Eco U2

Economics by Pratham Singh 1
Macro - Economics
For
GE, B.Com (H/P), BA (H/P),
BBE, BA (Eco), B.Sc (GE)
CHAPTER – 5
Money in Modern Economy
Barter Exchange: Barter system was a system in which goods were exchanged with goods. An
economy, where there is a direct barter of goods and service, is called a ‘Barter Economy’ or ‘C-C
economy’(Where C stands for commodity).
Q1. What is the Drawbacks/Limitations/Difficulties of Barter Exchange System.

The major difficulties of Barter Exchange are:
1. Lack of Double Coincidence of Wants: Barter system can work only when both buyer and
seller are ready to exchange each other’s goods. But it was not always possible. Double
coincidence of wants is very rare in the barter system.
2. Lack of common measure of value: In barter system, there was absence of common unit
of measurement in which the value of goods and service can be measured. In the absence of
common unit, proper valuation was not possible.
3. Lack of Store of Value: In Barter system, it was difficult for people to store their wealth in
terms of goods. Storing of goods carried some problems like cost of storage, loss of value
etc. So, it was difficult for people to store their purchasing power.
4. Lack of transfer of value: In barter system, it was very difficult to transfer gods from one
place to other, because it is expensive and requires labour.
5. Lack of Standard of Deferred payments or Contractual payment: Deferred payment
means future payments. In barter system, it was difficult to return value in future in terms
of goods of same quantity and quality. Therefore, future payments regarding principle and
Interest became difficult.
With so many difficulties, barter exchange could not continue for a long time. As a result it was
replaced by Money.
MONEY : Money is anything which is generally acceptable as a medium of exchange, acts as a

measure of value, store of value and means for standard of deferred payments.
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Q2. Write a short note on the ‘Functions of Money’.

Ans: Following are the functions of Money:
1. Medium of Exchange : Medium of exchange is an important functions of money. Money
as medium of exchnage means that it can be used to make payments for all transactions of
good and services because it has the quality of general acceptability. Now a person can buy
and sell goods at any time and place with the help of money. Money has separated the acts
of sale and purchase. This fucntions has removed the major difficulty of lack of double
coincidence of want. Now, exchange of goods become convenient and simple. Money saves
a lot of time and labour. Money works as medium of exchange because it is generally
acceptable and aprroved & authorised by Government.
2. Measure of Value (Unit of Value/Account) : Money as a measures of value means the
value of each goods and services are expressed in a common unit. For example: In india the
common unit for measure of value is INR (Indian Rupee), In America the common unit for
measure is USD (US Dollar). In barter system, the value of one goods was expressed in
terms of other good. But Now, this function of money has removed this difficulty. This
function provide maintenance of business accounts, which would be otherwise impossible
in barter exchange. When all values are expressed in terms of money, it becomes easier for
anyone to compare the relative values of any two goods. Money works as a unit of account
and it express the value of each good in monetary unit.
3. Store of value : It is a subsidiary or Secondary function of Money. Money as a store of

value means that money is an asset and can be stored for use in future. This function is also
known as ‘Asset function of Money’. In barter system it was very diffucult to store the value
in terms of goods because goods are perishable in nature and needed much space. But now
money has removed this difficulty.
Money as s store of value has the following benefits:
a. Money is available in fractional denomination, ranging Rs. 1 to Rs. 2000.
b. Money has the merit of general acceptability.
c. Value of money remains relatively stable to other goods.
d. It is the most liquid assets.
e. Savings in terms of money are much more secured than in terms of goods.
4. Standard of Deffered payments: It is a subsidiary function of money. Deffered payments

refer to those payments which are made in the future. Money has made deffered payments
much easier than before. In the absence of money, deferred payments were difficult. It was
difficult to arrange the goods of exactly the same quality at the time of repayment. It was
impossible to determine the amount of principle and interest in terms of goods. But now,
money has removed this difficulty, due to general acceptability of money, future payments
are expressed in terms of money. Money has simplified the borrowing and lending activities.
It has led to the creation of financial institutions. Money is unit in term of which debts and
future transactions can be settled. Thus loans are made and future contract are settled in term
of money.
5. Transfer of Value: Money also serves as a convenient mode of transfer of value. Goods
and property etc. can be transfer from one place to other with the help of money. Due to this
function, Money has promoted both consumption expenditure and investment expenditure
across all parts of the world. Concept of Global economy has come into existence. Markets
have expanded across international boarders.
Q3. Distinguish between Metallic Money and Paper Money.

Ans: Difference between Metallic Money and Paper Money.
a) Metallic money: Money made from some metals like gold, silver, copper etc. was called
metallic money. Metal pieces were stamp and their value was inscribed on them. The
metallic coins made of gold, silver or bronze have been the most common form of money
in use in till the recent past. In the old age intrinsic value of the metal was equated with
the face value of the coin. Overtime this practice came to abandoned. Presently intrinsic
value of the coin is totally ignored and only face value of the coin is considered and
accepted as the value of exchange. But metallic money had the following limitations :
a. It was not possible to change its supply according to the requirements of the nation both for
internal and external use.
b. Being heavy, it was not possible to carry large sums of money in the form of coins from
one place to another by merchants.
c. It was unsafe and inconvenient to carry precious metals for trade purpose over long
distances.
b) Paper Money: It has been inconvenient as well as risky to transfer metallic money. With a
view to overcome this difficulty, traders in the past used to deposit their metallic money
with the money lenders and obtain certificates of deposit. These certificates were used to
obtain metallic money as different stations. Thus, these certificates came to be used as
money. This led to origin of paper money. Though it is difficult to state the date when paper
money came into force, it is generally held by the historians that paper money was first
introduced in china in 807 AD. These days paper money is issued by the Central bank or the
government of country. Initially, paper money was convertible, it means it could be
converted into gold or silver. But these days, it is inconvertible in all countries of the world.
Inconvertible paper money is called fiat money. It is accepted money throughout the world
because it is backed by the law.
Q4. Distinguish between Money and Near Money.

