Money and Interest Rate Module-4 (PDF)

Money and Interest Rate Module- 4 Supply of Money – components of money supply, determinants of money supply: high powered money and money multiplier, RBI’s measures of money supply - old and new measures, liquidity aggregates, Velocity of circulation of money. Demand for Money: Keynesi...

Money and Interest Rate Module- 4 Supply of Money – components of money supply, determinants of money supply: high powered money and money multiplier, RBI’s measures of money supply - old and new measures, liquidity aggregates, Velocity of circulation of money. Demand for Money: Keynesian motives – transactions, precautionary and speculative demand for moneyKeynesian liquidity preference theory of interest, liquidity trap. Introduction to modern monetary theory; Introduction to digital money Money Meaning--- It refers to the stock of money held by people in spendable form. According to Crowther..Money can be anything that is generally acceptable as a means of exchange and that as same time acts as measure and store of value. According to Alfred Marshall “money constitutes all those things which are at any time and place generally accepted without doubt or special enquiry as a means of purchasing commodities and services. Constituents of Money Supply Money Supply Measures From April 1977, the Reserve Bank of India has adopted four concepts of money supply in its analysis of the quantum of and variations in money supply. Narrow Money : M1 = Currency with public + Demand deposits with the Banking system (current account, saving account) + Other deposits with RBI Broad Money : M2 = M1 + Savings deposits of post office savings banks M3 = M1 + Time deposits with the banking system M4 = M3 + Total deposits with post office savings Organisations. Measures of money supply 1. M1- Traditional approach (Narrow money) M1 = C + DD + OD C: Currency with the public DD: Demand deposits with the public in the commercial and cooperative banks OD: Other deposits held by the public with the RBI The money supply is the most liquid measure of money supply as the money included in it can be easily used as a medium of exchange. Measures of money supply Other deposit of the RBI includes: (i) Deposits of institutions such UTI, IDBI, IFCI, NABARD etc. (ii) Demand deposits of foreign central banks and foreign Governments. (iii) Demand deposits of IMF and World Bank Measures of Money supply 2. Measure M2 M2 = M1 + Savings deposit with the post office savings bank The reason why money supply M2 has been distinguished from M1 is that saving deposits with post office savings banks are not as liquid as demand deposits with commercial and co-operative banks as they are not chequable accounts. Measures of Money supply M3 (Broad Money) M3 = M1 + Time deposits with the banks RBI in its analysis of growth of money supply and its effects on the economy has shifted to the use of M3 measure of money supply. M4 M4 = M3 + Total Deposits with Post Office Savings Organisation. New Monetary Aggregates The Working Group on Money Supply: Analytics and Methodology of Compilation (Chairman: Dr. Y.V. Reddy), in 1998, recommended the compilation of 4 monetary aggregates on the basis of the balance sheet of the banking sector in conformity with the norms of progressive liquidity. The RBI has started publishing these new monetary aggregates as a measure of supply of money: NM0 (Monetary Base) NM1 (Narrow Money) NM2 NM3 (Broad Money) New Monetary Aggregates NM0 = Currency in Circulation + Bankers’ Deposits with RBI+ ‘Other’ Deposits with RBI Here, ‘Other’ deposits with RBI comprise mainly: Deposits of quasi-government and other financial institutions including primary dealers, Balances in the accounts of foreign Central banks and Governments, Accounts of international agencies such as the International Monetary Fund, etc. NM1,NM2 (Narrow Money) NM1 =Currency with the Public +Current Deposits with the Banking System + Demand Liabilities Portion of Savings Deposits with the Banking System+ ‘Other’ Deposits with RBI Thus, NM1 includes currency with the public and non- interest-bearing deposits with the banking sector including that of RBI. NM2 =NM1+ Certificate of deposits issued by Bank+ Short-term Time Deposits of Residents (including and up to the contractual maturity of 1 year) NM3 (Broad Money) NM3 = NM2+ Long-term Time Deposits of Residents+ Call/Term Funding from Financial Institutions. Thus, NM3 captures the complete balance sheet of the banking sector. Measurement of money supply Money supply refers to the total sum of money available to the public in the economy at a point of time. That is, money supply is a stock concept. Public refers to individuals, business firms, State and local government bodies etc. Money supply is the quantity or stock of money in circulation. Stock of money held by commercial banks as cash reserves is not regarded as money supply. This separation of producers of money(banks) from the users of money is important from the viewpoint of both monetary theory and policy. MONEY SUPPLY: STOCK AND FLOW VARIABLE When money supply is viewed at a point in time, it is a stock of money held by the public on a particular date. When viewed over a period of time, money supply becomes a flow concept. A unit of money is spendable and re-spendable. It thus passes from one hand to the other. The average number of times a unit of money circulates from one hand to another in the spending process during a given year is referred to as the “velocity of circulation of money” The flow of money is measured by: MV M: stock of money held by the public V : Velocity of circulation Velocity of Circulation of Money