Introduction to Money and Price Level

Money
In ancient time, people exchanged their excess goods or good from others. This is known as
the Barter System. Barter system is the foundation for the evolution of money. There were some
drawbacks in the Barter system. They are,
 No double coincidence of wants. – If someone have excess milk need vegetable,
people who have excess vegetable may not need milk.
 No common measurement
 Limitations to exchange more valuable goods
 Difficulty of exchanging services.
 Difficulty in the division of smaller units
 Difficulty in relation to mobility of goods and services
 Difficulty in storing the goods and services to use for the future requirements
 Limitations in the expansion of economic activities
Due to the draw backs in the barter system people gradually started using certain
commodity as money.
Evolution of Money

Commodity Metallic Token/ Paper

Money Money Money

Crypto Plastic Credit

currency Money Money

What is Money?
Money is whatever which is acceptable in exchanging for goods and services. In broader sense
money has the following exchange.
 Generally accepted medium of exchange
 Fulfills the main functions of money
Characteristics of money
 Acceptability  Intrinsic value not greater than face
 Convenience to identify value
 Portability  Stability of value
 Divisibility  Relative Scarcity (Limited in supply)
 Difficult to counterfeit  Durability
 Uniformity
Functions of Money
 Medium of exchange
 Store of value
 Unit of account ( a measure of value)
 Standard of deferred payment

1. Medium of exchange
The use of money as a medium of exchange removes the difficulties of barter. With this functions
some drawbacks such as no double co incidence of wants, problems in transportation, storage and
difficulties in dividing into smaller units were removed.
It enables sellers to exchange goods and services for money and then use the money to obtain
whatever goods and services they desire.
2. Store of value
The ability to save money for future use without any risk can be explained as store of value
functions of money. However, money is not such a good store of value. Inflation reduces the value
of money. In times of inflation people may use alternative forms of savings (land, jewelry, gold.)
3. Unit of account (measure of value)
If we exchange money for goods, it follows that goods will be priced in terms of money. By pricing
in terms of money, the problem of common medium of exchange in barter system can be overcome.
When all goods and services have money prices have money, it is easy to measure the value of one
thing in terms of another simply in terms of money.
4. Standard of deferred payment
Money can be used as a means of entering into agreements regarding future payments. The stability
of money plays an effective role in this function. Money is a convenient way of measuring and
repaying debt. When debts are denominated in money, the real value of debts may change due to
inflation and deflation and the changes in exchange rate.
Limited in the functions of Money
 The decrease in the value of money due to inflation
 Risk of holding money
 The opportunity cost of money
 Availability of more convenient methods
 Technical progress

Types of money

 Fiat Money
Fiat Money or fiat currency is money whose value is not derived from an intrinsic value or
guarantee that it can be converted in to valuable commodity such as Gold. Instead, it has a value
only by government order (fiat). Usually, the government declares the fiat currency typically
means notes and coins from central bank, to legal tender, making it unlawful to not accept the fiat
currency as a mean of repayment for all debts, public and private. The fiat money has very high
liquidity.
Fiat money, if physically represented in the form of currency (paper or coin) can be
accidentally damaged or destroyed.

 Bank Money (Commercial bank Money)

Commercial bank money or demand deposits are claim against financial institutions that can
be used for the purchase of goods and services. A demand deposit account is an account from
which funds can be withdrawn at any time by cheque or cash without giving the bank or financial
institutions any prior notice. Bank have the legal obligation to return funds held in demand deposits
immediately upon demand.

 Near Money
This refers to as anything which could be transferred to money very easily and without any
economic losses within a period of time. This type of money also possess very high degree of
liquidity.
E.g. Saving deposits, fixed deposits, treasury bills.
  Money Substitutes
These could be used as a temporary medium of exchange, instead of using money i.e. cash or
cheque, in any transaction. But these cannot be used as a store of value. Credit cards and debit
cards are some of examples

 Electric Money
Electric money refers to money or scrip which is exchanged electronically. Typically, this
involves use of computer network, the internet and digital stored value systems.
E.g. Electronic Fund Transfer, Direct deposit in e- banking system
How can we use E-Money?
 Transfer funds between accounts at the same situation
 Transfer funds to tour account at another branch
 Transfer funds to stock market
 Transfer fund to accounts of other family members within the same financial
institutions or at an external institution
 Pay person to person
 Settle any bill

Reasons for the use of e-money

 Easy and quick settlement attract customers
 International payments can be made
 Safer than currency
 Can be linked to internet of banks
 Competition among the commercial institutions

Question
Identify the advantages and disadvantages of e-money
Money Demand
The demand for money referred to as the preference or desire of people to have coins and
notes or money balances in their hand or at the bank at any time of the day or year.
People prefer holding money for three motives
 Transaction Motive
 Precautionary Motive
 Speculative Motive
Transaction motive
It means that holding money for day to day transactions. Household and firms hold a certain
amount of money because its usefulness as a generally acceptable medium of exchange. Holding
money facilitates the economic exchange.
There is a positive relationship between the income and the money demand for money for
transaction motive.

