Scribd Logo
Upload

Welcome to Scribd!

  • Monetary Theory Sem1 MLJinghan AC11

    Uploaded by

    kushboog019
    6 views79 pages

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    6 views79 pages

    Monetary Theory Sem1 MLJinghan AC11

    Uploaded by

    kushboog019

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 79
    Money —Monetary §) of. Account and Mone 1. Role of Money Introduction; Significance 3, The Circular Flow of! Meaning; Circular Flow Sectors; Circular Flov Exercises . Monetary Standard Meaning and Types ¢ « Na a Gres! . eons Ch Index Numbers Meaning of Index | Numbers; Index Numbers; , vi Money, Banking, International Trade and | 6. The Quantity Theory of Money and Its Variants “Meaning of Value of Money; fisher’s Quantity Theory of Cash Transactions Approach, The Cambridge Equatio Balances Approach; Transactions Approach vs. Approach; Superiority of Cash Balances Approach over Ti Approach; Exercises 7. Keynes’ Income and Expenditure Theory , Introduction, Income-Expenditure Approach; “Saving in Approach; Exercises ~ The Keynesian Theory of Money and Prices Introduction; Keynes’ Reformulated Quantity Theory Superiority of Keynesian Theory over the Traditional Qu: of Money; Criticisms of Keynes’ Theory of Money and Exercises : “ 1% 9. Friedman’s Restatement of the Quantity Theory of : Money - : Introduction PtSdouas Thane Friedman vs Keynes; 10. The Supply of Money : 5 Definitions of Money Supply: Determinants o Measures of Money Supply in India; Exercises 10A. The Demand for Money a? 10B. Keynes’ Fundamental Equations rinflation and Deflation : ; Meaning of Inflation; Types of Inflation; Demand-Pull In -Push Inflation; Causes of Inflation; Measures to | inflation; Effects of Inflation; The Inflationary Gap; D ef Control of Deflation; Exercises Evolution and Before the evolution of money, change of goods and services. This exchange of one good for som a may be exchanged for a cow, or 3 ‘sheep or 4 there must be a double coincidence of wa wants a cow, he has to find out a person who. to exchange it with the horse, In other cases, goods i doctor may be paid in kind as payment for his se paid a cock, or some wheat or rice or fruit. te economy. It is also a simple economy where people r consumption or for exchange with other goods which found in primitive societies, But it is still practised at p money has not spread much. Such non-monetised tural areas of underdeveloped countries. Difficulties of Barter such as the estimation of os acts as a medium of exchange, it means that it is tance — 03 prota ia acceptable. It, therefore, affords the freedom of choice. With money, we ——— = ‘an assorted bundle of goods and services. At the same time, we can purel planed oon ee best and also bargain in the market. Thus money gives us a good deal of, ee independence and also perfects the market mechanism by increa-sing e calcula po ; and widening the market . “TAS -a mediuiy of exchange, money acts as an intermediary. It facili Nieney performs three secondary change. It helps production indirectly through specialisation and divi ave as a sore of Vahet aan labour which, if turn, increase efficiency and output. According to Prof. Wall = Money as a Standard of Deke money, therefore, serves as a “actor of production,” enabling output to ing Lecien aa ar Bye: n money. It was easy under barter to In the last analysis money facilitates trade. ‘When acting as the intet Pi repayments in such perishable ari helps one good or service to be traded indirectly for others. oth the taking and (eons s eee et tote Money links the present values with those of the transactions. It makes possible contracts for the supply an saieod payment of money. It simplifies borrowing purchase and from house-building and borrow institutions. The buying and selling of shares, d possible by money. By acting as a standard of capital formation both by the govert 2. Secondary Functions ® The second primary function of money ig 48 a unit of value. Under barter one would have to Tesort to some st measurement, such as a length of string or a piece of wood. Since one would to use a standard to measure the length or height of any object, itis only sed that one particular standard should be accepted as the standard. Money i standard for measuring value just as the yard or metre is the standard for me: ing length: The monetary unit measures and expresses the values of all go and services| In fact, the monetary unit expresses the value of each good: Service in terms of price. Money is the common. denominator which determi therate of exchange between goods and services which are priced in terms off of the economy, ; % monetary unit. There can be no pricing process without a measure of values But there is the danger of changes in the The use of money as a standard of value eliminates the necessity of quoting t harms or benefits the creditors and debtors. If the Pies of apples in terms of oranges, the price of oranges in terms of nuts, and time, the creditors gain and debtors lose. On the: ‘ap Unlike aster, the prices