ECB 301 Notes (Examopedia)

ECB 301
Money, Banking and Financial Market

Semester – III
By Saumya Sharma
Money
Meaning and Functions
Meaning of Money:
Money is a concept which we all understand but which is difficult to define in
exact terms.
Money is anything serving as a medium of exchange. Most definitions of money
take ‘functions of money’ as their starting point. ‘Money is that which money
does.’ According to Prof. Walker, ‘Money is as money does.’
This means that the term money should be used to include anything which
performs the functions of money, viz., medium of exchange, measure of value,
unit of account, etc. Since general acceptability is the fundamental characteristic
of money, therefore, money may be defined as ‘anything which is generally
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acceptable by the people in exchange of goods and services or in repayment of
debts.’
Functions of Money:
In general terms, the main function of money in an economic system is “to
facilitate the exchange of goods and services and help in carrying out trade
smoothly.” Its basic characteristic is general acceptability. Functions of money
are reflected in the following well- known couplet:
“Money is a matter of functions four A medium, a measure, a standard, a store.”
Thus conventionally money performs the following four main functions, each of
which overcomes one or the other difficulty of barter. Medium of exchange and
measure of value are primary functions because they are of prime Importance
whereas standard of deferred payment and store of value are called secondary
functions because they are derived from primary functions.
1. Money as the Medium of Exchange:
Money came into use to remove the inconveniences of barter as money has
separated the act of purchase from sale. Medium of exchange is the basic or
primary function of money. People exchange goods and services through the
medium of money. Money acts as a medium of exchange or as a medium of
payments. Money by itself has no utility (except perhaps to the miser). It is only
an intermediary.
The use of money facilitates exchange, exchange promotes specialisation
Increases productivity and efficiency A good monetary system is, therefore, of
immense utility to human society. Money is also called a bearer of options or
generalised purchasing power because it provides freedom of choice to buy things
he wants most from those who offer best bargain.
2. Money as a Unit of Account or Measure of Value:
Money serves as a unit of account or a measure of value. Money is the measuring
rod, i.e., it is the units in terms of which the values of other goods and services are
measured in money terms and expressed accordingly Different goods produced in
the country are measured in different units like cloth m metres, milk in litres and
sugar in kilograms.

Without a common unit, exchange of goods becomes very difficult Values of all
goods and services can be expressed easily in a single unit called money Again
without a measure of value, there can be no pricing process. Without a pricing
process organised marketing and production is not possible. Thus, the use of
money as a measure of value is the basis of specialised production.
The measuring rod of money is also indispensable to all forms of economic
planning. Consumers compare the values of alternative purchases m terms of
money Producers also compare the values of alternative purchases m terms of
money. Producers compare the relative costliness of the factors of production in
terms of money and also plan their output on the basis of the money yield. It is,
therefore, highly important that the value of money should be stable.
3. Money as the Standard of Deferred Payments:
Deferred payments are payments which are made some time in the future. Debts
are usually expressed in terms of the money of account. Loans are taken and
repaid in terms of money.
The use of money as the standard of deterred or delayed payments immensely
simplifies borrowing and lending operations because money generally maintains
a constant value through time. Thus, money facilitates the formation of capital
markets and the work of financial intermediaries like Stock Exchange,
Investment Trust and Banks. Money is the link which connects the values of
today with those of the future.
4. Money as a Store of Value:
Wealth can be stored in terms of money for future. It serves as a store value of
goods in liquid form. By spending it, we can get any commodity in future. Keynes
places great emphasis on this function of money. Holding money is equivalent to
keeping a reserve of liquid assets because it can be easily converted into other
things.
People therefore normally wish to keep a part of their wealth in the form of
money because savings in terms of goods is very difficult. This desire is known as
liquidity preference. Clearly money is the best form of store of value. Wheat or

any other product which will command a value cannot be stored for a long
period.
Another Function ‘Liquidity of Money’ is added these days. Money is perfectly
liquid. Liquidity means convertibility into cash. Thus, the ability to convert an
asset into money quickly and without loss of value is called liquidity of asset.
Modern economists are laying stress on liquidity of money.
Since, by definition, money is the most generally accepted commodity, it is also
the most liquid of all resources. Possession of money enables one to get hold of
almost any commodity in any place and money never locks a buyer. It is this
peculiarity which distinguishes money from all other commodities. A preference
for liquidity is preference for money.
Money, thus, acts as common medium of exchange, a common measure of value,
as standard of deferred payments and a store of value.
High Powered Money

High powered money is the liability of the monetary authority of the
country. This is also called the monetary base and is created by the RBI.
High powered money includes currency (notes and coins), deposits with the
government and reserves of commercial banks with RBI. So, to sum up, high
powered money is
H=C+R
Where
H - High powered money
C - Currency
R - Cash Reserves of commercial banks
Money Multiplier

The phenomenon in which money is created in the form of the creation of
credits in the economy is referred to as the money multiplier and is based on
the fractional reserve banking system.
This is sometimes also known as the monetary multiplier. It is defined as the

maximum limit to which the money supply is affected as there are changes in
the amount of money deposited. This money multiplier effect is most
commonly seen in commercial banks since deposits are accepted by them and
after a while, they have kept the money as a reserve, to inject liquidity in the
economy, they start distributing the money as loans.
The Reserve ratio is referred to as the total amount of money, for the
withdrawal purposes by the customers, which should be kept by the
commercial banks in their reserves. It is also known as the cash reserve ratio
or the required reserve ratio.
Money Multiplier- Formula

The money multiplier effect is expressed in mathematical terms as-
where the required reserve ratio or the cash reserve ratio is represented by r
which is described as the minimum ratio that is required legally for the
commercial banks of the economy to keep the deposit with themselves. This
also applies to the central bank of India which is the RBI.
The deposit creation by a commercial bank

Money Multiplier- Example
Cash Reserves
Deposits Loans
(LRR=0.2)
Initial Round Rs. 100 Rs. 90 Rs. 10
Round 1 Rs. 90 Rs. 81 Rs. 9
Round 2 Rs. 81 Rs. 72.9 Rs. 8.1
Round 3 Rs. 72.9 Rs. 65.7 Rs. 7.2
Round 4 Rs. 65.7 Rs. 59.2 Rs. 6.5
Round 5 Rs. 59.2 Rs. 53.3 Rs. 5.9
Total Rs. 1000 Rs. 900 Rs. 100
Till the time the total deposits become equal to Rs. 1000, total loans lent
become 900, and the total cash reserve becomes Rs. 100, the rounds following
round 5 will be continued in the same manner.
More About the Money Multiplier Formula

The creation of the money supply is done by the banks through the deposits
they receive and keeping a certain amount as reserves and thus using the rest
of the amount for lending purposes. Money Multiplier in simple words is
considered as the largest amount of money that can be created through this
kind of banking. In this article, we will learn about this concept. We will learn
the credit multiplier formula or deposit multiplier formula, its example, etc.
which will help us to understand this concept clearly which plays a great role
in the monetary policy of the Central Bank or we can say in the banking
system of the economy.

Money Multiplier
The money multiplier is a concept which measures the amount of money
created by banks with the help of deposits after excluding the amount set for
reserves from the deposits. It tells the maximum number of times the amount
will be increased with respect to the given change in the deposits. The money
multiplier has an inverse relationship with the Legal Reserve Ratio (LRR).
LRR refers to the number of deposits that the banks are required to keep with
them as reserves all the time, to meet the uncertainties, and also to maintain
the trust of the public. There are two types of reserves that the banks are
required to maintain:
a. Cash reserves ratio (CRR), the reserves which the banks have to
maintain with the central bank.
b. Statutory Liquidity ratio (SLR), which shows the number of reserves that
the banks are required to maintain in the form of liquid assets with
themselves. The simple money multiplier formula works as a great tool
in the monetary economy for the Central Bank to control the money
creation because it works as a total money supply formula that is used
for calculating money supply.

Money Multiplier Formula
It is also known as the credit multiplier formula. The higher the LRR leads to
a lower money multiplier because the commercial banks will have to maintain
the larger reserves due to which there will be less amount available to lend to
the public.
Example
Suppose an initial deposit of ₹10,000 is made into the bank. The Legal
Reserve Ratio (LRR), which has to be maintained by the commercial banks,
is 20%. All the payments and deposits are done through the bank. The banks
keep only the minimum balance of LRR and lend the rest of the money to the
public.
Solution: Money multiplier Formula = 1÷ LRR
Money multiplier = 1÷ 20%

Money multiplier = (1÷0.20) * 100
Money multiplier = 5 times
It shows that the initial deposit of ₹10,000 will be increased up to 5 times
excluding the reserves.
The following table will explain the process:
Deposits Loans LRR @20%
Initial Deposit 10,000 8,000 2,000
1st 8,000 6,400 1,600
2nd 6,400 5,120 1,280
3rd 5,120 4,096 1,024
4th 4,096 3,276.8 819.20
5th 3,276.8 2,621.44 655.36
-- -- -- --
-- -- -- --
Total 50,000 40,000 10,000
Explanation
The initial deposits of ₹10,000 have been made into the bank, and the banks
are required to maintain 20% of the deposits with them as the LRR is 20%,

therefore the bank has to maintain 20% of ₹10,000 i.e. ₹2,000 with itself and
can lend the rest of the money i.e. ₹8,000 as loans to the public. As all the
payments are done through the banks, therefore the amount of ₹8,000 comes
again to the bank and the bank will keep 20% of this amount i.e. ₹1,600 with
itself, and will lend again the rest of the amount i.e. ₹6,400 to the public. This
process will go again and again till the time the value of deposits doesn't
become ₹50,000. As the value of the money multiplier is 5, it means the value
of initial deposits of ₹10,000 will become ₹50,000 till the end. This process
will continue till the initial deposits increase to ₹50,000.
Additional Information
Deposit Multiplier Formula: Mostly "deposit multiplier" as well as "money
multiplier" terms are often confused with and are also used interchangeably.
These both are very closely related and thus the distinction between them can
become very difficult to grasp.
• This deposit multiplier is also called the "deposit expansion multiplier".
• It is the basic process of money supply creation that is determined by the
fractional reserve banking system.
• Banks create checkable deposits as they loan out their reserves.
• The reserve requirement ratio of the bank helps to determine how much
money is available to loan out and hence the amount of these created
deposits.
• It is then the ratio of the amount of the checkable deposits and the
amount of reserve. It is also considered as the inverse of the reserve
requirement ratio ( RRR).
• This multiplier actually provides the basis for the money multiplier but
on the other hand, if we talk about money multiplier, here due to various
factors such as excess reserves, savings, and conversions to cash by the
consumers, the value of money multiplier is ultimately less.
• The simple deposit multiplier formula is given below:

Measurement of Supply of Money in India
Money Supply
Let us first understand the meaning of money supply or monetary supply.
Simply put, the money supply is the total stock of money that is in circulation in
an economy on any specific day.
This includes all the notes, coins and demand deposits held by the public on
such a day. Such as money demand, money supply is also a stock variable
One important point to note is that the stock of money kept with the
government, central bank, etc. is not taken into account in money supply. This
money is not in actual circulation in the economy and hence does not form a
part of the monetary supply.
Now there are essentially three main sources of money supply in our economy.
They are the produces of the money and are responsible for its distribution in
the economy. These are
i. The government who produces all the coins and the one rupee notes
ii. The Reserve Bank of India (RBI) which issues all the paper currency
iii. And commercial banks as they create the credit as per the demand
deposits

Measures of Money Supply in India
Now we come to the next logical question. How can we measure the amount of
money in the economy? It certainly isn’t an easy or straightforward task.
There is no one way to calculate the money supply in our economy. Instead, the
Reserve Bank of India has developed four alternative measures of money supply
in India.
These four alternative measures of money supply are labelled M1, M2, M3 and
M4. The RBI will collect data and calculate and publish figures of all the four
measures. Let us take a look at how they are calculated.
M1 (Narrow Money)
M1 includes all the currency notes being held by the public on any given day. It
also includes all the demand deposits with all the banks in the country, both
savings as well as current account deposits. It also includes all the other deposits
of the banks kept with the RBI. So M1 = CC + DD + Other Deposits
M2
M2, also narrow money, includes all the inclusions of M1 and additionally also
includes the saving deposits of the post office banks. So M2 = M1 + Savings
Deposits of Post Office Savings

M3 (Broad Money)
M3 consists of all currency notes held by the public, all demand deposits with
the bank, deposits of all the banks with the RBI and the net Time Deposits of all
the banks in the country. So M3 = M1 + time deposits of banks.
M4
M4 is the widest measure of money supply that the RBI uses. It includes all the
aspects of M3 and also includes the savings of the post office banks of the
country. It is the least liquid measure of all of them. M4 = M3 + Post office
savings
Value of Money
The yard measures distance”, said the teacher. “But what measures the yard?”
was the question. “Well”, came the reply, “distance itself’.
Similarly money measures “goods”. But what measures money?
“Goods” is the reply. Value, as we know, is the ratio of exchange between two
goods, and money measures that value through price. Money is an object of
desire. Efforts are made to obtain it not for its own sake but for the goods it can
purchase.
The value of money, then, is the quantity of goods in general that will be
exchanged for one unit of money. The value of money is its purchasing power,
i.e., the quantity of goods and services it can purchase. What money can buy
depends on the level of prices. When the price level rises, a unit of money can
purchase less goods than before. Money is then said to have depreciated.
Conversely, a fall in prices signifies that a unit of money can buy more than
before.
Money is then said to appreciate. The “general level of prices” and the value of
money are thus the same thing from two opposite angles. When the prices rise
the value of money falls and vice versa. In other words, the value of money and

the general price level are inversely proportions’ to each other. Violent changes
in the value of money (or the price level) disturb economic life and do great harm.
We must, therefore, carefully study the factors which’ determine the value of
money.
Suppose we have found by measurement that a room is four metres long.
Measuring it again next day we are surprised to see that the same room is five
metres in length. How could the room stretch itself by a metre overnight? Was
some partition knocked out or an extension added during the night? Or is it that
our metre measure has grown shorter by 2 centimeters? Which out of these is the
correct answer? In the same way, if a rupee can buy one kg of wheat today but
purchases only half a kg tomorrow, we are greatly perplexed.
We feel disgusted with our food-measure, the rupee, which has shrunk to half its
length. We want to know what has happened. We are told “the value of money
has changed.” Exactly this is what has happened in India. There are many times
more rupee notes circulating in the country now than previously, while the
number of goods has not increased to that extent. Hence a rupee buys less.
Measurement of Changes in the Value of Money:
Changes in prices are not uniform. Some prices rise, others fall; while still others
remain stationary. They are like bees dashing out of a hive higgledy-higgledy,
some buzzing off this way, some that way, while others keep hovering at the spot.
But there may be a trend in a particular direction. A comparison of price changes
would give a very confusing picture. We have to discover the extent of the overall
changes in the value of money before suggesting a remedy. The seriousness of the
disease must be known before a remedy can be suggested.
Index Numbers:
The device of index numbers comes to our aid in measuring changes in the value
of money or price level. An index number is a statement in the form of a table
which represents a change in the general price level. Index numbers have great
importance in these days. When it is desired to find out to what extent prices
have risen or fallen, an index number is prepared. In every advanced country,
index numbers are being regularly prepared officially by the governments and
also non-officially by other bodies interested in economic changes.

Preparation of Index Numbers:
The following steps are necessary for the preparation of index
numbers:
(a) Selection of the Base Year:
The first thing necessary is to select a base year. It is the year with which we wish
to compare the present prices, in order to see how much the prices have risen or
fallen. The base year must be a normal year. It should not be a year of famine, or
war, or a year of exceptional prosperity.
(b) Selection of Commodities:
The next step is to select the commodities to be included in the index number.
The commodities will depend on the purpose for which the index number is
prepared. Suppose we want to know how a particular class of people has been
affected by a change in the general price level. In that case, we should include
only those commodities which enter into the consumption of that class.
(c) Collection of Prices:
After commodities have been selected, their prices have to be ascertained. Retail
prices are the best for the purpose, because it is at the retail prices that a
commodity is actually consumed. But retail prices differ almost from shop to
shop, and there is no proper record of them. Hence we have to take the wholesale
prices of which there is a proper record.
(d) Finding Percentage Change:
The next step is to represent the present prices as the percentages of the base
year prices. The base year price is equated to 100, and then the current year’s
price is represented accordingly. This will be clear from the index number given
on the next page.
(e) Averaging.
Finally, we take the average of both the base year and the current year figures in
order to find out the overall change. In May 1985, the price index was 355 which
means that the price on the average were more than three-and a-half times as
much or 255 per cent higher than what they were in 1970-71.

Uses of Index Numbers:
Index numbers can be used for a number of purposes:
(i) Index numbers are used not merely to measure changes in the price level or
changes in the value of money. They can be used to measure quantitative change.
Thus, we can prepare an index number of wages, imports, exports, industrial
production, unemployment, profits, area under cultivation, enrolment in a
college, etc.
(ii) Such quantitative changes as are measured by index numbers can indicate
social and economic trends and help in framing policies with respect to them. For
instance, an index number of cost of living can guide us in the adjustment of
wages to changing prices.
(iii) We can also compare, with the help of index numbers, economic conditions
of a class of people at two different periods.
(iv) Index numbers can be used as basis for, and equitable discharge of, contracts
relating to borrowing and lending. We know when prices rise, creditors lose. It
may perhaps be considered more just to ensure that the creditor gets back the
same purchasing power. Hence, when prices rise, the debtor may be asked to pay
a correspondingly higher sum to discharge a debt.
Limitations:
It may, however, be pointed out that index numbers are not a faultless guide.

They suffer from a number of limitations, some of which are given
below:
(i) Approximations:
Index numbers are at best only approximations. They cannot be taken as
infallible guides. Their data are open to question and they lead to different
interpretations.
(ii) International Comparisons Difficult:
Use of index numbers for inter-national comparisons presents several difficulties.
The result is that such comparisons are difficult, if not impossible, on account of
the different bases, different sets of commodities or differences in their quality,
etc.
(iii) Comparisons between Different Times Difficult:
It is not easy to institute comparisons between different periods of time. Over
long periods, some popular commodities are replaced by others. Entirely new
commodities come to figure in consumption, or a commodity may be vastly
different from what’ it used to be. Think of a modern railway engine and one of
the early ones. Ford cat 1985 is a different commodity from the 1950 Ford.
(iv) Measure Sectional Price Levels Only:
Index numbers measure only changes in the sectional price-levels. An index
number, therefore, prepared for a particular purpose, may not be useful for
another. An index number that helps us to study the economic conditions of mill-
hands or railway coolies will be useless for a study of the conditions of college
lecturers.
An entirely different set of commodities will have to be selected. Different people
use different things and hold different assets. Therefore, different classes of
people are affected differently by a given change in the price-level. Hence, the
same index numbers cannot throw light on the effects of a price change on all
sections of society.
(v) Weighting Changes Result:

One set of weights may yield quite a different result from another, and weighting
is all arbitrary.
Conclusion:
We may conclude in the words of Coulborn who observes, “No general price-level
is in fact compiled in this way because the practical difficulties of collecting the
various prices and assessing weights strictly appropriate to the base year, and
approximately relevant to the subsequent ones, prove to be difficulties which are
insuperable in practice”
Quantity Theory of Money - Transaction Approach

The Quantity Theory of Money seeks to explain the factors that determine the
general price level in an economy. According to this theory, the supply of money
directly determines the price level.
Quantity Theory of Money – Transaction Approach

Fisher’s gave the Transaction Approach to the Quantity Theory of Money. The
following equation of exchange explains it:
MV = PT
Where,
• M – The total supply of money
• V – The velocity of the circulation of money
• P – The general price level
• T – The total transactions in physical goods
In simple words, this equation means that in an economy, the total value of all
goods sold during any period (PT) is equal to the total quantity of money spent
during that period(MV).

