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Economic exchanges without the mediation of money are referred to as barter

Double coincidence of wants.
Money also acts as a convenient unit of account. The value of all goods and services
can be expressed in monetary units.
The first and foremost role of money is that it acts as a medium of exchange.
Demand deposits as they are payable by the bank on demand from the account
Fixed deposits, have a fixed period to maturity and are referred to as time deposits.
Currency notes and coins are therefore called fiat money. They do not have intrinsic
value like a gold or silver coin. They are also called legal tenders as they cannot be
refused by any citizen of the country for settlement of any kind of transaction.
Cheques drawn on savings or current accounts, however, can be refused by anyone as
a mode of payment. Hence, demand deposits are not legal tenders.
The total stock of money in circulation among the public at a particular point of time is
called money supply.
Money supply, is a stock variable.
M1 = CU + DD
M2 = M1 + Savings deposits with Post Office savings banks
M3 = M1 + Net time deposits of commercial banks
M4 = M3 + Total deposits with Post Office savings organisations (excluding National
Savings Certificates)
CU is currency (notes plus coins) held by the public and DD is net demand deposits held
by commercial banks
The word net implies that only deposits of the public held by the banks are to be
included in money supply.
The interbank deposits, which a commercial bank holds in other commercial banks, are
not to be regarded as part of money supply.
M1 and M2 are known as narrow money.

M3 and M4 are known as broadmoney.

M1 is most liquid and easiest for transactions whereas M4 is least liquid of all.
M3 is the most commonly used measure of money supply. It is also known as
aggregate monetary resources
The Currency Deposit Ratio:
The currency deposit ratio (cdr) is the ratio of money held by the public in currency to
that they hold in bank deposits.
It reflects peoples preference for liquidity. It is a purely behavioural parameter
which depends, among other things, on the seasonal pattern of expenditure. For
example, cdr increases during the festive season as people convert deposits to cash
balance for meeting extra expenditure during such periods.
The Reserve Deposit Ratio:
Banks hold a part of the money people keep in their bank deposits as reserve money
and loan out the rest to various investment projects. Reserve money consists of two
things vault cash in banks and deposits of commercial banks with RBI. Banks use this
reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is
the proportion of the total deposits commercial banks keep as reserves.
Cash Reserve Ratio which specifies the fraction of their deposits that banks must
keep with RBI.
Statutory Liquidity Ratio which requires the banks to maintain a given fraction of
their total demand and time deposits in the form of specified liquid assets.
The rate of interest offered by the bank to deposit holders is called the borrowing
rate and the rate at which banks lend out their reserves to investors is called the
lending rate. The difference between the two rates, called spread, is the profit that
is appropriated by the banks.
collateral - a security pledged for the repayment of a loan
The total liability of the monetary authority of the country, RBI, is called the monetary
base or high powered money. It consists of currency (notes and coins in circulation
with the public and vault cash of commercial banks) and deposits held by the
Government of India and commercial banks with RBI.

RBI will undertake an open market sale of government securities of an amount

equal to the amount of foreign exchange inflow in the economy, thereby keeping the
stock of high powered money and total money supply unchanged. Thus it sterilises the
economy against adverse external shocks. This operation of RBI is known as
Speculative demand for money inversely related to the rate of interest
liquidity trap
What is a legal tender?
What is fiat money?
What is High Powered Money?
What is money multiplier? How will you determine its value? What ratios play an important role in
the determination of the value of the money multiplier?

The number of times a unit of money changes hands during the unit period is called the
velocity of circulation of money.

An individual may hold her wealth in the form of landed property, bullion, bonds, money
etc. For simplicity, let us club all forms of assets other than money together into a single
category called bonds. Typically, bonds are papers bearing the promise of a future
stream of monetary returns over a certain period of time. These papers are issued by
governments or firms for borrowing money from the public and they are tradable in the

Standard of Deferred Payments

Fisherian Approach:
the demand for money is transactions demand for money
M d = PT
Fisher's equation, PT = MV,
In Fisherian approach, the demand for money is defined only in a
mechanical sense and no attention is paid to various motives for which
money is demanded.
Fisher's transactions approach emphasized the medium of exchange
function of money, the Cambridge cash-balance approach is based on
the store of value function of money.
Cambridge approach, the demand for money implies demand for cash
Cambridge economists, however, simplified the demand for money
function by assuming, that the demand for money holdings (M d) is a
constraint proportion (K) of money income (PY) alone. Thus,
Md = KPY