of such commodities are expressed in terms off money over time brings losses t ereditors a ‘many units of dollars, rupees, francs, pounds, etc., depending on the nature of tf this difficulty, some of the countries have fixed ‘monetary unit in @ country. As a matter of fact, measuring the values of goods index which measures changes im the value 0 Services im the monetary unit facilitates the problem of measuring the exch Buarantees the future payment of debt by €0 @W.T. Newlyn, op. cit, p. 1 This function is known by various other names such as us ‘value, common measure of value or common denominator 'S Lester V. Chandler and §.M. Goldfield, The. nit of account, standard 1977 * “JM. Culbertson, Money and Banking, 1972, 16 Money, Banking and Inte amount of purchasing power when the contract was entered into. (ii) Money as a Store of Value. Another important function of money ‘acts as a store of value, “The good chosen as money is always something | ye can be kept for Jong periods without deterioration or wastage. It is a pre’ 5 pment. which wealth can be kept intact from one year to the next. Money is a! ond and vice-Versa. the present to the future. It is therefore essential that the money mor) Basis of the Credit should always be one which can be easily and safely stored.”"” Money as. mess transactions are either i of value is meant to meet unforeseen emergencies and to pay debts. N ct But money is at the back ‘this the asset function of money. “Money is not, of course, the only store of ‘credit without having sufficient ‘This function can be served by any valuable asset. One can store value fo by businessmen have always a cash future by holding short-term promissory notes, bonds, mortgages, preferred st. ” (iti) Equaliser of Marginal household furniture, houses, land, or any other kind of valuable goods, equaliser of marginal utilities forthe Principal advantages of these other assets as a store of value are that they, un maximise his satisfaction by spend ‘money, ordinarily yield an income in the form of interest, profits, rent or usel which he wants to purchase] Since 0 ‘ness. . and they sometimes rise in value in terms of money. On the other he ‘and are expressed in money, money helps they have certain disadvantages as a store of value, among which are the follo various goods. This happens when the rat ing: (1) They sometimes involve storage costs; (2) they may depreciate in te the various goods are equal, Similarly, f of money; and (3) they are “illiquid” in varying degrees, for they are not gener productivities of the various factors. {The main acceptable as money and it may be possible to convert them into money quick his profits. For this, he equalises the ma only by suffering a loss of value.” pricerThe price of each factor is nothing but the Keynes placed much emphasis on this function of money. According to hig (iv) Measurement of National Income. It was not pe to hold money is to keep it as a reserve of liquid assets which can be convert national income under the barter system. Money into real goods. It is a matter of comparative indifference whether wealth is income, This is done when the various goods and. money, money claims, or goods. In fact, money and money claims have cert are assessed in money terms. t advantages of security, convenience and adaptability over real goods, But (») Distribution of National Income. Money also store of value function of money also suffers from changes in the value of mé national income. Rewards of factors of production | This introduces considerable hazard in using money or assets as a store of val interest and profit are determined and paid in (Gi) Money as a Transfer of Value. Since money is a generally accep means of payment and acts as a store of value, it keeps on transferring val 4, Other Functions i from person to person and place to place. A person who holds money in cash Money also performs such funetions which aff assets can transfer that to any other person. Moreover, he can sell his assets and governments. a Delhi and purchase fresh assets at Bangalore. Thus money facilitates transfer 0 (i) Helpful in making decisions, Money is &: value between persons and places 3. Contingent Functions - , Money also performs certain contingent or incidental functions, according taking decisions. a Prof, David Kinley. They are: (ii) Money as a Basis of Adjustment. (i) Money as the Most Liquid of all Liquid Assets. Money is the most liquid 0: adjustment between money market and all liquid assets in which wealth is held, Individuals and firms may hold wealth in "AW. Stonier and D.C, Hague, op. cit, p. 406 Loe, cit, ‘consumer meets his daily requirements on: consumer has a scooter and in the near future’ selling his scooter and money accumulated by” " Ibid, 18 : Money, Banking and ‘Similarly, adjustments in foreign exchange are also made through the, international payments of various types are also adjusted and money. {tis on the basis of these functions that money guarantees the sol payer and provides options to the holder of money to use it any way, EXERCISES 1. Discuss the principal diffi ties faced by a barter economy, 2 What led to the emergence of money in the modem world? 