Assumptions
• The price level is measured over a period of time
• There are no credit sales in the market
• Money is only a medium of exchange
• Each unit of money can change hands several times during the said
time interval.
• All cash payments received during the year are equal to the volume
of goods and services sold multiplied their respective prices.
The Transaction Approach
Based on these assumptions, the equation of exchange becomes the Quantity
Theory of Money. This also shows that there is an exact, proportional
relationship between the price level and the supply of money.
In other words, the price levels are directly proportional to the quantity of
money in circulation in the economy. So, if the supply of money is doubled, then
the price of money would double too.
This is based on the idea that the demand and supply of money determine the
price levels. Fisher also extended the equation to include demand deposits (M’)
and their velocity (V’) in the total supply of money. Therefore, the equation
becomes:

Therefore, the general price levels depend on all five variables of the equation.
Quantity Theory of Money – Cash Balance Approach

The Cash Balance Approach to the Quantity Theory of Money is expressed as:
π = kR/M
Where,
• π is the purchasing power of money
• k is the proportion of income that people like to hold in the form of
money
• R is the volume of real income

• M is the stock of supply of money in the country at a given time
This equation shows that the purchasing power of money or the value of money
(π) varies directly with k or R. Also, it is inversely proportional with M. Further,
since π is the reciprocal of the general price level,
Further, in the Cash Balance Approach, k is more significant than M in order to

explain the changes in the purchasing power of money. This means that the
value of money depends upon the demand of the people to hold money.
Keynesian theory of Money and Prices

He then presented a reformulated quantity theory of money which brought about
a transition from a monetary theory of prices to a monetary theory of output. In

doing this, Keynes made an attempt to integrate monetary theory with value
theory and also linked the theory of interest into monetary theory. But “it is
through the theory of output that value theory and monetary theory is brought
into just a position with each other.”
Keynes does not agree with the older quantity theorists that there is a direct and
proportional relationship between quantity of money and prices. According to
him, the effect of a change in the quantity of money on prices is indirect and non-
proportional.
Keynes complains “that economics has been divided into two compartments with
no doors or windows between the theory of value and the theory of money and
prices.” This dichotomy between the relative price level (as determined by
demand and supply of goods) and the absolute price level (as determined by
demand and supply of money) arises from the failure of the classical monetary
economists to integrate value theory with monetary theory. Consequently,
changes in the money supply affect only the absolute price level but exercise no
influence on the relative price level.
Further, Keynes criticises the classical theory of static equilibrium in which

money is regarded as neutral and does not influence the economy’s real
equilibrium relating to relative prices. According to him, the problems of the real
world are related to the theory of shifting equilibrium whereas money enters as a
“link between the present and future”.
Keynes’s Reformulated Quantity Theory of Money:
The Keynesian reformulated quantity theory of money is based on the following:

Assumptions:
1. All factors of production are in perfectly elastic supply so long as there is any
unemployment.
2. All unemployed factors are homogeneous, perfectly divisible and

interchangeable.
3. There are constant returns to scale so that prices do not rise or fall as output
increases.
4. Effective demand and quantity of money change in the same proportion so

long as there are any unemployed resources.
Given these assumptions, the Keynesian chain of causation between changes in

the quantity of money and in prices is an indirect one through the rate of interest.
So when the quantity of money is increased, its first impact is on the rate of
interest which tends to fall. Given the marginal efficiency of capita], a fall in the
rate of interest will increase the volume of investment.
The increased investment will raise effective demand through the multiplier
effect thereby increasing income, output and employment. Since the supply curve
of factors of production is perfectly elastic in a situation of unemployment, wage
and non-wage factors are available at constant rate of remuneration. There being
constant returns to scale, prices do not rise with the increase in output so long as
there is any unemployment.
Under the circumstances, output and employment will increase in the same
proportion as effective demand, and the effective demand will increase in the
same proportion as the quantity of money. But “once full employment is reached,
output ceases to respond at all to changes in the supply of money and so in

effective demand. The elasticity of supply of output in response to changes in the
supply, which was infinite as long as there was unemployment falls to zero. The
entire effect of changes in the supply of money is exerted on prices, which rise in
exact proportion with the increase in effective demand.”
Thus so long as there is unemployment, output will change in the same

proportion as the quantity of money, and there will be no change in prices; and
when there is full employment, prices will change in the same proportion as the
quantity of money. Therefore, the reformulated quantity theory of money stresses
the point that with increase in the quantity of money prices rise only when the
level of full employment is reached, and not before this.
This reformulated quantity theory of money is illustrated in Figure 67.1 (A) and
(B) where OTC is the output curve relating to the quantity of money and PRC is
the price curve relating to the quantity of money. Panel A of the figure shows that
as the quantity of money increases from О to M, the level of output also rises
along the ОТ portion of the OTC curve.
As the quantity of money reaches OM level, full employment output OQF is being
produced. But after point T the output curve becomes vertical because any
further increase in the quantity of money cannot raise output beyond the full
employment level OQF.
Panel В of the figure shows the relationship between quantity of money and
prices. So long as there is unemployment, prices remain constant whatever the
increase in the quantity of money. Prices start rising only after the full
employment level is reached.

In the figure, the price level OP remains constant at the OM quantity of money
corresponding to the full employment level of output OQ 1. But an increase in the
quantity of money above OM raises prices in the same proportion as the quantity
of money. This is shown by the RC portion of the price curve PRC.
Keynes himself pointed out that the real world is so complicated that the
simplifying assumptions, upon which the reformulated quantity theory of money
is based, will not hold. According to him, the following possible complications
would qualify the statement that so long as there is unemployment, employment
will change in the same proportion as the quantity of money, and when there is
full employment, prices will change in the same proportion as the quantity of
money.”
(1) “Effective demand will not change in exact proportion to the quantity of
money.
(2) Since resources are homogenous, there will be diminishing, and not constant
returns as employment gradually increases.
(3) Since resources are not interchangeable, some commodities will reach a
condition of inelastic supply while there are still unemployed resources available
for the production of other commodities.
(4) The wage-unit will tend to rise, before full employment has been reached.
(5) The remunerations of factors entering into marginal cost will not all change in
the same proportion.”
Taking into account these complications, it is clear that the reformulated quantity
theory of money does not hold. An increase in effective demand will not change
in exact proportion to the quantity of money, but it will partly spend itself in

increasing output and partly in increasing the price level. So long as there are
unemployed resources, the general price level will not rise much as output
increases. But a sudden large increase in aggregate demand will encounter
bottlenecks when resources are still unemployed.
It may be that the supply of some factors becomes inelastic or others may be in
short supply and are not interchangeable. This may lead to increase in marginal
cost and price. Price would accordingly rise above average unit cost and profits
would increase rapidly which, in turn, tend to raise money wages owing to trade
union pressures. Diminishing returns may also set in. As full employment is
reached, the elasticity of supply of output falls to zero and prices rise in
proportion to the increase in the quantity of money.
The complicated model of the Keynesian theory of money and prices is shown
diagrammatically in Figure 67.2 in terms of aggregate supply (S) and aggregate
demand (D) curves. The price level is measured on the vertical axis and output on
the horizontal axis.
According to Keynes, an increase in the quantity of money increases aggregate

money demand on investment as a result of the fall in the rate of interest. This
increases output and employment in the beginning but not the price level. In the
figure, the increase in the aggregate money demand from D 1 to D2 raises output
from OQ1 to OQ2 but the price level remains constant at OP. As aggregate money
demand increases further from D2 to D3 output increases from OQ2 to OQ3 and the
price level also rises to OP3.
This is because costs rise as bottlenecks develop through the immobility of

resources. Diminishing returns set in and less efficient labour and capital are

employed. Output increases at a slower rate than a given increase in aggregate
money demand, and this leads to higher prices. As full employment is
approached, bottlenecks increase. Further-more, rising prices lead to increased
demand, especially for stocks. Thus prices rise at an increasing rate. This is
shown over the range in the figure.
But when the economy reaches the full employment level of output, any further
increase in aggregate money demand brings about a proportionate increase in the
price level but output remains unchanged at that level. This is shown in the figure
when the demand curve D5 shifts upward to D6 and the price level increases from
OP5 to OP6 while the level of output remains constant at OQ F.
Superiority of the Keynesian Theory over the Traditional
Quantity Theory of Money:
The Keynesian theory of money and prices is superior to the traditional quantity
theory of money for the following reasons.
Keynes’s reformulated quantity theory of money is superior to the traditional

approach in that he discards the old view that the relationship between the
quantity of money and prices is direct and proportional. Instead, he establishes
an indirect and non-proportional relationship between quantity of money and
prices.
In establishing such a relationship, Keynes brought about a transition from a

pure monetary theory of prices to a monetary theory of output and employment.
In so doing, he integrates monetary theory with value theory. He integrates
monetary theory with value theory and also with the theory of output and
employment through the rate of interest.

In fact, the integration between monetary theory and value theory is done
through the theory of output in which the rate of interest plays the crucial role.
When the quantity of money increases the rate of interest falls which increases
the volume of investment and aggregate demand thereby raising output and
employment. In this way, monetary theory is integrated with the theory of output
and employment.
As output and employment increase they further raise the demand for factors of
production. Consequently, certain bottlenecks appear which raise the marginal
cost including money wage rates. Thus prices start rising.
Monetary theory is integrated with value theory in this way. The Keynesian
theory is, therefore, superior to the traditional quantity theory of money because
it does not keep the real and monetary sectors of the economy into two separate
compartments with ‘no doors or windows between the theory of value and the
theory of money and prices.’
Again, the traditional quantity theory is based on the unrealistic assumption of

full employment of resources. Under this assumption, a given increase in the
quantity of money always leads to a proportionate increase in the price level.
Keynes, on the other hand, believes that full employment is an exception.
Therefore, so long as there is unemployment, output and employment will

change in the same proportion as the quantity of money, but there will be no
change in prices; and when there is full employment, prices will change in the
same proportion as the quantity of money. Thus the Keynesian analysis is
superior to the traditional analysis because it studies the relationship between the
quantity of money and prices both under unemployment and full employment
situations.

Further, the Keynesian theory is superior to the traditional quantity theory of
money in that it emphasises important policy implications. The traditional theory
believes that every increase in the quantity of money leads to inflation.
Keynes, on the other hand, establishes that so long as there is unemployment, the
rise in prices is gradual and there is no danger of inflation. It is only when the
economy reaches the level of full employment that the rise in prices is
inflationary with every increase in the quantity of money. Thus “this approach
has the virtue of emphasising that the objectives of full employment and price
stability may be inherently irreconcilable.”
Criticisms of Keynes Theory of Money and Prices:
Keynes’ views on money and prices have been criticised by the monetarists on the
following grounds.
1. Direct Relation:
Keynes mistakenly took prices as fixed so that the effect of money appears in his
analysis in terms of quantity of goods traded rather than their average prices.
That is why Keynes adopted an indirect mechanism through bond prices, interest
rates and investment of the effects of monetary changes on economic activity. But
the actual effects of monetary changes are direct rather than indirect.
2. Stable Demand for Money:
Keynes assumed that monetary changes were largely absorbed by changes in the
demand for money. But Friedman has shown on the basis of his empirical studies
that the demand for money is highly stable.

3. Nature of Money:
Keynes failed to understand the true nature of money. He believed that money
could be exchanged for bonds only. In fact, money can be exchanged for many
different types of assets like bonds, securities, physical assets, human wealth, etc.
4. Effect of Money:
Since Keynes wrote for a depression period, this led him to conclude that money
had little effect on income. According to Friedman, it was the contraction of
money that precipitated the depression. It was, therefore, wrong on the part of
Keynes to argue that money had little effect on income. Money does affect
national income.
Keynesian theory of demand for money

The Keynes’ Theory of Demand for Money!
Keynes treated money also as a store of value because it is an asset in which an
individual can store his (her) wealth.
To Keynes an individual’s total wealth consisted of money and bonds.
Keynes used the term ‘bonds’ to refer to all risky assets other than money.
So money holding was the only alternative to holding bonds. And the only
determinant of an individual’s portfolio choice was the interest rate on bonds.
This would affect an individual’s decision to divide his portfolio into money and
bonds. To Keynes, it costs money to hold money and the rate of interest is the
opportunity cost of holding money. At high rates of interest an individual loses a
large sum by holding money or by not holding bonds.
Capital gain/loss:
Another factor affecting an individual’s portfolio choice was expected change in
the rates of interest which would give rise to capital gain or loss. According to
Keynes when the interest rate was high relative to its normal level people would

expect it to fall in near future. A fall in the rate of interest would imply a Capital
gain on bonds. According to Keynes at a high rate of interest there would be low
demand for money as a store of value (wealth).
There are two reasons for this:
(i) At high rate of interest the opportunity cost of money holding (in terms of
forgone interest) is high.
(ii) At a high rate of interest future capital gain on bonds is likely due to a fall in
the rate of interest in future. It is because there is an inverse relation between the
rate of interest and the price of old bonds. Thus if the present rate of interest is
high, people will expect it to fall in near future, in which case they will expect to
make capital gain.
Since the demand for money would fall at high rates of interest, and increase at
low rates of interest, there is an inverse relation between the asset (speculative)
demand for money and the rate of interest.
Keynes also considered transactions and precautionary demand for money whose
primary determinant was income. Such demand would increase proportionately
with increase in income.
So Keynes’ demand function for money can be expressed as
Md = L(Y, i) … (3)
where Y is income and i is nominal interest rate and L stands for liquidity
preference.
Policy Conclusions:
Thus, in Keynes’ view, the demand for money is a function of both income and
interest rate, though in the classical theory, it was a function of income alone.
This point is important in explaining the differences in policy conclusions
between the classical and Keynesian models.
1. Determination of nominal income by the supply of money:
If the demand for money is exactly proportional to income, as in equations (1)
and (2), then nominal income (PY) is completely determined by the supply of
money. Since M= Md = kPY, if k is assumed to remain fixed in equation (1) an

increase in money supply (M) in equilibrium would result-in a proportional
increase in PY. So we get
ΔM = kΔPY
or, 1/K ΔM = Δ PY … (4)
Thus equation (4) makes it abundantly clear that PY can change only when M
changes, k remaining fixed. This means that changes in fiscal policy or
autonomous changes in investment demand have no role in determining the
equilibrium value of income. This is indeed the classical case of vertical LM curve,
in which if M is fixed the level of income is automatically fixed. And any shift of
the IS curve will only affect the rate of interest.
2. Role of fiscal policy change in income determination:
In Keynes’ money demand function, income is not proportional to the supply of
money. This means that income changes can occur due to changes in fiscal policy
and autonomous shifts in investment demand. In this case the LM curve will be
upward sloping and any shift of the IS curve will change the equilibrium value of
income. Of course, slopes of the IS and LM curves will determine the relative
importance of monetary factors and other determinants of income (that shift the
IS curve).
The Monetarists’ View:
The monetarists believe that the LM curve is quite steep, although not vertical.
This largely, if not entirely, explains why money exerts a dominant influence on
nominal income.
The Regressive Expectations Model:
According to Keynes the demand for money refers to the desire to hold money as
an alternative to purchasing an income-earning asset like a bond. All theories of
demand for money give a different answer to the basic question: If bonds earn
interest and money does not why should a person hold money? The first theory to
answer these questions known as the Keynesian theory of demand for money is
based on a model called the regressive expectations model.

This essentially says that people hold money when they expect bond prices to fall,
that is, interest rates to rise, and, thus, expect that they would incur a loss if they
were to hold bonds. ‘Bonds’ here represent the whole range of risky assets that
exist in reality. Since people’s estimates of whether the interest rate is likely to
rise or fall — and by how much — vary widely, at any given interest rate there will
be some people expecting it to rise and, thus, they would be holding money.
According to the regressive expectations model a bond holder has an expected
return on the bond from two sources, the bond’s yield — the interest, payment he
receives — and a potential capital gain — an increase in the price of the bond
from the time he buys it to the time he sells it. The bond’s yield i is normally
expressed as a percentage yield equal to Y divided by the face value of the bond.
Thus
i = Y/Pb …(5)
Since the yield Y is fixed percentage of the bond’s face value, the market price of a
bond is given by the ratio of yield to market rate:
Pb = Y/I …(6)
The expected percentage capital gain is the percentage increase in price from the
purchase price Pb to the expected sale price Peb. From this we can derive the
percentage capital gain, g = (Peb – Pb)/Pb. From equations (5) and (6), with a fixed
Y on the bond, we can get an expected price Peb, corresponding to an expected
interest rate, ie = Y/Peb. Thus, in terms of expected and current interest rates, the
capital gain can be expressed as
This is the expression for expected capital gain in terms of current and expected
interest rates.

The total percentage return (earning) on a bond — denoted by e — is the sum of
the market rate of interest at the time of purchase plus capital gains, e = i + g.
Now if we substitute for g from equation (7), we get an expression for the total
percentage return as the sum of interest yield and capital gains:
Now, with an expected return on bonds given by e, and with a zero return on
money, the asset-holder can be expected to put his liquid wealth into bonds, if he
expects the return e to be positive. If the return on bonds is expected to be
negative, he will put all his liquid wealth into money.
In Keynes’ regressive expectations model, each person is assumed to have an
expected interest rate ie corresponding to some normal long-run average rate that
is likely to prevail in the market. If actual rate rises above his long-run
expectation, he expects them to fall, and vice versa.
Thus, his expectations are regressive. Here we assume that his expected long- run
rate does not change much with changes in current market conditions.
The investor’s expected interest rate ie, together with the actual market interest
rate i, determines his expected percentage return e. On the basis of this we can
compute the critical level of the market rate ic, which would give him a net zero
return on bonds, that is, the value of i that makes e = 0.
When actual i > ic, we would expect him to hold all his liquid wealth in bonds.
When i < ic, he moves 100%, into money. To find this critical value, i c, we set the
total return shown in equation (8) equal to zero:
Here ic, the critical market rate of interest that makes e = 0, is expressed as ie/( 1 +
ie). This relationship between the individual’s demand for real balances and the
interest rate is shown in Fig. 19.2. Here we show the demand for real balances on
the horizontal axis.

It is the demand for real balances, M/P, that depends on the interest rate. Since
we are implicitly holding the general price level con-stant, changes in real
balances M/P correspond to changes in M.
In Fig. 19.2, if i exceeds ic, the investor puts all his W into bonds, and his demand
for money is zero. As i falls below ic — so that expected capital losses on bonds
exceed the interest yield and e becomes negative — the investor transfers his
entire liquid wealth into money.
This give us a demand-for-money curve — for an individual — that looks like a
step function. When i exactly equals e = 0 and the investor cannot choose
between bonds and money. At any other value of i, the investor is either 100% in
money or 100% in bonds.
The individual demand curves of Fig. 19.2 can now be added up to get the total
demand for money. Let us locate the individual with the highest critical interest
rate, icmax in Fig. 19.3. As the interest rate falls below that i max he shifts all of his
liquid wealth into money.
As the interest rate falls, more individual ics are passed and more people shift
from bonds to money. Ultimately, i will fall so much that no one will want to put
his liquid wealth into bonds, and the demand for money will equal total liquid
wealth, ∑W.

