MONEY

BARTER - before Money,

people traded goods (or work) for other goods. The direct exchange of goods and services for other goods and services without the use of money Simply a direct exchange Double coincidence of wants

Limitations of BARTER SYSTEM

Lack of Double Coincidence of wants
Lack of Common Measure of Value Invisibility of commodities

Difficulty of storage and Transfer of wealth

Difficulty in Deferred payments Lack of standardization

MONEY
Any medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts
Money has made things MUCH easier! Convenience Almost universally accepted

 Medium of exchange
Money facilitates

exchange by reducing transaction costs associated with meansof-payment uncertainty. Permits specialization, facilitates efficiencies

Functions of Money
A) Primary functions
B) Secondary Functions C) Contingent Functions

Primary functions
- Medium of Exchange (you can use it to buy things)
- Measure of Value (its how we determine what

something is worth)

Secondary Functions
- Standard of Deferred Payments - Store of Value (you can save it and it will not spoil like

fish) - Transfer of Value

Contingent Functions
Distribution of National Income
Maximization of Satisfaction Basis of Credit

Productivity of Capital
Liquidity Best Utilization of resources Guarantor of solvency

Types of money
MONEY

Commodity Money

Metallic Money Standard Money

Paper Money

Credit money

Token Money

Representative money

Fiat Money

Convertible paper money

Inconvertible Paper money

Types of MONEY
Coins metallic Notes - paper Currency coins and Paper Checks paper Electronic transfers $ taken from a banking account (Debit Card)

Today, most money is in the form of electronic transfers

Degrees of Liquidity

Significance of money
Resource allocation in an Economy
Consumption in an Economy Distribution in an Economy

Development in an Economy
Introducing Dynamism in Economy

Supply of Money

Meaning of Money Supply

The term Supply of Money, refers to the total stock of

money which is in circulation in an economy at any given point of time. It implies the total stock of money held by the public. Money is a stock as well as a flow concept. When money supply is viewed at a given point of time, it is a stock. It consists of total currency notes, coins demand deposits (deposits in saving account and current accounts) with the bank held by the public. Thus, stock of money held by the public is called money supply.

 When money supply is viewed over a period of

time, money supply becomes a flow concept. Here money may be spent several times during a given time period, passing from one hand to another. The flow of money supply over the period of time can be calculated by multiplying stock of money held by the public by the velocity of circulation of money. The flow of money supply as given by Fisher is : MV where M= the stock of money held by the public V = velocity of circulation of money.

 The average number of times a unit of money

circulating from one hand to another in the process of spending during a given year is called as the velocity of circulation of money.,

Components of Money Supply

Traditional viewpoint.
(a) currency money, i.e., legal tender money, i.e.,

coins and currency notes (High Power Money) and (b) Bank Money (i.e., deposits with banks).
Modern viewpoint.- money supply includes

money (i.e., currency notes + coins + demand deposit) as well as near money.

 Near money assets are highly liquid but are not as

liquid as the money is. The following assets are included in near money: Time deposits with the banks. Bill of exchange. Bond. Equity Shares
Other near Money Assets.- There are: Policies of life insurance company on the basis of which loan can be taken from the insurance company. Deposits of building societies. Traveler's cheques. Saving in units of Unit Trust.

Definition of Money Supply in India

Based on two fundamental functions of money

viz. medium of exchange and store of value, the reserve bank of India has adopted four measures of money supply expressed as M1, M2, M3 and M4

Concept of M1
M1 is defined in traditional sense. It is a narrow concept of money supply. That is why it is referred as narrow money it is measured as follows: M1 = C + DD + OD
Where C= currency with the public DD= demand deposits with banks (inter bank deposits are excluded) OD= other deposits held with the Reserve Bank of India which include demand deposits of quasi government institution like IDBI, IFCI etc , foreign central banks , government (central and state both ) the International Monetary Fund , the World Bank etc.

The usefulness of this measure of money supply lies in the fact that it can be easily controlled by the central bank.