Ans: Difference between Money and Near Money.
a) Money
Money is that part of a person’s wealth that can be readily used for purchasing goods and
services. In other words money is anything which is generally acceptable as a medium of
exchange, acts as a store of value, measure of value and unit of account.
It consist of currency notes, coins, cheques, bank drafts, etc. the currency notes are issued by the
central bank of a country. And coins are issued by the ministry of finance. Where as cheques
and bank drafts are issued by the commercial banks. Cheques and bank drafts are almost perfect
substitute for money. They are known as demand deposit.
Money has distinct features

a. Liquid Asset : Money is the most liquid asset. Liquid asset is an asset that can be easily be
exchanged for goods and service with no loss of value or time.
b. General Acceptability : People accepts money, without hesitation or doubt, as a means of
payment of debts or other transactions. In other words, it has the quality of general
acceptability.
c. Medium of Exchange: Money serves as a medium of exchange. All other goods and
services are exchanged for money.
d. Means and not an end: Money is useful to us in an indirect way. Using money we buy
those goods and services which satisfy our wants. Money, therefore, is a means to meet our
demand. It is not an end.
b) Near Money
There are other certain types of assets which cannot be encashed at a short notice or demand,
e,g, time deposit, LIC policies, bills of exchange , etc. Time deposit can be withdrawn either at
the end of the fixed period or by giving a prior notice to the bank and incurring a penalty.
These assets are known as near money or quasi money. Near money or quasi money assets
serve as the store of value function of money temporarily and are convertible into a medium of
exchange in a short period without loss in their face value.
Types of Near Money

In modern economies there are various kinds of financial assets which can be termed as money.
These instruments are:
1. Bonds, securities and Debentures : Bonds and securities are issued by the government
while debentures are issued by companies. They are means to borrow funds for short,
medium and long periods. They carry a fixed rate of interest. They are near money because
they can be converted into cash at short period of time in the money market. They are sold
and purchased in the market.
2. Bills of Exchange : Bills of exchange is another types of negotiable instrument. It is drawn
by an individual or firm to pay a stated sum of money on a specific date which is not more
than 90 days. This is not money in itself but it becomes money on the due date. The owner
of the bills of exchange can easily convert it into money by receiving less money than its
face value or can encash by deducting a certain amount of discount.
3. Treasury Bills: Treasury bills are issued by the government and it is a promise by the
government to pay a stated amount in 30,60 or 90 days. These treasury bills are like bills of
exchange which can be converted into money at a specific discount in the money market.
4. Life Insurance Policy: Life insurance policy is not like bills of exchange but certainly it is
like near money asset. The holder of LIC policy can obtain cash in the form of loan on his
policy from LIC itself. Thus, life insurance policy is a form of liquid asset which can be
regarded as near money.
5. Traveller’s cheque: Traveller’s cheques are like near money asset, they can be enchased as
different places where the branch of the issuing bank exists. Thus, they are liquid assets.
Thus, near money is that part of wealth, which is almost money, because it can be readily
converted into money without much capital loss.
Creation of Deposit Money
Q5. Using Ratio approach, explain as to how commercial banks create credit. What
are the limits of credit creating power of commercial bank?
OR
Explain the process of credit creation in a single bank economy using ratio approach.
Ans: Credit creation refers to the process of banking in which bank is able to advances more loan
than its primary deposit. It is a special function of commercial bank. Credit is created on the basis
of primary Deposit. Banks do not give loan in cash but only a account is opened and amount is
credited to customer account and again banks keep a part as reserve and rest is given as loan to
others thus, the process of credit creation goes on and the bank is able to give loan more than their
primary deposit.
Credit creation in Single Banking System

In this system let us assume that the entire commercial banking system is one unit. Let us call this
one unit simple ‘bank’. That’s why it is called single banking system. Let us also assumed that all
the receipts and payments are routed through bank. One who makes payment does it by writing
cheque. The one who receives payment, deposit the same in his deposit account.
Suppose initially people deposit Rs. 100(Primary Deposit). The bank uses this money for giving
loans. But the bank cannot use the whole deposit for this purpose. It is a legally compulsory for
the bank to keep a certain minimum fraction of these deposit as cash. The fraction is called the
Legal Reserve Ratio (LRR). The LRR is fixed by the central bank. It has two components. A
part of the LRR is to be kept with the central bank and this part of the ratio is called the Cash
Reserve Ratio(CRR). The other part is kept by the bank itself and is called the statutory liquidity
ratio (SLR).
The bank is required to keep a fraction of deposit as cash reserve because:

a. The banking experience has reveled that not all the depositors come to the bank for
withdrawal of money at the same time and also that normally they withdrew a fraction of
deposit.
b. There is a constant flow of new deposits into the bank. Therefore, to meet the daily demand
for withdrawal of cash, it is sufficient for bank to keep only a fraction of deposits as cash
reserve.
Let us now explain the process with numerical example:

Suppose the initial deposit in the bank is Rs. 100 and LRR is 20%. Banks keeps only 20% of Rs.
100 that is Rs. 20 as cash reserve, no more no less. Bank is now free to lend the remaining Rs. 80.
Banks opens a bank account in the name of borrowers and credit this Rs. 80 as loan in his account.
They are free to withdraw the money whenever they like. And Suppose they withdraw whole of
the amount for making payments.
Since all the transactions are routed through this bank, when borrowers spent the money, it
becomes the income of others and they deposit their income into the bank. Thus, there is increase
in demand deposit of the bank by Rs. 80. These deposit of Rs. 80 have resulted because of loan
given by the bank. In this sense, the bank is responsible for money creation. With this round,
increase in total deposit is Rs. 180 (=100 + 80).
When bank receives new deposit of Rs. 80, it keeps 20 percent of it as cash reserve and uses the
remaining Rs. 64 for giving loans. The borrowers use this loan for making payments. The money
come bank into the account of those who have received the payments. Bank deposits again rises
but by a smaller amount of Rs. 64. It is 80% of last deposit creation. The total deposits now
increases to Rs. 244 (= 100 + 80 + 64). The process does not end here.
The deposit creation continues in above manner. The deposits go on increasing round after round
but each time only 80% of the last round deposit. At the same time cash reserve go on increasing,
20 percent of the last cash reserve. The deposit (credit) creation comes to an end when total cash
reserve become equal to initial deposit. The total deposit creation is equal to Rs. 500, five time of
initial deposit.
It is shown in the table.

Round Deposit Loans Cash Reserve
Initial deposit 100 80 20
Round 1 80 64 16
Round 2 64 51.20 12.80
- - - -
- - - -
- - - -
Total 500 400 100
th th
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Money Multiplier
How many times the total deposit would be of the initial deposit is determined by the LRR or
CRR. The multiple is called the Money Multiplier. It is given by the formulae:
1
Money Multiplier =
𝐿𝑅𝑅
In the above example, LRR is 20% or 0.2 therefore:
1
Money Multiplier = =5
0.2
The total deposit/credit creation is thus:
1
Credit creation = Initial deposit ×
𝐿𝑅𝑅
= 100 × 5
= 500.
Result : Lower the LRR, higher the credit multiplier and more the money creation.
LIMITATIONS OF CREDIT CREATION

Banks cannot create unlimited credit. Credit creations have certain limitations :
a) Availability of Cash:
An important limitation on the credit creation is the availability of cash with the people. If
the volume of currency in circulation increases, the volume of primary deposit will also
increases, which enables the commercial bank to create large volume of credit.
b) Bank habits of the people:
More the bank habits of the people, larger will be the power of banks to create credit. In
developed countries, banking habits of the people are more than in an developing countries.
In developing countries, the liquidity preference of the people is more. Therefore, the credit
creation capacity of the bank is low.
c) Cash reserve ratio:
Banks keeps a certain ratio of their deposit in the form of cash reserves with central bank
so that they can meet the demands of the depositors for cash withdrawals. If cash reserve
ratio is larger, the capacity for credit creation of the banks will be lower.
d) Statutory Liquidity Ratio :
In several countries, including India, the commercial banks are required to maintain a
reserve in the form of cash, Gold and securities with themselves. . If statutory liquidity
ratio is larger, the capacity for credit creation of the banks will be lower.
e) Unutilized money :
The concept of credit creation is based upon the assumption that all the deposits with the
banks are utilized, but in real life this may not be true. Some portion of these deposits remain
unutilsed. Thus, credit creation power of banks reduces.
Q6. “Loans create deposits”. Examine this statement and explain the process of credit
creation in a multiple bank economy.
Ans: Credit creation refers to the process of banking in which bank is able to advances more loan
than its primary deposit. It is a special function of commercial bank. Credit is created on the basis
of primary Deposit. Banks do not give loan in cash but only a account is opened and amount is
credited to customer account and again banks keep a part as reserve and rest is given as loan to
others thus, the process of credit creation goes on and the bank is able to give loan more than their
primary deposit.
Credit creation in Multiple Banking System

In reality , a large number of banks operate in an economy. Process of credit creation in a multiple
banking system is similar to that of a single banking system. By using hypothetical balance sheet
of different commercial banks operating in the economy we will analyse the process of credit
creation. In comparison to the single banking system, credit money creation process of the multiple
banking system is surely more realistic.
The process of credit creation in a multiple bank economy is explained as follows:

Existence of a large number of banks does not materially affect the working of credit creation
process. These exists a banking system in an economy which has a number of banking unit.
Let us assume that Bank A receives a primary cash deposit of Rs. 100. Its balance sheet will be:
Primary Balance sheet of Bank A

Liabilities Rs. Assets Rs.
Deposit 100 Reserve 100
Total 100 Total 100
After keeping the reserve ratio of 20% that is Rs. 20, bank A can advance loan of Rs. 80 to
borrowers. If banks grants loan of Rs. 80 to the customer, the final balance sheet of bank A will
be the following type:
Final Balance sheet of Bank A
Deposit 100 Reserves 20
Loan 80
Total 100 Total 100
Suppose, the customer who took loan of Rs. 80 from bank A settles his debts with another person
of same amount who has account with the bank B. Now bank B receive primary deposit of Rs. 80.
The Primary balance sheet of bank B is given below:

Primary Balance sheet of Bank B
Total 80 Total 80
After keeping cash reserve of Rs. 16 (20% of Rs. 80), Bank B will lend the balance of Rs. 64 to the
customer as loan. The final balance sheet of bank B is seen as under:
Final Balance sheet of Bank B

Deposit 80 Reserves 16
Loan 64
Total 80 Total 80
The person who is granted the loan amount of Rs. 64 by bank B settles his debt with another
person with same amount who has account in bank C. Now bank C receives a deposit of Rs. 64.The
Primary balance sheet of bank C shall be as under:
Primary Balance sheet of Bank C
Total 64 Total 64
After keeping cash reserve of Rs. 12.80 (20% of Rs. 64), Bank C will lend the balance of Rs. 51.20
to the customer as loan. The final balance sheet of bank C is seen as under:
Final Balance sheet of Bank B