Thus, according to the average regressive expectations model as interest rates
fall, the demand for money increases, and the demand curve is likely to be
convex. Thus if the rate of interest continues to fall by the same percentage the
demand for money will increase by increasing amounts.
The main problem with this view is that it suggests that individuals should, at any
given time, hold all their liquid assets either in money or in bonds, but not some
of each. So this is a all-or-nothing choice! This is obviously not true in reality.
There are two problems with this analysis. In the first, if the money market
remained in equilibrium for a very long period, investors should gradually adjust
their expected interest rates to cor-respond to the actual prevailing interest rate.
They would all tend to adopt eventu-ally the same critical interest rate with the
passage of time. So the aggregate demand curve for money would look more and
more like the flat curve of Fig. 19.2, instead of the negatively sloped demand
curve with a variety of critical rates as shown in Fig. 19.3.
This prediction of the regressive ex-pectations model — that the elasticity of
demand for money with respect to changes in the interest rate is increasing over
time — is not supported by facts.
Secondly, if we assume that people actually do have a critical interest rate as

shown in Fig. 19.3, then the model clearly implies that, in this two-asset world,
investors hold either all bonds or all money, but not a mix of the two. The

negative slope of the aggregate demand curve is due to the fact that investors
differ in their opinion about the value of ie, and, thus, in their critical rates ic.
In fact, however, investors do not hold portfolios consisting of only one asset. As
a general rule, portfolios contain a mixture of assets; they are diversified. This
result — that people hold both money and bonds at the same time — has been
explained by James Tobin.
Criticisms of Keynes’ Theory:
James Tobin found two main weaknesses of the Keynesian theory of
the speculative demand for money:
(i) All-or-nothing choice:
In Keynes’ theory investors are assumed to hold all their wealth in bonds (other
than the amount of money held for transaction purposes) as long as the rate of
interest exceeded the ‘critical rate’ — a rate below which the expected capital loss
on bonds outweighed the interest earnings on bonds.
If, on the contrary, the interest rate fell below the critical level, investors would
hold no bonds, i.e., they would hold their entire wealth in money. So Keynes’
theory cannot explain why and how an individual investor diversifies his portfolio
by holding both money and bonds as stores of wealth.
(ii) Changes in the normal rate of interest:
Keynes assumed that investors hold money as an asset so long as the interest rate
is low. The reason is that they expect the interest rate to rise and return to
‘normal’ level. According to Keynes there exists a fixed or a slowly changing
normal level for the interest rate, around which the actual rate of interest
gravitates.
So the normal rate is taken as a benchmark against which to judge the possibility
of interest rate changes which determine the amount of money held for
speculative purposes.
According to Tobin the normal level itself keeps on changing over time — as has
been shown by the experience of the 1950s. This explains why portfolio
diversification takes place. An individual’s portfolio choice, i.e., his decision to

diversify does not depend on Keynes’ restrictive assumption about investor
expectations of a return of the interest rate to a normal level.
It is against this backdrop that we study Tobin’s portfolio theory of demand for
money.
In short, Keynes’ followers such as James Tobin have not been satisfied with his
theory of speculative demand for money which seeks to explain the inverse
relationship between the interest rate and money demand. They have identified
other reasons for the dependence of demand for money on the interest rate.
W. J. Baumol and Tobin have also extended Keynes’ analysis of the transactions
demand for money. We may now discuss these two extensions of Keynes’ theory
one by one.
On the other hand non-Keynesians — called monetarists — have refined and
modified the classical quantity theory of money. This is another notable
development in the area of monetary economics. Friedman’s analysis treats the
demand for money in the same way as the demand for an ordinary commodity.
It can be viewed as a producer’s good; businesses hold cash balances to improve
efficiency in their financial transactions and are willing to pay, in terms of
forgone interest income, for this efficiency. Money can also be viewed as a
consumer’s good; it yields utility to the consumer in terms of smoothing out
timing differences between the expenditure and income streams and also in
terms of reducing risk.
Inflation
Inflation and unemployment are the two most talked-about words in the
contemporary society.
These two are the big problems that plague all the economies.

Almost everyone is sure that he knows what inflation exactly is, but it remains a
source of great deal of confu-sion because it is difficult to define it
unam-biguously.
1. Meaning of Inflation:
Inflation is often defined in terms of its supposed causes. Inflation exists when
money supply exceeds available goods and services. Or inflation is attributed to
budget deficit financing. A deficit budget may be financed by the additional
money creation. But the situation of monetary expansion or budget deficit may
not cause price level to rise. Hence the difficulty of defining ‘inflation’.
Inflation may be defined as ‘a sustained upward trend in the general level of
prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a
persistent and appreciable rise in the general level or average of prices’. In other
words, inflation is a state of rising prices, but not high prices.
It is not high prices but rising price level that con-stitute inflation. It constitutes,
thus, an over-all increase in price level. It can, thus, be viewed as the devaluing of
the worth of money. In other words, inflation reduces the purchasing power of
money. A unit of money now buys less. Inflation can also be seen as a recurring
phenomenon.
While measuring inflation, we take into ac-count a large number of goods and
services used by the people of a country and then cal-culate average increase in
the prices of those goods and services over a period of time. A small rise in prices
or a sudden rise in prices is not inflation since they may reflect the short term
workings of the market.
It is to be pointed out here that inflation is a state of disequilib-rium when there
occurs a sustained rise in price level. It is inflation if the prices of most goods go
up. Such rate of increases in prices may be both slow and rapid. However, it is
difficult to detect whether there is an upward trend in prices and whether this
trend is sus-tained. That is why inflation is difficult to define in an unambiguous
sense.
Let’s measure inflation rate. Suppose, in December 2007, the consumer price
index was 193.6 and, in December 2008, it was 223.8. Thus, the inflation rate
during the last one year was

223.8- 193.6/ 193.6 x 100 = 15.6
As inflation is a state of rising prices, de-flation may be defined as a state of
falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e.,
a rise in the value of money or purchasing power of money. Disinflation is a
slowing down of the rate of inflation.
2. Types of Inflation:
As the nature of inflation is not uniform in an economy for all the time, it is wise
to distin-guish between different types of inflation. Such analysis is useful to
study the distribu-tional and other effects of inflation as well as to recommend
anti-inflationary policies. Infla-tion may be caused by a variety of factors. Its
intensity or pace may be different at different times. It may also be classified in
accordance with the reactions of the government toward inflation.
Thus, one may observe different types of inflation in the
contemporary society:
A. On the Basis of Causes:
(i) Currency inflation:
This type of infla-tion is caused by the printing of cur-rency notes.
(ii) Credit inflation:
Being profit-making institutions, commercial banks sanction more loans and
advances to the public than what the economy needs. Such credit expansion leads
to a rise in price level.
(iii) Deficit-induced inflation:
The budget of the government reflects a deficit when expenditure exceeds
revenue. To meet this gap, the government may ask the central bank to print
additional money. Since pumping of additional money is required to meet the
budget deficit, any price rise may the be called the deficit-induced inflation.
(iv) Demand-pull inflation:
An increase in aggregate demand over the available output leads to a rise in the
price level. Such inflation is called demand-pull in-flation (henceforth DPI). But
why does aggregate demand rise? Classical economists attribute this rise in

aggre-gate demand to money supply. If the supply of money in an economy
ex-ceeds the available goods and services, DPI appears. It has been described by
Coulborn as a situation of “too much money chasing too few goods.”
Keynesians hold a different argu-ment. They argue that there can be an

autonomous increase in aggregate de-mand or spending, such as a rise in
con-sumption demand or investment or government spending or a tax cut or a
net increase in exports (i.e., C + I + G + X – M) with no increase in money
sup-ply. This would prompt upward adjust-ment in price. Thus, DPI is caused by
monetary factors (classical adjustment) and non-monetary factors (Keynesian
argument).
DPI can be explained in terms of Fig. 4.2, where we measure output on the
horizontal axis and price level on the vertical axis. In Range 1, total spending is
too short of full employment out-put, YF. There is little or no rise in the price
level. As demand now rises, out-put will rise. The economy enters Range 2, where
output approaches towards full employment situation. Note that in this region
price level begins to rise. Ul-timately, the economy reaches full em-ployment
situation, i.e., Range 3, where output does not rise but price level is pulled
upward. This is demand-pull in-flation. The essence of this type of in-flation is
that “too much spending chasing too few goods.”

(v) Cost-push inflation:
Inflation in an economy may arise from the overall increase in the cost of
production. This type of inflation is known as cost-push inflation (henceforth
CPI). Cost of pro-duction may rise due to an increase in the prices of raw
materials, wages, etc. Often trade unions are blamed for wage rise since wage rate
is not completely market-determinded. Higher wage means high cost of
production. Prices of commodities are thereby increased.
A wage-price spiral comes into opera-tion. But, at the same time, firms are to be
blamed also for the price rise since they simply raise prices to expand their profit
margins. Thus, we have two im-portant variants of CPI wage-push in-flation and
profit-push inflation.
Any-way, CPI stems from the leftward shift of the aggregate supply
curve:
B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping
inflation. What speed of annual price rise is a creeping one has not been stated by
the economists. To some, a creeping or mild inflation is one when annual price
rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is
con-sidered to be helpful for economic development. Others argue that if annual
price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no
danger.
(ii) Walking Inflation:
If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a
situation of walking inflation. When mild inflation is allowed to fan out, walking
inflation appears. These two types of inflation may be described as ‘moderate
inflation’.
Often, one-digit inflation rate is called ‘moderate inflation’ which is not only
predict-able, but also keep people’s faith on the monetary system of the country.
Peoples’ confidence get lost once moderately maintained rate of inflation goes out
of control and the economy is then caught with the galloping inflation.
(iii) Galloping and Hyperinflation:
Walking inflation may be converted into running inflation. Running inflation is
danger-ous. If it is not controlled, it may ulti-mately be converted to galloping or
hyperinflation. It is an extreme form of inflation when an economy gets
shattered.”Inflation in the double or triple digit range of 20, 100 or 200 p.c. a
year is labelled “galloping inflation”.
(iv) Government’s Reaction to Inflation:
In-flationary situation may be open or suppressed. Because of anti-infla-tionary
policies pursued by the govern-ment, inflation may not be an embar-rassing one.
For instance, increase in income leads to an increase in con-sumption spending
which pulls the price level up.
If the consumption spending is countered by the govern-ment via price control
and rationing device, the inflationary situation may be called a suppressed one.
Once the government curbs are lifted, the sup-pressed inflation becomes open
infla-tion. Open inflation may then result in hyperinflation.

3. Causes of Inflation:
Inflation is mainly caused by excess demand/ or decline in aggregate supply or
output. Former leads to a rightward shift of the aggregate demand curve while
the latter causes aggregate supply curve to shift left-ward. Former is called
demand-pull inflation (DPI), and the latter is called cost-push infla-tion (CPI).
Before describing the factors, that lead to a rise in aggregate demand and a
decline in aggregate supply, we like to explain “demand-pull” and “cost-push”
theories of inflation.
(i) Demand-Pull Inflation Theory:
There are two theoretical approaches to the DPI—one is classical and other is the
Keynesian.
According to classical economists or mon-etarists, inflation is caused by an
increase in money supply which leads to a rightward shift in negative sloping
aggregate demand curve. Given a situation of full employment, classi-cists
maintained that a change in money supply brings about an equiproportionate
change in price level.
That is why monetarists argue that inflation is always and everywhere a monetary
phenomenon. Keynesians do not find any link between money supply and price
level causing an upward shift in aggregate demand.
According to Keynesians, aggregate demand may rise due to a rise in consumer
demand or investment demand or govern-ment expenditure or net exports or the
com-bination of these four components of aggreate demand. Given full
employment, such in-crease in aggregate demand leads to an up-ward pressure in
prices. Such a situation is called DPI. This can be explained graphically.

Just like the price of a commodity, the level of prices is determined by the
interaction of aggregate demand and aggregate supply. In Fig. 4.3, aggregate
demand curve is negative sloping while aggregate supply curve before the full
employment stage is positive sloping and becomes vertical after the full
employ-ment stage is reached. AD1 is the initial aggregate demand curve that
intersects the aggregate supply curve AS at point E1.
The price level, thus, determined is OP1. As ag-gregate demand curve shifts to
AD2, price level rises to OP2. Thus, an increase in aggre-gate demand at the full
employment stage leads to an increase in price level only, rather than the level of
output. However, how much price level will rise following an increase in
aggregate demand depends on the slope of the AS curve.
(ii) Causes of Demand-Pull Inflation:
DPI originates in the monetary sector. Monetarists’ argument that “only money
matters” is based on the assumption that at or near full employment excessive
money supply will in-crease aggregate demand and will, thus, cause inflation.
An increase in nominal money supply shifts aggregate demand curve rightward.
This enables people to hold excess cash bal-ances. Spending of excess cash
balances by them causes price level to rise. Price level will continue to rise until
aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real
sector. Aggregate demand may rise if there is an increase in consumption
expenditure following a tax cut. There may be an autonomous increase in
business investment or government expendi-ture. Government expenditure is
inflationary if the needed money is procured by the gov-ernment by printing
additional money.
In brief, increase in aggregate demand i.e., in-crease in (C + I + G + X – M)
causes price level to rise. However, aggregate demand may rise following an
increase in money supply gen-erated by the printing of additional money
(classical argument) which drives prices up-ward. Thus, money plays a vital role.
That is why Milton Friedman argues that inflation is always and everywhere a
monetary phenom-enon.
There are other reasons that may push ag-gregate demand and, hence, price level
up-wards. For instance, growth of population stimulates aggregate demand.
Higher export earnings increase the purchasing power of the exporting countries.
Additional purchasing power means additional aggregate demand. Purchasing
power and, hence, aggregate de-mand may also go up if government repays
public debt.
Again, there is a tendency on the part of the holders of black money to spend
more on conspicuous consumption goods. Such tendency fuels inflationary fire.
Thus, DPI is caused by a variety of factors.
(iii) Cost-Push Inflation Theory:
In addition to aggregate demand, aggregate supply also generates inflationary
process. As inflation is caused by a leftward shift of the aggregate supply, we call
it CPI. CPI is usu-ally associated with non-monetary factors. CPI arises due to the
increase in cost of produc-tion. Cost of production may rise due to a rise in cost of
raw materials or increase in wages.
However, wage increase may lead to an in-crease in productivity of workers. If
this hap-pens, then the AS curve will shift to the rightward not leftward—
direction. We assume here that productivity does not change in spite of an
increase in wages.

Such increases in costs are passed on to consumers by firms by rais-ing the prices
of the products. Rising wages lead to rising costs. Rising costs lead to rising
prices. And, rising prices again prompt trade unions to demand higher wages.
Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve
to shift leftward.
This can be demonstrated graphically where AS1 is the initial aggregate supply
curve. Below the full employment stage this AS curve is positive sloping and at
full em-ployment stage it becomes perfectly inelastic.
Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now
there is a leftward shift of aggregate supply curve to AS2. With no change in
aggregate demand, this causes price level to rise to OP 2 and output to fall to OY2.
With the reduction in output, employment in the economy de-clines or
unemployment rises. Further shift in AS curve to AS3 results in a higher price
level (OP3) and a lower volume of aggregate out-put (OY3). Thus, CPI may arise
even below the full employment (YF) stage.
(iv) Causes of Cost-Push Inflation:
It is the cost factors that pull the prices up-ward. One of the important causes of
price rise is the rise in price of raw materials. For in-stance, by an administrative
order the govern-ment may hike the price of petrol or diesel or freight rate. Firms

buy these inputs now at a higher price. This leads to an upward pres-sure on cost
of production.
Not only this, CPI is often imported from outside the economy. Increase in the
price of petrol by OPEC com-pels the government to increase the price of petrol
and diesel. These two important raw materials are needed by every sector,
espe-cially the transport sector. As a result, trans-port costs go up resulting in
higher general price level.
Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade
unions demand higher money wages as a compen-sation against inflationary
price rise. If in-crease in money wages exceed labour produc-tivity, aggregate
supply will shift upward and leftward. Firms often exercise power by push-ing
prices up independently of consumer de-mand to expand their profit margins.
Fiscal policy changes, such as increase in tax rates also leads to an upward
pressure in cost of production. For instance, an overall in-crease in excise tax of
mass consumption goods is definitely inflationary. That is why govern-ment is
then accused of causing inflation.
Finally, production setbacks may result in decreases in output. Natural disaster,
gradual exhaustion of natural resources, work stop-pages, electric power cuts,
etc., may cause ag-gregate output to decline. In the midst of this output
reduction, artificial scarcity of any goods created by traders and hoarders just
simply ignite the situation.
Inefficiency, corruption, mismanagement of the economy may also be the other
reasons. Thus, inflation is caused by the interplay of various factors. A particular
factor cannot be held responsible for any inflationary price rise.
4. Effects of Inflation:
People’s desires are inconsistent. When they act as buyers they want prices of
goods and services to remain stable but as sellers they expect the prices of goods
and services should go up. Such a happy outcome may arise for some individuals;
“but, when this happens, others will be getting the worst of both worlds.”
When price level goes up, there is both a gainer and a loser. To evaluate the
conse-quence of inflation, one must identify the na-ture of inflation which may be

anticipated and unanticipated. If inflation is anticipated, peo-ple can adjust with
the new situation and costs of inflation to the society will be smaller.
In reality, people cannot predict accurately fu-ture events or people often make
mistakes in predicting the course of inflation. In other words, inflation may be
unanticipated when people fail to adjust completely. This creates various
problems.
One can study the effects of unanticipated inflation under two broad
head-ings:
(a) Effect on distribution of income and wealth; and
(b) Effect on economic growth.
(a) Effects of Inflation on Distribution of Income and Wealth:
During inflation, usu-ally people experience rise in incomes. But some people
gain during inflation at the ex-pense of others. Some individuals gain be-cause
their money incomes rise more rapidly than the prices and some lose because
prices rise more rapidly than their incomes during inflation. Thus, it redistributes
income and wealth.
Though no conclusive evidence can be cited, it can be asserted that
following catego-ries of people are affected by inflation differ-ently:
(i) Creditors and debtors:
Borrowers gain and lenders lose during inflation because debts are fixed in rupee
terms. When debts are repaid their real value declines by the price level increase
and, hence, creditors lose. An individual may be interested in buying a house by
taking loan of Rs. 7 lakh from an in-stitution for 7 years.
The borrower now wel-comes inflation since he will have to pay less in real terms
than when it was borrowed. Lender, in the process, loses since the rate of interest
payable remains unaltered as per agree-ment. Because of inflation, the borrower
is given ‘dear’ rupees, but pays back ‘cheap’ rupees. However, if in an inflation-
ridden economy creditors chronically loose, it is wise not to advance loans or to
shut down business.

Never does it happen. Rather, the loan-giving institution makes adequate
safeguard against the erosion of real value. Above all, banks do not pay any
interest on current account but charges interest on loans.
(ii) Bond and debenture-holders:
In an economy, there are some people who live on interest income—they suffer
most. Bondhold-ers earn fixed interest income: These people suffer a reduction
in real income when prices rise. In other words, the value of one’s savings
decline if the interest rate falls short of inflation rate. Similarly, beneficiaries
from life insurance programmes are also hit badly by inflation since real value of
savings deterio-rate.
(iii) Investors:
People who put their money in shares during inflation are expected to gain since
the possibility of earning of business profit brightens. Higher profit induces
own-ers of firm to distribute profit among inves-tors or shareholders.
(iv) Salaried people and wage-earners:
Any-one earning a fixed income is damaged by in-flation. Sometimes, unionised
worker suc-ceeds in raising wage rates of white-collar workers as a compensation
against price rise. But wage rate changes with a long time lag. In other words,
wage rate increases always lag behind price increases. Naturally, inflation results
in a reduction in real purchasing power of fixed income-earners.
On the other hand, people earning flexible incomes may gain during inflation.
The nominal incomes of such people outstrip the general price rise. As a re-sult,
real incomes of this income group in-crease.
(v) Profit-earners, speculators and black marketers:
It is argued that profit-earners gain from inflation. Profit tends to rise during
inflation. Seeing inflation, businessmen raise the prices of their products. This
results in a bigger profit. Profit margin, however, may not be high when the rate
of inflation climbs to a high level.
However, speculators dealing in business in essential commodities usually stand
to gain by inflation. Black marketers are also ben-efited by inflation.