The value of K has been assumed to be stable in the sense that the
determinants of K do not change significantly in the long run.
K in the Cambridge equation was just the reciprocal of V in Fisner's
equation (i.e., K = 1/V).
The General Theory of Employment, Interest and Money-Keynes
Keynes identified three motives for the demand for money or the
liquidity preference: (a) the transactions motive, (b) the precautionary
motive, and (c) the speculative motive.
Keynes, the total demand for money implies total cash balances and
total cash balance may be classified into two categories: (a) active
cash balances consisting of transactions demand for money and
precautionary demand for money, and (b) idle cash balancesconsisting of speculative demand for money.
Define :Transaction Motive
Define : Precautionary Motive
Idle Cash Balances or Speculative Demand for Money
The speculative demand for holding money balances is the unique
Keynesian contribution.
With the given the level of income, the speculative demand for money
and the current rate of interest are inversely related.
the demand for money for speculative motive is highly sensitive to and
is a
negative function of the rate of interest

Demand for Money in Underdeveloped Countries

Dualistic Economy:
Financial Dualism.
Influence on Non-Economic Forces.
Unstable Income Velocity.
Interest-Inelastic Demand.

Constituents of Money Supply

Traditional View.

Modern View.
The basic difference between the traditional and modern views is due
to heir emphasis on the medium of exchange function of money and
the store of value function of money respectively.
Currency money is legal tender money and thus is called high-powered
one rupee note and the coins are issued and managed by the Finance
Ministry of the Government of India.
All other notes are issued and managed by the Reserve Bank of India.
in India, the minimum reserve method is the governing principle of
note issue.
Factors Influencing Currency Money
Volume of Transactions.
Nature of Trade.
Method of Payment.
The Price level.
Banking Habits.
Distribution of Income.
Other Factors.

Bank Money
The money created by the banks is known as secondary money.
total money supply in an economy is composed of (a) the primary or
high-powered money. And (b) the secondary or bank money
The relative proportions of the two constituents of money supply, i.e.,
currency money and bank money, depend upon the degree of
monetisation of the economy, the development of the banking system
and the banking habits of the people.

Definitions of Money Supply

Traditional Approach.
Monetarist Approach.
Gurley and Shaw Approach.

Redcliffe Committee Approach.

Velocity of money refers to the average number of times a unit of
money changes hands or is transferred from one person to another
during a given period of time.
Money supply (M) is the product of monetary base (B) and the money
multiplier (m). Thus, M = mB
Monetary Base. Magnitude of the monetary base (B) is the significant
determinant of the size of money supply.
Money Multiplier. Money multiplier (m) has positive influence upon
the money supply
The smaller cash-reserve ratio enables greater expansion in the credit
by the banks and thus increases the money supply and vice versa.

Determinants of Money Supply

Monetary Base.
Money Multiplier.
Reserve Ratio.
Currency Ratio
Confidence in Bank Money.
Time-Deposit Ratio.
Value of Money.
Real Income.
Interest Rate.
Monetary Policy.
Seasonal Factors.
inflation is the continuous and persistent rise in the general level of
Inflation is always accompanied by a rise in the price level. It is a
process of uninterrupted increase in prices,
Inflation is a monetary phenomenon and it is generally caused by
excessive money supply,

Inflation is essentially an economic phenomenon as it originates in the

economic system and is the result of action and interaction of
economic forces,
Inflation is a dynamic process as observed over the period.
A cyclical movement of prices is not inflation,
Pure inflation starts after full employment.
Inflation may be demand-pull or cost-push.

Types of Inflation
On the Basis of Speed
Creeping Inflation: rise about 2 percent annually.
Walking Inflation: 5 percent annually.
Running Inflation: 10 percent annually
Galloping or Hyper-Inflation:
On the Basis of Inducement
Wage-Induced Inflation.
Profit-Induced Inflation
Scarcity-Induced Inflation.
Deficit-Induced Inflation.
Currency-Induced Inflation.
Credit-Induced Inflation.
Foreign Trade-Induced Inflation
On the Basis of Time
Peace-Time Inflation.
War-Time Inflation.
Post-War Inflation.
On the Basis of Scope
Comprehensive Inflation.
When the prices of all goods and services increase throughout
the economy, it is the case of comprehensive inflation. This leads
to a rise in the general price level
Sporadic Inflation.
Sporadic inflation is sectoral inflation, since, instead of affecting
whole economy, it affects a few sectors.
On the Basis of Government Reaction
Open Inflation.

