SCERT

12TH ECONOMY Learn from the Experienced

CHAPTER-5
Monetary Economics

Introduction

Examine the effect of monetary system including regulation of money and

associated Financial Institutions

Money

It is accepted as payment for goods and services and repayment of debts and
that serves as a medium of exchange, money is the basis of credit

Evolution of money
Barter System

Before money was invented, exchange took place by barter system

Barter system was introduced by a Mesopotamia tribes

Metallic standard

After modern money system evolved, metallic standard is the premier one
Some kinds of metal either gold or silver is determined the standard value of the
money .Their face value is equal to their intrinsic metal value

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Gold Standard

The standard currency is directly linked with gold, mainly weight of the gold
Value is maintained to the value of a fixed weight of gold

Silver standard

Government allows conversion of its currency into fixed amount of silver

Paper currency standard

The paper currency notes are issued by the treasury or by the central bank as a
legal tender
The paper standard is also known as a managed currency standard
The quantity of money in circulation is controlled by the Monetary Authority to
maintain price stability

Plastic money

It is the latest type of money

It is an alternative to cash and are considered as the standard money
They aim to remove the need for carrying cash

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Cryptocurrency

It is a digital currency in which encryption techniques are used to regulate the

generation of units of currency
It operates independently without the interference of the central Bank
Decentralized cryptocurrencies such as Bitcoins act as an outlet for personal wealth
that is beyond restriction and confiscation

Functions of Money
Function of money

Primary functions

Money as a medium of exchange

All changes take place in terms of money

Money can be obtained during true sale of goods and services
Money act as the intermediary in sales and purchase

Money as a measure of value

It is used to measure the value of goods and services

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All values are expressed in terms of money

Used to determine the rate of exchange between various commodities

Secondary functions

Money as a store of value

Saving in terms of commodity are not prominent

Savings are now done in terms of money
Money can be easily converted into other marketable assets Eg: land, machinery

Money as a standard for deferred payments

In the absence of money, the borrowed amount could be returned only in terms of
goods and services
Money now act the standard for deferred payments

Money as a means of transferring purchasing power

The exchange of goods is now extended to abroad

It is necessary to transfer purchasing power from one place to another
Hence money act as a means of transferring purchasing power

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Contingent functions

Basis of the Credit System

Business transactions are done through cash or on credit

Money facilitates distribution of national income

The task of distribution of national income was exceedingly Complex under the barter
system
Money facilitated the distribution of income (eg) rent, wage, interest and profit

Money helps to equalise marginal utility and marginal productivities

Money plays an important role because prices of all commodity are expressed in
money
Money also helps to equalise marginal productivity in various factor of production

Money increase productivity of capital

Capital in the form of money can be put to any use

Capital can be transferred from the less productivity to the more productivity uses

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Other functions

Money helps to maintain repayment capacity

Money has the quality of general acceptability like repayment capacity

Every firms keep asserts in the form of liquid cash

Money gives liquidity to capital

Money is the most liquid form of capital it can be put to any use

Supply of money

Money supply means the total amount of money in an economy

The money which is in circulation at any given point of time
Money supply determinants of price level and interest rates

Meaning of money supply

Indian currency notes issued by Reserve Bank of India

One rupee coins are issued by the Ministry of Finance
Currency notes are called fiat money and legal tender
RBI publish information of four alternative measures of money supply they are M1
M2 M3 and M4
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M1= currency coins and demand deposit

M2= m1+ savings deposit with post office savings bank
M3= m2+ time deposit of all commercial cooperative banks
M4= m3+ total deposits with post office

M1 and M2 are known as narrow money

M3 and M4 known as broad money

Indian currency symbol was designed by Mr.D.Uday Kumar from Tamilnadu

Postgraduate from IIT Bombay
This symbol was selected by Union Cabinet on 15th July 2010
The new symbol is an amalgamation of Devagiri RA and Roman R without the stem
The symbol for India came into use on 15th July 2010
After America Britain Japan Europe
India is the fifth country to accept a unique currency symbol

Determinants of money supply

Currency deposit ratio (CDR)

It is the ratio of money held by the public in currency to that they hold in the
Bank deposit

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Reserve deposit ratio (RDR)

It consists of two things

a) Vault cash in bank
b) Deposit of commercial banks with RBI

Cash reserve ratio (CRR)

It is the fraction of the deposit the bank must keep with RBI

Statutory liquidity ratio (SLR)

It is a fraction of the total demand and time deposit of the commercial bank in the
form of specified liquid assets

Quantity theory of money

Explain the relationship between quantity of money and value of money

It can be explained by Irving fisher transaction approach and Cambridge cash balance
approach
Irving fisher quantity theory of money