Thus, there occurs a redistribution of in-come and wealth. It is said that rich
becomes richer and poor becomes poorer during infla-tion. However, no such
hard and fast gener-alisation can be made. It is clear that someone wins and
someone loses during inflation.
These effects of inflation may persist if in-flation is unanticipated. However, the
redistributive burdens of inflation on income and wealth are most likely to be
minimal if inflation is anticipated by the people. With anticipated inflation,
people can build up their strategies to cope with inflation.
If the annual rate of inflation in an economy is anticipated correctly people will
try to protect them against losses resulting from inflation. Workers will demand
10 p.c. wage increase if inflation is expected to rise by 10 p.c.
Similarly, a percent-age of inflation premium will be demanded by creditors from
debtors. Business firms will also fix prices of their products in accordance with
the anticipated price rise. Now if the entire society “learn to live with inflation”,
the redistributive effect of inflation will be mini-mal.
However, it is difficult to anticipate prop-erly every episode of inflation. Further,
even if it is anticipated it cannot be perfect. In addi-tion, adjustment with the new
expected infla-tionary conditions may not be possible for all categories of people.
Thus, adverse redistributive effects are likely to occur.
Finally, anticipated inflation may also be costly to the society. If people’s
expectation regarding future price rise become stronger they will hold less liquid
money. Mere hold-ing of cash balances during inflation is unwise since its real
value declines. That is why peo-ple use their money balances in buying real
estate, gold, jewellery, etc. Such investment is referred to as unproductive
investment. Thus, during inflation of anticipated variety, there occurs a diversion
of resources from priority to non-priority or unproductive sectors.
(b) Effect on Production and Economic Growth:
Inflation may or may not result in higher output. Below the full employment
stage, inflation has a favourable effect on production. In general, profit is a rising
function of the price level. An inflationary situation gives an incen-tive to
businessmen to raise prices of their prod-ucts so as to earn higher volume of
profit. Ris-ing price and rising profit encourage firms to make larger investments.

As a result, the multi-plier effect of investment will come into opera-tion
resulting in a higher national output. How-ever, such a favourable effect of
inflation will be temporary if wages and production costs rise very rapidly.
Further, inflationary situation may be as-sociated with the fall in output,
particularly if inflation is of the cost-push variety. Thus, there is no strict
relationship between prices and output. An increase in aggregate demand will
increase both prices and output, but a supply shock will raise prices and lower
output.
Inflation may also lower down further pro-duction levels. It is commonly
assumed that if inflationary tendencies nurtured by experi-enced inflation persist
in future, people will now save less and consume more. Rising sav-ing
propensities will result in lower further outputs.
One may also argue that inflation creates an air of uncertainty in the minds of
business community, particularly when the rate of in-flation fluctuates. In the
midst of rising infla-tionary trend, firms cannot accurately estimate their costs
and revenues. That is, in a situa-tion of unanticipated inflation, a great deal of
risk element exists.
It is because of uncertainty of expected inflation, investors become reluc-tant to
invest in their business and to make long-term commitments. Under the
circum-stance, business firms may be deterred in in-vesting. This will adversely
affect the growth performance of the economy.
However, slight dose of inflation is neces-sary for economic growth. Mild
inflation has an encouraging effect on national output. But it is difficult to make
the price rise of a creep-ing variety. High rate of inflation acts as a dis-incentive
to long run economic growth. The way the hyperinflation affects economic
growth is summed up here. We know that hyper-inflation discourages savings.
A fall in savings means a lower rate of capital forma-tion. A low rate of capital
formation hinders economic growth. Further, during excessive price rise, there
occurs an increase in unpro-ductive investment in real estate, gold, jewel-lery,
etc. Above all, speculative businesses flourish during inflation resulting in
artificial scarcities and, hence, further rise in prices.

Again, following hyperinflation, export earn-ings decline resulting in a wide
imbalances in the balance of payment account. Often gallop-ing inflation results
in a ‘flight’ of capital to foreign countries since people lose confidence and faith
over the monetary arrangements of the country, thereby resulting in a scarcity of
resources. Finally, real value of tax revenue also declines under the impact of
hyperinfla-tion. Government then experiences a shortfall in investible resources.
Thus economists and policymakers are unanimous regarding the dangers of high
price rise. But the consequence of hyperinfla-tion are disastrous. In the past,
some of the world economies (e.g., Germany after the First World War (1914-
1918), Latin American coun-tries in the 1980s) had been greatly ravaged by
hyperinflation.
Inflation and Unemployment

The relationship between inflation and unemployment has traditionally been an inverse
correlation. However, this relationship is more complicated than it appears at first glance,
and it has broken down on a number of occasions over the past 50 years. Since inflation
and employment (and unemployment) are some of the most closely monitored economic
indicators, we'll delve into their relationship and how they affect the overall economy.
Labor Supply and Demand
When unemployment is high, the number of people looking for work significantly exceeds
the number of jobs available. In other words, the supply of labor is greater than the
demand for it.
Let's take wage inflation—the rate of change in wages—as a proxy for inflation in the
economy. With so many workers available, there's little need for employers to "bid" for the
services of employees by paying them higher wages. In times of high unemployment,
wages typically remain stagnant, and wage inflation (or rising wages) is non-existent.
In times of low unemployment, the demand for labor by employers exceeds the supply. In
such a tight labor market, employers typically need to pay higher wages to attract
employees, ultimately leading to rising wage inflation.
Over the years, economists have studied the relationship between unemployment and
wage inflation, as well as the overall inflation rate.
1:1

The Phillips Curve
A.W. Phillips was one of the first economists to present compelling evidence of the inverse
relationship between unemployment and wage inflation. Phillips studied the relationship
between unemployment and the rate of change of wages in the United Kingdom over a
period of almost a full century (from 1861 to 1957), and he discovered that the latter could
be explained by two things: the level of unemployment and the rate of change of
unemployment.
Phillips hypothesized that when demand for labor is high and there are few unemployed
workers, employers can be expected to bid wages up quite rapidly. However, when
demand for labor is low, and unemployment is high, workers are reluctant to accept lower
wages than the prevailing rate, and as a result, wage rates fall very slowly.
A second factor that affects wage rate changes is the rate of change in unemployment. If
the economy is booming, employers will bid more vigorously for workers—which means
that demand for labor is increasing at a fast pace (i.e., percentage of unemployment is
decreasing rapidly)—than they would if the demand for labor were either not increasing
(e.g., percentage unemployment is unchanging) or only increasing at a slow pace.
Since wages and salaries are a major input cost for companies, rising wages should lead to
higher prices for products and services in an economy, ultimately pushing the overall
inflation rate higher. As a result, Phillips graphed the relationship between general price
inflation and unemployment, rather than wage inflation. The graph is known today as the
Phillips Curve.
Phillips Curve Implications
Low inflation and full employment are the cornerstones of monetary policy for the modern
central bank. For instance, the U.S. Federal Reserve's monetary policy objectives are
maximum employment, stable prices, and moderate long-term interest rates.
The tradeoff between inflation and unemployment led economists to use the Phillips
Curve to fine-tune monetary or fiscal policy. Since a Phillips Curve for a specific economy
would show an explicit level of inflation for a specific rate of unemployment and vice
versa, it should be possible to aim for a balance between desired levels of inflation and
unemployment.
The rate of change of the Consumer Price Index or CPI is the rate of inflation or an
indicator of rising prices in the U.S. economy.
Figure 1 shows the rate of change of the CPI and unemployment rates in the 1960s.

If unemployment was 6%—and through monetary and fiscal stimulus, the rate was
lowered to 5%—the impact on inflation would be negligible. In other words, with a 1% fall
in unemployment, prices would not rise by much.
If instead, unemployment fell to 4% from 6%, we can see on the left axis that the
corresponding inflation rate would rise to 3% from 1%.
Figure 1: U.S. inflation (CPI) and unemployment rates in the 1960s
U.S. Bureau of Labor Statistics

Monetarist Rebuttal
The 1960s provided compelling proof of the validity of the Phillips Curve, such that a lower
unemployment rate could be maintained indefinitely as long as a higher inflation rate
could be tolerated. However, in the late 1960s, a group of economists who were staunch
monetarists, led by Milton Friedman and Edmund Phelps, argued that the Phillips Curve
does not apply over the long term. They contended that over the long run, the economy
tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.
The natural rate is the long-term unemployment rate that is observed once the effect of
short-term cyclical factors has dissipated and wages have adjusted to a level where supply
and demand in the labor market are balanced. If workers expect prices to rise, they will
demand higher wages so that their real (inflation-adjusted) wages are constant.
In a scenario wherein monetary or fiscal policies are adopted to lower unemployment
below the natural rate, the resultant increase in demand will encourage firms and
producers to raise prices even faster.
As inflation accelerates, workers may supply labor in the short term because of higher
wages – leading to a decline in the unemployment rate. However, over the long-term,

when workers are fully aware of the loss of their purchasing power in an inflationary
environment, their willingness to supply labor diminishes and the unemployment rate
rises to the natural rate. However, wage inflation and general price inflation continue to
rise.
Therefore, over the long-term, higher inflation would not benefit the economy through a
lower rate of unemployment. By the same token, a lower rate of inflation should not inflict
a cost on the economy through a higher rate of unemployment. Since inflation has no
impact on the unemployment rate in the long term, the long-run Phillips curve morphs
into a vertical line at the natural rate of unemployment.
Friedman's and Phelps's findings gave rise to the distinction between the short-run and
long-run Phillips curves. The short-run Phillips curve includes expected inflation as a
determinant of the current rate of inflation and hence is known by the formidable moniker
"expectations-augmented Phillips Curve."
The natural rate of unemployment is not a static number but changes over time due to
the influence of a number of factors. These include the impact of technology, changes in
minimum wages, and the degree of unionization. In the U.S., the natural rate of
unemployment was at 5.3% in 1949; it rose steadily until it peaked at 6.2% in 1978-79,
and then declined afterward. It is expected to be around 4.5% for the remainder of the
2020 decade.
Relationship Breakdown
The 1970s
The monetarists' viewpoint did not gain much traction initially as it was made when the
popularity of the Phillips Curve was at its peak. However, unlike the data from the 1960s,
which definitively supported the Phillips Curve premise, the 1970s provided significant
confirmation of Friedman's and Phelps' theory. In fact, the data at many points over the
next three decades do not provide clear evidence of the inverse relationship between
unemployment and inflation.
The 1970s were a period of both high inflation and high unemployment in the U.S. due to
two massive oil supply shocks. The first oil shock was from the 1973 embargo by Middle
East energy producers that caused crude oil prices to quadruple in about a year. The
second oil shock occurred when the Shah of Iran was overthrown in a revolution and the
loss of output from Iran caused crude oil prices to double between 1979 and 1980. This
development led to both high unemployment and high inflation.

The 1990s
The boom years of the 1990s were a time of low inflation and low unemployment.
Economists attribute a number of reasons for this positive confluence of circumstances.
These include:
• The global competition that kept a lid on price increases by U.S. producers
• Reduced expectations of future inflation as tight monetary policies had led to
declining inflation for more than a decade
• Productivity improvements due to the large-scale adoption of technology
• Demographic changes in the labor force, with more aging baby boomers and fewer
teens working.
CPI vs. Unemployment
In the graphs below, we can see the inverse correlation between inflation—as measured by
the rate of change of the CPI—and unemployment reasserts itself, only to break down at
times.
• In 2001, the mild recession as a result of 9/11 pushed unemployment higher to
roughly 6% while inflation fell below 2.5%.
• In the mid-2000s, as unemployment fell, inflation was steady around 1% to 2.5%.
• During the Great Recession, the rate of change of the CPI fell dramatically as
unemployment soared to almost 10%.
• From 2012 to 2015, we can see that the inverse correlation broke down where
inflation and unemployment moved in tandem.
• From 2016 to 2019, unemployment steadily declined to 50-year lows (before the
onset of COVID-19 at the end of 2019), while inflation remained around 2%. In other
words, the inverse correlation between the two indicators wasn't as strong as it was
in prior years.
• In the year 2020, unemployment soared to almost 15% (in April 2020) as a result of
the economic impacts of the global pandemic caused by COVID-19, but decreased
steadily through January 2021. In January 2021, the unemployment rate fell by 0.4
percentage points, to 6.3%. Although this measure is lower than the high reached in
April 2020, it remains well above pre-pandemic levels (3.5%) in February 2020.
During this time, inflation remained relatively unaffected, although prices began to
rise sharply starting in February of 2021. These price rises were primarily due to the
simultaneous supply shocks to the global economy, although likely increased as a
result of the shortage of labor in essential industries.

Current Environment Wages
An unusual feature of today's economic environment has been the paltry wage gains
despite high corporate profits and declining unemployment since the Great Recession.
• In the graph below, the annual percentage change in wages (red dotted line) for the
private sector has barely nudged higher since 2008
• Since 1954, inflation-adjusted corporate profits have increased more than eightfold,
while real wages have only increased six-fold.
• Over most of the past decade, inflation remained under control, although it
increased sharply during the COVID-19 pandemic.
The Bottom Line

The inverse correlation between inflation and unemployment depicted in the Phillips
Curve works well in the short run, especially when inflation is fairly constant as it was in
the 1960s. It does not hold up over the long-term since the economy reverts to the natural
rate of unemployment as it adjusts to any rate of inflation.
Because it's also more complicated than it appears at first glance, the relationship between
inflation and unemployment has broken down in periods like the stagflationary 1970s and
the booming 1990s.

In recent years, the economy has experienced low unemployment, low inflation, and
negligible wage gains. However, the Federal Reserve is currently engaged in tightening
monetary policy or hiking interest rates to combat the potential of inflation. We have yet to
see how these policy moves will have an impact on the economy, wages, and prices.
Concept of Inflationary Gap

In his pamphlet ‘How to pay for the War’ published in 1940, Keynes explained
the concept of the inflationary gap. It differs from his views on inflation given in
his General Theory. In the General Theory, he started with underemployment
equilibrium. But in How to Pay for the War, he began with a situation of full
employment in the economy. He defined an inflationary gap as an excess of
planned expenditure over the available output at pre-inflation or base prices.
According to Lipsey, “The inflationary gap is the amount by which
aggregate expenditure would exceed aggregate output at the full
employment level of income.” The classical economists explained inflation
as mainly due to increase in the quantity of money, given the level of full
employment. Keynes, on the other hand, ascribed it to the excess of expenditure
over income at the full employment level.
The larger the aggregate expenditure, the larger the gap and the more rapid the
inflation. Given a constant average propensity to save, rising money incomes at
full employment level would lead to an excess of demand over supply and to a
consequent inflationary gap. Thus Keynes used the concept of the inflationary
gap to show the main determinants that cause an inflationary rise of prices.
The inflationary gap is explained with the help of the following
example:
Suppose the gross national product at pre-inflation prices is Rs. 200 crores. Of
this Rs. 80 crores is spent by the government. Thus Rs. 120 (Rs. 200-80) crores
worth of output is available to the public for consumption at pre-inflation prices.
But the gross national income at current prices at full employ-ment level is Rs.
250 crores. Suppose the government taxes away Rs. 60 crores, leaving Rs. 190
crores as disposable income. Thus Rs. 190 crores is the amount to be spent on the

available output worth Rs. 120 crores, thereby creating an inflationary gap of Rs.
70 crores.
This inflationary gap model is illustrated as under:
In reality, the enitre disposable income of Rs. 190 crores is not spent and a part of
it is saved. If, say 20 per cent (Rs. 38 croes) of it is saved, then Rs. 152 crores (Rs.
190-Rs. 38 crores) would be left to create demand for goods worth Rs. 120 crores.
Thus the ac-tual inflationary gap would be Rs. 32 (Rs. 152-120) crores instead of
Rs. 70 crores.
The inflationary gap is shown diagrammatically in Figure 5 where OY F is the foil
employment level of income, 45° ine represents aggregate supply AS and C + 1 +
G line the desired level of consumption, invest-ment and government
expenditure (or aggregate demand curve). The economy’s aggregate demand
curve (C + l + G) = AD intersects the 45° line (AS ) at point E at the income level
OF, which is greater than the full employment income level OY F.
The amount by which aggregate demand (YFA) exceeds the aggre-gate supply
(YFB) at the foil employment income level is the inflationary gap. This is AB in the
figure. The excess volume of total spending when resources are fully employed
creates inflationary pressures. Thus the inflationary gap leads to inflationary
pressures in the economy which are the result of excess aggregate demand.

The inflationary gap can be wiped out by increase in savings so that the aggregate
demand is reduced. But this may lead to deflationary tendencies.
Another solution is to raise the value of available output to match the disposable
income. As aggregate demand increases, businessmen hire more labour to
expand output. But there being foil em-ployment at the current money wage, they
offer higher money wages to induce more workers to work for them. As there is
already foil employment, the increase in money wages leads to proportionate rise
in prices.
Moreover, output cannot be increased during the short run because factors are
already folly employed. So the inflationary gap can be closed by increasing taxes
and reducing expenditure. Monetary policy can also be used to decrease the
money stock. But Keynes was not in favour of monetary measures to control
inflationary pressures within the economy.
Despite these criticisms the concept of inflationary gap has proved to be of much
importance in explaining rising prices at foil employment level and policy
measures in controlling inflation.
It tells that the rise in prices, once the level of foil employment is attained, is due
to excess demand generated by increased expenditures. But the output cannot be
increased because all resources are fully employed in the economy. This leads to
inflation. The larger the expenditure, the larger the gap and more rapid the
inflation.
As a policy measure, it suggests reduction in aggregate demand to control
inflation. For this, the best course is to have a surplus budget by raising taxes. It
also favours saving incentives to reduce consumption expenditure.