Precautionary Motive
Certain amount of money is held by households and firms in order to meet unplanned
emergencies such as accidents, unexpected illness and unemployment.
The precautionary demand for money also rise with
the income.
Speculative motive
Demand for money to earn profits in future from investments is called the demand for
money on speculative motive. There is a negative (inverse) relationship between the demand for
money on speculative motive and interest rates (r).

Macro-Economic Variable which affect the demand for money

 Real Income – there is a positive relationship between the real income and the money
demand.
 Rate of Interest – There is a negative relationship between demand for money and the rate
of interest. When the interest goes up, people prefer to invest and the money in hand goes
down.
 Price Level. – when the price level goes up the demand
 Future expectations – if people expect the price of treasury bills to go up in the future
they will buy more treasury bills today reducing the demand for money
 Organizational factors – this is the time interval between two receipts of income. If he
time interval is high then the demand for money increase
 New trends in money market
Supply of money
The total amount of money available in the entire economy is referred to as money supply
or the stock of money
Types of monetary aggregates in detail
 Narrow Money supply (M1)
 Broad Money Supply (M2)
 Consolidated Broad Money supply (M2b)
 Financial survey (Monetary Survey) (M4)

Narrow Money Supply (M1)

This includes the money held for transaction motive and money which facilitates medium
of exchange function.
M1 = Cp + DDp

Where,
M1 = Narrow Money Supply
Cp = Currency held by the public
DD p = Demand Deposits held by the public at commercial banks

Broad Money Supply (M2)

This definition includes narrow money supply and money held for the precautionary
motive and money which facilitates the store of value function.
M2 = M1 + TSDcp

Where,
M2 = Broad Money Supply
TSD p = Time and Saving Deposits held by the public at commercial banks
 Consolidated Broad Money Supply (M2b)
The consolidated Broad Money Supply includes all terms in broad money supply and
adjusted foreign currency deposits.
M2b = M2 + TSD NRFC + RD FCBU

Where,
M2 b = Consolidated Broad Money Supply
TSD NRFC = 50% of Time and Saving Deposits of Non-resident s’ foreign currency account
RD FCBU = Time and savings deposits of residents’ foreign currency banking unit

Very Money Supply (Financial survey/ Monetary Survey)

This monetary aggregates contains all items in consolidated broad money supply and time
and saving deposits held by public in licensed specialized banks and registered financial
institutions.
M4 = M2b + LSB + REC

Where,
M4 = Very Broad Money Supply
LSB = Time and Saving Deposits of Licensed Specialized banks
REC = Time and savings deposits of registered finance companies

Factors affecting the Money Supply in any country

 Net domestic assets held by the banking system – this includes the net credit to the
government by the banking system and credit given to the private sector by the banking
system.
 Net Foreign Assets held by the banking system – difference between the foreign assets
and foreign liabilities held by central bank and commercial bank.
 Other net assets held by the banking system
Financial System of Sri Lanka
The financial system of Sri Lanka comprises,
 Financial Institutions
 Financial Markets
 Financial infrastructure
 Financial institutions regulating the financial system

Financial Institutions
These institutions provide financial services by using various financial instruments. There are 2
main types of financial institutions.
 Financial Intermediaries
The financial intermediaries, carryout vital financial intermediation function of borrowing
from surplus units and lending to deficit units.
E.g. Unit Trust, Employee Provident fund, leasing companies, insurance companies
 Institutions which provide financial services
These institutions provide services to general public and other business organizations and
maintain the money market transactions efficiently.
E.g. Merchant Banks, Fund Management companies, Primary dealers in the securities
market and share brokers
Financial system regulations

Classification of financial institutions by the central bank

 Central Bank
 Licensed Commercial Banks
 Licensed Specialized Banks
 Deposit Taking Institutions
 Licensed Financial Companies
 Thrift and credit cooperatives societies
 Specialized financial institutions
 Primary Dealers
 Specialized Leasing Companies
 Share Brokers
 Unit trust management companies
 Market intermediaries
  Investment trust companies
 Contractual saving institutions
 Insurance companies
 Employees Provident Fund
 Employees Trust Fund
 Approved Provident Fund
 Public Service Fund

Financial market
Financial market facilitates the purchase and sale of financial instruments to fulfill liquidity
procurement.
Financial market contain two sub markets
 Money market
 Capital market

Money market
The money market is the market for short-term interest bearing assets with maturities less
than one year such as treasury bills commercial papers and certificates of deposits
The main issuers in money market a government bank and private companies while main
investors of banks insurance companies and pension and provident funds
Capital market
The capital market is the market for trading in assets for maturity of greater than 1 year
such as treasury bonds private debt securities debt and debentures and equity shares.

