Unit 1 Money PDF

Unit 1: Money Money – Meaning, functions, measurement; theories of money supply determination, Measures of Monetary Stock in India and New monetary equations, Demand for Money, Value of Money- Fisher’s, Cambridge and Keynesian Equation. Meaning of Money Money is anything that is generally accep...

Unit 1: Money Money – Meaning, functions, measurement; theories of money supply determination, Measures of Monetary Stock in India and New monetary equations, Demand for Money, Value of Money- Fisher’s, Cambridge and Keynesian Equation. Meaning of Money Money is anything that is generally accepted as a medium of exchange, a measure of value, a store of value, and a standard for deferred payment. It plays a foundational role in economic activities, enabling the exchange of goods and services, savings, and investments. The evolution of money began with the barter system, which involved the direct exchange of goods and services. However, the barter system faced challenges like the double coincidence of wants, divisibility, and value determination. These issues led to the emergence of money as a more efficient tool for transactions.  Key Characteristics of Money: 1. General Acceptability: Recognized as a medium of exchange across the economy. Example: The Indian Rupee (INR) is widely accepted for all transactions in India. 2. Durability: It does not perish easily, maintaining its usability over time. Example: Metal coins last for years without significant wear. 3. Portability: Easy to carry and use for transactions. Example: Digital wallets allow easy transfer of money online. 4. Divisibility: Can be divided into smaller units. Example: 1 Rupee is further divisible into 100 paise. 5. Homogeneity: Every unit of the currency is identical in value and form. Example: A ₹100 note has the same value regardless of where it is used.  Functions of Money Money serves several critical functions in an economy, broadly categorised into primary, secondary, and contingent functions. Primary Functions 1. Medium of Exchange: Money facilitates the buying and selling of goods and services, eliminating the inefficiencies of the barter system. Example: A customer buys groceries worth ₹1,000 at a supermarket instead of exchanging wheat for rice. 2. Measure of Value (Unit of Account): Money acts as a standard benchmark to express the value of goods and services. Example: A car priced at ₹8,00,000 and a scooter priced at ₹80,000 can be compared using money as the measuring unit. Secondary Functions ∙ Store of Value: Money retains its value over time and can be saved for future use. Example: ₹50,000 saved in a fixed deposit account retains purchasing power for the future, unlike perishable goods like fruits. ∙ Standard of Deferred Payment: Money enables credit transactions where payments can be postponed or made in instalments. Example: Buying a home through a mortgage with monthly EMIs. ∙ Transfer of Value: Money facilitates the movement of value across locations and time. Example: An individual working in Mumbai transfers ₹10,000 to their family in Bangalore. Contingent Functions ∙ Basis for Credit: Money underpins the credit system used by banks and financial institutions. Example: A bank loans ₹5,00,000 to a business, using its deposits as a reserve base. ∙ Distribution of National Income: Wages, rents, interests, and profits are paid in monetary terms, helping distribute income. Example: Salaries paid in INR to employees in various industries. ∙ Liquidity Provision: Money ensures liquidity, allowing individuals and businesses to meet short-term needs. Example: Cash reserves of a company to handle day-to-day expenses. Measurement of Money The money supply refers to the total stock of money available in an economy at a particular time. It is classified into different measures, commonly denoted as M1, M2, M3, and M4 in India, as defined by the Reserve Bank of India (RBI). Narrow Money (M1) -M1 = Currency in Circulation + Demand Deposits (in Banks) + Other Deposits (in RBI) -Components: i.Currency in Circulation: Notes and coins used in daily transactions. Example: Cash used to buy groceries. ii.Demand Deposits: Funds in checking accounts available on demand. Example: Money in a savings account. iii.Other Deposits with the RBI: Includes funds from certain public institutions. Broad Money (M3) - M3 = M1 + Time Deposits (in Banks) - Components: i.Includes all elements of M1. ii.Time Deposits: Fixed deposits and recurring deposits that are not immediately accessible but earn interest. Example: ₹1,00,000 in a fixed deposit. M2 and M4 i.M2: M1 + Post Office Savings Deposits. Example: Money in a Post Office Savings Account. ii.M4: M3 + Total Post Office Deposits (including recurring and fixed deposits). Relevance of Measures: iii.M1: Indicates liquidity in the economy. iv.M3: Monitored for overall economic analysis and monetary policy. Significance of Money in the Economy 1. Facilitates Trade and Commerce: Money simplifies transactions, enhancing trade efficiency. Example: Businesses conduct cashless transactions via UPI in India. 