Deposit 64 Reserves 12.80
Loan 51.20
Total 64 Total 64
The process goes on till original deposit of Rs. 100 is completely exhausted. The original deposit
of Rs.100 becomes additional deposits of Rs. 80, Rs.64, Rs. 51.20 etc. if we add up all these deposit,
the total will be Rs. 500. Following table shows total credit creation of all the banks.
Bank New Deposit Required reserve New lons

A 100 20 80
B 80 16 64
C 64 12.80 51.20
Other banks - - -
- - - -
- - - -
Total 500 100 400
Total new deposits = Primary deposit × credit multiplier
1 1
Credit Multiplier = = 20% = 5
𝐿𝑅𝑅
Total new deposit = 100 × 5 = Rs. 500
Demand for Money & Supply of Money

Q7. What are the various measures of money supply in India? Which of these are more
important?
Ans: Money supply refers to total volume of money held by public at a particular point of time
in an economy.
Features of Money Supply
a. It includes ‘Money held by public only’. It does not include stock of money held by
Government and banking system of a country
b. It is a ‘stock’ Concept.
Components of Money supply

There are mainly two principle components of Money supply:
(1) Currency: It consists of coins and paper.
Coins: coins are made up of metal. The metallic coins are issued by the monetary authority
of the country. The metal used in coins has no significance and these coins are token coins
since their face value is much higher than their intrinsic value. In India, today coins of Rs.1,
Rs. 2,, Rs.5 and Rs. 10 are in use.
Paper currency : Paper currency or currency notes are the most important part of the money
supply. The central bank in every country has monopoly right of issuing currency notes. In
India, one rupee note is issued by the Ministry of Finance while the remaining notes of
higher denominations are issued by central bank i.e., Reserve Bank of India. The central
bank is permitted to issue notes to any extent provided a minimum reserve kept in the form
of gold and foreign securities. In our country, RBI has to keep a minimum reserve of Rs.
200 crores in which there is a gold bullion of Rs. 115 crores and foreign securities of Rs. 85
crore.
(2) Demand Deposits: Demand deposit are the most important component of money supply.
These are the money deposit made by the depositor to the bank. Bank agrees to pay money
on demand at any time and to whomsoever the owner of the deposit may wish. For this
purpose people use cheques to meet financial obligations.
In India, Upto 1967-68 a single measure M was used by the RBI. M is the sum of currency and
demand deposits held by the public. Traditionally, M is known as the narrow measures of money
supply. Form 1967-68 to 1977 a broad measure of money supply known as AMR (Aggregate
money resources) was followed. AMR includes currency, demand deposit and time deposit. In
1977, RBI introduce four measures of monetary aggregates. These are M1, M2, M3 and M4.
Measures of Money supply

a. M1 = Currency (notes and coins) + Demand Deposits + Other deposits with RBI
b. M2 = Currency (notes and coins) + Demand Deposits + Other deposits with RBI + Deposits
with post office saving bank account.
c. M3 = Currency (notes and coins) + Demand Deposits + Other deposits with RBI + Net
Time(Term/Fixed) deposits with commercial banks
d. M4 = Currency (notes and coins) + Demand Deposits + Other deposits with RBI + Net
Time(Term/Fixed) deposits with commercial banks + Total Deposits with post offices
Note: Oher deposits with RBI include :

- Demand deposits witInh RBI of Public Financial Institutions
- Demand Deposits with RBI of foreign central banks and of foreign govrnments
- Demand deposits of World bank, IMF etc.
It does not include, Deposits of the govt. of the country with RBI and Deposits of country’s
banking system with RBI.
There are two approaches regarding Money supply. They are:

a. Traditional or Narrow Approach: It is a narrow definition of money. Money supply
according to this approach includes coins, currency notes and demand deposits. It includes
M1 and M2 measures of money supply. M1 is the most liquid and easiest for the
transactions. It measured on a specific day. Beside all the components of M1, M2 also
includes savings of the people with post office.
b. Modern or Broader Approach: Money supply according to this approach includes coins,
currency nots, demand deposits, post office savings, Net term deposits etc. It include M3
and M4 measures of money supply. M3 include all the components of M1 and in addition
to that it also include net (time/fixed) deposit. And Beside all the components of M3,M4
also include savings with the post offices.
These approaches are in decreasing order of liquidity. M1 is most liquid and easiest for
transactions, whereas, M4 is least liquid of all.
Q8. What is high powered money? How does it influence money supply in an economy.
Ans: High powered money (H) or outside money is the money produced (issued) by the RBI and
the government and kept by the public and bank. It consists of two things: (i) Currency(coins and
notes) held by the public (Cp); and (ii) cash reserve with the banks (R).
H = Cp + R
High powered money (M0) = Currency with public (Notes + coins) + Cash reserve with
Banks
A part of these cash reserve of the bank is held by them in their own cash vault (SLR) and a part is
deposited in the Reserve bank of India in the accounts which banks hold with RBI (CRR).
It must be noted that RBI and Government are the producers of the high-powered money and the
commercial banks do not have any role in producing this high powered money (H).
Money (M) vs. High powered Money (H)

Money consists of currency and demand deposit, while high powered money consists of
currency(coins and notes) and cash reserve with banks. It means, ‘currency held by the public’ is
common in both of them. The only difference is that of ‘Money’ includes demand deposit of banks
, while ‘High powered money’ include cash reserve with banks.
High powered money directly influence the supply of money. Supply of money increases when
there is increase in high powered money. Increase in H cause a multiple increase in supply of money
through banks loan making system. The ratio of increase in money supply to increase in H is called
Money Multiplier.
𝑀𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 (𝑀)