3. Describe the various stages in the evolution of money. 4 Discuss the nature and functions of money. 'S.Define money and discuss its miain functions ‘8. “Money is what money does.” Explain this statement and define money. 7. Distinguish between (a) money proper and money-of-account, (b) money and near '8 Discuss the theoretical and empirical definitions of money Money is of vital importance to the 0 economy. Money plays an important: is a consumer, a producer, a busit administrator. “An individual need money plays an important role in experience.’ We study below the i 2. SIGNIFICANCE OR Money is of vital importance to an ec Its static role emerges from its static or tr money plays an important part in the life system as a whole. Static Role of Money In its static role, the importance of money barter in the following ways: (@ By serving as a medium of exchange, coincidence of wants and the ineonvenii barter. The introduction of money as a) transactions of barter into separate climinating the double coincidence of directly with commodities ie. C<*C, €0 money, in tun, buys other comm commodities and M to money. (i By acting as a unit of account, value. The use of money as a stand the price of apples in terms of 0 ‘Lester V. Chandler and $.M. G *The explanation in this section Money.” 0 Money, Banking and ‘80 on. Money is the standard of measuring value and value expressed. is price, The prices of different commodities are expressed in terms of units of dollars, rupees, pounds, etc. depending on the nature of monetary ‘country. The measurement ofthe values of goods and services in the unit facilitates the problem of measuring the exchange values of goods. market. (ii) Money acts as a standard of deferred payments, Under barter, it to take loans in goats or grains but difficult to make repayments in such able articles in the future. Money has simplified both taking and repay loans because the unit of account is durable. It also overcomes the diffic indivisibiity of commodities (iv) By acting as a store of value, money removes the problem of stori ‘commodities under barter. Money being the most liquid asset can be kept for Periods without deterioration or wastage (») Under barter, it was difficult to transfer value in the form of ani grains etc. from one place to another. Money removes this difficulty of barter facilitating the transfer of value from one place to another. A person can tran his money through draft, bill of exchange, etc. and his assets by selling them, ‘cash at one place and buying them at another place. 4n its dynamic role, money plays an important part in the daily life of a per whether he is a consumer, a producer, a businessman, an academician, a politici or an administrator. Besides, it influences the economy in a number of ways, (1) To the Consumer. Money possesses much significance for the cons ‘The consumer receives his income in the form of money rather than in goods: services. With money in hands, he can get any commodity and service he Ii in whatever quantities he needs, and at any time he requires. Not only this, mor ‘acts as an equaliser of marginal utilities for the consumer. The main aim off Consumer is to maximise his satisfaction by spending his limited income ifferent goods which he wants to purchase. Since prices of goods indicate Marginal utilities and are expressed in money, mor ‘marginal utilities of goods. This is done by substitui for others having lower utilities. Thus money en ational distribution of his (2) To the ney helps in equalising ing goods with higher utiliti Wo gives him profit. Thus a pr af production and receipts but also profit with the help “money. Further, money helps in the general low of goods and services trang the growth of Je is possi a Shased with money and all output is ponte outby Prot Pigou, “ia te a ment of moné : 4 Bel) As the Basis of Credit. The entire credit is based on money. All monetary pills of exchange etc. These are eredit bank deposits that are money, Banks issue st credit, Credit creation, in tur, plays a major role depositors to investors. Thus credit expands investment on saving lying in bank deposits and helps in maintaining a within the economy. : ze As a Means to Capital Formation. By | ‘ment, money acts as a means to capital formation. Money can be stored and storing of money implies savings, deposits to earn interest on them. Banks, in turn, men for investment in capital equipment, buying of raw from different sources and places. This makes capital mo formation and economic growth. (6) As an Index of Economic Growth. Money is sho oa i growth, The various indicators of growth are national in and economic welfare. These are calculated and Changes in the value of money or prices also reflect Fall in the value of money (or rise in prices) means: progressing in real terms. On the other hand, & € ‘money (or fall in prices) reflects retardation of the Prices imply a growing