If the government takes no steps to check the price and the

market mechanism is allowed to function without any
interference, it is called open inflation.
Suppressed Inflation. If the government actively makes efforts
to check the price rise through price control and rationing, it is
called suppressed inflation.
On the Basis of Employment Level
The price rise is as a result of expansion of money supply in the pre-full
employment stage is called partial inflation
Full Inflation. The increase in the money supply after the full
employment level leads to full inflation.
Ratchet Inflation. Under ratchet inflation, the prices
sectors are not allowed to fall even though there is every
the price to fall due to the resistance from industrialists
unions. The net result is a general rise in prices. This is
ratchet inflation.

in certain
reason for
and trade
known as

Stagflation. The simultaneous existence of high rates of inflation and

of high unemployment is called stagflation.
Inflation is the result of disequilibrium between demand and supply
forces and is attributed to (a) an increase in the demand for goods and
services in the country, and (b) a decrease in the supply of goods in
the economy.
Factors Causing Increase in Demand
Increase in Money Supply.
Increase in Government Expenditure.
Increase in Private Expenditure.
Reduction in Taxation.
Increase in Exports.
Increase in Population.
Paying off Debts.
Black Money.

Factors Causing Decrease in Supply

Scarcity of Factors of Production.
Trade Union Activities.
Natural Calamities.
Increase in Exports.
Law of Diminishing Returns.
International Causes.

Effects of Inflation
Effects on Product
Disrupt Price System.
Reduces Saving.
Discourages Foreign Capital
Encourages Hoarding.
Encourages Speculation Activities
Reduces Volume of production.
Affects Pattern of Production.
Quality Fall.
Effects on Distribution
Debtors and Creditors.
During inflation, the debtors are the gainers and the creditors are the
Wage and Salary Earners. Wage and salary earners usually
suffer during inflation
Fixed Income Groups. The fixed-income groups are the worst
sufferers during inflation.
The business community, i.e., the producers, traders,
entrepreneurs, speculators, etc., stand to gain during inflation,
Investors. The effect of inflation on investors depends on in
which asset the money is invested.
Farmers. Farmers generally gain during inflation
Non-Economic Consequences
Social Effects. Inflation is socially unjust and unequitable
because it leads to redistribution of income and wealth in favour of the

rich. This widens the gap between haves and have-nots and creates
conflict and tension in the society.
Moral Effects. Inflation adversely affects business morality and
ethics. It encourages black marketing and enables the businessmen to
reap wind-fall gains by undesirable means In order to increase the
profit margin the producers reduce the quality by introduction of
adulteration in their products.
Political Effect. Inflation also disrupts the political life of a

Control of Inflation
Monetary Policy
Monetary policy is adopted, by the monetary authority or the central
bank of a country to influence the supply of money and credit by
changing interest rate structure and availability of credit.
Increasing Bank Rate
Sale of Government Securities.
Higher Reserve Ratio.
Selective Credit Control.
Consumer Credit Control.
Higher Margin Requirements.
Monetary measures alone will not be sufficient when there are costpush inflationary pressures.
If the inflationary price rise is due to scarcity of output, then the
monetary policy will not be of much use.
Monetary policy will also not help in controlling inflation if the inflation
is due to deficit financing
Excess reserves possessed by the commercial banks can make the
monetary measures of the central bank to control inflation ineffective.
The greatest merit of monetary policy is its flexibility
Fiscal Policy

Fiscal policy is the budgetary policy of the government relating to

taxes, public expenditure, public borrowing and deficit financing.
Increase in Taxation.
Reduction in Public Expenditure.
Public Borrowing.
Control of Deficit Financing.
Fiscal measures to become effective, stable political set up, political
will of the government and public cooperation are required,
Direct Controls
Direct Controls on Prices.
The purpose of price control is to fix an upper limit of commodity price
Rationing. When the government fixes the quota of certain
goods so that each person gets only a limited quantity of the goods, it
is called rationing. Rationing becomes necessary when the essential
consumer goods are relatively scarce.
Direct controls are considered superior to monetary and fiscal
measures because of the following reasons: (a) They can be applied
easily and quickly and hence they produce rapid effects, (b) They are
more selective and discriminatory than monetary and fiscal controls,
(c) there can be variations in the intensity of operations of direct
controls from time to time and in different sectors.
Other Measures
Expansion of Output.
Proper Wage Policy.
Encouragement to Saving.
Population Control.
Indexing. Economists also suggest indexing as an antiinflationary
Indexing refers to monetary corrections by periodic adjustments in
money incomes of the people and in the value of financial assets,
saving deposits, etc., held by the public in accordance with changes in
the prices.

