UNIT 3

Management Awakening 1

APRIL 9, 2015
CYBERSONY
I.B.M.
 UNIT-3
Function of money, Value of money, Inflation and measures to control it, Brief idea of
function of banking system, Commercial and central banking, Business fluctuations
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of
debts in a particular country or socio-economic context. The main functions of money are distinguished as: a medium of
exchange; a unit of account; a store of value; and, sometimes, a standard of deferred payment. Any item or verifiable
record that fulfills these functions can be considered money.The money supply of a country consists of currency
(banknotes and coins) and bank money (the balance held in checking accounts and savings accounts). Bank money,
which consists only of records (mostly computerized in modern banking), forms by far the largest part of broad money in
developed countries.

Money is what money does

The word "money" is believed to originate from a temple of Juno, on Capitoline, one of Rome's seven hills. In the ancient
world Juno was often associated with money. The temple of Juno Moneta at Rome was the place where the mint of
Ancient Rome was located.

FUNCTIONS
In Money and the Mechanism of Exchange (1875), William Stanley Jevons famously analyzed money in terms of four
functions: a medium of exchange, a common measure of value (or unit of account), a standard of value (or standard of
deferred payment), and a store of value.

Medium of exchange

When money is used to intermediate the exchange of goods and services, it is performing a function as a
medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the "coincidence of wants"
problem. Money's most important usage is as a method for comparing the values of dissimilar objects.

Measure of value

A unit of account is a standard numerical monetary unit of measurement of the market value of goods, services,
and other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit
of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. To
function as a 'unit of account', whatever is being used as money must be:

• Divisible into smaller units without loss of value; precious metals can be coined from bars, or melted down into
bars again.
• Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why diamonds, works
of art or real estate are not suitable as money.
• A specific weight, or measure, or size to be verifiably countable. For instance, coins are often milled with a
reeded edge, so that any removal of material from the coin (lowering its commodity value) will be easy to
detect.

Money acts as a standard measure and common denomination of trade. It is thus a basis for quoting and
bargaining of prices. It is necessary for developing efficient accounting systems.

Standard of deferred payment

While standard of deferred payment is distinguished by some texts, particularly older ones, other texts subsume
this under other functions. A "standard of deferred payment" is an accepted way to settle a debt – a unit in
which debts are denominated, and the status of money as legal tender, in those jurisdictions which have this
concept, states that it may function for the discharge of debts. When debts are denominated in money, the real
value of debts may change due to inflation and deflation, and for sovereign and international debts via
debasement and devaluation.

Store of value

To act as a store of value, a money must be able to be reliably saved, stored, and retrieved – and be predictably
usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time.
Some have argued that inflation, by reducing the value of money, diminishes the ability of the money to
function as a store of value.

INFLATION
Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual
percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.

Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects different people in different ways. It also
depends on whether inflation is anticipated or unanticipated. If the inflation rate corresponds to what the majority of people
are expecting (anticipated inflation), then we can compensate and the cost isn't high. For example, banks can vary their interest
rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.
Problems arise when there is unanticipated inflation:

• Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is
similar to getting an interest-free loan.
• Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic
output in the long run.
• People living off a fixed-income, such as retirees, see a decline in their
purchasing power and, consequently, their standard of living.
• The entire economy must absorb repricing costs ("menu costs") as price lists,
labels, menus and more have to be updated.
• If the inflation rate is greater than that of other countries, domestic
products become less competitive.

Finally, inflation is a sign that an economy is growing. In some situations, little

inflation (or even deflation) can be just as bad as high inflation. The lack of
inflation may be an indication that the economy is weakening. As you can see, it's
not so easy to label inflation as either good or bad - it depends on the overall
economy as well as your personal situation.

Cost Push Inflation

Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit
margins. Higher costs shift a firms supply curve upwards and lead to an increase in price. There are many reasons why costs
might rise:

� Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of
these commodities or alternative by a fall in the value of the pound in the foreign exchange markets which increases
the UK price of imported inputs

� Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause is
important in those industries, which are labour-intensive. If labour costs amount for example to 25% of a firms total
costs then a 10% increase in the total wage bill will cause the firms total costs to rise by 2.5%. Firms may decide not
 to pass these higher costs onto their customers (they may be able to achieve some cost savings in other areas of the
business) but in the long run, wage inflation tends to move closely with general price inflation

� Higher indirect taxes imposed by the government for example a rise in the specific duty on alcohol and cigarettes,
an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of
products to which VAT is applied. These taxes are levied on producers who, depending on the price elasticity of
demand and supply for their products can opt to pass on the burden of the tax onto consumers. For example, if the
government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push
inflation.

Oil Prices and Inflation

How strong is the relationship between changes in crude oil prices and inflation?