“The analysis of the inflationary gap in terms of such aggregates as national
income, investment outlays and consumption expenditures clearly reveals what
determines public policy with respect to taxes, public expenditures, savings
campaigns, credit control, wage adjustment—in short, all the conceivable anti-
inflationary measures affecting the propensities to consume, to save and to invest
which together determine the general price level.”
Inflation in India
Inflation is defined as an increase in the price of most everyday or common
goods and services, such as food, clothing, housing, recreation,
transportation, consumer staples, and so on. Inflation is defined as the
average change in the price of a basket of goods and services over time.
Inflation is defined as a drop in the purchasing power of a country's
currency unit.
What is inflation?
• Inflation is the rate at which the price of goods and services in a given
economy rises.
• Inflation occurs when prices rise as manufacturing expenses, such
as raw materials and wages, rise.
• Inflation can result from an increase in demand for products and
services, as people are ready to pay more for them.
• Let us consider we can buy 1 litre of milk for Rs. 50 at the current time.
Exactly 1 year before 1 litre of milk cost us Rs. 40.
• Here there is an increase of Rs. 10 per litre of milk or the purchasing
power of Rs.40 has reduced from buying 1 litre of milk to 800ml of
milk in 1 year.
Causes of Inflation
Demand-Pull Inflation
Various variables might cause an increase in aggregate demand. Some of
them are

• Fiscal Stimulus
• Population Pressure
• Increase in Net Exports
• Monetary Stimulus
• Policy Decisions
Cost-Push Inflation
The fundamental cause of cost-push inflation is rising production costs.
The following reasons can cause production costs to rise.
• Employees' salaries being raised
• Raw material prices increasing
• Firms profit margins
• Import prices
• Increase in indirect taxes
Measure Inflation
How to measure Inflation?
• A simple way to measure inflation is to compare the current prices of
goods and services to the base year (target year of comparison). (To
read more on this topic, click here Base Year)
• Let us consider we can buy 1 litre of milk for Rs. 50 at the current time.
Exactly 1 year before 1 litre of milk cost us Rs. 40.
• Here there is an increase of Rs. 10 per litre of milk or the purchasing
power of Rs.40 has reduced from buying 1 litre of milk to 800ml of
milk in 1 year.
((50-40)/40)*100=25
• Therefore we can say that there is an inflation of 25% in milk prices
compared to last year.
• However, while calculating the inflation in an economy we consider
different goods while calculating the inflation rate at different levels.
• Generally, inflation is measured in the following 3 places:

o At Consumer Level - Consumer Price Index (CPI)
o At Wholesale Level - Wholesale Price Index (WPI)
o At Producers Level - Producers Price Index (PPI)
Impact
Impact of Inflation
Positive Impacts
Increased Profits for Producers
o In most cases, inflation benefits the producers of goods. They
make more money because they can sell their products at higher
prices.
Increased Investment Returns
o During periods of inflation, investors and entrepreneurs are given
additional incentives to invest in productive activities. As a result,
they benefit from higher returns.
Increase in production output
o When producers receive the appropriate investment, they produce
more goods and services. As a result, inflation causes an increase
in product/service production.
Negative Impacts
Real-Income falls for groups with fixed income.
o An individual's true income is the purchasing power of his income
money. To put it another way, Real Income=Money Income/Price
Level.
o This means that people on fixed incomes, such as salaried
workers, pensioners, and the like, will see a drop in real income.
To put it another way, their purchasing power will reduce.
Income Distribution Inequality Rises
o Profits for business owners and entrepreneurs rise as a result of
inflation.

o As a result, income inequality becomes more pronounced during
this time period.
o People in fixed-income groups, on the other hand, see a decrease
in their real income.
Disturbs the Planning Process
o Inflation raises the prices of goods, raw materials, and factor
services. As a result, the government must spend more money
to complete any investment project initiated during the
planning period.
o If the government fails to raise more financial resources through
savings or taxation, the entire planning process is thrown off.
Inflation Targeting
• Inflation Targeting is a central banking policy that focuses on
altering monetary policy to attain a set annual inflation rate.
• Inflation targeting is founded on the assumption that preserving
price stability, which is achieved by managing inflation, is the
greatest way to generate long-term economic growth.
• New Zealand was the first country to embrace inflation
targeting, and since then, a large number of nations, including India,
have chosen it as their primary monetary policy tool.
Measures to control
Measures to control Inflation
• Inflation can be majorly caused due to two reasons. One is the
Demand-Pull inflation and the other is the cost-push inflation on
the supply side.
• In the case of demand-pull inflation all the control measures revolve
around reducing the demand, this can be done by either reducing
the money supply or increasing prices by taxation.

• In the case of cost-push inflation, the control measures revolve around
increasing the supply to meet the demand in the market and
reduce the prices by providing subsidies and technological expertise.
• In all cases, the inflation control measulres can be divided into
Monetary Measures, Fiscal Measures and Administrative Measures.
Important Terms
Important Terms related to Inflation
The following are the terms associated with inflation along with their
definitions:
Deflation
• Deflation is the inverse of Inflation. It is the persistent decrease in the
price level. Deflation occurs when the inflation rate falls below 0%.
Recession
• A recession is a period of slow economic activity. A recession is usually
preceded by a major drop in consumer expenditure.
• Such a slowdown in economic activity might endure for several
quarters, thereby halting an economy's expansion.

• Economic metrics such as GDP, profits, employment collapse under
this situation.
Disinflation
• Disinflation is the reduction in the rate of inflation. Disinflation occurs
when the inflation rate falls below its current level but is still more than
0%.
Runaway/Hyperinflation
• When the rate of inflation is extremely high, it is called
runaway/hyperinflation inflation. In this situation, money becomes
worthless and new currency may have to be introduced.
Stagflation
• Stagflation is persistently high inflation, high employment and low
growth resulting in a stagnant economy.
Base Effect
• It is a term that is commonly used in the context of inflation. The base
effect is a distortion in a monthly inflation figure caused by
exceptionally high or low levels of inflation in the previous month. A
base effect can make determining inflation levels over time challenging.
Running/Galloping inflation
• When the rate of inflation reaches double digits (>10%), it is called
running/galloping inflation.
Bottleneck Inflation
• When supply reduces dramatically while demand remains constant, the
rise in prices is called bottleneck inflation. Supply-side issues, dangers,
or mismanagement can lead to such circumstances. Bottleneck
inflation is one of the examples of demand-pull inflation.
Core Inflation
• It is the total inflation in the country (Headline Inflation) minus the
inflation in the food and energy articles (volatile articles).

Phillips Curve
• The Phillips curve is a graphic representation of the inverse
relationship between unemployment and inflation. According to the
hypothesis, the lower the unemployment rate, the higher the rate of
inflation, and vice versa.
Reflation
• To recover from the recession, RBI tries to increase the money supply
and the government tries to give fiscal stimulus in the form of tax cuts
or subsidies. These actions take the economy from a deflationary path
towards a reflationary path. Reflation is thus, the increase in price
levels when the economy recovers from recession.
Inflation Tax
• The term "inflation tax" does not refer to a legal tax paid to the
government; rather, it refers to the penalty for retaining currency
during a period of high inflation.
• It is a form of taxation in which the government alters the money
supply. When the supply of money expands, the value of existing
money decreases, resulting in a form of tax on existing money holders.

Double Dip Recession
• When an economy experiences two periods of contraction mediated by
a brief period of expansion, it is known as a double-dip recession.
• Double Dip Recession is also known as W-shaped recessions because
the curve of gross domestic product (GDP) and other economic data on
graphs resembles the letter W.
Skewflation
• Skewflation is the episodic price rise in one/small groups of
commodities while prices of the remaining goods and services remain
the same. Example: Price rise of onions.

GDP Deflator
• GDP Deflator is the ratio of the value of goods and services produced
by an economy in a given year at current prices to the value of goods
and services produced during the base year at current prices.
• The GDP deflator is used to determine how much of the growth in GDP
is due to higher pricing rather than an increase in output.
Inflationary gap
• The inflationary gap is the difference between the general level of
prices and the rise in the level of prices due to inflation.
Deflationary Gap
• A deflationary gap is a difference between the general level of prices
and the fall in the level of prices due to deflation.
Monetary Inflation
• When inflation occurs due to the excessive money printed by the RBI it
is called monetary inflation.
Open inflation
• A situation where the price level rises without any price control
measures by the government is called open inflation.
Suppressed / Repressed inflation
• During war or pandemic like situations, the government imposes price
controls and rationing to keep prices under check. But the moment
these checks have been withdrawn the prices of the goods and services
rise. This rise in prices is called repressed inflation.
Headline Inflation
• Headline inflation is the measure of total inflation within an economy.
It is usually presented in the form of CPI or WPI.
Structural Inflation
• It is inflation that is a part of a particular economic system. A complete
change in the economic policy would be needed to get rid of it.

Creeping inflation
• If the rate of inflation is low (up to 4%), it is called creeping inflation. It
is safe and essential for job creation and economic growth.
Walking/Trotting inflation
• When the rate of inflation is moderate (4-9%), it is called
walking/trotting inflation.
Misery index
• Misery Index is the Rate of inflation plus the rate of unemployment.
Conclusion
Inflationary effects are not uniformly dispersed throughout the economy.
Inflation rates that are unexpected or unanticipated are damaging to the
economy. They contribute to market volatility, making it difficult for
businesses to set long-term budgets. However, moderate inflation is good. It
allows new employment and growth opportunities to the economy.
Banking
Meaning and Functions of Commercial Banking
Meaning of Commercial Banks:
A commercial bank is a financial institution which performs the functions of
accepting deposits from the general public and giving loans for investment with
the aim of earning profit.
In fact, commercial banks, as their name suggests, axe profit-seeking institutions,
i.e., they do banking business to earn profit.
They generally finance trade and commerce with short-term loans. They charge
high rate of interest from the borrowers but pay much less rate of Interest to their

depositors with the result that the difference between the two rates of interest
becomes the main source of profit of the banks. Most of the Indian joint stock
Banks are Commercial Banks such as Punjab National Bank, Allahabad Bank,
Canara Bank, Andhra Bank, Bank of Baroda, etc.
Functions of Commercial Banks:
The two most distinctive features of a commercial bank are borrowing and
lending, i.e., acceptance of deposits and lending of money to projects to earn
Interest (profit). In short, banks borrow to lend. The rate of interest offered by
the banks to depositors is called the borrowing rate while the rate at which banks
lend out is called lending rate.
The difference between the rates is called ‘spread’ which is appropriated by the
banks. Mind, all financial institutions are not commercial banks because only
those which perform dual functions of (i) accepting deposits and (ii) giving loans
are termed as commercial banks. For example post offices are not bank because
they do not give loans. Functions of commercial banks are classified in to two
main categories—(A) Primary functions and (B) Secondary functions.
Let us know about each of them:
(A) Primary Functions:
1. It accepts deposits:
A commercial bank accepts deposits in the form of current, savings and fixed
deposits. It collects the surplus balances of the Individuals, firms and finances
the temporary needs of commercial transactions. The first task is, therefore, the
collection of the savings of the public. The bank does this by accepting deposits
from its customers. Deposits are the lifeline of banks.
Deposits are of three types as under:
(i) Current account deposits:
Such deposits are payable on demand and are, therefore, called demand deposits.
These can be withdrawn by the depositors any number of times depending upon
the balance in the account. The bank does not pay any Interest on these deposits
but provides cheque facilities. These accounts are generally maintained by

businessmen and Industrialists who receive and make business payments of large
amounts through cheques.
(ii) Fixed deposits (Time deposits):
Fixed deposits have a fixed period of maturity and are referred to as time
deposits. These are deposits for a fixed term, i.e., period of time ranging from a
few days to a few years. These are neither payable on demand nor they enjoy
cheque facilities.
They can be withdrawn only after the maturity of the specified fixed period. They
carry higher rate of interest. They are not treated as a part of money supply
Recurring deposit in which a regular deposit of an agreed sum is made is also a
variant of fixed deposits.
(iii) Savings account deposits:
These are deposits whose main objective is to save. Savings account is most
suitable for individual households. They combine the features of both current
account and fixed deposits. They are payable on demand and also withdraw able
by cheque. But bank gives this facility with some restrictions, e.g., a bank may
allow four or five cheques in a month. Interest paid on savings account deposits
in lesser than that of fixed deposit.
Difference between demand deposits and time (term) deposits:
Two traditional forms of deposits are demand deposit and term (or
time) deposit:
(i) Deposits which can be withdrawn on demand by depositors are called demand
deposits, e.g., current account deposits are called demand deposits because they
are payable on demand but saving account deposits do not qualify because of
certain conditions on withdrawal. No interest is paid on them. Term deposits,
also called time deposits, are deposits which are payable only after the expiry of
the specified period.
(ii) Demand deposits do not carry interest whereas time deposits carry a fixed
rate of interest.
(iii) Demand deposits are highly liquid whereas time deposits are less liquid,

(iv) Demand deposits are chequable deposits whereas time deposits are not.
2. It gives loans and advances:
The second major function of a commercial bank is to give loans and advances
particularly to businessmen and entrepreneurs and thereby earn interest. This is,
in fact, the main source of income of the bank. A bank keeps a certain portion of
the deposits with itself as reserve and gives (lends) the balance to the borrowers
as loans and advances in the form of cash credit, demand loans, short-run loans,
overdraft as explained under.
(i) Cash Credit:
An eligible borrower is first sanctioned a credit limit and within that limit he is
allowed to withdraw a certain amount on a given security. The withdrawing
power depends upon the borrower’s current assets, the stock statement of which
is submitted by him to the bank as the basis of security. Interest is charged by the
bank on the drawn or utilised portion of credit (loan).
(ii) Demand Loans:
A loan which can be recalled on demand is called demand loan. There is no stated
maturity. The entire loan amount is paid in lump sum by crediting it to the loan
account of the borrower. Those like security brokers whose credit needs fluctuate
generally, take such loans on personal security and financial assets.
(iii) Short-term Loans:
Short-term loans are given against some security as personal loans to finance
working capital or as priority sector advances. The entire amount is repaid either
in one instalment or in a number of instalments over the period of loan.
Investment:
Commercial banks invest their surplus fund in 3 types of securities:
(i) Government securities, (ii) Other approved securities and (iii) Other
securities. Banks earn interest on these securities.

(B) Secondary Functions:
Apart from the above-mentioned two primary (major) functions, commercial
banks perform the following secondary functions also.
3. Discounting bills of exchange or bundles:
A bill of exchange represents a promise to pay a fixed amount of money at a
specific point of time in future. It can also be encashed earlier through
discounting process of a commercial bank. Alternatively, a bill of exchange is a
document acknowledging an amount of money owed in consideration of goods
received. It is a paper asset signed by the debtor and the creditor for a fixed
amount payable on a fixed date. It works like this.
Suppose, A buys goods from B, he may not pay B immediately but instead give B
a bill of exchange stating the amount of money owed and the time when A will
settle the debt. Suppose, B wants the money immediately, he will present the bill
of exchange (Hundi) to the bank for discounting. The bank will deduct the
commission and pay to B the present value of the bill. When the bill matures after
specified period, the bank will get payment from A.
4. Overdraft facility:
An overdraft is an advance given by allowing a customer keeping current account
to overdraw his current account up to an agreed limit. It is a facility to a depositor
for overdrawing the amount than the balance amount in his account.
In other words, depositors of current account make arrangement with the banks
that in case a cheque has been drawn by them which are not covered by the
deposit, then the bank should grant overdraft and honour the cheque. The
security for overdraft is generally financial assets like shares, debentures, life
insurance policies of the account holder, etc.
Difference between Overdraft facility and Loan:
(i) Overdraft is made without security in current account but loans are given
against security.

(ii) In the case of loan, the borrower has to pay interest on full amount sanctioned
but in the case of overdraft, the borrower is given the facility of borrowing only as
much as he requires.
(iii) Whereas the borrower of loan pays Interest on amount outstanding against
him but customer of overdraft pays interest on the daily balance.
5. Agency functions of the bank:
The bank acts as an agent of its customers and gets commission for
performing agency functions as under:
(i) Transfer of funds:
It provides facility for cheap and easy remittance of funds from place-to-place
through demand drafts, mail transfers, telegraphic transfers, etc.
(ii) Collection of funds:
It collects funds through cheques, bills, bundles and demand drafts on behalf of
its customers.
(iii) Payments of various items:
It makes payment of taxes. Insurance premium, bills, etc. as per the directions of
its customers.
(iv) Purchase and sale of shares and securities:
It buys sells and keeps in safe custody securities and shares on behalf of its
customers.
(v) Collection of dividends, interest on shares and debentures is made on behalf
of its customers.
(iv) Acts as Trustee and Executor of property of its customers on advice of its
customers.
(vii) Letters of References:
It gives information about economic position of its customers to traders and
provides similar information about other traders to its customers.

6. Performing general utility services:
The banks provide many general utility services, some of which are as
under:
(i) Traveller’s cheques .The banks issue traveler’s cheques and gift cheques.
(ii) Locker facility. The customers can keep their ornaments and important
documents in lockers for safe custody.
(iii) Underwriting securities issued by government, public or private bodies.
(iv) Purchase and sale of foreign exchange (currency).
Balance Sheet
The balance sheet of a commercial bank provides a picture of its functioning. It is
a statement which shows its assets and liabilities on a particular date at the end
of one year.
The assets are shown on the right- hand side and the liabilities on the left-hand
side of the balance sheet. As in the case of a company, the assets and liabilities of
a bank must balance. The balance sheet which every commercial bank in India is
required to publish once in a year is shown as under:
We analyse the distribution of assets and liabilities of a commercial bank on the

basis of the division given in the above Table.
The Distribution of Assets:
The assets of a bank are those items from which it receives income and profit.
The first item on the assets side is the cash in liquid form consisting of coins and
currency notes lying in reserve with it and in its branches. This is a certain
percentage of its total liabilities which it is required to keep by law. Cash reserves

do not yield income to the bank but are essential to satisfy the claims of its
depositors.
The second item is in the form of balances with the central bank and other banks.
The commercial banks are required to keep a certain percentage of their time and
demand deposits with the central bank. They are the assets of the bank because it
can withdraw from them in cash in case of emergency or when the seasonal
demand for cash is high.
The third item, money at call and short notice, relates to very short-term loans
advanced to bill brokers, discount houses and acceptance houses. They are
repayable on demand within fifteen days. The banks charge low rate of interest
on these loans. The fourth item of assets relates to bills discounted and
purchased.
The bank earns profit by discounting bills of exchange and treasury bills of 90
days duration. Some bills of exchange are accepted by a commercial bank on
behalf of its customers which i ultimately purchases. They are a liability but they
are included under assets because the bank can get them rediscounted from the
central bank in case of need.
The fifth item, investments by the bank in government securities, state bonds and
industrial shares, yields a fixed income to the banks. The bank can sell its
securities when there is need for more cash. The sixth item relating to loans and
advances is the most profitable source of bank assets as the bank changes interest
at a rate higher than the bank rate.
The bank makes advances on the basis of cash credits and overdrafts and loans
on the basis of recognised securities. In the seventh item are included liabilities of
the bank’s customers which the bank has accepted and endorsed on their behalf.

They are the assets of the bank because the liabilities of customers remain in the
custody of the bank.
The bank charges a nominal commission for all acceptances and endorsements
which is a source of income. The eighth item relates to the value of permanent
assets of the bank in the form of property, furniture, fixtures, etc. They are shown
in the balance sheet after allowing for depreciation every year. The last item
includes profits retained by the bank after paying corporation tax and profits to
shareholders.
The Distribution of Liabilities:
The liabilities of commercial banks are claims on it. These are the items which
form the sources of its funds. Of the liabilities, the share capital of the bank is the
first item which is contributed by its shareholders and is a liability to them. The
second item is the reserve fund. It consists of accumulated resources which are
meant to meet contingencies such as losses in any year.
The bank is required to keep a certain percentage of its annual profits in the
reserve fund. The reserve fund is also a liability to the shareholders. The third
item compresses both the time and demand deposits. Deposits are the debts of
the bank to its customers.
They are the main source from which the bank gets funds for investment and are
indirectly the source of its income. By keeping a certain percentage of its time and
demand deposits in cash the bank lends the remaining amount on interest.
Borrowings from other banks are the fourth item.
The bank usually borrows secured and unsecured loans from the central bank.
Secured loans are on the basis of some recognised securities, and unsecured loans
out of its reserve funds lying with the central bank. The fifth item bills payable

refer to the bills which the bank pays out of its resources. The sixth items relates
to bills for collection.
These are the bills of exchange which the bank collects on behalf of its customers
and credits the amount to their accounts. Hence it is a liability to the bank. The
seventh item is the acceptance and endorsement of bills of exchange by the bank
on behalf of its customers. These are the claims on the bank which it has to meet
when the bills mature.
The eighth item contingents liabilities relate to those claims on the bank which
are unforeseen such as outstanding forward exchange contracts, claims on
acknowledge debts, etc. In the last item, profit and loss, are shown profits payable
to the shareholders which are a liability on the bank.
The various items of the balance sheet shown in Table 1 are a rough indicator of
the assets and liabilities of commercial banks. The balance sheet of a particular
bank showed its financial soundness. By studying the balance sheets of the major
commercial banks of a country, one can also know the trend of the monetary
market. “The bank balance sheet reflects bank credit extension on its asset side in
loans and investments, and on the liabilities side reflects the bank’s operations as
an intermediary in time deposits and its role as an element in the nation’s
monetary system in demand deposits.”
Table 1. Form of Balance Sheet:

Liabilities Assets
1. Share Capital 1. Cash
2. Reserve Fund 2. Balances with the Central Bank
and other banks.
3. Deposits 3. Money at call and Short-Notice
4. Borrowings from other banks 4. Bills Discounted and Purchased.