Money Multiplier(m) =
𝐻𝑖𝑔ℎ 𝑝𝑜𝑤𝑒𝑟𝑒𝑑 𝑚𝑜𝑛𝑒𝑦 (𝐻)
Or Money supply = High powered money × Money multiplier

Some economists call it ‘The H theory of money supply’. However it is more popularly called
‘Money multiplier theory of Money Supply’.
On the basis of High powered money a bank can create credit. Higher the value of High powered
money, higher the credit creation in the economy, which result increase in supply. On the contrary,
lower the value of high powered money, lower the credit creation in the economy, which result fall
in money supply. Thus , we can say high powered money directly influence the money supply
in economy.
It is graphically shown in the following figure:
The base of the figure shows the supply of high powered money (H) while the top of the figure
shows the total stock of money supply. It will be seen that the total stock of money is determined
by a multiple of the high powered money. It will be further seen that where as currency held by the
public (Cp) uses the same amount of high powered money, i.e., there is one to one relationship
between currency held by the public and the money supply. In contrast to this, bank deposits are a
multiple of the cash reserve of the banks (R) which are part of supply of high powered money.
That is, one rupees of high powered money kept as bank reserve gives to much more amount of
bank deposits. Although banks use the reserve of high powered money to give more loans to the
business man and thus create demand deposits, they do not affect the either the amount of currency
held by the public or the composition of high powered money.
Thus, the money supply is determined by the size of multiplier and amount of high powered money.
Q9. What are the three motives of holding money/Demand for money?
Q. What do you mean by Liquidity Preference theory?
Q. What do you mean by demand for money?
Ans: Meaning of Demand for Money: Money is the most liquid of all assets in the sense that it
is universally acceptable and hence can be exchanged for other commodities very easily. J.M
Keynes in his book “The general theory of Employment, Interest and Money” has explained the
demand for money in liquidity preference . Money is held by the public because of its liquidity
power. Money can be first used to buy anything whereas other assets are to be first converted into
money to buy goods and service. According to Keynes, there are three motives of demand for
money or liquidity preference. These are:
(1) TRANSACTIONS MOTIVE: The transactions motive of individual and firms to hold
money refers to the demand for money to carry out day to day transaction. People need
money to handle their daily transactions. It is because there is a time gap between the
expenditure and income. Income is received after a month or a specified time period
whereas expenditure is incurred by the individuals/household/firms almost everyday. In
such a case each individual and firm would like to hold a part of their income in cash for
meeting their daily transactions. The amount of cash kept for this purpose depends upon
three factors:
a. Size of Income
b. Periodicity of income received
c. Mode of Expenditure.
If the income is large and time lag is long, the large amount of cash will be demanded for
transaction motive. Thus, there is a direct relationship between money demand for
transaction purpose and the level of income. The relation between the transaction demand
for money and level of income can be expressed in Symbolic form as:
Lt = f(Y)
(Here, Lt = Transaction demand for money and Y = Income level)
Variations in the market rate of interest has no impact on the money demand for transaction
purpose. Transaction demand for money thus, is directly related to the level of income and is
independent of the rate of interest.
It is shown by following diagram:
In the first diagram, there is a upward sloping line starting from point of origin. It shows that as
income increases, demand for transaction purpose increases and vice versa. At income level OY,
quantity of money demanded for transaction purpose is OL. When the income increases from OY
to OY1, transaction demand for money increases from OL to OL1.
In the second diagram, vertical straight line is shows the money demanded for transaction purpose.
This straight line shows whatever the rate of interest be, the demand for money for transaction
purpose remains constant. At OR or OR1 rate of interest, money demand for transaction purpose
remains same OL.
2. PRECAUTIONARY MOTIVE: Besides meeting day to day transactions people also
withhold some cash for some emergencies situations of life which cannot be anticipated like
sleekness, unemployment, accident, losses etc. . The money held due to this is termed as money
held for precautionary motive. The amount held for precautionary motive is also a direct function
of the level of income and independent of the rate of interest. It is symbolically shown as :
Lp = f(Y)
(Here, Lp = Money demand for precautionary motive and Y = Level of Income)
There is a direct relationship between the level of income and the money demand for precautionary
motive. Higher income induces a person to set aside a large part of his income for contingent
expenses. The precautionary motive is similar to the transaction motive for holding money in the
sense in both cases money held to meet the expenditure on transactions. However, in the case of
transaction motive, money is held for ordinary transactions, while in the case of precautionary
motive, transactions are unforeseen and uncertain. Transactions and precautionary demand for
money is dependent of level of income and independent of rate of interest.
It is explained with the help of following diagram:
In the first diagram, there is a upward sloping line starting from point of origin. It shows that as
income increases, demand for precautionary purpose increases and vice versa. At income level OY,
quantity of money demanded for precautionary purpose is OL. When the income increases from
OY to OY1, precautionary demand for money increases from OL to OL1.
In the second diagram, vertical straight line is shows the money demanded for precautionary
purpose. This straight line shows whatever the rate of interest be, the demand for money for
precautionary purpose remains constant. At OR or OR1 rate of interest, money demand for
precautionary purpose remains same OL.
3. SPECULATIVE MOTIVE OR ASSET DEMAND FOR MONEY:

The third motive for holding cash is the desire to earn profits. Wealth can be stored in the form of
landed property, bonds, money, bullion etc. For simplicity, all forms of assets except money can
be grouped in the form of bonds. Thus, according to Keynes there are two types of assets, i.e.
money and bonds. The aim is to choose the best option – cash deposited in the saving account
(Money) or bond price. Interest is earned on cash deposited in saving bank account and monetary
return is earned on bonds.
It is speculation about future changes in interest rate and bond price that the resulting demand for
money is called speculative demand for money. In other words, Speculative demand for money
refers to the demand for cash balances for the purpose of investment in the money market.
Relationship between bond price and interest rate

