Money: Functions of Money

The Four Jobs of Money Medium of exchange Standard of value/Unit of account Store of value Standard of deferred payments

 Medium of exchange
The most important job of money is to serve as a medium of exchange When any good or service is purchased, people use money Money makes it easier to buy and sell because money is universally accepted Money, then, provides us with a shortcut in doing business By acting as a medium of exchange, money performs its most important function

Money versus Barter

Without money, the only way to do business is by bartering For barter to work, I must want what you have and you must want what I have
This makes it pretty difficult to do business

Everything, then, must be assessed in money: for this enables men always to exchange their services, and so makes society possible

Aristotle, Nicomachean Ethics

Shows no coincidence of needs and no barter is going on

Money as a Medium of Exchange Money facilitates exchange by reducing the cost of trading. Without money, we would have to barter.

Money As a Medium of Exchange Money does not have to have any inherent value/usefulness to function as a medium of exchange. All that is necessary is that everyone believes that other people will exchange it for other goods/services

Standard of Value Money is a common denominator in which the relative value of goods and services can be expressed A job that pays Rs 2 an hour would be nearly impossible to fill, while one paying RS 50 an hour would be swamped with applications

Money as a Unit of Account Money is used as a common denominator to measure the relative values of goods and services. Without money, we would have to measure the value of goods and services in terms of other goods and services. Money is a useful unit of account only if its value relative to the average of all other prices doesnt change too quickly.

Store of Value If you could buy 100 units of goods and services with $100 in 1982, how many units could you buy with $100 in 2000? Answer: you could have bought just 51 units During this period, inflation robbed the dollar of almost half of its purchasing power Over the long run, particularly since World War II, money has been a very poor store of value However, over relatively short periods of time, say, a few weeks or months, money does not lose much of its value

Money as a Store of Value

Money is a financial asset that can be used to store wealth (income that you have saved and not consumed). As a store of wealth, money pays no interest, but is perfectly liquid. Moneys usefulness as a store of wealth depends on how will it maintains its value.

Standard of Deferred Payment

Many contracts promise to pay fixed sums of money well into the future A couple of examples are 30-year corporate bonds and a 20-year mortgage

Standard of Deferred Payment

You have taken education loan or housing loan say Rs 20 lakhs to repay in installments after two/three years with interests Hosing loan is for longer terms and EMI is fixed. Any way , most of the durable consumer goods are purchased with loans which are paid afterwards / in instalments. These are possible as settlement is done through money

Standard of Deferred Payment How well does money do its job as a standard of deferred payment? About as well as it does as a store of value Usually quite well in the short run, but not well at all over the long run of, say, three years or more

 Money versus Barter

Without money, the only way to do business is by bartering For barter to work, I must want what you have and you must want what I have
Everything, then, must be assessed in money: for this enables men always to exchange their services, and so makes society possible

This makes it pretty difficult to do business

Aristotle, Nicomachean Ethics

Monetary Standards: Fiat vs Commodity Money

Fiat Money System: Circulating money is paper money with low cost of production and low value in nonmonetary uses. The quantity of fiat money is controlled by the monetary authority in the economy as to keep the purchasing power of a unit of money very high relative to its cost of production.

Money - Prices and Interest rate

Classical Economists such as Irving Fisher holds that there is proportional relation between Money supply and the Price level This is explained on the basis of the following assumptions Economy is always at the full employment and Aggr. Output is fixed at full employment level of output Velocity of circulation of money is fixed as this is determined on the basis of payment habits, liquidity preference, propensity to consume and development of the banking and credit institutions which do change slowly

 Classical theory express this relation in the following identity MV= PT V= PT/M P=M/PT Modern Quantity theory States that growth of money supply determines the nominal GDP and hence the nominal aggr. Demand through which prices are influenced

 Hence targeting Money supply is essential In the Economy. Here monetary policy is important to regulate the economy.

Keynesian liquidity preference theory of money

Keynesian theory does not believe that the economy remains always at full employment level. There could be involuntary unemployment in the economy due to lack of aggr. demand. Use diagram to explain

Equilibrium aggr. Output with unemployment in the economy

AS

Price level

YE

Yf

 Keynesian economy also does not believe that velocity of circulation of money is constant Hence Keynesian economy challenges the direct and proportional relationship between money supply and the price level. It shows that increase in money supply and hence aggregate nominal demand may not always increase price level : When the economy is operating at unemployment equilibrium.