economy. Thus money is ait (7) In the Distribution and Calculation of Income, factors of production in a modern economy are paid wages, capitalist his interest, a landlord his ent, an But all are paid their rewards in money. Am marginal productivity of each factor in terms. For this, he equalises the marginal productivity o price is, in fact, its marginal productivity payments ae made to various factors of production in money, the cale national income becomes €25). (8) In National and International Trade. Money facilitates both natio international trade. The use of money as a medium of exchange, as & ‘alue and as a transfer of value has made it possible to sell commodities not ‘within a country bot also internationally. To facilitate trade, money has helped establishing money and capital markets. There are banks, financial i stock exchanges, produce exchanges, international financial institutions, which operate on the basis of the money economy and they help in both nati and interational trade : Further, trade relations among different countries have led to internatio cooperation, As aesult, the developed countries have been helping the grows o underdeveloped countries by giving them loans and technical assistance. This has been made possible because the value of foreign aid received and its repayment by the developing countries is measured in money. (9) In Solving the Central Problems of an Economy. Money helps in solving the central problems of an economy: what to produce, for whom to produce, how) to produce and in what quantities. This is because on the basis of its functions} money facilitates the flow of goods and services among consumers, produces and the government. (10) To the Government. Money is of immense importance to the governmen Money facilitates the buying and collection of taxes, fines, fees and prices 0 services rendered by the government to the people. It simplifies the floating management of public debt and government expenditure on development an non-developmental activities. It would be impossible for modern governments t carry on their functions without the use of money. Not only this, modern gover ‘ments are welfare states which aim at improving the standard of living of th people by removing poverty, inequalities and unemployment, and achieving growth with stability. Money helps in achieving these goals of economic poli ‘through its various instruments. (11) To the Society. Money confers many social advantages. It is on the basi ‘of money that the superstructure of credit is built in the society which simplified ‘consumption, production, exchange and distribution. It promotes national when people use the same currency in every nook and comer of the country, ‘acts as a lubricant for the social life of the people, and oils the wheels of materi Progress. Money is at the back of social prestige and political power. ‘Thus money is the pivot round which the whole science of economics cluste 3. DEFECTS OF MONEY ‘The Bible says, “The love of money is the root of all evil.” ting on this saying Of the Bible the classical economists did not attach muc importance to money. They regarded its a veil or garment or wrapper for go Rightly so, According to 206% change of g00ds ed, The evils mic Defects £ Sone economic defects are as under: (1) Instability in the Value of Money. The jts value does not remain stable over time means rise in the price level or inflation. O money means fallin the price level or deflation by increase or decrease in the supply for money are disastrous and even moderate Inflation or fall in the value of money causes direc creditors and consumers. On the contrary, deflation or brings down the level of output, employment value of money adversely affects consumers, society, (2) Unequal Distribution of Wealth and Income, is that changes in the value of money lead to income. Inflation or deflation which brings benefits t0 others leads to redistribution of wealth and income not only betwe industrial classes, but between different persons in the {n the structure of the society widen the differences and lead to class conflict. (3) Growth of Monopolies, Too much of money ‘capital in the hands of a few capitalists. This leads’ exploit both consumers and workers. (4) Wastage of Resources. Money is the basis of c ‘much of credit, it may be used for productive and credit is used for production, it leads to over ‘and consequently to wastage of resources. Similarly, given for unproductive uses, they also lead to wastage: (5) Black Money. Money being the store of value tendency to hoard money and become rich ‘money. When people evade taxes and black money. This leads to a “parallel” , Money, Banking and ‘encourages conspicuous consumption, black marketing, speculation, ete. (6) Cyclical Fluctuations. Another defect of the institution of money leads to cyclical fluctuations in the economy. When the supply of Creases it leads to a boom and when it contracts there is a slump. In a ‘output, employment and income increase which lead to overproduction, contrary, they decline during