2. Promotes Economic Stability: Governments use monetary tools to manage inflation and deflation. Example: The RBI reduces repo rates to encourage borrowing during economic slowdowns. 3. Encourages Savings and Investments: The store of value function motivates individuals to save and invest, driving economic growth. Example: Investments in PPF or mutual funds. Determinants of Money Supply: In order to explain the determinants of money supply in an economy, we shall use M, the concept of money supply, which is the most fundamental concept of money supply. We shall denote it simply by M rather than M1. This concept of money supply is composed of currency held by the public (Cp) and demand deposits with the banks (D). Thus M = Cp + D …(1) Where M = Total money supply with the public Cp = Currency with the public D = Demand deposits held by the public The two important determinants of the money supply, as described in equation (1), are (a) the amount of high-powered money, which is also called Reserve Money by the Reserve Bank of India, and (b) the size of the money multiplier. New Monetary Aggregates RBI's third working group for measuring money supply in India was formed in 1998. The working group recommended that the proposed monetary aggregates should be applied from fiscal year 1999-2000. However, the old monetary aggregate would need to be continued for some time for comparability. There are two basic changes in the New monetary aggregate: ∙ Since the post office is not a part of the banking sector, postal deposits are not treated as money, as it was treated in M2 and M4. ∙ The new series clearly distinguishes between monetary aggregated and liquidity aggregates New monetary aggregates NM0, NM1, NM2, NM3 Liquidity aggregates= L1, L2, L3 Weekly Compilation NM0 = Monetary Base / High powered Money = Currency in Circulation + Banker's Deposit with RBI + Other Deposit with RBI Fortnightly Compilation NM1 = Currency with Public Demand Deposit with Bank + Other Deposit with RBI NM2 = NM1 + Time liabilities portion of Saving deposit with bank + Certificate of Deposit + Term Deposit of Maturity within a year (Excluding FCNR Bank Deposit) NM3 = NM2 + Time deposit with maturity over one year (Excluding FCNR Bank Deposit) + Call/Term Borrowing by Banking System. Certificate of Deposit: It is a certificate offered by a bank that guarantees payment of a specified interest until a maturity date. The larger the amount of the Certificate deposit, the longer the term and the greater the interest. A certificate of Deposit is the same as a Fixed Deposit in terms of Interest, Time, amount, etc. But there are some differences between FD and CD. The CD is negotiable; FD is not. You can not take a loan against CD, but you can take a loan against FD. The minimum investment in CD is ₹1,00,000. But there is no such requirement in FD. FCNR-Bank Deposit (Foreign Currency Non-Resident- Bank Deposit): It is a type of Bank account only for NRI. They can deposit their foreign currency in Indian banks for saving purposes. This type of bank account is called an FCNR Account. The person does not need to Convert their currency into the India Rupee. It is a type of FD account for NRI. Call Borrowing or Call Money: Call money is a short-term loan which is due to be paid immediately in full as and when demanded by the lender. Call money loans do not have a defined schedule of payment and maturity. Furthermore, the lender of the call money need not provide prior notice to the borrower about the repayment. 'Term Money' refers to borrowing/lending of funds for a period exceeding 14 days. Liquidity Aggregates: L1, L2, L3 The working group under the chairmanship of Dr. Y. V Reddy (1998), then Deputy Governor of RBI, had suggested four New Monetary Measures, NMO, NM1, NM2, NM3 & Three Liquidity Aggregates. Monthly Compilation L1 = NM3 + Postal Deposit (excluding National Saving Certificate) L2 = L1 + Term Money Borrowings, Certificate of Deposit and Term Deposit of Financial Institutions like IDBI, HDFC, SIDBI, NABARD etc. Quarterly Compilation L3 = L2 + Public Deposit with NBFI (Non-Banking Financial Institutions) Like Muthoot Fincorp Ltd., Bajaj Finance Limited etc. Theories of Money Supply Determination Approaches of Demand for Money Demand for money:- the demand for money arises from two important functions of money. First is that money acts as a medium of exchange and second is that it is a store of value. The individuals and businesses wish to hold money partly in cash and partly in the form of assets. There are three approaches to the demand for money. 