Money market: Keynesian demand for money

According to Keynes Money is demanded by public for three motives: 1. Transaction 2.Precautionary motives 3.Speculative motives Both Transaction and precautionary demands for money are depended on the level of income and it is positively related

 Speculative demand for money is money demand as an asset There are other financial assets: Bonds, debenture, Govt. Securities, Corporate securities, Stocks etc. Difference between Money and other financial assets Money: most liquid Holding money is riskless But money is non income earning asset

 Other financial assets have less liquidity but they yield income Speculator wants money to buy other non money financial assets at a low price and sell them at a higher price and the difference between buying and selling prices are their incomes from trading financial assets. Bond price i.e. price of fin asset is inverse related to the interest rate.

 let the market rate of interest is 5% If you hold cash of Rs. 95 for a year, you forego interest income at the rate of 5%. If you invest on a bond then you get Rs. 95(1+.o5) =99.75 Hence Pv.of Bond= Rs.100/1+0.05= Rs. 95 present value of bond 1+0.05=95/100=.95 1+r= .95 r =1- .95=.05

When interest rate is 10% Present value of bond yielding Rs 100 is PV= 100/1+10% =100/1.1=90 Bond price is nothing but the present value of bond at a given rate of interest. Let Bv is the future yield from the bond then Bp= Br/1+r

 thus demand for real balance or liquidity ( L) has two components Ld= transaction and precautionary demand which depend income and positively related. Ls= which depends on interest rate and inversely related

Liquidity preference: Keynesian theory of Money

r MS/p

r1 r0

L2=Md+change in Md/p

L1= Md/p
M//P Ld Ls M/P

L(r) = M/P

Money Demand

Equals

Real Money Balances

Money Market equilibrium

LM

Supply' Supply r LM

r2 r1 L (r,Y) M/P M/P r1

r2

M/P

A contraction in the money supply raises the interest rate that equilibrates the money market. Why? Because a higher interest rate is needed to convince people to hold a smaller quantity of real balances. As a result of the decrease in the money supply, LM shifts upward.

Types of Money
Narrow money Broad money Broader Money Money and near Money Fiat Money Vrs Commodity Money

Components of Money stock in India: RBI Report

Year
2006-07 2007-08 2008-09 2009-10

M0
595227 730422

M1
851753 932875

M3
2763516 3306510 4037610 4901751

888314 1109240 960390 1255771

components of Money
There are four measures of Money M0= Base money = Currency in circulation M1 = Mo + demand deposits with the commercial banks + other deposits with RBI M2= M1 + short term post office deposits M3= M1 = Time deposits with the banks M4= M3+ total post office deposits

Individu al Bank A B C D E F G

Amount Deposite Lent Out Reserves d 100 80 64 51.20 40.96 32.77 26.21 80 64 51.20 40.96 32.77 26.21 20.97 20 16 12.80 10.24 8.19 6.55 5.24

H
I J K Total

20.97
16.78 13.42 10.74 457.05

16.78
13.42 10.74

4.19
3.36 2.68

357.05

100

Bank created Money Supply

Groups involved in creation of Bank money 1. Commercial banks 2. Depositors 3. Borrowers 4. Central Bank: RBI

Let us think that there are individual Banks A, B, C, D, E, and so on Let a depositor open deposit of Rs 100 with bank A This bank (A) opens and IOU for the depositor This is its liability Then the bank also has the asset in terms of cash

 Bank A will not keep the money reserve It will give loan to the public . This is how bank does the business They take deposits from the public with the promise of paying interest Banks give loan to the public from the deposit money to earn interest income Difference between credit interest earnin gand deposit interest cost is the profit of the bank on which banking business is based.

What is fractional Reserve System

Commercial banks are legally bound to keep some per cent of deposit as reserve cash This reserve ratio is fixed by the central bank This done in order to meet the cash withdrawal by the depositor Reserve cash enables the banks ensure confidence

Money multiplier
Money multiplier The expansion of Rs100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit. This limit is the value that the money multiplier calculates. The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio. Formula The money multiplier, m, is the inverse of the reserve requirement, R:[ Example For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction: So then the money multiplier, m, will be calculated as: 1/5 This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.

Table : the process of Money Multiplier

individual Bank A B C D E F G H I J K Amount Deposited 100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.06 L Lent Out 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.06 6.04 Reserves 20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.19 3.36 2.68 2.02

1.51

individual Bank

Amount Deposited

Lent Out

Reserves

N O P Q 3.4 2.55 1.75

4.53

3.4 2.55 1.75 1.12

0.85 0.63 0.44

Total

500

400

100