The quantity theory of money is very old theory

It was first propounded in 1588 by an Italian economist Davanzatti

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But this theory was popularised by an American economist Irving Fisher, who
published his book “The purchasing power of money” in 1911
MV=PT
money supply
𝑀=
Quantity of money

V = velocity of money
P = price level
T = volume of transaction

According to his theory in a country at any given period the total quantity of money
MV will be equal to total value of all goods and services bought and sold PT

MV=PT MV
𝑃=
Supply of money = demand for money PT

Quantity of money determine price level and price level in its turn directly with the
quantity of money, provided V and T remains constant
This statement applicable only for currency money but in modern world money is not
only currency sometimes it is in demand deposit or credit money
Therefore Irving Fisher extended his original equation of exchange to include Bank
deposit M1 and its velocity V1 in his revised equation

𝑃𝑇 = MV + M1 ∗ V1

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𝑀𝑉 + 𝑀1 ∗ 𝑉1
𝑃=
𝑇
In the revised equation the price level is determined by
The quantity of money in circulation M
The velocity of circulation of money V
The volume of bank credit money M1
The velocity of circulation of credit money V1 and the volume of trade T

Cambridge approach (cash balances approach)

Marshall's equation
M = KPY

M is the quantity of money

Y why is the aggregate real income of the community
P is purchasing power of money
K represent the fraction of the real income which the public desire to hold in the
form of money
P = M/KY

The value of money can be found out by dividing the total quantity of goods with
the public decide to hold out of the total income by the total supply of money

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According to Marshall’s equation the value of money is influenced not only by

changes in M but also by changes in k

Keynes equation

n = pk or P = n/k

n is the total supply of money

p is the general price level of consumption goods
K a is the total quantity of consumption units the people decide to keep in the
form of cash

According to Keynes people desire to hold money in an altered by Monetary

Authority, price level and value of money can be stabilized through regulating
quantity of money by the Monetary Authority
later keyens extended is equation in the following form

n=p(k+rk) or p=n/(k+rk)
N = total money supply
P = price level of consumer goods
K = people decide to hold money in hand in the total income of them
r= cash reserve ratio
K = communities total money deposit in bank
Price level is changed directly and proportionately changing in money volume
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Inflation

Meaning of inflation

Rise in the general price level consequently the purchasing power of currency is
falling

Types of inflation
It is a four types
3. Running inflation
1. Creeping inflation
2. Walking inflation

Creeping inflation 4. Galloping inflation

or Hyperinflation
Inflation moves slowly and very mild
The price rise will not be perceptible but spread over a long time
This inflation is not dangerous to the economy
This is also known as mild inflation or moderate inflation

Walking inflation

When the annual inflation rate is single digit (3 % to 9%)

It is also called walking or trolling inflation

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Running inflation

When the price rise rapidly increasing like a running horse @ speed of 10% to 20%
per annum, it is called running inflation

Galloping inflation

It is also called as hyperinflation

Inflation runs into two or three digits like 20% to 100%
The first hyperinflation of the 21st century is Zimbabwe

Demand pull Inflation VS cost push inflation

Demand pull Inflation

When the demand and supply play a crucial role in deciding the inflation level in the
society at a point of time
If the demand is high and the supply is low the price of the product automatically
increases

Cost push inflation

When the cost of the raw material and other inputs rises which leads to inflation.
Increase in wages paid to labour also leads to inflation

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Wage price spiral

The effect of relationship between the rising wages and rising price or inflation

Other types of inflation (on the basis of inducement)

Currency inflation

The excess supply of money in circulation causes rise in price level

Credit inflation
When banks are liberal in lending credit which leads to increase in money supply
intern leads to rise in prices

Deficit induced inflation

Due to deficit budget and that deficit is generally financed through printing of
currency by the central bank which leads to price rise

Profit induced inflation

When the firm aims at higher profit they fix the price with higher margin so prices
go up

Scarcity induced inflation

Scarcity of goods happen either due to fall in production or due to black marketing
which leads to price rise
This kind of inflation happened in Venezuela in the year 2018
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Tax induced inflation

Increase in indirect taxes like excise duty customs duty and sales tax leads rise in
prices eg: petrol and diesel it is also called as Taxflation

Causes of inflation

Increase in money supply

Inflation is caused by an increase in supply of money which leads to increase in

aggregate demand
Higher the growth rate of the nominal money supply
Higher is the rate of inflation

Increase in disposable income

When the disposable income of the people increases it rises the demand for goods
and services
It is due to rise in national income or reduction in taxes or reduction in the saving
of the people
Increase in public expenditure
When government expand its developmental activities and social welfare programs
this is also the cause for price rise
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The demand for goods and services increases when they are given credit to buy
goods on hire, purchase and instalment basis