1. The classical approach 2. The Keynesian approach 3. The post-Keynesian approach The classical approach Classical emphasises the transaction demand for money in terms of the velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the exchange of goods and services and store of value. In Fisher’s equation of exchange Supply Side MV = PT Demand Side M = Total quantity of money V = Velocity of circulation P = Avg. Price level T = Total amount of goods and services exchanged for money PT = Demand for money MV = supply of money The Neoclassical Theory The neoclassical theory of demand for money was put forward by the Cambridge economists Marshall and Pigou. They emphasised on store of value. The key feature of the Cambridge equation is that it makes the demand for money a function of money income and only of it. According to this approach, demand for money can be expressed as Md = kPY Y = real national income P = Average price level of currently produced goods and Services PY = Nominal income  The Keynesian Approach Liquidity preference Keynes' suggested three motives that led to the demand for money in an economy. 1. The transaction demand 2. The precautionary demand 3. The speculative demand 4. Liquidity Trap The Transactions Demand for Money People require money to carry out day-to-day transactions, but most of them receive income once a month. Individuals hold cash in order "to bridge the interval between the receipt of income and its expenditure". Transactions demand for money is a function of income. Interest rate and transaction demand:-according to Keynes, transaction demand for money is interest-inelastic. Precautionary Demand for Money The precautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies. According to Keynes, precautionary demand for money is a function of income, like the transaction demand for money. Keynes holds that the transaction and precautionary motives are relatively interest-inelastic but are highly income-elastic. Speculative Demand for Money The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate. According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and the lower the rate of interest, the higher the speculative demand for money. Liquidity Trap: A liquidity trap is a situation when monetary policy becomes ineffective due to very low interest rates, and consumers prefer to save rather than invest in higher-yielding bonds or other investments. Post Keynesian approaches Baumol's inventory theoretic approach: William Baumol's made an important addition to the demand for money in Keynesian transactions. Baumol’s analysis is based on holding an optimum money inventory for transaction purposes.  Keynes’s transaction demand for money is a function of the level of income and the relationship between transaction demand and income is linear and proportional. Baumol says that the relation between transaction demand and income is neither linear nor proportional, rather changes in income lead to less than proportionate change in the transaction demand for money. Keynes considered transaction demand for money to be interest inelastic, but Baumol shows that demand for money is a function of the rate of interest. Tobin Portfolio Selection Model In his famous article “Liquidity Preference as Behaviour towards Risk, " James Tobin formulated the risk aversion theory of liquidity preference based on portfolio selection. This theory removes two major defects of the Keynesian theory of liquidity preference. The two defects were:-  The liquidity preference function depends upon the inelasticity of expectations of future interest rates. An individual holds either money or bonds. Tobin removed both defects. His theory does not depend on elasticity expectations of future interest rates. Still, it proceeds on the assumption that the expected value of capital gain or loss from holding interest-bearing assets is always zero. This theory explains that an individual portfolio holds money and bonds rather than only one at a time. Friedman's theory Friedman asserts that "money does matter". He points out that his theory is a theory of demand for money and not a theory of output, money incomes or prices. Friedman's theory, a unique blend of Keynesian and non-Keynesian elements, offers a comprehensive understanding of the demand for money. Instead of identifying the key determinant of demand for money, he classified the holder of funds between: 1. Ultimate wealth holder and 2. Business enterprises. According to him, the demand for money depends upon three major sets of factors: 1. The total wealth held in various forms. 