The velocity of circulation of money is the speed at which units of money are exchanged in an economy during a specific period to enable people to conclude transactions. The higher the number of times a unit of money travels, the higher its contribution to the nation’s money supply and the more it raises the overall price levels in the country. It is a useful economic indicator as it shows the amount of money that must be in circulation in an economy to ensure smooth transactions. Transactions Velocity of Money The transactions velocity is the economy- wide money value of all transactions during a year, divided by the average money supply during the period Transactions Velocity = Money value of transactions/ Money Supply The transactions velocity is the number of times on average that a currency is used for a transaction. #Consider a company town, in which weekly town product is Rs.100. The money supply is Rs.100. The workers are paid Rs100 in wages each Friday, and on Saturday they spend the entire Rs.100 in the company store. Total transactions per year are 52 ×Rs.200 = Rs10,400 RS RS Income Velocity of Money Let Y denote the nominal national income and product per year, and let M denote the average nominal money supply. The income velocity v of money is nominal income divided by nominal money, v=Y/M In the company town, Y = 52 ×Rs.100 = Rs.5,200, so the income velocity is v = Y /M = Rs.5,200 /Rs.100 = 52. Factors affecting the Velocity of Circulation of Money Some factors affecting the velocity of money circulation are listed below: I. Money supply: Money supply is nothing but money in circulation in an economy. A reduced money supply increases its velocity. II. Transactions and their frequency: A higher number of transactions increases the velocity of money circulation. If the trade volume increases and more products and services are purchased and sold, the frequency of transactions increases. This will increase the velocity of the circulation of money. III. Consumer actions: The volume depends on consumers’ actions. In an economy, if people are paid well at regular intervals, they tend to spend freely and frequently. As financial uncertainty reduces, it curbs their tendency to save and the need to hold cash. The higher the spending, the higher the velocity. IV. Credit facilities: A country’s monetary and fiscal policies regulate the money flow in an economy. These policies control the cash available to the public for spending. Therefore, velocity increases when adequate lending and borrowing facilities are available. V. The value of money is another factor that boosts the velocity of its circulation. Inflation reduces the value of money. Hence, people spend more money at a higher frequency to buy the same goods as earlier, leading to increased transactions. Other factors, such as business conditions, economic cycles, interest rates, demand- supply dynamics, etc., affect money value. VI. Other factors: Certain factors, such as the ease of payment, affect the velocity of money. The more people find spending convenient, the more likely they are to do so. For example, people will spend more with electronic payment methods, such as UPI (Unified Payment Interface), debit cards , etc., instead of withdrawing money from the bank every time. Money Multiplier money multiplier is the degree to which money supply is expanded as a result of the increase in high-powered money. Thus m= M /H Rearranging we have, M = H.m Thus money supply is determined by the size of money multiplier (m) and the amount of highpowered money (H). If we know the value of money multiplier we can predict how much money will change when there is a change in the amount of high-powered money. Size of Money Multiplier As M = Cp + D... (1) The public hold the amount of currency in a certain ratio of demand deposits with the banks. Let this currency-deposit ratio be denoted by k, Cp = kD Substituting kD for Cp in equation (1) we have M = kD + D = (k + 1)D... (2) (H) as H = Cp + R... (3) where R represents cash or currency reserves which banks keep as a certain ratio of their deposits and is called cash-reserve ratio and is denoted by r. Thus R = rD Now substituting rD for R and kD for Cp in equation (3) we have H = kD + rD or H = (k + r) D... (4) Now money multiplier is ratio of total money supply to the high-powered money, therefore we divide equation (1) by equation (4), to get the value of multiplier, which we denote by m. m= M/H or m=(1+k)/(r+k) Demand For Money In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3. THEORIES OF MONEY DEMAND 1. Classical theory 2. Keynesian theory 3. Post- Keynesian theory KEYNESIAN DEMANDFOR MONEY Keynes’ approach to the demand for money is based on two important functions- 1. Medium of exchange 2. Store of value Keynes explained the theory of demand for money with following questions- 1. Why do people prefer liquidity? 2. What are the determinants of liquidity preference?  KEYNESIAN DEMANDFOR MONEY.1 Transaction Demand People prefer to be liquid for day-to-day expenses. The amount of money held for transaction motive depends on: 1. Level of income- The higher the income, the more money is required for increased spending. 