In theory the causal relationship is fairly clear. An increase in international oil prices such as that seen in the first year of the
new decade when prices average over $28 a barrel more than $10 a barrel higher than in 1999 - causes an inward shift in short
run aggregate supply and puts upward pressure on the price level. Put another way, a sharp jump in the price of crude oil
causes an exogenous inflationary shock and the impact of this will be greatest when a particular country is (a) a large-scale net
importer of oil and (b) has many industries in different sectors of the economy that rely on crude oil and by-products as
essential inputs in the production process.

Research suggests that a $3-4 rise in oil prices can be expected to add directly about 0.1% to UK consumer price inflation after
a time-time lag of about two years. This is not in itself a major contributor to higher retail prices for consumers. Of greater
impact are the knock-on effects of increased costs working their way through the supply-chain as businesses pass on higher
costs.

Analysis from economists at the Bank of England has estimated that a $1 rise in oil adds a further 0.1% to inflation after two
years (including the direct and noticeable effect on the price of petrol on the forecourts). A significant rise in global oil prices
would have many other inflationary effects: for example, increasing the cost of heating oil and aviation fuel, plastics, chemicals,
as well as raising the material costs of all firms.

But other economic factors might help to limit the inflationary impact of this exogenous shock. Consider the impact of higher
oil prices on aggregate demand. Firstly, an increase in retail price inflation in the shops reduces the growth of real incomes
thereby putting downward pressure on consumer demand (as we have seen previously, household spending is easily the main
component of AD). Higher input costs will also have the effect of squeezing company profit margins which, together with a
slower growth of demand, may lead to cutbacks in planned investment spending.

The monetary policy authorities might also respond to rising oil prices by increasing short-term interest rates which also acts to
dampen down spending. A rise in interest rates is by no means automatic, because the Bank of England takes a full range of
inflation indicators into account when making monthly decisions on the direction of monetary policy. If policy is tightened, we
would expect to see slower economic growth in the short term, a possible rise in unemployment and a reduction in the ability
of workers to bid for pay increases that keep pace or exceed the current rate of inflation. Deflationary macroeconomic policies
designed to control cost-push inflation will have the effect of reducing real national output below its potential (thereby creating
a negative output gap). Indeed if a slowdown becomes a recession, then the demand for oil will decline putting downward
pressure on oil prices.

The evidence for the UK is that the volatility in crude oil prices is no longer as important in influencing the rate of inflation as
it was ten or twenty years previously. Our oil-energy dependency ratio has declined and the flexibility of our labour and
product markets has increased, which has the effect that pay is more flexible in response to changes in inflationary pressure (i.e.
wages no longer automatically rise when inflation surges). To add to this, many businesses have experienced a decline in their
ability to immediately pass on increases in input costs when there are short term changes in raw material prices this is partly
due to the effects of increased international competition arising from globalization.

Demand Pull Inflation

Demand-pull inflation is likely when there is full employment of resources and short run aggregate supply is inelastic. In these
circumstances an increase in AD will lead to a general increase in prices. AD might rise for a number of reasons some of which
occur together at the same moment of the economic cycle

� A depreciation of the exchange rate, which increases the price of imports and reduces the foreign price of UK
exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already
at full employment, prices are pulled upwards.
 � A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more disposable income
causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a
greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond
potential GDP.

� The rapid growth of the money supply perhaps as a consequence of increased bank and building society borrowing
if interest rates are low and consumer confidence is high. Monetarist economists believe that the root causes of
inflation are monetary in particular when the monetary authorities permit an excessive growth of the supply of
money in circulation beyond that needed to finance the volume of transactions produced in the economy.

� Rising consumer confidence and an increase in the rate of growth of house prices both of which would lead to an
increase in total household demand for goods and services

� Faster economic growth in other countries providing a boost to UK exports overseas. Remember that export sales
provide an extra flow of income and spending into the UK circular flow. Exports are counted as an injection of AD.

The effects of an increase in AD on the price level can be shown in the next two diagrams. Higher prices following an
increase in demand lead to higher output and profits for those businesses where demand is growing. The impact on
prices is greatest when SRAS is inelastic.

Controlling inflation

A variety of methods and policies have been proposed and used to control inflation.

Monetary policy

Governments and central banks primarily use monetary policy to control inflation. Central banks such as the U.S. Federal
Reserve increase the interest rate, slow or stop the growth of the money supply, and reduce the money supply. Some banks
have a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

Most central banks are tasked with keeping their inter-bank lending rates at low levels, normally to a target annual rate of about
2% to 3%, and within a targeted annual inflation range of about 2% to 6%. Central bankers target a low inflation rate because
they believe deflation endangers the economy.