a depression, thereby leading to ‘Such cyclical fluctuations bring untold miseries to the people. Non-economic Defects Money has the following non-economic defects: npey_ consumers receive money (1) Besides the above noted economic drawbacks of money the institution ny dividends by selling the services money has brought down the moral, social and political fibre of the society, nthe form of labour, land, and ca leads to corruption, turpitude, political bankruptcy and artificiality in religion ‘y income on whichever goods ‘based on materialism. In fact, money is “the cause of theft and murder, of partly spend their money income and part ‘deception and betrayal. Money is blamed when the prostitute sells her body ‘pie and small firms, in turn, buy the: ‘when the bribed judge perverts the law . .. significantly enough avarice is call is oducing commodities. These services win, Oe ty mre process in & capitalist (2) Political Instability. Overissue of money leading to hyper-inflation lead Profit isthe difference between outlay andi Political instability and downfall of government. This has happened in mi receipt-are calculated in terms of money, Latin American countries In fact, there is a circular flow of ber of 8 : Rech ‘an economy is €8s smporant role in its functioning: mon a Tendency to Exploit. People who want to amass money and wealth, demand the services of the factors of production to produ ‘underhand methods and have tendency fo exploit others. Even nations are not factors of production are paid for their services i ‘behind in this, As pointed out by Davenport, “Money has enabled strong natig goods with it, Thus money flows back to firms to destroy backward communities to win them on their side with the help payments to consumers for the services rendered | financial aid,” tion of goods of varied types. Conelusion Money and the Price Mechanism in a AIll these defects are not due to money but are the result of the attitude of, towards the use of money. It is of immense importance to every type of so Whether it be capitalist or socialist. It is impossible to imagine this world with Money. Moncy is an indispensable lubricant, a tool of convenience, for a conti US and smooth functioning of the economic machine. But its uncontrolled instead of solving, creates many complicated problems. It is these comp determine the production of innumerable production and help in the distribution of goo expressed in money, the price mechanism under | without money. Problems that led Disraeli to remark. "Money has made more people mad |n a capitalist economy where means of love.” So the best way is to keep money under control like a faithful and ol Production is also carried out by private: Servant and not to let it tke the role of a master, The controlling authority off tant function of solving the central problems of money is the government which can achieve this by a judicious monetary pol through the price mechanism. The price J ‘out any direction and control by the: 4. ROLE OF MONEY IN A CAPITALIST ECONOMY The central problems of a capitalist econ % and for whom to produce are solved through the A capitalist economy is one in which each individual in his capacity as a them as under. Ms oe This problem of what, how much and L, Von Mises, The Theory of Money and Credit, p. 93 mechanism on the basis of the! profit yx Money, Banking and ‘expenditure and receipt of a firm. The size of profit depends upon py ‘Commodities. The larger the difference between price and cost, the Profit, Again the higher the price, the greater are the efforts of the produce the different types of commodities indifferent quantities. On hhand, prices depend upon consumers’ choices of the various . also the consumers’ choices which determine what to produce, how i Produce, how to produce and for what type of consumers, Its, in fact, competition between consumers and producers which the demand and supply of both goods and services in a capitalist economy, being sufficient flexibility under capitalism, prices adjust themselves to in deraand, in production techniques, and in the supply of factors of prod Changes in prices, in turn, bring adjustments in production, factor demi ‘consumer incomes. Money is, therefore, the basis of the price mechanism y apitalism. It is a pivot around which the entire capitalist economy revol Since such an economy functions without any government interference, mg Plays & crucial role in maximising the wants of consumers and profits Producers, For the Consumer. Under capitalism, the consumer is the king who buys 0 those ‘Commodities which give him the maximum satisfaction witha given ‘ income. This he does by equalising marginal utilities of different goods ‘wishes to buy. When the price of each cou ‘modity expressed in money equals its inal utility, the consumer gets maximus Satisfaction. Thus money enables a Sumer to make a rational choice out of various commodities he wants to buy his given money income. Figure 2.1 ill ‘ates this argument. Suppose only two. modities are produced in a capital