2. The price and return on this form of wealth and alternate Forms. 3. The tastes and preferences of the wealth-owning units.  RATIONALE OF MEASURING MONEY SUPPLY: Empirical money supply analysis is essential for two reasons. 1. It facilitates analysis of monetary developments to provide a deeper understanding of the causes of money Growth. 2. It is necessary from a monetary policy perspective, as it allows for a framework to evaluate whether the stock of money in the economy is consistent with the standards for price stability and to understand the nature of deviations from this standard. The central banks worldwide adopt monetary policy to stabilise price levels and GDP growth by directly controlling the money supply. This is achieved mainly by managing the quantity of the monetary base. The success of monetary policy depends, to a large extent, on the controllability of the money supply and the monetary base.  The supply of money in the economy depends on: (a) The decision of the central bank is based on the authority conferred on it and (b) The supply responses of the country’s commercial banking system to the changes in policy variables initiated by the central bank to influence the total money supply in the economy. The central banks of all countries are empowered to issue currency. Therefore, the central bank is the primary source of money supply in all countries. In effect, high-powered money issued by monetary authorities is the source of all other forms of money. 2. Monetarist Theory Milton Friedman’s monetarist theory emphasises that the money supply is a key determinant of economic activity and is influenced by the central bank’s policies and the banking system's behaviour. Key Equation: Ms = C + D Where: Ms: Money supply; C: Currency in circulation; D: Demand deposits in banks The monetarists highlight the role of the money multiplier in determining the money supply: Ms = m x B Where: m: Money multiplier; B: Monetary base (currency + reserves) Example: If the monetary base is ₹1,000 crore and the money multiplier is 4, the money supply becomes: Ms = 4 x1,000 = ₹4,000 crore. Role of the RBI: By controlling the monetary base (B) through operations like bond purchases or sales, the RBI indirectly influences the total money supply. Keynesian Theory John Maynard Keynes introduced a more flexible view of money supply, focusing on the demand-side factors and the interaction between the central bank, commercial banks, and the public. Keynes believed that the money supply is endogenously determined, driven by economic activities and the public’s liquidity preferences. Key Factors Influencing Money Supply: Central Bank Policy: Determines base money or high-powered money (H). Example: RBI lowering the repo rate to encourage borrowing. Commercial Banks’ Credit Creation Ability: Banks multiply the base money through loans. Example: A ₹100 deposit allows banks to create ₹1,000 of credit with a 10% reserve ratio. Public Behaviour: The extent to which the public holds cash vs. deposits. Example: During the demonetisation in India (2016), people deposited more cash into banks, increasing deposits and potential money supply. The central bank does not entirely control the money supply; it depends on the interaction between banks and the public. 4. Endogenous Money Theory This modern approach posits that the money supply is demand-driven and created by the banking system in response to the needs of the economy. Key Terms: Banks create money through lending based on demand. The central bank accommodates this demand by providing reserves. Example: A business needs a ₹10 lakh loan to expand operations. The bank creates this money by crediting the business’s account. The RBI later adjusts reserves to support this creation if required. 5. Structuralist Theory The structuralist theory focuses on the structural aspects of the economy, such as financial development, institutional frameworks, and government policies, in determining the money supply. Key Features: Credit demand, financial market structures, and policy goals influence money supply. The theory emphasises that underdeveloped banking systems and the informal sector often constrain money supply in developing countries (like India). Example: In rural India, where formal banking penetration is limited, informal credit systems dominate, affecting the overall money supply in the region.