Higher interest rates reduce the amount of money because fewer people seek loans, and loans are usually made with new
money. When banks make loans, they usually first create new money, then lend it. A central bank usually creates money lent to
a national government.

Fixed exchange rates

Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of
other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the
value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the
value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in
the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed
exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

Gold standard

The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally
freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented,
including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it
can be redeemed for the equivalent specie

Wage and price controls

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have
been successful in wartime environments in combination with rationing.In general, wage and price controls are regarded as a
temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of
inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse
effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and
discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that
is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official
prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the
long term.

Stimulating economic growth

If economic growth matches the growth of the money supply, inflation should not occur when all else is equal.[64] A large
variety of factors can affect the rate of both. For example, investment in market production, infrastructure, education, and
preventative health care can all grow an economy in greater amounts than the investment spending.

Cost-of-living allowance

The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values
constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are
tied to a cost-of-living index, typically to the consumer price index. A cost-of-living allowance (COLA) adjusts salaries based on
changes in a cost-of-living index. It does not control inflation, but rather seeks to mitigate the consequences of inflation for
those on fixed incomes. Salaries are typically adjusted annually in low inflation economies. During hyperinflation they are
adjusted more often. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

FINANCIAL INSTITUTIONS

The structural network of institutions that offer financial services within a county. The members of the banking system and the
functions they typically perform include:
(1) commercial banks that take deposits and make loans,
(2) investment banks which specialize in capital market issues and trading, and
(3) national central banks that issue currency and set monetary policy.

Functions of Banking System

• Banks accept various types of deposits from public especially from its clients, including saving account deposits,
recurring account deposits, and fixed deposits. These deposits are payable after a certain time period

• Banks provide loans and advances of various forms, including an overdraft facility, cash credit, bill discounting, money
at call etc. They also give demand and demand and term loans to all types of clients against proper security.

• Credit creation is most significant function of banks. While sanctioning a loan to a customer, they do not provide cash
to the borrower. Instead, they open a deposit account from which the borrower can withdraw. In other words, while
sanctioning a loan, they automatically create deposits, known as a credit creation from commercial banks.

Agency functions include:

• To collect and clear checks, dividends and interest warrant.

• To make payments of rent, insurance premium, etc.
• To deal in foreign exchange transactions.
• To purchase and sell securities.
• To act as trustee, attorney, correspondent and executor.
• To accept tax proceeds and tax returns.

Utility functions include:

 • To provide safety locker facility to customers.
• To provide money transfer facility.
• To issue traveller's cheque.
• To act as referees.
• To accept various bills for payment: phone bills, gas bills, water bills, etc.
• To provide merchant banking facility.
• To provide various cards: credit cards, debit cards, smart cards, etc.

Difference between commercial banks and central banks

A central bank is a banker's bank. It is normally part of or connected to the government of a country and manages the
country's financial system. A commercial bank provides banking services to businesses, institutions and some individuals. The
money it takes in from its customers is deposited at its local central bank. Nearly all the country's banks have accounts at the
central bank to keep their money and for borrowing to offset any temporary shortages of cash. Nearly every country in the
world has a central bank. RBI is the central Bank in India.
Deposits

Both commercial banks and central banks take in deposits of money. Commercial banks receive their deposits, in the form of
checking, savings and certificates of deposit, from their corporate or individual customers and deposit that money at their
country's central bank. Commercial banks serve individuals and businesses, while central banks serve the country's banking
system, providing money transfers back and forth between banks and governmental institutions both domestically and in cases
of transactions with foreign entities. Commercial banks normally have branches in different parts of their region. Central banks
maintain regional branch banks throughout the country.

Loans

Commercial banks lend out the money they take in deposits. They make personal loans, auto loans, business loans and
mortgages. Occasionally, they will take in less money than they need to cover the loans they make, so their books will show a
negative balance. To cover the cash shortfall, commercial banks borrow from their central banks.

Services

Central banks manage the monetary policy of their respective countries through their operations, which set interest rates and
regulate commercial banking activities. Commercial banks set their prime lending rates off a spread tied to the rates set by their
central banks. Commercial banks use the central bank's money transfer wire system to move money throughout their branch
system and between the bank and customers. The central bank monitors money movement in and out of commercial banks,
always watching to maintain the financial strength of the commercial banks and step in to protect depositors' money if a
commercial bank becomes insolvent.
Functions of BANKS

• Processing payments via telegraphic

transfer, internet banking, or other
• Issuing bank drafts and bank cheques
• Accepting money on term deposit
• Lending money by overdraft, installment
loan, or other
• Providing documentary and stady,
guarantees, performance bonds, securities
underwriting commitments and other
forms of off-balance sheet exposure.

• Cash management and treasury

• merchant banking and private equity
financing