2. Price level 3. Spending habits 4. Time interval of income receipt Transaction demand for money is income determined. Hence it is income elastic and is relatively stable. It is expressed as: Lt = f (Y) Where, Lt = transaction demand for money F = Functional relationship Y= level of income 2. Precautionary Demand Precautionary demand is the demand for liquidity to cover unforeseen expenditures such as an accident or health emergency. Precautionary demand for money is also income determined and is stable. It is expressed as: Lp = f (Y) Both transaction demand and precautionary demand for money can be combined because they are both income- determined. It can also be called “active cash balance”. L1 = Lt + Lp Thus Active cash balance: L1 = f(Y) 3.Speculative demand for money A section of people hold money for speculative purposes. The notion of holding money for speculative motive was a new and revolutionary Keynesian idea. Money held under the speculative motive serves as a store of value The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate. If bond prices are expected to rise which, in other words, means that the rate of interest is expected to fall, businessmen will buy bonds to sell when their prices actually rise. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, businessmen will sell bonds to avoid capital losses. 3.Speculative demand for money Rate of interest is inversely related to the bond prices. Given the expectations about the changes in the rate of interest in future, less money will be held under the speculative motive at a higher current rate of interest and more money will be held under this motive at a lower current rate of interest. Thus the demand for money under speculative motive is a function of the current rate of interest, increasing as the interest rate falls and decreasing as the interest rate rises. KEYNESIAN DEMANDFOR MONEY AGGREGATE DEMANRD FOR MONEY According to Keynes The amount of money held as M1 , that is, for transactions and precautionary motives, is completely interest-inelastic and is mainly a function of the size of income and business transactions together with the contingencies growing out of the conduct of personal and business affairs. M1 = L1 (Y) ……….(i) The higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. M2 = L2 (r)………….(ii) Where, L2 is the speculative demand for money, and r is the rate of interest. KEYNESIAN DEMANDFOR MONEY Since total demand of money Md = M1 + M2 , we get from (i) and (ii) above Md = L1 (Y) + L2 (r) LIQUIDITY TRAP A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest." LIQUIDITY TRAP The liquidity preference curve LP becomes quite flat i.e., perfectly elastic at a very low rate of interest; it is horizontal line beyond point E′′ towards the right. This perfectly elastic portion of liquidity preference curve indicates that at a very low rate of interest people will hold with them as inactive balances any amount of money they come to have. This portion of liquidity preference curve with absolute liquidity preference is called liquidity trap by the economists because expansion in money supply gets trapped in the sphere of liquidity trap and therefore cannot affect rate of interest and therefore the level of investment. According to Keynes, it is because of the existence of liquidity trap that monetary policy becomes ineffective to tide over economic depression. LIQUIDITY PREFERENCE THEORY OF RATE OF INTEREST Keynes’ theory of interest is known as liquidity preference theory of interest According to Keynes, the rate of interest is a purely monetary phenomenon and is determined by demand for money and supply of money. “interest is a reward for parting with liquidity for a specified period.” Since people prefer liquidity or want to hold money to meet their various motives, they need to be paid some reward for surrendering liquidity or money. LIQUIDITY PREFERENCE THEORY OF RATE OF INTEREST And this reward is the rate of interest that must be paid to them in order to induce them to part with liquidity or money. Rate of interest is calculated in terms of money, The rate of interest can be controlled by the monetary authority. Money is the most liquid asset and people generally have liquidity preference, i. e., a preference for holding their wealth in the form of cash rather than in the form of interest or other income yielding assets. The Demand for Money in a Two- asset Economy.In order to explain the demand for money and interest-rate determination. Kenyes assumed a simplified economy where there are two assets which people can keep in their portfolio balance. These two assets are : (1) money in the form of currency and demand deposits in the banks which earn no interest, and (2) long term bonds. The demand for money by the people depends upon how they decide to balance their portfolios between money and bonds supply of money The supply of money , at a given time, is fixed by the monetary authority of the country. Hence the money supply curve is: perfectly inelastic curve. Determination of the Rate of Interest The rate of interest is determined at the level where the demand for money equals the supply of money. In this figure, the vertical line QM represents the supply of money and L the total demand for money curve. Both the curve intersect at E2 where the equilibrium rate of interest OR is established. Effect of an increase in money supply Effect of an increase in money supply To sum up Keynes’s theory of interest: (a) Interest is a monetary phenomenon and the rate of interest is determined by the intersection of demand for money and supply of money; (b) Given the supply of money, the rate of interest rises as the demand for money increases and falls as the demand for money decreases, (c) Given the demand for money, the rate of interest falls as the supply of money increases and rises as the supply of money decreases (d) The rate of interest cannot be reduced beyond the lower limit set by the liquidity trap. For further study refer H L Ahuja Macro-Economics – Theory and Policy Ch 20,21 ForIntroduction to modern monetary theory; Introduction to digital money refer PDF