economy. They are capital goods and eo sumer goods taken on the vertical and hori zontal axes respectively. The production Possibility curve PP, represents the'area of » j j x satisfaction with a lesser quantities of ine growth of research of a capitalist economy. Since tors sed on mutual exchanges thro Bar syn other words, money helps in services from these is of Credit ae capitalist system of pro Rents are a form of money which are merce, pile, industry, anspor A mer credit instruments that banks advance Toans to the di economy. The amount of cai dole the price of loanable funds, and loans find {eans of Capital Formation . ‘The very basis of capitalism is the capital and ‘of capital. The growth of a nie ation. And capital accumulation is a process eee money incomes, deposit them with banks and other in turn, lend them to agriculturists, industrialist, men for investment in capital assets. The different s a formation under capitalism—receiving income, saving. performed in money terms. ‘ Link between the Present and the Future Money establishes a link between the present and. of enterprise and freedom of consumption under consumption on the part of the consumer leads tO Money income. Saving leads to the production of ‘and capital goods contribute to the’ growth of th ‘Money that consumers save in the present and future. Similarly, freedom of enterprise under and the trader to make payments in the future Py Money, Banking and Int “This is possible through money when the goods are stored in the p in the future. I is in these ways that money helps to establish a link [present and the future. Leads to Business Cycles . ‘Besides these apparent merits of money in a capitalist economy, it serious defect in that an excess of money leads to inflation and its to deflation. These changes in the quantity of money result in cyclical ‘with their attendant consequences on the economy. In fact, an excess supply creates more demand which, in turn, leads to overproduction, t0 commodities in the market and finally to depression and mass unet There is thus wastage of resources and loss in productivity when t business cycles ina capitalist economy. But Schumpeter regarded business & the cost of economic development, a permanent feature of the dynamic p & capitalist economy which takes it to a higher level of development every) a cycle takes place. In fine money plays a crucial role in the functioning of a capitalist ecor 5. ROLE OF MONEY IN A SOCIALIST ECONOMY ferences of the common man. ommodities that the planners decide to produce “The problem of how to produce is also decided uthority. “It establishes the rules for combining In a socialist economy, the central authority owns and controls the means Production and distribution. All mines, farms, factories, financial institut distributing agencies (such as internal and extemal trade, shops, stores, means of transport and communications etc. are owned, controlled and reg i by government departments and state corporations. Therefore, the pricing p pg the scale of output of a plant fo fale! pi {in a socialisteconomy does not operate freely but works under the control regulation of the central planning authority Marx believed that money had no role to play ina socialist economy. bead it led to the exploitation of labour at the hands of capitalists. He, advocated the abolition of money and exchange by bartering goods measur inal cost to price. Since all resources in the ferms of labour value me ty a : materials, machines of boar val ed by the government, the raw a seeping with the Marxian ideas, the Bolshevik Government in R old at prices which are equa to their marginal cost of prod aera money as a medium of exchange in 1917. Money payments for: |a commodity happens to be above its average cost, the plant < Se 00 swe abled foal ner ansactns pa profits, and if itis below the average cost of mh ‘ BY. Although some comimunist writers had prematurely hai former cas, the industry would expand and in ying Out of money, it became obvious that the socialist economy needed a down production, and ultimately a position of euMeNeY nearly as much a «private enterprise economy.” Accordingly, mil process of trial and error. The process of trial and: exchanges, money and monetary incentives were reintroduced in the New on the basis of historically given prices which wo nome Poliey (1921-27) in the USSR. Since then the Soviet economy ha Fadjustments in prices from time to time. Thus “all using money in produetion, distribution and exchange such that money production and of the productive resources im medium of exchange, a store of value, and a unit of account decisions of individuals as consumers and as We have given above a brief description ofthe role of money in the Ibasis of these prices. As a result of these deci economy which is the finest variant of a socialist econcm jpplied of each commodity is determined. If! y in action, produce is also solved by the state in a ‘economy. The central planning authority takes this decision at the time ing what and how much to produce in