)

Transaction Motive: - Demand for money for the current transactions of individuals and business firms. - Individuals hold cash in order to bridge the interval between the receipt of income and its expenditure. Precautionary Motive: - Desire for people to hold cash balances for unforeseen contingencies (Unemployment, sickness, accidents.) . - It depends upon the psychology of individual and the conditions in which he lives. The money held in both the motives are mainly the function of the size of Income. M1 = L1(y) Y= Income L1 = Demand Function M1= Money demanded for Transaction and Precautionary motive

b)

c)

Speculative Demand for money Desire to hold ones resources in liquid form in order to take advantage of the market movements regarding the future changes in the rate of interest

The cash is used to make speculative gains by dealing in bonds whose prices fluctuate i.e Less money will be held under speculative motive at a higher current rate of interest, More money will be held under this motive at a lower current rate of interest.

Thus demand for money under speculative motive is a function of rate of interest M2 = L2 (r) r = rate of interest, L2 = demand function for speculative motive M2 = money demanded for speculative motive

Liquidity Trap

The demand for money is a decreasing function of the rate of interest Higher the rate of interest lower the demand for money for speculative motive and less money would be kept as inactive balance and vice versa. The LP curve becomes perfectly elastic at very low rate of interest

Rate Of interest

Liquidity Trap LP

Speculative Demand

Liquidity Trap

i.e it indicates a absolute liquidity prefrences of the people. At low rate of interest people will hold money as inactive balance which is called as a liquidity trap. The expansion of money supply gets trapped and cannot effect rate of interest and the level of investment. However demand of money does not depend so much upon the current rate of interest as on expectations about changes in the rate on interest

Aggregate Demand for Money

M d = M 1 + M2 Md = L1 (Y) + L2 (r )
Active Balance Idle Balance Total Demand of Money
L (Y1) L (Y3)

I n t e r e s t R a t e

L1 (Y1) L12(Y2) L3 (Y3)

L2

INFLATION

What Is Inflation?
Inflation

is an increase in the average level of prices for goods and services. is an index, which shows how prices of goods and services that is representative of the economy as a whole are growing.

It

How is Inflation caused?

Inflation is caused by a combination of four factors:

The supply of money goes up. The supply of other goods goes down. Demand for money goes down. Demand for other goods goes up.

How inflation is calculated?

Whole

sale Price Index (WPI) Consumer Price Index (CPI)

WPI

Wholesale Price Index measures the average of the changes of goods and services price on the basis of wholesale price. Presently 435 commodities price level is being tracked. The price index which is available on a weekly basis with the shortest possible time lag of only two weeks. India considers 1993-94 financial year as base year for present WPI index calculation.

WPI

Each commodity has some weightage in the WPI index. 1. Primary Articles (weightage: 22.02525%) 2. Fuel, Power, Light & Lubricants (weightage: 14.22624%) 3. Manufactured Products (weightage: 63.74851%)

CPI

It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. CPI is a fixed quantity price index and considered by some a cost of living index.

CPI is used by the government, private sector, embassies, etc to compute the dearness allowance (DA )

CPI
Why is India not switching over to the CPI?

There are four different types of CPI indices, and that makes switching over to the Index from WPI fairly 'risky and unwieldy.

CPI Industrial Workers CPI Urban Non-Manual Employees CPI Agricultural labourers CPI Rural labour.

CPI cannot be used in India because there is too much of a lag in reporting CPI numbers

Types Of Inflation
Demand

Pull Inflation

Cost-

Push Inflation

Demand Pull Inflation

The inflation resulting from an increase in aggregate demand at full employment level which exceeds the supply of goods at current prices. The reason for increase in demand are: Increases in the money supply Supply of money goes up, rate of interest falls, Investment will increase, Increase income of factors of production, consumption expenditure will increase, leads to increase in demand.

Increases in Government purchases Demand for other goods go up. Increases in the price level in the rest of the world Increase in marginal propensity to consume

Demand Pull Inflation

AS P2 Price Level P1 P AD2 AD1 AD Y Aggregate Demand and Supply

Cost Push Inflation

Inflation can result due to decrease in aggregate supply Aggregate supply is the total value of the goods and services produced in a country, plus the value of imported goods less the value of exports. The reason for decrease in supply are

Wage Push Inflation: An increase in wage rates Profit- Push Inflation An increase in the prices of raw materials

These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation

Cost Push Inflation

AS1 AS P1 Price Level P

AD Y1 Y

Output

Deflation

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below zero percent resulting in an increase in the real value of money a negative inflation rate. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when the inflation decreases, but still remains positive). Inflation reduces the real value of money over time, conversely, deflation increases the real value of money. Money refers to the functional currency (mostly unstable monetary unit of account) in a national or regional economy.

Currently, mainstream economists generally believe that deflation is a problem in a modern economy. Deflation is correlated with recessions including the Great Depression, as banks defaulted on depositors. Additionally, deflation may cause the economy to enter the liquidity

trap.

Hyperinflation

In economics, hyperinflation is inflation that is very high or "out of control", a condition in which prices increase rapidly as a currency loses its value. Many of the worst periods of hyperinflation are preceded by deflation. With high levels of government debt, severe cases of deflation cause a loss of confidence in the nation's currency by shrinking the economy and making the government's debt appear increasingly unsustainable. The loss of confidence then causes the flow of money to speed up as individuals become desperate to exchange cash for real goods as fast as possible, producing hyperinflation.

Stagflation
A condition of slow economic growth and relatively high unemployment - a time of stagnation accompanied by a rise in prices, or inflation. Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fuelling sharp inflation in developed countries.