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IMPORTANT OBSERVATIONS:
1. Supply of money is a stock variable
2. Money in hands of public. Public here refers to households, fi rms and institutions. Govt and banking system
are not part of it
M1 = C + DD + OD
M2 = M1 + Saving Deposits with Post Offices
M3 = M1 + Net Time Deposits of Banks
M 4 = M3 + Total Deposits with Post Office Savings Organization (excluding NSC)
H- high power money or monetary base. It is the actual physical money printed by govt and RBI; and held in the
hands of the public.
H= C+R [ currency held by public+ reserves with banks]
High powered money acts as the base for creating demand deposits.
MONEY MULTIPLIER:
The currency deposit ratio of 0.5 means that, at all times, currency:DD in the economy should be 1:2
After currency dd ratio effect takes place, you find actuall dd. On this dd u directly apply r ratio to find reserve
Explanation:
1. Govt draws cheque of 600 on RBI
2. Currency = 200 and dd= 400
3. Reserves = 40, 360 is lent out
4. This 360 is again is split in 1:2 ratio. 120 is maintained as cash and 240 as dd
5. Of this 240 dd, 24 is reserve and remaining 216 is lent out. This continues until initial deposit= total reserve
CREDIT CREATION IN A MULTIPLE BANK MODEL:
Credit multiplier:
Th e credit multiplier is the ratio of the change in the amount of credit to the change in reserves
Although a change in deposits can occur due to change in both the primary deposits and in the secondary deposits, a
change in credit occurs only when there is a change in the secondary deposits
CLASSICAL APPROACH
Assumptions:
Transactions value is independent of M, Vt, Pt
Money- stock of money is determined by monetary system
Velocity- assumed to be constant cause payment practices change slowly
Price- Price is the only variable which is influenced by M
K gives the demand for money for every rupee of income per unit time. K depicts the proportion of money income
which the public likes to hold as money.
demand for money is a function of money income
The above equation looks very similar to the Fisher’s equation, except for V , which represents the income
velocity (and not the transactions velocity).
transactions approach lays stress on the mechanical aspects, cash balance approach is infl uenced by K, which is a
behavioural ratio
cash balance approach can be easily expressed in terms of the simple demand supply analysis whereas the same
cannot be said for the transactions approach.
CLASSICAL THEORY OF INTEREST:
According to classical theory, ROI is determined by demand and supply of capital
Supply of capital:
Source of capital is savings
Savings is a fn of ROI
normal state for an economy is full employment. Hence, income cannot be taken as a variable and it cannot have
an infl uence on savings in the short run. Th erefore at the full employment level of income, saving is a direct
function of the rate of interest
Assumptions:
1. Perfect mobility of funds
2. Perfect competition exists- borrower and lender are price takers
3. ROI is assumed to be constant
4. Theory is in flow terms
LD= I + ΔMD
Where I= Gross investment expenditure, ΔMD= incremental demand for money
LS= S + DH + ΔMs
Where S= aggregate savings
DH= dishoarding of previously accumulated cash balance
ΔM= Incremental supply of money
The horizontal distance between the S and LS curves is the sum of DH and ΔM. Th is distance increases as r increases
because while ΔM is given exogenously, DH is an increasing function of r.
Th e horizontal distance between I and LD curves is ΔMD. Th is distance increases as r decreases because ΔMD is a
decreasing function of r
the LD and LS curves intersect each other at point E. Th e equilibrium rate of interest is r ** . Th e S-I equilibrium of
the classical theory yields r * as the equilibrium rate of interest.
Critical appraisal:
Pros:
recognizes the fact that loanable funds are demanded for purposes other than investment expenditures and also
that besides saving there exist other sources of loanable funds also.
Classical- only real factors LD theory- both real and monetary factors
Considers dishoarding
Cons:
Some savings may not come through loan market
Not all dishoardings are lent out
Etc
KEYNESIAN APPROACH