The central bank is the apex bank in a country. It is called by different

names in different countries. It is the Reserve Bank of India in India,
the Bank of England in England, the Federal Reserve System in USA,
the Bank of France in France
1. The central bank is the apex institution of the monetary and
banking structure of the country. The commercial bank is one of
the organs of the money market.

The central bank is a no-profit institution which implements the

economic policies of the government. But the commercial bank is
a profit-making institution.

3. The central bank is owned by the government, whereas the

commercial bank is owned by shareholders.
4. The central bank is a banker to the government and does not
engage itself in ordinary banking activities. The commercial is a
banker to the general public.
5. The central bank has the monopoly of notes issue. They are legal
tender while the commercial bank can issue only cheques. But
the cheques are in the nature of near-money.
6. The central bank is the banker's bank. As such, it grants
accommodations to other banks in the form of rediscount
facilities, keeps their cash reserves, and clears their balances. On
the other hand, the commercial bank advances loans to and
accepts deposits from the public.
7. The central bank controls credit in accordance with the needs of
business and economy. The commercial bank creates credit to
meet the requirements of business.
8. The central bank helps in establishing financial institutions so as
to strengthen money and capital markets in a country. On the
other hand, the commercial bank helps industry by underwriting
shares and debentures, and agriculture by meeting its financial
requirements through cooperatives or individually.
9. Every country has only one central bank with its offices at
important centres of the country. On the other hand, there are
many commercial banks with hundreds of branches within and
outside the country.

10. The

central bank is the custodian of the foreign currency reserves

of the country. While the commercial bank is the dealer of foreign
11. The chief executive of the central bank is designated as
"Governor", whereas the chief executive of the commercial bank
is called 'Chairman'.

Functions of the Central Bank

Regulator of Currency
Central banks have been following different methods of note issue in
different countries.
the Reserves Bank of India is required to keep Rs 115 crores in gold
and Rs 85 crores in foreign securities. There is no limit to the issue of
notes after keeping this minimum amount of Rs 200 crores in gold and
foreign securities
Banker, Fiscal Agent and Adviser to the Government
As banker to the government, the central bank keeps the deposits of
the central and state governments and makes payments on behalf of
governments. But it does not pay interest on government deposits. It
buys and sells foreign currencies on behalf of the government. It keeps
the stock of gold of the government. Thus it is the custodian of
government money and wealth.
As a fiscal agent, the central bank makes short-term loans to the
government for a period not exceeding 90 days.
The central bank also advises the government on such economic and
money matters as controlling inflation or deflation, devaluation or
revaluation of the currency, deficit financing, balance of payments, etc.
Custodian of Cash Reserves of Commercial Banks
Custodian and Management of Foreign Exchange Reserves
Lender of the Last Resort: this function as a sine qua non of central
The central bank lends to financial institutions in order to help them in
times of stress so as to save the financial structure of the country from
collapse. It acts as lender of the last resort through discount house on
the basis of treasury bills, government securities and bonds at "the

front door" The other method is to give temporary accommodation to

the commercial banks or discount houses directly through the "back
door". The difference between the two methods is that lending at the
front door is at the bank rate and in the second case at the market
rate. Thus the central bank as lender of the last resort is a big source
of cash and also
influences prices and market rates.
Clearing House for Transfer and Settlement
Controller of Credit
Answer the Following
1.An index number which accounts for the relative importance of the items is
known as
(i) weighted index
(ii) simple aggregative index
(iii) simple average of relatives
2. In most of the weighted index numbers the weight pertains to
(i) base year
(ii) current year
(iii) both base and current year
3. The impact of change in the price of a commodity with little weight in the
index will be
(i) small
(ii) large
(iii) uncertain
4. A consumer price index measures changes in
(i) retail prices
(ii) wholesale prices
(iii) producers prices
5. The item having the highest weight in consumer price index for industrial
workers is
(i) Food
(ii) Housing
(iii) Clothing
6. In general, inflation is calculated by using
(i) wholesale price index
(ii) consumer price index
(iii) producers price index
1. The base year has an index of _________________________
2. A simple index is where________________ item(s) is/are monitored.
3. The Laspeyre index is an example of a __________ weighted index.
4. The Paasche index is an example of a___________________ weighted index.

5. The Laspeyre index is easier to calculate than the Paasche index. TRUE/FALSE.
6. You cannot directly compare years with the Paasche index TRUE/FALSE
7. It is not possible to have an index below 100.


8. If the price index of bananas was 100 in 1993 and that for apples was 110, then the price
of a kg of bananas was:
a. Less than for apples
b. More than for apples
c. Impossible to compare