Financial instruments
The financial market instruments can be listed as follows
Instruments issued by government
 Treasury bills
 Treasury bonds
 Government debt securities
 Debt securities issued by companies
 Commercial papers
 Debentures
Instruments issued by commercial banks
 Certificates of deposits
 Asset backed securities
 Hire purchase
 Interbank call money market instruments
 Shares

Credit rating
Credit rating refers to the rating of the financial instruments on the basis of qualitative
aspects and it assesses the ability of borrowers to repay their debts.

Central Bank of Sri Lanka

Objectives and functions of central bank of Sri Lanka
Central Bank has two core objectives
 Maintaining economic and price stability
 Maintaining financial system stability

Maintaining economic and price stability

Price stability safeguards the value of the currency in terms of what it will purchase at own
and in other currencies. Price stability of stable prices means low inflation. Experience has shown
that economies performs will when the inflation is low and is expected to be low

Maintaining financial system stability

Stable financial system creates a favorable environment for depositors and investors,
encourage efficient financial intermediation, and efficient functioning of markets and hence
promotes investment and economic growth. Financial system stability means the effective
functioning of the financial system and the absence of Banking, currency and balance of payment
crisis.
Functions of central bank
 Management of monetary policy
 Management and of issuance of currency
 Employee’s provident fund
 Management public debt
 Management financial intelligence
 Management of official foreign reserves
 Management of foreign exchange policies
 Microfinance and regional development
 Lender of last resort

Monetary policy and its impact on business

Monetary policy is the process which controls the
 Money supply
 Availability of money
 Cost of money or rate of interest
, in order to achieve the objectives of the economy
There are several objectives of current monetary policy Framework such as
 Monetary targeting
 Flexible inflation targeting

Instruments of monetary policy

The instruments used by the central bank to influence money supply and interest rates to
meet the objectives of economic and price stability and financial system stability are known as
financial policy instruments
There are 2 main instruments
 Quantitative or general control instruments
 Qualitative or selective control instruments
Quantitative instruments
Central bank through its monetary policy will use quantitative method to change the total
quantity of money supply and credit in general

 Bank rate policy

This is the minimum rate at which the central bank of country provides loans to commercial
banks of the country. Through the changes in the bank at the Central Bank can influence the
creation of credit by commercial banks

 Reserved rate policy

Reserve rate is the ratio of commercial Bank deposit that are maintained as a cash reserve
in the form of cash in hand in Central Bank. And increase or decrease in the reserve ratio will
produce an increase or decrease in the monetary supply

 Open market operations

Open market operations and other important instruments of credit control. The term open
market operation means the purchase and sale of securities by Central Bank to absorb or inject
excess liquidity in the open market

Qualitative or selective control instruments

Qualitative controls main to be regulate the flow of credit for particular or specific purpose.

 Setting a maximum maturity period for

 Setting preferential rates of interest
 Setting limits for loan guarantees
 Setting limits for investment and loans
 Setting limits for letter of credit and cash balance
 Indirect control moral suasion
 Control of loan flow from commercial banks by getting their cooperation instead
of direct control
Commercial banks
The commercial banks accept demand deposits from general public and operate as a
business of profit and involved in financial intermediation
Functions of commercial banks
Primary functions
 Accepting deposits
 Lending money
Secondary functions
 Collection of cheque and bills
Agency functions
 Issuing letter of credit
 Issuing letter of reference
 Issuing travelers cheque
 Safety locker facilities
 Modern facilities
 Electronic fund transfer
 Automated teller machines
 Issuing debit cards and credit cards

Financial intermediaries
Financial intermediaries facilitates the process of channeling between those who wish to
lend or invest and those who wish to borrow or require investment funds
Examples of financial intermediaries;
 Insurance organizations
 Leasing companies
 Unit trust
 Employee provident fund and trust funds
 Authorized institutions to accept deposits and carry on banking
services
 Thrift and cooperative societies
 Rural banks
Profitability and liquidity in relation to commercial banks
Commercial banks have to main objectives which are
 Liquidity
 Profitability
It is generally said that more liquid asset, lowering the profitability of those assets