Price of bond is inversely related to the market rate of interest. For example, Let price of bond
be Rs. 1000. It provides fixed return of 4% per annum which means bond has fixed annual income
of Rs. 40. Let us assume that rate of interest increases to 5%, in such a case Price of bond will be
Rs. 800 in order to provide fixed return of Rs. 40. Similarly, if rate of interest falls to 2%, in such
a case price of bond will be Rs. 2000 in order to provide fixed return of Rs. 40.
Price of Bond Interest Rate Return
2000 2% 40
1000 4% 40
800 5% 40
Thus, with fall in the market rate of interest, price of bond rises and vice versa. Price of bond is
inversely related to market rate of interest.
Relation between Speculative demand and interest rate (Concept of LIQUIDITY TRAP):
Demand for cash for speculative purpose depends upon the rate of interest. When people expects
that the rate of interest will be lower in future, the price of bond will be high, to earn capital gain
and they may like to keep money in liquid form for speculation purpose. Thus, speculative demand
for money will be higher.
On the other hand, if rate of interest is expected to high in near future, the price of bond will be
lower, it would be loss for people. People lower the demand of money for speculation purpose.
It is explained with the help of following

diagram:
Demand for money is shown on X- axis and rate
of interest is shown on Y- axis. LPC is the liquid
preference curve. At OR the, demand for money
is OS. When the rate of interest rises to OR1, the
demand for money is falls to OM1. And when the
rate of interest falls to OR2, the demand for
money rises to OM2. After a certain level, LPC
does not touch X- axis it flatter. From point A to
B, the curve is flatter (perfectly Elastic). Keynes made a hypothetical situation that when there
is great extent of low interest rate, people wish to keep liquid (cash) for speculative purpose. At
the time of depression, Govt. reduces the rate of interest very much, so that people could invest
more. But at the time of depression , people don’t want to invest their money, they hold the
liquidity because of speculation(fear/risk). And due to this, even at the lower rate of interest, money
will not come in the market. This situation is known as the ‘Liquidity Trap’ indicated by the flat
portion of curve (form point A to point B).
Quantity Theory of Money
Q10. Critically examine the Quantity theory of Money.

Ans: Quantity theory of money is the oldest theory of determination of value of money. It was
propounded in 1566 by French economists Jean Bodin. It was further elaborated by many
economists like Marshall, Pigou, Robertson etc. But the credit of this theory goes to Irving Fisher
who presented Quantity theory of money in his book, “The purchasing power of money” in 1881.
According to the quantity theory of money there is a direct and proportionate relation
between quantity of money and general price level and an inverse relation between quantity
of money and value of money. In this regard the definition given by S.W. Taussig is worth and
mentioning. According to him, “Double the quantity(supply) of money, the price will be twice as
before and the value of money one half. Halve the quantity(supply) of money, the price will be
one as before and the value of money double.
The above definition given by Taussig reveals two main conclusion:

a) There is a direct proportional relationship between quantity(supply) of money and price
level. Every increase in quantity of money will results a proportionate increase in price
level.
b) There exists an inverse proportionate relation between the quantity of money and the value
of money. Every increase in the quantity of money will results a proportionate decrease in
the value of money.
It is explained with the help of following diagram:
Value of Money
Price Level
2P 2P
P P
P/2 P/2
In the first diagram, X- axis represent the supply of money and Y axis represent the value of money.
When OM is the quantity (supply) of money, the value of money OP. If we double the quantity
(supply) of money to 2M. The value of money declines and becomes P/2. Similarly, if
quantity(supply) of money is reduced to one half (i.e., M/2), then the value of money increases to
2/P. Thus, there is a negative proportional relationship between quantity (Supply) of money
and the value of money.
In the second diagram X- axis represent the quantity (supply) of money and Y – axis represent the
general price level. If OM is the supply of money, the OP is the price level. If we double the
quantity of money to 2M, then the price level doubles and become 2P. similarly is the supply of
money is reduced to M/2, the price level reduced to P/2.This proves direct proportional
relationship between quantity(supply) of money and price level.
The relationship between quantity of money and general price level has been explained with the
help of an equation. The equation has been provided by professor Irving fisher. The equation is
given below:
Supply of Money = Demand for Money
M.V = P.T ------ (1)
Where, ;
M = Total money stock (Supply of money)
V = velocity of money is the number of a times a unit of money changes hands during a specified
period.
MV = Total supply of money
T = Total number of all transactions
P = General price level.
PT = Total demand for money.
Then equation (1) can be written as:

MV = PT
𝑴𝑽
Or P = ---------where V and T are constant
𝑻
But equation (1) is criticized by the economists because it ignores the flow of credit money or
money in the banking system. Then, Irving fisher presented another equation which includes
cash money as well as credit money.
𝑴𝑽+𝑴′𝑽′
P=
𝑻
where,
M’ = Amount of money held in the form of bank deposits
V’ = Velocity of M’
According to fisher, at a given period of time, V , V’, and T remain constant. And there is a direct
relation between the quantity of money (M) and price level (P).
It is explained with the help of following example.
Suppose, M = Rs. 100; V = 8; M’= Rs. 200, V’ = 4; Y = 400
𝑀𝑉+𝑀′𝑉′
P=
𝑇
100 ×8 + 200×4
=
400
800 + 800
= 400
1600
= 4
P = Rs. 4
1 1
And Value of Money = =
𝑃 4
When M and M’ is doubled. Means the quantity of money is doubled. The Price level is
doubled and Value of money is half. We shall have the following equation.
M = Rs. 200; V = 8; M’ = Rs. 400; V’= 4; Y =400
𝑀𝑉+𝑀′𝑉′
P=
𝑇
200 ×8 + 400×4
=
400
1600 + 1600
= 400
3200
= 4
P = Rs. 8
1 1
And Value of Money = =
𝑃 8
It is evident from the above example that when the quantity of money is doubled, price level is
also doubled, that is, it increases from 4 to 8 and the value of money reduces from 1/4 to 1/8.
Conclusion: In whatever direction be the change in the quantity of money, in the same
direction will be a proportionate change in the price level, whereas this proportionate change
in the value of money will in the opposite direction. For example, if the quantity of money is
increased by 10%, price level too increased by 10% whereas value of money will fall by 10%
and vice versa.
Assumption of the Theory