accordance withthe overall obj the plan. In making this decision, social preferences are given weightage. If ‘words, higher weightage is given to the production of those goods and which are needed by the majority of the people over luxury items. They are ‘on the minimum needs of the people, and are sold at fixed prices ‘government stores. Since goods are produced in anticipation of demand, increase in demand brings about shortages and this leads to rationing. “Thus in a socialist society the problem of income distribution is auton solved because all resources are owned by the state and their rewards fixed and paid by the state. Economic surpluses are deliberately ct utilised for capital accumulation and growth. Capital Accumulation Besides, capital accumulation is possible through money. It is mon provides liquidity and mobility required for capital accumulation. In a economy the sources of investment funds are basically the same as capitalist economy. The turnover tax, planned profits of public enter amortisation quotas and taxation of agricultural produce in kind or in lo ‘curement prices are all expressed in money and help in capital accumm Foreign Trade Moreover, socialist economies do not enter into foreign trade on bilatert relations based on commodity transactions, Rather, being members of the Bank and the IMF, they make payments in monetary terms in their in trade relations. Circular Flow of Money There is also circular flow of money in a socialist economy. The units receive funds for investment from the state budget as grants or as loar the state bank to purchase the necessary inputs and for making paym workers. The workers spend their wages on consumer goods. The produci receive revenues from sales, which, in turn, go into tax payments ‘earnings and as repayments of loans to the state bank. These funds from the state budget and the state bank to the producing units. Thus mon in the circular low of goods and services in a socialist economy, To conclude, the role of money in a socialist economy may be less is good servant, bat 3 3. Monee ale of money je does money pay ia in i 5 What he sac and dam oe Chapter 3 The Circular Flow of Money 1, MEANING ‘The circular flow of money refers to the process whereby money payments receipts of an economy flow in a circular manner continuously through time. various components of money payments and receipts are saving, investment taxation, loans, government purchases, exports, imports, etc. These are shown diagrams in the form of currents and cross-currents in such a manner that the t money payments equal the total money receipts in the economy. 2. CIRCULAR FLOW OF MONEY BETWEEN HOUSEHOLD AND BUSINESS SECTORS. ‘We begin with a simple hypothetical economy where there are only two s ‘the household and business. The household sector owns all the factors of prod tion, that is land, labour, capital and enterprise. This sector receives income in form of rent, wages, interest and profit, by selling the services of these factors ‘business sector. The business sector consists of producers who prodi ies and sell them to the household sector. The household sector consis who buy commodities produced by the business sector. ‘in the first instance, money flows in the form of such income payt interest and profits from the business sector to the hou the former buys the services of the factors of production to so received is, in turn, spent by the household sector to buy g business sector, In this way, money flows in a circular circular Flow of Money the Cire payments PPO equal to their sales, and there are no changes acme (3) The business sector does not keep any undistributed money as reserve. The money it receives by selling goods and “ervices to the household sector is fully spent in making payments as rent, wages, st and profits to the household sector, 11s these assumptions that keep the flow of money to monet FIG. 3.1 nanner in the economy. But these assumptions are unrealistic and do: actual working of the economy. i The fact is that there are regular withdrawals and injections from the citculat fl { money in the economy. A withdrawal or leakage is any income’ not enter into the circular flow of money, and an injection is an addition fo the ular flow of money. A leakage occurs in theincome flow and an injection in expenditure flow. 5. CIRCULAR FLOW OF MONEY WITH SAVING AND INVESTMENT In the circular flow of money, saving is one ofthe leakages and invesunent is 8 njection, In fact, the household and business seetors do mot spend the ‘money income. The consumers who represent the ho ; their income wholly in purchasing goods and services. their income for a variety of motives. Similarly, business entire income from the sale of goods. But they keep & part undistributed profits. Such savings of consumers and are invested in bonds, shares, debentures, ete. in the into the capital market, 3 On the other hand, business firms borrow funds ‘making investment. Thus savings which flow into away by the business sector for investment and ‘maintained in the economy. Money, Banking