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

 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) Modern Approach
Coins, currency, (Broad Money)
Demand Deposits

Money
Coins, Currency, Near Money
Demand Deposits
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.
 A bond is a fixed income instrument that
represents a loan made by an investor to a
borrower (typically corporate or
governmental). ... Bonds are used by
companies, municipalities, states, and
sovereign governments to finance projects
and operations. Owners of bonds are
debtholders, or creditors, of the issuer.
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 and deposits with
IMF,WB.
Measurement
Money Supply M2

M2= M1 + Saving deposit of people 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+ Euro dollars

Time deposits are not 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

measurement of money supply.docx

M4.svg
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 +RR + ER

Cp = Currency held by the public

RR= Cash reserves of currency with the banks
ER= Excess reserves with RBI

 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
Theory of Money supply
 The analysis of how money supplied by the
central bank multiplies itself in the process of
monetary transactions.
 It states that the total supply of money ( M)
equals the supply of the high-power money(H)
multiplied by money multiplier.
M=mH
Where M = C( currency with the public) +
DD(demand deposits)
H = C + R( reserves with bank )+E(Excess
reserves of RBI)
Money Multiplier
 The two determinant of money multiplier are
- currency -deposit ratio (c)-C/DD
- Reserve deposit ratio (r)-R/DD
- Excess reserve (e) - E/DD

M/H = C + DD/C + R + E

M/ H = C /DD + 1 ( Dividing DD to both nu. and de.)

C /DD + R / DD + E/ DD

M/ H= c + 1/c + r +e ( c= C/DD; r= R/DD; e= E/DD)

M= c + 1/c + r + e * H
M= mH
Where m = c + 1/c + r +e
Money Multiplier
 The higher the currency deposit ratio, the
smaller the money multiplier and vice versa
 The higher the reserve–deposit ratio, the
lower the value of money multiplier and vice
versa.
 What is money multiplier? What ratios play
an important role in the determination of the
value of money multiplier?
Factors that determine
the money multiplier m  1  c
r ec

 Required reserve ratio r:

 the money multiplier and the money supply are
negatively related to r
 Currency ratio c:
 the money multiplier and the money supply are
negatively related to c.
 Excess reserves ratio e:
 the money multiplier and the money supply are
negatively related to the excess reserves ratio e.
24
Factors that determine
the money multiplier

 The excess reserves ratio e is negatively

related to the market interest rate
 Opportunity cost of holding excess reserves
 Relative expected return on excess reserves relative
to loans and securities
 The excess reserves ratio e is positively
related to expected deposit outflows
 Excess reserves provide insurance against losses due
to deposit outflows.
25
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
Keynesian Approach
Apporach

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
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
Or
“desire of the public to hold cash”

 The desire for liquidity arises because of three motives

 Transaction motive
 Precautionary motive
 Speculative motive

 Total demand for money - M= M1+M2

M1= L1(y) ; M2 = L2(r)
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.

b) 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 direct function of
the size of Income.”

M1 = L1(y)
Y= Income
L1 = Demand Function
M1= Money demanded for Transaction and Precautionary motive
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 an inverse 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 speculative 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 Rate Liquidity Trap
very low rate of interest Of
interest
LP

Speculative Demand
 An important feature of the LP schedule is
that if the roi falls to a very low level, the LP
curve becomes perfectly elastic.
 It means that at this extremely low roi ,
people will have no desire to lend money and
will keep the whole money with them.
 It further implies that roi cannot be lowered
any more.
 This feature of LP schedule is known as
LIQUIDITY TRAP.
 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

 Md = M 1 + M 2

 Md = L1 (Y) + L2 (r )
I
Total Demand of Money
Active Balance Idle Balance
n L (Y1) L (Y3)
t L1 (Y1) L12(Y2) L3 (Y3)
e
r
e
s
t
R L2
a
t
e
MONEY INCOME
Determination of
Interest Rate
Equilibrium Interest Rate
Excess quantity of money demanded
Excess money People sell Bonds prices fall
demand Bonds

Interest rate
rises

Excess demand for money causes interest rates to rise.

Excess demand for money causes interest rates
to rise.
Bond prices and interest rates are inversely related, with increases in interest
rates causing a decline in bond prices.
Excess quantity of money
supplied
Excess money People buy Bonds prices
supplied Bonds rises

Interest rate
falls

Excess supply for money causes interest rates to fall.

INFLATION
What Is Inflation?
 Inflation is an increase in the average level of
prices for goods and services.

 It is an index, which shows how prices of

goods and services that is representative of
the economy as a whole are growing.
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

P
Price Level

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.
Thanks a lottt!!!