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.