and International Figure 3.2 shows how the circular flow of money is altered by the inclusi saving and investment. Expenditure has now two paths: (i) directly via consu tion from the households to the business sector, and (i) indirectly via invest expenditure by the business sector. Consumption Expenditure’ Capital Market Household Sector FIG. 32 In the centre of Figure 3.2, there is the capital (or credit or financial) market Which shows the inflow of savings from the household sector and the business Sector into the capital market, and the ouiflow of investment into the business Sector from the capital market. The capital market coordinates the saving and investment activities of the houschold and business sectors and maintains the Circular flow of money in the economy 4. CIRCULAR FLOW OF MONEY WITH GOVERNMENT SECTOR Sofarwe have been working on the circular flow of money in a two-sector model of an economy. To this we add the government sector so as to make it a three= ‘sector closed model. For this, we add taxation and government purchases (of Jexpenditure) in our presentation. Taxation is a leakage from the circular flow at Purchases are injections into the circular flow of money, take the circular flow between the household sector and the governme: in the form of personal income-tax and commodity taxation paid. {sector are outflows or leakages from the circular flow. But circular Flow of Money The Cire we take the household, business and goverment ic Now ™ flows, and outflows in the circular low, At dads ne nan sie te rom te ctl flow of money. ens wo eda contmpn ot «kit ye household sector. Reduced consumption in tm reduces savin orcs of the firms. On the other hand, tes on business fis and incor investment and production. The Bovernmeat offsets these leakages — reds ie purchases from the business sector and buying services ofthe howe, by artor equal to the amount of taxes, Thus total sale again equal production bold scoys_ and the circular flows of money income and expenditure remain oF ym. Figure 3.3 shows that taxes flow out of the household and business _ and go to the government. ‘Now the government makes investment and for “chases goods from the household sector. Thus govemument purchases of ths parry services are an injection in the cxcula flow of money, ad aes ae equil secto aly sovernment purchases exceed net taxes then the government wl incur a deficit equal to the difference between the two, ic, government expenditure and {s_The government finances its deficit by borrowing from te capital matet which receives funds from the household sector in oe tiaras le ¥ ic ber and, if net taxes exceed government purchases the government’ ical. Inti cs Se gone tes te a ad supplies funds to the capital market which are received by the business secon, ‘Money, Banking and International Tr S-CIRCULAR FLOW OF MONEY WITH THE FOREIGN SECTOR ‘So far the circular flow of money has been shown in the case of a clo Sconomy. But the actual economy is an open one where foreign trade plays, ‘Important role. Exports are an injection or inflows into the circular flow ‘money. They create incomes for the domestic firms. When foreigners buy go {and services produced by domestic firms, they are exports in the circular flow ‘money. On the other hand, imports are leakages from the circular flow. They ‘expenditures incurred by the household sector to purchase goods from fore Countries. These exports and imports in the circular flow are shown in Figure 3 ‘Take the inflows and outflows of the household, business and governmen ‘cctors in relation to the foreign sector. The household sector buys goods im Ported from abroad and makes payment for them which is a leakage from the circular flow of money. The householders may receive transfer payments from, the foreign sector for the services rendered by them in foreign countries, On the other hand, the business sector exports goods to foreign countries and) its receipts are an injection in the circular flow of money. Similarly, there. are ‘mary services rendered by business firms to foreign countries such as shipping, insurance, banking, etc. for which they receive payments from abroad, They Feceive royalties, interests, dividends, profits, etc. for investments made in fo ign countries. On the other hand, the business sector makes payments to foreign sector for imports of capital goods, machinery, raw materials, consum jo, and 5 00! cireular Flow of Money phe Ci" vices from abroad. These moe) business sector, modern Likes, and lend to and bortow from and 7 the government receives payments good *ceives payments from foreigners crc ecg eatin and als and orance and banking Services pines also receives royalties, interests, cies -These are injections into the circular abromeages are payments made 10 fore mea the services. Figure 34 shows the cireular flow of money . win ving, tox and imports shown as eas fom the ea wn hand side of figure, and investment, ae inetions into the circular flow, on the! ‘ports and transfer payments have been

    You might also like