5. Bills Payable 5. Investments
6. Bills for collection 6. Loans, Advances, Cash Credits
and Overdrafts.
7. Acceptances. Endorsements and 7. Liabilities of Customer for
other obligations Acceptances. Endorsements and
other Obligations.
8. Contingent Liabilities 8. Property, Furniture, Fixtures less
Depreciation
9. Profit and Loss 9. Profit and Loss.
Process of Credit Creation

Credit (Money) Creation by Commercial Banks:
RBI produces money while commercial banks increase the supply of money by
creating credit which is also treated as money creation. Commercial banks create
credit in the form of secondary deposits.
Mind, total deposits of a bank is of two types:
(i) Primary deposits (initial cash deposits by the public) and (ii) Secondary
deposits (deposits that arise due to loans given by the banks which are assumed
to be redeposited in the bank.) Money creation by commercial banks is
determined by two factors namely (i) Primary deposits i.e. initial cash deposits
and (ii) Legal Reserve Ratio (LRR), i.e., minimum ratio of deposits which is
legally compulsory for the commercial banks to keep as cash in liquid form.
Broadly when a bank receives cash deposits from the public, it keeps a fraction of
deposits as cash reserve (LRR) and uses the remaining amount for giving loans.
In the process of lending money, banks are able to create credit through
secondary deposits many times more than initial deposits (primary deposits).
Process of money (credit) creation:

Suppose a man, say X, deposits Rs 2,000 with a bank and the LRR is 10%, which
means the bank keeps only the minimum required Rs 200 as cash reserve (LRR).
The bank can use the remaining amount Rs 1800 (= 2000 – 200) for giving loan

to someone. (Mind, loan is never given in cash but it is redeposited in the bank as
demand deposit in favour of borrower.) The bank lends Rs 1800 to, say, Y who is
actually not given loan but only demand deposit account is opened in his name
and the amount is credited to his account.
This is the first round of credit creation in the form of secondary deposit (Rs
1800), which equals 90% of primary (initial) deposit. Again 10% of Y’s deposit
(i.e., Rs 180) is kept by the bank as cash reserve (LRR) and the balance Rs 1620
(=1800 – 180) is advanced to, say, Z. The bank gets new demand deposit of Rs
1620. This is second round of credit creation which is 90% of first round of
increase of Rs 1800. The third round of credit creation will be 90% of second
round of 1620. This is not the end of story.
The process of credit creation goes on continuously till derivative deposit
(secondary deposit) becomes zero. In the end, volume of total credit created in
this way becomes multiple of initial (primary) deposit. The quantitative outcome
is called money multiplier. If the bank succeeds in creating total credit of, says Rs
18000, it means bank has created 9 times of primary (initial) deposit of Rs 2000.
This is what is meant by credit creation.
In short, money (or credit) creation by commercial banks is determined by (i)
amount of initial (primary) deposits and (ii) LRR. The multiple is called credit
creation or money multiplier.
Symbolically:
Total Credit creation = Initial deposits x 1/LPR.
Money Multiplier:
It means the multiple by which total deposit increases due to initial (primary)
deposit. Money multiplier (or credit multiplier) is the inverse of Legal Reserve
Ratio (LRR). If LRR is 10%, i.e., 10/100or 0.1, then money multiplier = 1/0.1 =
10.
Smaller the LRR, larger would be the size of money multiplier credited to his
account. He is simply given the cheque book to draw cheques when he needs
money. Again, 20% of Sohan’s deposit which is considered a safe limit is kept for
him by the bank and the balance Rs 640 (= 80% of 800) is advanced to, say,

Mohan. Thus, the process of credit creation goes on continuously and in the end
volume of total credit created in this way becomes multiple of initial cash deposit.
The bank is able to lend money and charge interest without parting with cash
because the bank loan simply creates a deposit (or credit) for the borrower. If the
bank succeeds in creating credit of, say, Rs 15,000, it means that the bank has
created credit 15 times of the primary deposit of Rs 1,000. This is what is meant
by credit creation.
Similarly, the bank creates credit when it buys securities and pays the seller with
its own cheque. The cheque is deposited in some bank and a deposit (credit) is
created for the seller of securities. This is also called credit creation. As a result of
credit creation, money supply in the economy becomes higher. It is because of
this credit creation power of commercial banks (or banking system) that they are
called factories of credit or manufacturer of money.
Concept of Microfinance
Microfinance, according to McGuire and Conroy (2000), is “the provision of
financial services, primarily savings and credit, to poor households that do
not have access to formal financial institutions.” The Task Force on
Supportive Policy and Regulatory Framework for Microfinance set up by
NABARD in November 1998 defined microfinance as “the provision of
thrift, credit and other financial services and products of very small amounts
to the poor in rural, semi urban or urban areas, for enabling them to raise
their income levels and improve living standards” (Sharma, 2001; Reddy,
2005, Reji, 2009). These financial services, according to Satish (2005) and
Dasgupta (2006), generally include deposits, loans, payment services,
money transfers, and insurance to poor and low income households and
their microenterprises. However, the expression microfinance according to
Torre and Vento (2006) denotes offering the financial services to “Zero or
low income beneficiaries”.
Wanchoo (2007) defines microfinance as “any activity that includes the
provision of financial services such as credit, savings, and insurance to low

income individuals who either fall below the nationally defined poverty line
or fall just above that, with the goal of creating social value”. The creation of
social value means making efforts in direction of eradication of poverty,
improving livelihood opportunities for the poor through the provision of
capital for micro-enterprise, promotion of savings for poor so that current
problems and future risks can be minimized. However, how much below or
above the poverty line has not been defined anywhere in the literature so far.
Arabi (2009) and Satish (2005) defines microfinance as “small scale
financial services primarily credit and deposits that are provided to people
who farm, fish or herd” and adds that it “operates small or microenterprises
both in urban and rural areas”. According to Dinesha and Jayasheela
(2009), these financial services are provided by financial institutions to the
poor to meet their normal financial needs life cycle, economic opportunity
and emergency. In the words of Dhandapani (2009) microfinance means
extension of small loans to the poor, especially women to start business,
invest in self employment works with the aim to increase their income and
standard of living. As per the definition of Nagayya and Rao (2009),
microfinance refers to entire range of financial and non-financial services
including skill upgradation and entrepreneurial development of poor.
Sehrawat etal. (2011) however, defines microfinance as “a financial service
provided by financial institutions to the poor which may include savings,
credit, insurance, leasing, money transfer, equity transaction, etc. to meet
their normal financial needs like life cycle, economic opportunity and
emergency.
In short, it can be said that the concept of microfinance involves ‘Banking
for the poor and Banking with the poor’. Such banking initiatives open doors
of finance for destitute and underprivileged people who otherwise do not
have access to finance from formal financial sources due to lack of collateral
security (Nagayya and Rao, 2009; Barman et al. 2009). Microfinance targets
the poorest segment of clients. They are self-employed and household-based

entrepreneurs. Their diverse “micro-enterprise” includes small retail shops,
street vending, artisanal manufacture, etc.
Components of Microfinance (Microfinance vs Microcredit)
The term `microfinance’ and `microcredit’ are often used interchangeably
but in reality there is the difference between the two. Microcredit is the
extension of small loans to entrepreneurs too poor to qualify for traditional
bank loans. Microfinance is a broader concept encompassing not only the
extension of credit to the poor, but also the provision of other financial
services like savings, cash withdrawals and insurance (Dasgupta, 2006;
Nagayya and Rao, 2009). Microcredit is the component of microfinance.
There are four components of microfinance:
• Microcredit: It is a small amount of money lent to a client by a bank
or other institution. Microcredit can be offered, often without
collateral, to an individual or through group lending. The purpose of
such a loan is to provide credit to those who require it.
• Microsavings: These are small sums of money that allow poor people
to save small amounts of money for future use. These saving accounts
are often without minimum balance requirements. It helps low
households to save in order to meet unexpected expenses and plan for
future investments. These are the means of collateral to microcredit
(Sinha, 2005).
• Microinsurance: It is an economic instrument characterised by low
premium designed to service low income people not served by typical
social or commercial insurance schemes and helps in mitigating risks
affecting property and health
Central Banking – Functions

A central bank plays an important role in monetary and banking system of a
country.

It is responsible for maintaining financial sovereignty and economic stability of a
country, especially in underdeveloped countries.
“A Central Bank is the bank in any country to which has been entrusted the duty
of regulating the volume of currency and credit in that country”-Bank of
International Settlement.
It issues currency, regulates money supply, and controls different interest rates in
a country. Apart from this, the central bank controls and regulates the activities
of all commercial banks in a country.
Some of the management experts have defined central bank in
different ways, which are as follows:
According to Samuelson, “Every Central Bank has one function. It operates to
control economy, supply of money and credit.”
According to Vera Smith, “The primary definition of Central Bank is the banking
system in which a single bank has either a complete or residuary monopoly of
note issue.”
According to Kent, “Central Bank may be defined as an institution which is
charged with the responsibility of managing the expansion and contraction of the
volume of money in the interest of general public welfare.”
According to Bank of International Settlement, “A Central Bank is the bank in
any country to which has been entrusted the duty of regulating the volume of
currency and credit in that country.”
Bank of England was the world’s first effective central bank that was established
in 1694. As per the resolution passed in Brussels Financial Conference, 1920, all
the countries should establish a central bank for interest of world cooperation.
Thus, since 1920, central banks are formed in almost every country of the world.
In India, RBI operates as a central bank.

Functions of Central Bank
1. Bank of Issue:
Central bank now-a-days has the monopoly of note-issue in every country. The
currency notes printed and issued by the central bank are declared unlimited
legal tender throughout the country.
Central bank has been given exclusive monopoly of note-issue in the interest of
uniformity, better control, elasticity, supervision, and simplicity. It will also avoid
the possibility of over-issue by individual banks.
The central banks, thus, regulate the currency of country and the total money-
supply in the economy. The central bank has to keep gold, silver or other
securities against the notes issued. The system of note-issue differs from country
to country.
The main objects of the system of currency regulation in general are
to see that:
(i) People’s confidence in the currency is maintained,
(ii) Its supply is adjusted to demand in the economy.
Thus, keeping in view the aims of uniformity, elasticity, safety and security, the
system of note-issue has been varying from time to time.
2. Banker, Agent and Adviser to the Government:
Central bank, everywhere, performs the functions of banker, agent and adviser to
the government.
“The central bank operates as the government’s banker, not only because it is
more convenient and economical to the government, but also because of the
intimate connection between public finance monetary affairs.”
As banker to the government, it makes and receives payments on behalf of the
government. It advances short-term loans to the government to tide over
difficulties.
It floats public loans and manages the public debts on behalf of the government.
It keeps the banking accounts and balances of the government after making
disbursements and remittances. As an adviser to the government it advises the

government on all monetary and economic matters. The central bank also acts as
an agent to the government where general exchange control is in force.
3. Custodian of Cash Reserves:
All commercial banks in a country keep a part of their cash balances as deposits
with the central bank, may be on account of convention or legal compulsion. They
draw during busy seasons and pay back during slack seasons. Part of these
balances is used for clearing purposes. Other member banks look to it for
guidance, help and direction in time of need.
It affects centralisation of cash reserves of the member banks. “The centralisation
of cash reserves in the central bank is a source of great strength to the banking
system of any country. Centralised cash reserves can at least serve as the basis of
a large and more elastic credit structure than if the same amount were scattered
amongst the individual banks.
It is obvious, when bank reserves are pooled in one institution which is,
moreover, charged with the responsibility of safeguarding the national economic
interest, such reserves can be employed to the fullest extent possible and in the
most effective manner during periods of seasonal strain and in financial crises or
general emergencies…the centralisation of cash reserves is conducive to economy
in their use and to increased elasticity and liquidity of the banking system and of
the credit structure as a whole.”
4. Custodian of Foreign Balances:
Under the gold standard or when the country is on the gold standard, the
management of that standard, with a view to securing stability of exchange rate,
is left to the central bank.
After World War I, central banks have been keeping gold and foreign currencies
as reserve note-issue and also to meet adverse balance of payment, if any, with
other countries. It is the function of the central bank to maintain the exchange
rate fixed by the government and manage exchange control and other restrictions
imposed by the state. Thus, it becomes a custodian of nation’s reserves of
international currency or foreign balances.

5. Lender of Last Resort:
Central bank is the lender of last resort, for it can give cash to the member banks
to strengthen their cash reserves position by rediscounting first class bills in case
there is a crisis or panic which develops into ‘run’ on banks or when there is a
seasonal strain. Member banks can also take advances on approved short-term
securities from the central bank to add to their cash resources at the shortest
time.
This facility of turning their assets into cash at short notice is of great use to them
and promotes in the banking and credit system economy, elasticity and liquidity.
Thus, the central bank by acting as the lender of the last resort assumes the
responsibility of meeting all reasonable demands for accommodation by
commercial banks in times of difficulties and strains.
De Kock expresses the opinion that the lending of last resort function of the
central bank imparts greater liquidity and elasticity to the entire credit structure
of the country. According to Hawtrey, the essential duty of the central bank as the
lender of last resort is to make good a shortage of cash among the competitive
banks.
6. Clearing House:
Central bank also acts as a clearing house for the settlement of accounts of
commercial banks. A clearing house is an organisation where mutual claims of
banks on one another are offset, and a settlement is made by the payment of the
difference. Central bank being a bankers’ bank keeps the cash balances of
commercial banks and as such it becomes easier for the member banks to adjust
or settle their claims against one another through the central bank.
Suppose there are two banks, they draw cheques on each other. Suppose bank A
has due to it Rs. 3,000 from bank B and has to pay Rs. 4,000 to B. At the clearing
house, mutual claims are offset and bank A pays the balance of Rs. 1,000 to B and
the account is settled. Clearing house function of the central bank leads to a good
deal of economy in the use of cash and much of labour and inconvenience are
avoided.

7. Controller of Credit:
The control or adjustment of credit of commercial banks by the central bank is
accepted as its most important function. Commercial banks create lot of credit
which sometimes results in inflation.
The expansion or contraction of currency and credit may be said to be the most
important causes of business fluctuations. The need for credit control is obvious.
It mainly arises from the fact that money and credit play an important role in
determining the level of incomes, output and employment.
According to Dr. De Kock, “the control and adjustment of credit is accepted by
most economists and bankers as the main function of a central bank. It is the
function which embraces the most important questions of central banking policy
and the one through which practically all other functions are united and made to
serve a common purpose.”
Thus, the control which the central bank exercises over commercial banks as
regards their deposits, is called controller of credit.
8. Protection of Depositors Interests:
The central bank has to supervise the functioning of commercial banks so as to
protect the interest of the depositors and ensure development of banking on
sound lines.
The business of banking has, therefore, been recognized as a public service
necessitating legislative safeguards to prevent bank failures.
Legislation is enacted to enable the central bank to inspect commercial banks in
order to maintain a sound banking system, comprising strong individual units
with adequate financial resources operating under proper management in
conformity with the banking laws and regulations and public and national
interests.
Methods of Credit Control used by Central Bank

The following points highlight the two categories of methods of credit
control by central bank.

The two categories are: I. Quantitative or General Methods II.
Qualitative or Selective Methods.
I. Quantitative or General Methods:

1. Bank Rate Policy:
The bank rate is the rate at which the Central Bank of a country is prepared to re-
discount the first class securities.
It means the bank is prepared to advance loans on approved securities to its
member banks.
As the Central Bank is only the lender of the last resort the bank rate is normally
higher than the market rate.
For example:
If the Central Bank wants to control credit, it will raise the bank rate. As a result,
the market rate and other lending rates in the money-market will go up.
Borrowing will be discouraged. The raising of bank rate will lead to contraction of
credit.
Similarly, a fall in bank rate mil lowers the lending rates in the money market
which in turn will stimulate commercial and industrial activity, for which more
credit will be required from the banks. Thus, there will be expansion of the
volume of bank Credit.
2. Open Market Operations:
This method of credit control is used in two senses:

(i) In the narrow sense, and
(ii) In broad sense.
In narrow sense—the Central Bank starts the purchase and sale of Government
securities in the money market. But in the Broad Sense—the Central Bank
purchases and sale not only Government securities but also of other proper and
eligible securities like bills and securities of private concerns. When the banks
and the private individuals purchase these securities they have to make payments
for these securities to the Central Bank.
This gives result in the fall in the cash reserves of the Commercial Banks, which
in turn reduces the ability of create credit. Through this way of working the
Central Bank is able to exercise a check on the expansion of credit.
Further, if there is deflationary situation and the Commercial Banks are not
creating as much credit as is desirable in the interest of the economy. Then in
such situation the Central Bank will start purchasing securities in the open
market from Commercial Banks and private individuals.
With this activity the cash will now move from the Central Bank to the
Commercial Banks. With this increased cash reserves the Commercial Banks will
be in a position to create more credit with the result that the volume of bank
credit will expand in the economy.
3. Variable Cash Reserve Ratio:
Under this system the Central Bank controls credit by changing the Cash
Reserves Ratio. For example—If the Commercial Banks have excessive cash
reserves on the basis of which they are creating too much of credit which is
harmful for the larger interest of the economy. So it will raise the cash reserve
ratio which the Commercial Banks are required to maintain with the Central
Bank.
This activity of the Central Bank will force the Commercial Banks to curtail the
creation of credit in the economy. In this way by raising the cash reserve ratio of
the Commercial Banks the Central Bank will be able to put an effective check on
the inflationary expansion of credit in the economy.

Similarly, when the Central Bank desires that the Commercial Banks should
increase the volume of credit in order to bring about an economic revival in the
country. The Central Bank will lower down the Cash Reserve ratio with a view to
expand the cash reserves of the Commercial Banks.
With this, the Commercial Banks will now be in a position to create more credit
than what they were doing before. Thus, by varying the cash reserve ratio, the
Central Bank can influence the creation of credit.
Which is Superior?
Either variable cash reserve ratio or open market operations:
From the analysis and discussions made above of these two methods of credit, it
can be said that the variable cash reserve ratio method is superior to open market
operations on the following grounds:
(1) Open market operations is time consuming procedure while cash reserves
ratio produces immediate effect in the economy.
(2) Open market operations can work successfully only where securities market
in a country are well organised and well developed.
While Cash Reserve Ratio does not require such type of securities market for the
successful implementation.
(3) Open market operations will be successful where marginal adjustments in
cash reserve are required.
But the variable cash reserve ratio method is more effective when the commercial
banks happen to have excessive cash reserves with them.
These two methods are not rival, but they are complementary to each other.
II. Qualitative or Selective Method of Credit Control:
The qualitative or the selective methods are directed towards the diversion of
credit into particular uses or channels in the economy. Their objective is mainly
to control and regulate the flow of credit into particular industries or businesses.
The following are the important methods of credit control under
selective method:

1. Rationing of Credit.
2. Direct Action.
3. Moral Persuasion.
4. Method of Publicity.
5. Regulation of Consumer’s Credit.
6. Regulating the Marginal Requirements on Security Loans.
1. Rationing of Credit:
Under this method the credit is rationed by limiting the amount available to each
applicant. The Central Bank puts restrictions on demands for accommodations
made upon it during times of monetary stringency.
In this the Central Bank discourages the granting of loans to stock exchanges by
refusing to re-discount the papers of the bank which have extended liberal loans
to the speculators. This is an important method of credit control and this policy
has been adopted by a number of countries like Russia and Germany.
2. Direct Action:
Under this method if the Commercial Banks do not follow the policy of the
Central Bank, then the Central Bank has the only recourse to direct action. This
method can be used to enforce both quantitatively and qualitatively credit
controls by the Central Banks. This method is not used in isolation; it is used as a
supplement to other methods of credit control.
Direct action may take the form either of a refusal on the part of the Central Bank
to re-discount for banks whose credit policy is regarded as being inconsistent
with the maintenance of sound credit conditions. Even then the Commercial
Banks do not fall in line, the Central Bank has the constitutional power to order
for their closure.
This method can be successful only when the Central Bank is powerful enough
and has cordial relations with the Commercial Banks. Mostly such circumstances
are rare when the Central Bank is forced to resist to such measures.

