Unit 2: Money
Money: Kinds and Functions
Definition of Money
Money is anything that is generally acceptable as a medium of exchange for goods and services and for the settlement of debts.
It evolved from the barter system, which required a "double coincidence of wants" (you must have what I want, and I must have what you want), which was highly inefficient.
Kinds of Money
- Commodity Money: An item that has intrinsic value (value in itself) apart from its use as money.
Example: Gold, silver, salt, cattle, grains.
- Fiat Money: Money that has no intrinsic value and is declared by the government to be "legal tender." We accept it because the government says we must.
Example: Rupee notes, Dollar bills, coins.
- Fiduciary Money: Money that is accepted as a medium of exchange because of the *trust* between the payer and the payee, not because of a government order.
Example: Cheques, demand drafts. (You can refuse to accept a cheque).
- Bank/Credit Money: The demand deposits held by people in commercial banks, which can be transferred by cheque or digitally. This forms a major part of the money supply.
Functions of Money
Money has four primary and secondary functions:
- 1. Medium of Exchange (Primary): This is the main function. Money acts as an intermediary, eliminating the need for a double coincidence of wants.
- 2. Measure of Value / Unit of Account (Primary): Money provides a common yardstick to measure and compare the value of diverse goods and services. (e.g., a pen is $1, a book is $10).
- 3. Store of Value (Secondary): Money allows you to save purchasing power for the future. It is the most liquid asset (easily converted to goods), though its value can be eroded by inflation.
- 4. Standard of Deferred Payment (Secondary): Money is used to state the value of future payments, such as loan contracts or salaries.
Value of money
The value of money does not refer to its face value (e.g., $10). It refers to its purchasing power: how many goods and services a unit of money can buy.
The value of money has an inverse relationship with the general price level (P).
Value of Money = 1 / P (General Price Level)
- When inflation occurs (prices rise), the value of money falls.
- When deflation occurs (prices fall), the value of money rises.
Quantity theory of money
This theory, primarily associated with Irving Fisher, explains the link between the money supply and the price level.
Fisher's Equation of Exchange (Transaction Version)
The theory is built on a simple identity called the Equation of Exchange:
MV = PT
- M = Money Supply (total amount of money in the economy).
- V = Velocity of Circulation (the average number of times a unit of money is spent on transactions in a year).
- P = General Price Level.
- T = Total Volume of Transactions (total number of trades made in the economy).
The Classical Theory
The Classical economists turned this identity into a theory by making two key assumptions:
- V is Stable: They assumed velocity (V) is constant in the short run, as it depends on stable institutional factors and payment habits (e.g., how often people get paid).
- T is Stable: They assumed the volume of transactions (T) is fixed at the full-employment level (based on Say's Law).
If V and T are constant, the equation becomes:
M (constant V/T) = P
Conclusion of QTM: There is a direct and proportional relationship between the Exampley supply (M) and the price level (P). If the central bank doubles the money supply (M), the price level (P) will also double, leading to inflation. Money is "neutral" and only affects prices, not real output (T).
Cambridge Version (Cash Balance Approach)
An alternative version (by Marshall, Pigou) that focuses on money *demand* rather than *velocity*. It leads to the same conclusion.
M_d = kPY
Where 'k' is the fraction of real income (Y) that people want to *hold* as cash. In equilibrium, M_s = M_d, so **M_s = kPY**. Since 'k' and 'Y' (at full employment) are assumed constant, an increase in M_s must lead to a proportional increase in P.
Supply of Money: Definitions, Determinants of Money Supply
Definition of Money Supply
The Money Supply is the total stock of money held by the public at a particular point in time.
"Public" means it excludes money held by the government and the central bank (RBI), as this is not in active circulation.
Determinants of Money Supply
The money supply is determined by:
- The Central Bank (e.g., RBI):
- High-Powered Money (H): Also called the "monetary base." This is the currency issued by the central bank (notes + coins + commercial bank reserves at the central bank). The central bank controls H.
- Statutory Liquidity Ratio (SLR): The fraction of deposits banks must hold as liquid assets (e.g., government bonds). A lower SLR allows more lending.
- Cash Reserve Ratio (CRR): The fraction of deposits banks must hold as reserves *with the central bank*. A lower CRR allows more lending.
- The Commercial Banking System:
- Through the credit creation (money multiplier) process, banks create "bank money" (deposits) by lending out their excess reserves.
- The Public:
- Currency-Deposit Ratio (CDR): The public's preference for holding cash vs. depositing it in banks. If people hold more cash (high CDR), banks have fewer reserves and can create less credit.
Measures of Money Supply
Central banks use several measures of money supply, from narrow (most liquid) to broad (less liquid). In India, the RBI uses the following:
M1 (Narrow Money)
This includes the most liquid forms of money, used for transactions.
M1 = C + DD + OD
- C: Currency (notes and coins) held by the public.
- DD: Demand Deposits held by the public in commercial banks (e.g., current/checking accounts).
- OD: "Other Deposits" with the RBI (a very small component).
M2
M2 = M1 + Savings deposits with Post Office saving banks
M3 (Broad Money)
This is the most commonly used measure of money supply, as it represents the total credit capacity of the economy.
M3 = M1 + Time Deposits with the banking system
- Time Deposits: Deposits that are locked in for a fixed period, like Fixed Deposits (FDs). They are less liquid than demand deposits.
M4
M4 = M3 + All deposits with Post Office savings banks (excluding NSC)
Exam Tip: Liquidity: M1 > M2 > M3 > M4.
Breadth: M4 > M3 > M2 > M1.
Money Market: equilibrium in the money market
The Money Market is where the demand for money and the supply of money interact to determine the equilibrium interest rate (r). This is based on Keynes's Liquidity Preference Theory.
Money Supply (Ms)
In this model, we assume the Money Supply (Ms) is fixed by the central bank. It does not change with the interest rate. Therefore, the Ms curve is a vertical line.
Money Demand (Md) or Liquidity Preference (LP)
Keynes argued people demand to hold money (liquidity) for three reasons:
- Transactions Motive (L_T): Money needed for day-to-day transactions (e.g., buying food, transport). This depends positively on the level of Income (Y).
- Precautionary Motive (L_P): Money held for emergencies or unforeseen opportunities. This also depends positively on Income (Y).
- Speculative Motive (L_S): Money held as an asset to "speculate" on the bond market. This depends inversely on the interest rate (r).
- Logic: The interest rate is the *opportunity cost* of holding money (which pays 0%). When 'r' is high, the opportunity cost is high, so people hold less money (and more bonds). When 'r' is low, the cost is low, so people hold more money (expecting 'r' to rise, which would make bond prices fall).
The total Money Demand (Md) curve is therefore downward-sloping with respect to the interest rate.
Equilibrium
Equilibrium in the money market occurs at the interest rate (r*) where Money Demand equals Money Supply (Md = Ms).
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How Equilibrium is Restored:
- If r > r* (e.g., at r1): Ms > Md. People have *more* money than they want to hold. They will use this excess money to buy bonds. The increased demand for bonds pushes bond prices *up* and interest rates *down* towards r*.
- If r < r* (e.g., at r2): Md > Ms. People *want* to hold more money than they have. They will sell bonds to get money. The increased supply of bonds pushes bond prices *down* and interest rates *up* towards r*.