Cheap money policy

Cheap money policy like policy of credit expansion which leads to increase in money
supply which rises the demand for goods and services in the economy which leads
to price
Deficit financing
In order to meet its mounting expenses the government tend to borrow from the
public and even by printing more notes this raises aggregate demand in relation to
aggregate supply thereby increases the prices

Black assets, activities on money

The existence of Black Money and black asset due to corruption, tax evasion,
which Increase the aggregate demand, people will spend money lavishly.
Black marketing and hoarding reduce the supply of goods which tend to rise the
price level

Repayment of public debt

Whenever the government repay its past internal debt to the public it leads to
increase the money supply with public, which tend to rise the aggregate demand for
goods and services
Increase in export
When exports are encouraged domestic supply of goods decline, leads the price rise
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Effects of inflation

It can be classified into two heads

Effects on production Effects on distribution

Effects on production
When the inflation is very moderate
During this time this period act as an incentive to traders and producers
Still employment can be generated and the resources are not fully exhausted
The profit is due to rising prices
It encourages the business class to invest in production
Which leads generation of employment and income

a. Inflation discourages savings on the part of the public

b. When money undergoes depreciation the foreign capital will drain out of the country
c. Discourages entrepreneurs and businessman from taking business risk
d. Inflation increases investment in speculative activities rather than productive purposes

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Effects of distribution

Debtors and creditors

Debtors are the gainers while the creditors are losers

Fixed income groups

The fixed income groups are the worst hit during inflation because their income is
fixed it is not related to the rising cost of living
Entrepreneurs
Inflation is the boon to entrepreneurs whether they are manufacturers, traders,
merchants or businessman
They experience windfall gain, the prices of their stocks suddenly goes up

Investors

The investors who generally invested in fixed interest building bonds and securities
they lose during inflation
Those who invest in shares stand to gain by rich dividend and appreciation in the
value of shares
Measures to control inflation

Keynes and Milton friedman suggested three measures to prevent and control
inflation

Monetary measures Fiscal measures Other measures

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Monetary measures

These measures has to be adopted by the central bank of the country

a. Increase in bank rate
b. Sale of government securities in open market
c. High cash reserve ratio and Statutory liquid ratio
d. Consumer credit control
e. Higher margin requirements
f. Higher repo rate and Reverse repo rate

Fiscal measures

a. It is a most important instrument to tackle inflationary situation

b. Reduction of government expenditure
c. Public borrowing and enhancing taxation

Other measures

a. It can be divided into short term measures and long term measures

Short term measures

a. Distribution of essential commodities through fair price shopping through (PDS)

b. In shortage of basic goods government has resorted to import so that inflation
may not get triggered

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Long term measures

Accelerating economic growth especially the wage goods have a direct bearing on the
general price and the cost of living
Restriction on present conception and improve a way for saving and investment
which can accelerate economic growth in long run

Meaning of deflation disinflation and stagflation

Deflation

The essential features of deflation is falling prices, reduce the money supply and
unemployment
The price fall from the level of full employment both income and Employment will
be adversely affected

Disinflation

Slowing down the rate of inflation by controlling the amount of credit

It is a process of reversing the inflation without creating unemployment or reducing
output in the economy

Stagflation

It is a combination of stagnant economy growth, high unemployment and high

inflation

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Trade cycle

In the capitalist economy it has both ups and downs, study about these ups and
downs are called the study of business cycle or trade cycle or industrial fluctuations
Meaning of trade cycle
Oscillation in aggregate economic activity particularly in employment, output, income
tax ect
The fluctuations are periodical, differing in intensity and changing its coverage

Phases of trade cycle

Boom or prosperity phase

When there is full employment and the movement of the economic beyond full
employment is called as boom.
During this period there will be a hectic activity in the economy
Money wages rise, profits increase, and interest rate go up
There will be full of optimism
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Recession

It occurs during the failure of a company or Bank burst the boom and brings a
phase of recession
Investments are drastically reduced
Production comes down
Income and profits decline
Business activity shows signs of dullness
Money market becomes tight

Depression

During depression the level of economic activity becomes extremely low

Closure of business become a common feature
Which leads to unemployment
Profits and wages will be low
It is the worst phase of the business cycle
Extreme point of depression is call Trough
Autonomous investment of the government alone can help the economy to come out
from the depression

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Recovery

After a period of depression recovery sets in

It begins with the revival of demand for capital goods
Autonomous investments boost the activity
Which leads to more production, profit income wages and employment
Recovery may be initiated by innovation or investment or by government expenditure

Good luck

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