1) Constant Velocity of Money (both Cash Money V and Credit Money V1)
2) Quantity of goods and services remains constant. Economy is working on full employment
level.
3) Constant Number of Transactions
4) Constant Proportion between M (Cash Money) and M1 (Credit Money)
Limitations / Criticism of the Theory

1) Unrealistic Assumptions
2) Measurement of Variables (T, V, V1) in the equation is difficult
3) Price is affected by other factors. Price is affected not only by quantity of Money but also
by other factors such as weather condition, rainfall, flood, natural calamities etc.
4) One sided Theory : This theory analyses the supply side of money whereas demand side is
taken as unchanged.
5) Fails to explain trade cycles : It does not explain why in time of recession, price level does
not go up with increase in the money supply. And In the time of boom price level does not
fall with fall in money supply.
6) Proportionate change in the money and price level is doubtful.
7) Store of Value of Money is ignored. People do not spend whole of money on the purchase
of goods and services, but keep a part of it for future.
Monetary Policy
Q11. What are the objectives of Monetary Policy?

Ans: Monetary policy refers to those policy measures which are taken by the central bank of a
country to control and regulate the money supply. In advanced countries, monetary policy mainly
plays a regulatory role. But in a developing country, like India, monetary policy has to play the
twin role: promotional and regulatory. That is, monetary policy has to develop and promote banks,
money market, capital market, sock exchange etc. and at the same time, control and regulate the
growth of capital by quantitative and qualitative methods. In other words, monetary policy of
refers to that policy through which the central bank of the country (Reserve Bank in India)
controls the supply of money, availability of money, cost of money or the rate of interest in
order to achieve the objective of growth and stability in the economy.
Objectives of Monetary Policy

a) Price Stability
The main objective of government policy is attain price stability in the country. Price
stability means control of wide fluctuations in the general price level in the economy.
Consistently upward tends of prices is called inflation. which is the main worry of less
developed countries like India. If prices are gone up to a great extent then they may lead to
fall in the level of production and employment. This may give birth to depression in the
economy.
To ensure price stability, strong monetary policy is required. The monetary policy does not
depend upon central bank alone but rather on a large number of commercial bank.
b) Exchange stability
The main objective of monetary policy is to preserve gold reserve of a country. For this, it
is necessary that our exports are boosted and imports reduced. Normally exchange stability
is not possible without price stability because increase in price will make our exports costlier
which leads to devaluation of rupee. Thus, price stability is a must to make exchange rate
stable.
c) Full employment
This is the another objective of full employment, particularly in less developed countries.
Full employment refers to the sitation wherein all person who are able to work and willing
to work, get work. Under cheap monetary policy, loans are made available to the public at
cheap rate of interest, they will go for heavy investment. This will help in creating more
employment opportunities. Hence, the level of full employment get achieve.
d) Economic Growth
Economic growth refers to process of sustained rise in per capita income, national income
and standard of living. In underdeveloped countries there is low production capacity.
Production capacity is low mainly because of low rate of capital formation. On account of
low rate of capital formation economies fail to utilize fully their natural resources and
human resources. Accordingly, the government should adopt such a monetary policy which
may accelerate the rate of capital formation in the country.
e) Economic Equality
It is the another objective of monetary policy. In capitalist and mixed economies there are
widespread inequalities in the distribution of wealth and income. As a result, the society is
divided into two class- rich and poor. Rich class exploits the poor. Monetary policy serves
as an instrument of achieving equal distribution income and wealth through faster delivery
of credit to weaker sections of the society at lower rate of interest.
Q12. Explain the instruments of Monetary Policy used by the central bank to control
credit.
Ans: Monetary policy refers to those policy measures which are taken by the central bank of a
country to control and regulate the money supply. In other words, monetary policy of refers to that
policy through which the central bank of the country (Reserve Bank in India) controls the supply
of money, availability of money, cost of money or the rate of interest in order to achieve the
objective of growth and stability in the economy.
Various monetary instruments used by the central bank of country divided into two parts.
A. Quantitative Instruments
1. Bank Rate
2. Repo Rate
3. Open Market operation
4. Cash reserve ratio (CRR)
5. Statutory liquidity ratio (SLR)
B. Qualitative Instruments
1. Margin Requirements
2. Moral suasion
Quantitative instruments are those instruments which affect the amount of credit in the economy.
Qualitative instruments are those selective instruments which affect the amount of credit in specific
areas.
A. Quantitative Instruments
1. Bank Rate
Bank rate is the rate at which the central bank of a country offers loan to the commercial
bank .Central bank has the authority to change in Bank rate. Central bank has been actively
used Bank rate to control credit. Increase in bank rate increases the cost of borrowing from
the central bank. Also, increase in bank rate cause in increase in market interest rate (rate of
interest charged by the commercial bank form general public). It discourages borrowers
from taking loans, Which reduces credit creation capacity of the commercial bank. Thus,
there would be less credit in the market which results fall in aggregate demand and hence
fall in price. On the other hand, Decrease in bank rate lowers the rate of interest and credit
becomes cheap. Thus, there would be more credit creation in the market. The aggregate
demand increases and prices tends to rise.
2. Repo Rate
The Repo Rate (or Policy Interest rate) is the rate at which the central bank of a country
lends money to commercial banks for short term period (1 to 14 days). Central bank has the
authority to change repo rate. Repo rate is directly related with rate of Interest. The increase
in Repo rate increases the rate of interest, and it will increase the cost of borrowing. Credit
becomes dear or expensive. It reduces the ability of commercial banks to create credit. Thus,
there would be less credit in the market which results fall in aggregate demand and hence
fall in price. On the other hand, decrease in Repo rate lowers the rate of Interest and credit
becomes cheap. Thus, there would be more credit creation in the market. The aggregate
demand increases and prices tends to rise.
3. Open Market Operations