3. Moral Persuasion:
This method is frequently adopted by the Central Bank to exercise control over
the Commercial Banks. Under this method Central Bank gives advice, then
request and persuasion to the Commercial Banks to co-operate with the Central
Bank is implementing its credit policies.
If the Commercial Banks do not follow or do not abide by the advice or request of
the Central Bank no gross action is taken against them. The Central Bank merely
was its moral influence and pressure with the Commercial Banks to prevail upon
them to accept and follow the policies.
4. Method of Publicity:
In modern times, Central Bank in order to make their policies successful, take the
course of the medium of publicity. A policy can be effectively successful only
when an effective public opinion is created in its favour.
Its officials through news-papers, journals, conferences and seminar’s present a
correct picture of the economic conditions of the country before the public and
give a prospective economic policies. In developed countries Commercial Banks
automatically change their credit creation policy. But in developing countries
Commercial Banks being lured by regional gains. Even the Reserve Bank of India
follows this policy.
5. Regulation of Consumer’s Credit:
Under this method consumers are given credit in a little quantity and this period
is fixed for 18 months; consequently credit creation expanded within the limit.
This method was originally adopted by the U.S.A. as a protective and defensive
measure, there after it has been used and adopted by various other countries.
6. Changes in the Marginal Requirements on Security Loans:
This system is mostly followed in U.S.A. Under this system, the Board of
Governors of the Federal Reserve System has been given the power to prescribe
margin requirements for the purpose of preventing an excessive use of credit for
stock exchange speculation.
This system is specially intended to help the Central Bank in controlling the
volume of credit used for speculation in securities under the Securities Exchange
Act, 1934.

Recent Reforms in Banking Sector in India
In the context of economic liberalisation and growing trend towards globalisation
(external liberalisation), various banking sector reforms have been introduced in
India to improve the operation efficiency and upgrade the health and financial
soundness of banks so that Indian banks can meet internationally accepted
standards of performance.
Reforms in the banking sector were introduced on the basis of the
recommendations of different committees:
(i) The first Narasimhan Committee (1991),
(ii) The Verma Committee (1996),
(iii) The Khan Committee (1997), and
(iv) The Second Narasimhan Committee (1998).
The First Phase of Reforms:
The banking sector reforms are directed toward improving the policy
framework, financial health and the institutional framework:
(a) Change in Policy Framework:
Improvement in policy framework has been undertaken by reducing the Cash
Reserve Ratio (CRR) to the initial standard and phasing out Statutory Liquidity
Ratio (SLR), deregulation of interest rates, widening the scope of lending to
priority sectors and by linking the lending rates to the size of advances.
(b) Improving Financial Health:
Attempts to improve the financial soundness of the banking sector have been
made by prescribing prudential norms. Moreover, steps have been taken to re-
duct the proportion of Non-Performing Assets (NPAs).
(c) Improvements of Institutional Framework:
Such improvements have been achieved in three ways:
(i) Recapitalisation,

(ii) Creating a competitive environment, and
(iii) Strengthening the supervisory system.
Second Phase Reforms:
The first phase of the bank sector reforms is completed. The second generation
reforms which are underway concentrate on strengthening the very foundation of
the banking system in three ways: by reforming the structure of the bank
industry, technological upgradation, and humaning resource development.
Prudential Regulation:
There are two types of banking regulations—economic and prudential. In the pre-
reform era (before July 1991) the Reserve Bank of India (RBI) regulated banks by
imposing constraints on interest rates, tightening entry norms and directed
lending to ensure judicious end use of bank credit.
However, such economic regulation of banks hampered their productivity and
efficiency. Hence, the RBI switched over to prudential regulation which calls for
imposing minimum limit on the capital level(s) of banks.
The objective is to maintain the wealth of banks in particular and to ensure the
soundness of the financial system in general. It allows much greater scope for the
free play of market forces than what is permitted by economic regulations alone.
On the basis of recommendations of the Committee on Banking Sector Reforms,
April 1998 (the second Narasimhan Committee) the RBI issued prudential
norms. The major objective of setting such norms was to ensure financial safety,
soundness and solvency of banks. These norms are directed toward ensuring that
banks carry on their operations as prudent entities, are free from undue risk-
taking, and do not violate banking regulations in pursuit of profit.
The main focus of reforms was in three areas:
(i) NPAs,
(ii) Capital adequacy, and
(iii) Diversification of operations,
(i) Non-Performing Assets (NPAs):

One serious problem faced by the public sector banks in the 1990s was a high
proportion of NPAs. An NPA is an asset from which income is overdue for more
than six months. According to the second Narasimhan Committee report (1998),
“No other single indicator reflects the quality of assets and their
impact on banks’ viability than the NPA figures in relation to
advances.”
The gross NPAs of scheduled commercial banks (SCBs) increased over the period
March 31, 1998 to March 31,2002 from Rs 50,815 crores to Rs 70,904 crores.
Gross NPA of public sector banks (PSBs) were also correspondingly higher.
However, the share of PSBs in total NPAs declined from 90% to 80% during the
period (1998-2002).
Furthermore, there was a decline in the ratio of gross NPAs and net NPAs,
measured as percentage of advances as well as assets. These ratios represent the
quality of banks assets and are thus taken as measures of soundness of the
banking system. Gross and net NPAs as a proportion of gross advances and total
assets of SCBs declined substantially during this period.
However, the ratio of gross and net NPAs as a proportion of gross advances and
of total assets increased substantially for new private sector banks from 2001-02
due to the merger of strong banks with weak banks.
But the root cause of increase in NPAs is the increasing proportion of bad debt. In
case of some banks, net NPAs even exceeded their net worth. This means that
such banks had negative net worth.
RBI Guidelines:
The RBI offered three options to banks to restructure bad debts:
(i) Debt Recovery Tribunals (DRTs);
(ii) Settlement Advisory Committees (SACs); and
(iii) Recapitalisation from the Government.
Guidelines on SACs were revised in July 2002 to provide a uniform, simplified,
non-discriminatory and non-discretionary mechanism for the recovery of the
stock of NPAs of all banks.

Altogether, seven DRTs have been set up for speedy recovery of loans. Finally
with a view to enhancing the effectiveness of DRTs, the Central government
amended the Recovery of Debts due to Banks and Financial Institutions Act in
Jan, 2002.
(ii) Capital Adequacy Ratio:
Banking sector reforms were initiated by implementing prudential norms
consisting of Capital Adequacy Ratio (CAR). The core of such reforms has been
the broadening of prudential norms to the internationally accepted standards.
In 1988 the Basle Committee for international banking supervision made an
attempt worldwide to reduce the number of bank failures by tying a bank’s CAR
to the riskiness of the loans it makes. For instance, there is less chance of a loan
to a government going bad than a loan to, say, an internet business. So, the bank
will not have to hold as much capital in reserve against the first loan as against
the second.
Throughout the world, commercial banks are under the legal obligation to
maintain minimum capital funds for the sake of safety. The reason is that a
bank’s capital base is vitally important for its long-term variability. It also acts as
a shock absorber in the medium term since it gives the power to absorb shocks
and thus avoid the risk of bankruptcy.
A bank’s capital funds must be equivalent to the prescribed ratio on the aggregate
of the risk weighted assets and other exposures. CAR is a measure of the amount
of a bank’s capital expressed as a percentage of its risk weighted credit exposures.
It is related to risk weight assigned to asset acquired by banks in the normal
process of conducting business. It is also related to the proportion of capital to be
maintained on such aggregate risk weighted assets.
CAR is calculated on the basis of risk weightage on assets in the books of accounts
of banks. Any type of business transaction carried out by a bank involves a certain
specific type of risk. So, for the sake of safety, a portion of capital has to be set
aside to make provision for this risk. This portion acts as a hedge against
uncertainty, i.e., a ‘secret reserve’ to absorb any possible future loss.

Higher Capital Adequacy will improve the efficiency of banks in two
ways:
(i) By forcing banks to reduce operating costs, and
(ii) By improving long-term viability through risk reduction.
Capital adequacy enables banks to mobilise more capital at reasonable cost.
The two important new parameters which are crucial for the growth of banks are
asset quality and risk weightage.
On the basis of the Basle Committee proposals (1988), two tiers of
capital have been prescribed for Indian SCBs:
Tier I—capital which can absorb losses without forcing a bank to stop trading,
and
Tier II—capital which can absorb losses only in the event of a winding up.
Following the recommendations of the first Narasimhan Committee (1991) the
RBI directed the banks to maintain a minimum capital of 8% as the risk-weighted
assets; the second Narasimhan Committee (1998) suggested raising the ratio
further. In March 2002, the capital to risk-weighted asset ratio (CRAR) was
raised to 9%. It was subsequently raised to 10% with a view to tightening of the
capital adequacy norm further.
At the end of March 2002, all SCBs (except five) had CRARs in excess of the
stipulated 9%. The capital of PSBs has increased through government capital
infusion, equity issues to public, and retained earnings.
(iii) Diversification in Bank Operations:
During the period of economic liberalisation PSBs have diversified their activities
considerably. They have moved in new areas such as mutual funds, merchant
banking, venture capital funding and other para-banking activities such as
leasing (lease financing), hire-purchase, factoring and so on.
The main objective has been to make profits by deriving maximum economies of
scale and scope, enlarging customer base and providing various types of banking

services under one umbrella (both directly as also through subsidiaries). Many
banks such as the SBI have become a one-stop financial services centre.
Monetary Policy
Monetary policy is adopted by the monetary authority of a country that
controls either the interest rate payable on very short-term borrowing or the
money supply. The policy often targets inflation or interest rate to ensure
price stability and generate trust in the currency.
The monetary policy in India is carried out under the authority of the
Reserve Bank of India.
What are the main objectives of monetary policy?
Simply put the main objective of monetary policy is to maintain price
stability while keeping in mind the objective of growth as price stability is a
necessary precondition for sustainable economic growth.
In India, the RBI plays an important role in controlling inflation through the
consultation process regarding inflation targeting. The current inflation-
targeting framework in India is flexible.
What role does the Monetary Policy Committee play?
The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance
Act, 2016, to provide for a statutory and institutionalized framework for a
Monetary Policy Committee, for maintaining price stability, while keeping in
mind the objective of growth. The Monetary Policy Committee is entrusted
with the task of fixing the benchmark policy rate (repo rate) required to
contain inflation within the specified target level.
The Government of India, in consultation with RBI, notified the ‘Inflation
Target’ in the Gazette of India dated 5 August 2016 for the period beginning
from the date of publication of the notification and ending on March 31,
2021, as 4%. At the same time, lower and upper tolerance levels were
notified to be 2% and 6% respectively.

What are the instruments of monetary policy?
Some of the following instruments are used by RBI as a part of their
monetary policies.
• Open Market Operations: An open market operation is an
instrument which involves buying/selling of securities like government
bond from or to the public and banks. The RBI sells government
securities to control the flow of credit and buys government securities
to increase credit flow.
• Cash Reserve Ratio (CRR): Cash Reserve Ratio is a specified
amount of bank deposits which banks are required to keep with the
RBI in the form of reserves or balances. The higher the CRR with the
RBI, the lower will be the liquidity in the system and vice versa. The
CRR was reduced from 15% in 1990 to 5 % in 2002. As of 31st
December 2019, the CRR is at 4%.
• Statutory Liquidity Ratio (SLR): All financial institutions have to
maintain a certain quantity of liquid assets with themselves at any
point in time of their total time and demand liabilities. This is known
as the Statutory Liquidity Ratio. The assets are kept in non-cash forms
such as precious metals, bonds, etc. As of December 2019, SLR stands
at 18.25%.
• Bank Rate Policy: Also known as the discount rate, bank rates are
interest charged by the RBI for providing funds and loans to the
banking system. An increase in bank rate increases the cost of
borrowing by commercial banks which results in the reduction in credit
volume to the banks and hence the supply of money declines. An
increase in the bank rate is the symbol of the tightening of the RBI
monetary policy. As of 31 December 2019, the bank rate is 5.40%.
• Credit Ceiling: With this instrument, RBI issues prior information or
direction that loans to the commercial bank will be given up to a
certain limit. In this case, a commercial bank will be tight in advancing
loans to the public. They will allocate loans to limited sectors. A few

examples of credit ceiling are agriculture sector advances and priority
sector lending.
Limitations of the Monetary Policy
1. Restricted Scope of Monetary Policy in Economic

Development:
In reality the monetary policy has been assigned only a minor role in the
process of economic development. The monetary policy is not given any
predominant role in the process of economic development.
The role assigned to the Reserve Bank is minor indeed. The Reserve Bank in
expected to see that the process of economic development should not be
hindered for want of availability of adequate funds.
2. Limited Role in Controlling Prices:
The monetary policy of Reserve bank has played only a limited role in
controlling the inflationary pressure. It has not succeeded in achieving the
objective of growth with stability.
The former Governor of Reserve Bank, I.G. Patel states,’ the role of
monetary policy in combating inflation is strictly limited and that monetary
policy can be effective only if it is a part of an overall framework of policy
which includes not only fiscal and foreign exchange policy but also what is
described as an income policy’. In India, however, the monetary policy of the
Reserve Bank is not appropriately integrated with fiscal, foreign exchange
and income policies.
3. Unfavourable Banking Habits:
An important limitation of the monetary policy is unfavourable banking
habits of Indian masses. People in India prefer to make use of cash rather
than cheque. This means that a major portion of the cash generally

continues to circulate in the economy without returning to the banks in the
form of deposits. This reduces the credit creation capacity of the banks.
Moreover in India there is predominance of currency in the money supply.
This hampers the credit creating capacity of the banks. Due to high
proportion of currency in money supply, banks have to face the problem of
large withdrawals of currency every time they create credit. Fortunately, the
recent trend is increasing deposit ratio in money supply. It is expected to
make money policy more effective.
4. Underdeveloped Money Market:
Another limitation of monetary policy in India is underdeveloped money
market. The weak money market limits the coverage, as also the efficient
working of the monetary policy.
The money market comprises of the parts, the organised money market and
unorganised money market. The money policy works only in organised
money market. It fails to achieve the desired results in unorganised money
market.
5. Existence of Black Money:
The existence of black money in the economy limits the working of the
monetary policy. The black money is not recorded since the borrowers and
lenders keep their transactions secret. Consequently the supply and demand
of money also not remain as desired by the monetary policy. In the words of
V. Pandit, ‘Black money is rightly regarded as a threat to the official money
credit policy mechanism to manage demand and price in several sectors of
the economy.
6. Conflicting Objectives:
An important limitation of monetary policy arises from its conflicting
objectives. To achieve the objective of economic development the monetary
policy is to be expansionary but contrary to it to achieve the objective of
price stability a curb on inflation can be realised by contracting the money

supply. The monetary policy generally fails to achieve a proper coordination
between these two objectives.
7. Influence of Non-Monetary Factors:
An important limitation of monetary policy is its ignorance of non-monetary
factors. The monetary policy can never be the primary factor in controlling
inflation originating in real factors, deficit financing and foreign exchange
resources.
The Reserve Bank has no control over deficit financing. It cannot regulate
the deficit financing, which affects money supply considerably.
8. Limitations of Monetary Instruments:
An important limitation of monetary policy is related to the inherent
limitations in the various instruments of credit control. There are
limitations regarding frequent and sharp changes in the bank rate, as these
are supposed to conflict with the development objectives. Most bank rates
are virtually fixed and mutually unrelated so that the scope for adjustment is
very limited.
The margin requirements have tended to be so high for most of time due to
prolonged inflation, that the scope for further increase in them is limited.
The CRR and SLR have also been fixed very high locking most of the funds
in low yielding assets. These limitations of monetary instruments hamper
the smooth working of monetary policy.
9. Not Proper Implementation of the Monetary Policy:
Successful application of monetary policy is not merely a question of
availability of instruments of credit control. It is also a question of
judgement with regard to timing and the degree of restraint employed or
relaxation allowed.
However, past experience shows that Reserve Bank’s credit restrictions have
always fallen short of the required extent of restraint. The Bank has adopted
a hesitant attitude in the field of monetary control.