Concept of M2
M2 is a broader concept of money supply in India

than M1. In addition to the above mentioned three items of M1, this concept of M2 includes saving deposits with post office saving banks. Thus, banks

M2 = M1 + saving deposits with post office savings

Post office saving banks is not as liquid as demand

deposits with banks (commercial or cooperative) as they are not chequeable account. However, saving deposits with post office are more liquid than time deposits with the bank.

Concept of M3:
M3 is again a broad concept of money supply. It is

based on Milton Freidmans approach to the definition of money of money supply which include time deposits besides demand deposits and currency money as the components of money supply thus, M3 = M1 + Time Deposits with Banks

Concept of M4
M4 is an expanded measure of M3.
M4 =M3 + Total Deposits with the Post Office

Saving Organization(excluding NSC)

The Reserve Bank of India regards these four

measures of money supply i.e. M1, M2, M3 and M4 in the descending order of liquidity. It supplies data on them in its annual Report on Currency and Finance.

Demand for money and Quantity Theory of Money

Demand for Money

There are various Theories regarding the demand for

Money which have been given developed by various economists from time to time. The demand for money arises because of the two important functions of money Medium of Exchange Store of value

Approaches to the Demand for money

The Classical Approach(Irving Fisher's Equation)-

Based on Cash Transaction Approach

The Neo-Classical Approach(Keynes quantity theory

of demand)-Based on Cash balance approach

The Post Keynesian Approach-(Friedmans Quantity

theory of demand)

The Classical Quantity Theory of Money

Fishers Quantity Theory of Money and Price Level

This approach was formulated by the famous American economist Irving Fisher . The Crux of Fishers quantity theory is his famous equation of exchange, MV=PT P = price level, or 1/P = the value of money; M= the total quantity of money in circulation; V= the velocity of circulation of M; T = the total amount of goods and services exchanged for money or transactions performed by money.

Fisher Expanded Eq.(i) to include the money supply created by the banks through the process of credit creation based on their deposits. The expanded equation is written as: PT = MV + M'V' M' = the total quantity of credit money (Bank deposits) ; V'= the average velocity of circulation of M';

Explanation of the Fishers Equation

1) PT represents the demand for money, as it is the money

value of transactions or value of all the purchases and sales. In simple words, according to Fisher, PT is PQ. That is, price level (P) multiplied by quantity bought (Q) by the community () gives the total demand for money. Therefore PT is demand for money.
MV+M'V' is the total supply of the money in the community

consisting of the quantity of actual money M and its velocity of the circulation V plus the total quantity of credit money M' and its velocity of circulation V'. Therefore MV+M'V' is the supply for money.

 2) The total value of purchases or demand for money

(PT) in a year is measured by MV+M'V'. So, the equation, PT= MV+M'V' means the demand for money (PT) is equal to the supply of money (MV+M'V').

3) In order to find out the effect of the quantity of money on the price level or the value of money, we write the equation as P= MV+M'V' T

 So, P is directly related to MV and M'V' but inversely

related to T. The truth of this proposition is evident from the fact that if M and M' are doubled, while V, V' and T remains constant, P is also doubled, but the value of money (1/P) is reduced to half.
A simple equation to illustrate the fishers equation; P= MV+M'V'

Assumption of the Theory

Fishers theory is based on the following

assumptions: 1.P is a passive factor in the equation of exchange, which is affected, by the other factors. 2.The proportion of M' to M remains constant. 3.V and V' are assumed to be constant and are independent of changes in M and M'.

4.T also remains constant and is independent of other factors such as M, M', V and V'. 5.It is assumed that the demand for money is proportional to the value of transactions. 6.The supply of money is assumed as an exogenously determined constant. 7.It is based on the assumptions of the existences of full employment in the economy.

Criticisms
Fishers transaction equation is a truism ,a tautology-it

has no theoretical value. It does not explain how a change in M changes P It is a static theory as it is based on the assumptions that M and V, and M and V have fixed relationship which is not realistic M refers to a point of time and V to a period of time: this means internal inconsistency

 Price(P) is regarded to be only a passive factor which is

unrealistic because it does affects output ,and Not only M determines P, but also P determines M-this is Keynes contra-quantity theory causation argument.

 Keynes Theory and Friedmans Theory from notes