Commercial banks do their business with funds collected from other to whom they have to
pay interest. Accordingly commercial banks cannot survive and grow unless they make profit
which require them to extend their credit operations and long term investments to maximum level.
On the other hand the survival of banks depends on confidence of people hence they should possess
sufficient liquid funds to meet customer needs
Accordingly a bank can rise profits at cost of losing liquidity or maintaining liquidity with
an opportunity cost of earning profit. So maintaining a balance between liquidity and profitability
is a challenge for commercial banks

Price level and inflation

The value of goods or service is the price. When the price changes the amount of goods
and services which can be bought will also change. The price of a good or service can be explain
in two ways
 Absolute price
The absolute price is the amount of money that is asked or paid for a good or service
expressed in currency terms

 Relative price
The relative prices the price of a commodity search in terms of another goods or service
General Price level
General Price level is the hypothetical measure of overall prices for some set of goods and
services in an economy. There are three concepts associated with this general price level
Inflation - it is the continuous increase in the general price level
Deflation - it is the continuous decrease in the general price level
Disinflation - it is the decrease in the rate of inflation

Types of inflation
 Creeping or mild inflation
Creeping or mild inflation is when price 3% a year or less. This type of inflation is
beneficial for the economic growth
 Walking inflation
This type of strong inflation is between 3 to 10 % per year. It is harmful to the
economy because it heats up economic growth to fast
 Galloping inflation
When inflation rises to 10 % or more it wreaks absolute havoc on the economy.
Money loses value so that businesses’ and employees’ income can't keep up with cost and
prices. This will result in foreign investors avoiding the country and leads to unstable
economic structure
 Hyperinflation
Hyperinflation is where price skyrocket more than 50 % a month. This is very rare.
Some governments experienced hyperinflation during war because government prints
more money to pay the expense.
 Stagflation
Stagflation is a condition where the economy growth is stagnant but there is still a
price inflation
 Spiral inflation
Self-sustaining upward trends in price level full by reinforcing feedback of a vicious
circle
  Headline inflation
Headline inflation is a measure of total inflation within the country including
commodities such as food and energy prices, which tend to be more volatile and disposed
to inflation spikes

 Core inflation
Core inflation represents the long run trend in the price level. In measuring long
and inflation transitory price changes should be excluded. It is done by excluding
frequently changed prices such as prices of food and energy when calculating the inflation.
 Suppressed inflation
The existing inflation disguised by the government control the other interference in
the economy such as subsidies, rationing price controls and wage policy. Such suppression
can only be temporary because no governmental measures can completely contain
accelerating inflation in long run

Causes of inflation
There are two main causes of inflation demand pull inflation cost push inflation

 Demand pull inflation

Demand pull inflation is the type of inflation that results in aggregate demand of an
economy exceeds aggregate supply.
 There are two alternative approaches to demand pull inflation theory
 Quantity theory of money
 Keynesian theory

Quantity theory of money

The quantity theory of money is the study on the behavior of price level on the basis
of monetary equation
It states that there is a direct and proportional relationship between changes in the
price level and money stock.
It says that when the money supply increases it will lead to an increase in demand
resulting in demand pull inflation

Keynesian theory
The Keynesian theory explains the reason for inflation by analyzing the aggregate
demand and aggregate supply. It states that not only the money supply but also the velocity
of circulation of money also contribute for demand pull inflation

 Cost push inflation

Cost push inflation is a situation where are the prices of goods are people towards due to
increase in price of inputs
Price of input rise due to increase in import price in decrease in labor cost activities of
oligopolistic organization and supply shocks.
Relationship between price level and rate of interest
Due to inflation the savings may be dropped the savers are not in a position to save. At the
same time a drop in the real rate of interest leads to drop in saving

Real rate of interest = nominal rate of interest - rate of inflation

The negative real rate of interest brings about and adverse impact on the savers and fixed
income earners.
In times of inflation the fixed income earners face demerits due to drop in their purchasing
power

Economic effect of inflation

 Unfavorable to savers
 Wealth moves from debtors to creditors
 Discuss the decision making process in the economy
 Unfavorable distribution of income
 Increase in absolute poverty
 Lay of spectacles for export competitiveness
 Increase cost of living
 Depreciation of currency
Measures taken to control inflation

 Limit the growth in aggregate demand

 Remove the barriers in efficient distribution of resources
 Facilitate production to increase aggregate supply