In short, the monetary policy of the Reserve Bank suffers from many
limitations. It requires improvements in many directions.
Financial Market
A Financial Market is a term meant for a Business setup where different types
of bonds and securities trade are done at lower rates of transaction. It includes
different kinds of Financial securities like bonds, shares, derivatives, and
forex Markets, to name a few.
To ensure that a capitalist economy functions well, the Financial Market is
very necessary as it helps in resource allocation and creates liquidity for
Businesses.
The Financial Market ensures that the flow of capital between investing and
collecting parties is mobilized properly.
Understanding Financial Markets and Institutions

Financial Markets help in smooth functioning of economies by allocating
resources while also creating liquidity for Business enterprises. Different
types of Financial holdings can be traded in these Markets. A vital importance
of Financial Markets is that it enforces informational transparency to set
efficient and appropriate Market prices.
Notably, macroeconomic factors like tax and other aspects often influence the
Market values of Financial holdings which are not indicative of their intrinsic
value. There are various types of Financial Markets, the New York Stock
Exchange is one of the biggest stock Markets on this globe and this Financial
Market records trade worth trillions of dollars everyday.
As an institution, Financial Markets aid in the flow of investments and
savings. In turn, this facilitates the growth of funds, which goes on to help in
production of goods and services. Another significance of Financial Markets

is that it contributes to the demands of receivers, investors and even that of a
country’s economy.
Different institutions which offer Financial holdings like mutual funds,
insurances, pension, etc. combined with that of Financial Markets which offer
bonds and shares contribute to a nation’s economic growth.
Types of Financial Markets

• Stock Markets- In this kind of Market, an organization makes a listing
of its shares which traders and investors buy and sell. Stock Marketing,
through the usage of IPO(Initial Public Offering), allows companies to
increase their capital.
• Over The Counter Markets- It is a kind of decentralized Market,
without fixed geographical locations. Here, the trade is directly done
between two parties instead of an agent/broker. Most stock trading is
done through exchanges.
• Bond Markets- The kind of securities that allow investors to borrow
money from the lender for a certain period of time, with a fixed interest
rate is known as bonds. Bonds are issued to aid Financial projects by
different state and central government bodies, municipal corporations,
etc. Bonds are usually issued as bills and notes.
• Money Markets- This kind of Market trades in holdings with higher
liquidities and is relatively safer. In addition, the interest return is also
cheaper. The capacity of trading between organizations and traders is
quite huge if viewed on the wholesale level.
• Derivative Markets- This is a kind of Market where a contract is
signed between two or more parties depending upon the Financial
securities or assets. The worth of the derivatives is derived from the
primary source of security to which it is linked, thus making it
“secondary security”.
• Forex Market- Foreign Exchange Market, also called the Forex
Market, is the kind of Market that basically deals with currencies. As

cash is the most liquid asset, Forex Market has the highest liquidity of
all Markets around the globe. Banks, commercial organizations, and
investment management firms comprise the majority of the Forex
Market.
Functions of Financial Market

Financial Markets helps in mobilizing savings, determining and settling the
prices of various securities, providing liquidity to assets, and easing access to
all types of traders.
While studying the functions of Financial Markets, students must take note
of these aspects discussed below.
• Mobilising Funds: Among the diverse types of functions served by
Financial Markets, one of the most crucial functions is that of
mobilisation of savings. Financial Markets also utilise this savings
investing it for productive use, thereby contributing to capital and
economic growth.
• Determination of Prices: Another vital function served by Financial
Markets is that of pricing different securities. Essentially, demand and
supply in Financial Markets along with its interaction between investors
determine these pricing.
• Liquidity of Financial Holdings: Tradable assets must be provided
with liquidity for its smooth functioning and flow. This is another role of
the Financial Market which goes on to help in the functioning of a
capitalist economy. It not only allows investors to easily sell their
securities and assets, but also allows them to easily convert them into
cash money.
• Ease of Access: Financial Markets also offer efficient trading since
they bring traders to the same Market. As a result, relevant parties do
not have to spend any resource, be it capital or time, to find interest
buyers or sellers. Additionally, it also provides necessary information

related to trading, which also reduces the effort that interested parties
must put in to complete their trades.
Structure & Functions of Money Market in India

Here are two kinds of markets where borrowing and lending of money takes
place between fund scarce and fund surplus individuals and groups. The
markets catering the need of short term funds are called Money Markets while
the markets that cater to the need of long term funds are called Capital
Markets.
Thus, money markets is that segment of financial markets where borrowing
and lending of the short-term funds takes place. The maturity of the money
market instruments is one day to one year. In our country, Money Markets
are regulated by both RBI and SEBI.
Indian money market is divided into organized and unorganized segments.
Unorganized market is old Indigenous market mainly made of indigenous
bankers, money lenders etc. Organized market is that part which comes
under the regulatory purview of RBI and SEBI. The nature of the money
market transactions is such that they are large in amount and high in volume.
Thus, the entire market is dominated by small number of large players. At
the same time, the money market in India is yet underdeveloped. The key
players in the organized money market include Governments (Central and
State), Discount and Finance House of India (DFHI), Mutual Funds,
Corporate, Commercial / Cooperative Banks, Public Sector Undertakings
(PSUs), Insurance Companies and Financial Institutions and Non-Banking
Financial Companies (NBFCs).
Structure of Organised Money Market in India:
The organized money market in India is not a single market but is a
conglomeration of markets of various instruments. They have been discussed
below:

Call Money / Notice Money / Term Money Market
Call Money, Notice Money and Term Money markets are sub-markets of the
Indian Money Market. These refer to the markets for very short term funds.
Call Money refers to the borrowing or lending of funds for 1 day. Notice
Money refers to the borrowing and lending of funds for 2-14 days. Term
money refers to borrowing and lending of funds for a period of more than 14
days.
Treasury Bill (T – Bills)
The bill market is a sub-market of the money market in India. There are two
types of bills viz. Treasury Bills and commercial bills. While Treasury Bills or
T-Bills are issued by the Central Government; Commercial Bills are issued by
financial institutions.
Commercial Bills
Commercial bills market is basically a market of instruments similar to Bill of
Exchange. The participants of commercial bill market in India are banks and
financial institutions but this market is not yet developed.
Certificate Of Deposits (CDs)
Certificate of Deposit (CD) refers to a money market instrument, which is
negotiable and equivalent to a promissory note. All scheduled commercial
banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs)
and Select All India Financial Institutions permitted by RBI are eligible to
issue certificates of deposits.
Commercial Papers (CP)
Commercial Paper (CP) is yet another money market instrument in India,
which was first introduced in 1990 to enable the highly rated corporates to
diversify their resources for short term fund requirements.
Money Market Mutual Funds (MMMFs)
Money Market Mutual Funds (MMMFs) were introduced by RBI in 1992 but
since 2000, they are brought under the purview of the SEBI. They provide
additional short-term avenue to individual investors.

The Repo / Reverse Repo Market
Repo (repurchase agreement ) was introduced in December 1992. Repo
means selling a security under an agreement to repurchase it at a
predetermined date and rate. Repo transactions are affected between banks
and financial institutions and among bank themselves, RBI also undertake
Repo. IN 1996, Reverse Repo was introduced. Reverse Repo means buying a
security on a spot basis with a commitment to resell on a forward basis.
Reverse Repo transactions are affected with scheduled commercial banks and
primary dealers.
Discount And Finance House Of India (DFHI)
It was established in 1988 by RBI and is jointly owned by RBI, public sector
banks and all India financial institutions which have contributed to its paid
up capital. DFHI plays important role in developing an active secondary
market in Money Market Instruments. From 1996, it has been assigned status
of a Primary Dealer (PD). It deals in treasury bills, commercial bills, CDs,
CPs, short term deposits, call money market and government securities.
Functions of Money Markets:
Due to short maturity term, the instruments of money market are liquid and
can be converted to cash easily and thus are able to address the need of the
short term surplus fund of the lenders and short term borrowing
requirements of the borrowers. Thus, the major function of the money
markets is to cater to the short term financial needs of the economy. The other
functions are as follows:
1. Money Markets help in effective implementation of the RBI’s monetary
policy
2. Money markets help to maintain demand and supply equilibrium with
regard to short term funds
3. They cater to the short term fund requirement of the governments
4. They help in maintaining liquidity in the economy

Capital Market
Capital Market is a place where different financial instruments are traded
between different entities. On one side, there are entities that have abundant
capital, much more than they require and on the other side, there are entities
who need capital for various purposes.
What are Capital Markets?
Capital markets are venues where savings and investments are channeled
between the suppliers who have capital and those who are in need of capital.
The entities that have capital include retail and institutional investors while
those who seek capital are businesses, governments, and people.
Capital markets seek to improve transactional efficiencies. These markets
bring those who hold capital and those seeking capital together and provide a
place where entities can exchange securities.
Primary and Secondary Markets

The word "market" can have many different meanings, but it is used most
often as a catch-all term to denote both the primary market and the
secondary market. In fact, "primary market" and "secondary market" are
both distinct terms; the primary market refers to the market where
securities are created, while the secondary market is one in which they are
traded among investors.
Knowing how the primary and secondary markets work is key to
understanding how stocks, bonds, and other securities trade. Without them,
the capital markets would be much harder to navigate and much less
profitable. We'll help you understand how these markets work and how they
relate to individual investors.

The Primary Market
The primary market is where securities are created. It's in this market that
firms sell (float) new stocks and bonds to the public for the first time. An
initial public offering, or IPO, is an example of a primary market. These
trades provide an opportunity for investors to buy securities from the bank
that did the initial underwriting for a particular stock. An IPO occurs when a
private company issues stock to the public for the first time.
For example, company ABCWXYZ Inc. hires five underwriting firms to
determine the financial details of its IPO. The underwriters detail that the
issue price of the stock will be $15. Investors can then buy the IPO at this
price directly from the issuing company.
This is the first opportunity that investors have to contribute capital to a
company through the purchase of its stock. A company's equity capital is
comprised of the funds generated by the sale of stock on the primary
market.
The Secondary Market
For buying equities, the secondary market is commonly referred to as the

"stock market." This includes the New York Stock Exchange (NYSE),
Nasdaq, and all major exchanges around the world. The defining
characteristic of the secondary market is that investors trade among
themselves.
That is, in the secondary market, investors trade previously issued securities
without the issuing companies' involvement. For example, if you go to buy
Amazon (AMZN) stock, you are dealing only with another investor who
owns shares in Amazon. Amazon is not directly involved with the
transaction.

In the debt markets, while a bond is guaranteed to pay its owner the full par
value at maturity, this date is often many years down the road. Instead,
bondholders can sell bonds on the secondary market for a tidy profit if
interest rates have decreased since the issuance of their bond, making it
more valuable to other investors due to its relatively higher coupon rate.
Securities and Exchange Board of India (SEBI)
SEBI (Securities and Exchange Board of India) was set up in 1988 for the
regulation of the functions of securities market. It promotes orderly and
healthy development in the stock market. However, initially, SEBI did not
have complete control over the stock market transactions. It was just left as
a watchdog for observing the activities, but could not regulate and control
them. As a result, in May 1992, SEBI was granted legal status and is now a
body corporate that has a separate legal existence and perpetual succession.
Reasons for the establishment of SEBI
When the dealings of stock markets grew, it also gave rise to a lot of
malpractices in the stock market like price rigging, delay in delivery of
shares, violation of rules and regulations of stock exchange, etc. The
existence of these malpractices made the customers lose faith and
confidence in the stock exchange. Therefore, the Government of India
decided to set up a regulatory body or an agency known as
SEBI(Securities and Exchange Board of India).
Purpose and Role of SEBI
The main purpose of the formation of SEBI was to keep a check on
malpractices and protect the interest of investors. Simply put, SEBI was set
up to fulfil the needs of three groups, which are:
• Issuers. SEBI provides a marketplace for issuers in which they can
raise finance easily and fairly.

• Investors. SEBI provides protection for investors and supplies
accurate and correct information.
• Intermediaries. SEBI provides a competitive professional market for
intermediaries.
Objectives of SEBI
The main objective of SEBI is protection of the interest of investors,
promotion of the development of stock exchange, and regulation the
activities of stock market. The objectives of SEBI are as follows:
• Regulation of the activities of stock market.
• Protection of the rights of investors and ensuring safety of their
investment.
• Prevention of fraudulent and malpractices by having a balance between
self-regulation of business and its statutory regulations.
• Regulation and development of a code of conduct for the
intermediaries like underwriters, brokers, etc.
Functions of Securities and Exchange Board of India (SEBI)
To meet the three objectives SEBI performs the three main functions;
namely, Protective Functions, Developmental Functions, and
Regulatory Functions.
1. Protective Functions
The functions performed by SEBI to protect the interest of investors and
provide safety of investment are protective functions. The functions
performed by SEBI as protective functions are as follows:
i) Check a Price Rigging
Manipulation of price of securities to inflate or depress the market price of
securities is known as Price Rigging. SEBI through protective functions
prohibits these kinds of practices as it can cheat and defraud the investors.

ii) Prohibits Insider Trading
Any person who is connected with the company such as promoters,
directors, etc., is an insider. They have all the sensitive information about
the company which can affect the price of the securities. However, this
sensitive information is not available to the people at large, and if the
insiders use this privileged information to make profit, it is known as
Insider Trading. SEBI to protect the interest of investors, keep a strict
check on the insiders when they buy securities of the company and takes
strict actions against them on insider trading.
For example, the directors of a company know that the company will be
issuing Bonus Shares to the shareholders at the end of the financial year and
they use this information to make profit by purchasing shares from the
market. This purchase of shares by the directors will be considered insider
trading.
iii) SEBI prohibits fraudulent and unfair trade practices
SEBI does not allow the companies to make any statement that can mislead
the people and induce the sale or purchase of securities by any other person.
iv) Educate Investors
SEBI undertakes various steps to educate the investors so that they can
easily evaluate the securities of different companies and select the most
profitable security.
v) SEBI under protective functions, promotes fair practices and code of
conduct in the security market.
To do so, SEBI takes the following steps:
• It has issued guidelines for the protection of the interest of debenture
holders wherein the company cannot change the terms in the mid-
term.
• It empowers investigating cases of insider trading and also has
provisions for imprisonment and a stiff fine.

• It has also stopped the practice of making preferential allotments of
shares that are unrelated to market prices.
2. Developmental Functions
SEBI performs developmental functions to promote and develop the
activities in stock exchange and to increase the business in stock exchange.
The functions performed by SEBI under developmental functions are as
follows:
i) It promotes the training of intermediaries of the securities market.
ii) It tries to promote the activities of the stock exchange. To do so, it adopts
a flexible and adaptable approach in the following ways:
• SEBI has given permission for internet trading through registered
stock brokers.
• In order to reduce the cost of issue, SEBI has also made underwriting
optional.
• Lastly, it has permitted initial public offer of primary market through
stock exchange.
3. Regulatory Functions
SEBI performs regulatory functions to regulate the business in stock
exchange. The functions performed by SEBI under regulatory functions are
as follows:
• To regulate the intermediaries like underwriters, brokers, etc., SEBI
has framed a set of rules and regulations and a code of conduct.
• It also conducts inquiries and audits of stock exchanges.
• SEBI registers and regulates the working of mutual funds, etc.
• SEBI has brought the intermediaries under the regulatory purview and
has made private placement more restrictive.
• SEBI regulates the takeover of companies.

• Ultimately, it registers and regulates the working of stock brokers,
share transfer agents, sub-brokers, merchant brokers, trustees, and
everyone who is associated with the stock exchange in any manner.
Financial Instruments
What Is a Financial Instrument?
Financial instruments are assets that can be traded, or they can also be seen
as packages of capital that may be traded. Most types of financial
instruments provide efficient flow and transfer of capital all throughout the
world's investors. These assets can be cash, a contractual right to deliver or
receive cash or another type of financial instrument, or evidence of one's
ownership of an entity.
Understanding Financial Instruments
Financial instruments can be real or virtual documents representing a legal
agreement involving any kind of monetary value. Equity-based financial
instruments represent ownership of an asset. Debt-based financial
instruments represent a loan made by an investor to the owner of the asset.
Foreign exchange instruments comprise a third, unique type of financial
instrument. Different subcategories of each instrument type exist, such as
preferred share equity and common share equity.
Types of Financial Instruments

Financial instruments may be divided into two types: cash instruments and
derivative instruments.
Cash Instruments
• The values of cash instruments are directly influenced and determined
by the markets. These can be securities that are easily transferable.

• Cash instruments may also be deposits and loans agreed upon by
borrowers and lenders.
Derivative Instruments
• The value and characteristics of derivative instruments are based on
the vehicle’s underlying components, such as assets, interest rates, or
indices.
• An equity options contract, for example, is a derivative because it
derives its value from the underlying stock. The option gives the right,
but not the obligation, to buy or sell the stock at a specified price and
by a certain date. As the price of the stock rises and falls, so too does
the value of the option although not necessarily by the same
percentage.
• There can be over-the-counter (OTC) derivatives or exchange-traded
derivatives. OTC is a market or process whereby securities–that are not
listed on formal exchanges–are priced and traded.
Types of Asset Classes of Financial Instruments
Financial instruments may also be divided according to an asset class, which
depends on whether they are debt-based or equity-based.
Debt-Based Financial Instruments
Short-term debt-based financial instruments last for one year or less.
Securities of this kind come in the form of T-bills and commercial paper.
Cash of this kind can be deposits and certificates of deposit (CDs).
Exchange-traded derivatives under short-term, debt-based financial
instruments can be short-term interest rate futures. OTC derivatives are
forward rate agreements.
Long-term debt-based financial instruments last for more than a year.
Under securities, these are bonds. Cash equivalents are loans. Exchange-
traded derivatives are bond futures and options on bond futures. OTC
derivatives are interest rate swaps, interest rate caps and floors, interest rate
options, and exotic derivatives.

Equity-Based Financial Instruments
Securities under equity-based financial instruments are stocks. Exchange-
traded derivatives in this category include stock options and equity futures.
The OTC derivatives are stock options and exotic derivatives.
Government Security
What Is a Government Security?
In the investing world, "government security" applies to a range of
investment products offered by a governmental body. For most readers, the
most common types of government securities are those items issued by the
U.S. Treasury in the form of Treasury bonds, bills, and notes. However, the
governments of many nations will issue these debt instruments to fund
necessary ongoing operations.
Government securities come with a promise of the full repayment of
invested principal at maturity of the security. Some government securities
may also pay periodic coupon or interest payments. These securities are
considered conservative investments with low risk since they have the
backing of the government that issued them.
Understanding Government Securities
Government securities are debt instruments of a sovereign government.
They sell these products to finance day-to-day governmental operations and
provide funding for special infrastructure and military projects. These
investments work in much the same way as a corporate debt issue.
Corporations issue bonds as a way to gain capital for buying equipment,
funding expansion, and paying off other debt. By issuing debt, governments
can avoid hiking taxes or cutting other areas of spending in the budget each
time they need additional funds for a project.
After issuing government securities, individual and institutional investors
will buy them to either hold until maturity or sell to other investors on the
secondary bond market. Investors buy and sell previously issued bonds in

the market for a variety of reasons. They may be looking to earn interest
income from the bond's periodic coupon payments or to allocate a portion of
their portfolio into conservative risk-free assets. These investments are often
considered risk-free because when it comes the time for redemption at
maturity, the government can always print more money to satisfy the
demand.
Examples of Government Securities
Here are some of the most commonly issued government securities.
Savings Bonds
Savings bonds offer fixed interest rates over the term of the product. Should
an investor hold a savings bond until its maturity they receive the face value
of the bond plus any accrued interest based on the fixed interest rate. Once
purchased, a savings bond cannot be redeemed for the first 12 months it is
held. Also, redeeming a bond within the first five years means the owner will
forfeit the months of accrued interest.
T-Bills
Treasury bills (T-Bills) have typical maturities of 4, 8, 13, 26, and 52 weeks.
These short-term government securities pay a higher interest rate return as
the maturity terms lengthen. For example, as of Sept. 10, 2021, the yield on
the four-week T-bill was 0.06% while the one-year T-bill yielded 0.08%.
Treasury Notes
Treasury notes (T-Notes) have two, three, five, or 10-year maturities making
them intermediate-term bonds. These notes pay a fixed-rate coupon or
interest payment semiannually and will usually have $1,000 face values.
Two and three-year notes have $5,000 face values.
Yields on T-Notes change daily. However, as an example, the 10-year yield
closed at 1.35% on Sept. 10, 2021. Over a 52-week range, the yield varied
between 0.07% and 0.08%.

Treasury Bonds
Treasury bonds (T-Bonds) have maturities of between 10 and 30 years.
These investments have $1,000 face values and pay semiannual interest
returns. The government uses these bonds to fund deficits in the federal
budget. Also, as mentioned earlier, the Fed controls the money supply and
interest rates through the buying and selling of this product.

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ECB 301

Money, Banking and Financial Market

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High Powered Money

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This is sometimes also known as the monetary multiplier. It is defined as the

Money Multiplier- Formula

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More About the Money Multiplier Formula

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Deposits Loans LRR @20%

Initial Deposit 10,000 8,000 2,000

1st 8,000 6,400 1,600

2nd 6,400 5,120 1,280

3rd 5,120 4,096 1,024

4th 4,096 3,276.8 819.20

5th 3,276.8 2,621.44 655.36

Total 50,000 40,000 10,000

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Quantity Theory of Money - Transaction Approach

Quantity Theory of Money – Transaction Approach

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Quantity Theory of Money – Cash Balance Approach

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Further, in the Cash Balance Approach, k is more significant than M in order to

Keynesian theory of Money and Prices

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Further, Keynes criticises the classical theory of static equilibrium in which

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2. All unemployed factors are homogeneous, perfectly divisible and

4. Effective demand and quantity of money change in the same proportion so

Given these assumptions, the Keynesian chain of causation between changes in

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Thus so long as there is unemployment, output will change in the same

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According to Keynes, an increase in the quantity of money increases aggregate

This is because costs rise as bottlenecks develop through the immobility of

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Keynes’s reformulated quantity theory of money is superior to the traditional

In establishing such a relationship, Keynes brought about a transition from a

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Again, the traditional quantity theory is based on the unrealistic assumption of

Therefore, so long as there is unemployment, output and employment will