Open market operations refers to sale and purchase of government securities in the open
market by central bank. When the central bank sells these securities to the commercial
banks, cash moves from commercial banks to central bank. It will reduce the cash reserves
of commercial banks. And the ability to create credit by commercial banks also get reduced.
Thus, there would be less credit in the market which results fall in aggregate demand and
hence fall in price. On the contrary, when central banks purchase these securities from
commercial bank, the cash reserves of commercial banks will increase. It increases the
ability to create credit by commercial bank. Thus, there would be more credit in the market.
The aggregate demand increases and prices tends to rise. Hence, The central banks controls
the process of money creation by commercial bank by open market operations.
4. Cash Reserve Ratio

CRR (Cash Reserve Ratio) refers to the minimum percentage of Bank’s total deposit
required to kept with Central Bank. Commercial banks have to keep with the Central Bank
, a certain portion of their deposit as a matter of law. A change in Cash Reserve Ratio affects
the ability of bank of Credit creation. For instance, an increase in CRR reduces the reserves
of commercial bank. It will reduce the credit creation ability of Bank which results fall in
aggregate demand and hence fall in price. On the other hand, When the CRR is decreased,
credit creation ability of the commercial bank is enhanced. The aggregate demand increases
and prices tends to rise.
5. Statutory Liquidity Ratio

SLR (Statutory Liquidity Ratio) refers to the minimum percentage of Bank’s total deposit
required to maintain in cash or other liquid assets with themselves. A change in Statutory
Liquidity Ratio affects the ability of bank of Credit creation. For instance, an increase in
SLR reduces the reserves of commercial bank. It will reduce the credit creation ability of
Bank which results fall in aggregate demand and hence fall in price. On the other hand,
When the SLR is decreased, credit creation ability of the commercial bank is enhanced. The
aggregate demand increases and prices tends to rise.
B. Qualitative Instruments
1. Margin requirement
Margin is the difference between the amount of Loan and the market value of the security
offered by the borrower against the loan. If margin requirement is fixed by the Central Bank
is 20%, then commercial banks are allowed to give loan only up to 80%. By changing the
margin requirement, the Central bank affect the amount of loan made against securities. An
increase in margin requirement reduces the borrowers capacity. Thus, there would be less
credit creation in the market which results fall in aggregate demand and hence fall in price.
On the other hand. A fall in margin requirements encourages the people to borrow more.
Thus, there would be less credit creation in the market. The aggregate demand increases and
prices tends to rise.
2. Moral suasion
The word “suasion” literally means persuation on moral ground, with no implied force. In
this technique, the RBI issues letter to the banks encouraging them to exercise their control
over credit and grant loans for essential purposes only and not for speculative purposes. It
is very useful method of restricting availability of credit in a situation of excess demand in
India. During deflation, the RBI issues instruction to member banks to increase the
availability of credit to borrowers for non – essential purpose also.

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Economics by Pratham Singh 1

Q1. What is the Drawbacks/Limitations/Difficulties of Barter Exchange System.

MONEY : Money is anything which is generally acceptable as a medium of exchange, acts as a

Q2. Write a short note on the ‘Functions of Money’.

3. Store of value : It is a subsidiary or Secondary function of Money. Money as a store of

4. Standard of Deffered payments: It is a subsidiary function of money. Deffered payments

Q3. Distinguish between Metallic Money and Paper Money.

Q4. Distinguish between Money and Near Money.

Money has distinct features

Types of Near Money

Creation of Deposit Money

Credit creation in Single Banking System

The bank is required to keep a fraction of deposit as cash reserve because:

Let us now explain the process with numerical example:

It is shown in the table.

LIMITATIONS OF CREDIT CREATION

Credit creation in Multiple Banking System

The process of credit creation in a multiple bank economy is explained as follows:

Primary Balance sheet of Bank A

The Primary balance sheet of bank B is given below:

Final Balance sheet of Bank B

Final Balance sheet of Bank B

Bank New Deposit Required reserve New lons

Demand for Money & Supply of Money

Components of Money supply

Measures of Money supply

Note: Oher deposits with RBI include :

There are two approaches regarding Money supply. They are:

Money (M) vs. High powered Money (H)

𝑀𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 (𝑀)

Or Money supply = High powered money × Money multiplier

It is shown by following diagram:

3. SPECULATIVE MOTIVE OR ASSET DEMAND FOR MONEY:

Relationship between bond price and interest rate

It is explained with the help of following

Quantity Theory of Money

Q10. Critically examine the Quantity theory of Money.

The above definition given by Taussig reveals two main conclusion:

It is explained with the help of following diagram:

Then equation (1) can be written as:

Assumption of the Theory

Limitations / Criticism of the Theory

Q11. What are the objectives of Monetary Policy?

Objectives of Monetary Policy

3. Open Market Operations

4. Cash Reserve Ratio

5. Statutory Liquidity Ratio

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