DSBS I B.

Tech II Semester (2021-2022)

(A19HS1MG01)

FUNDAMENTALS OF ECONOMICS

UNIT-V: Government Sector; External Sector; Demand for Money; Supply of

Money; Integrating Money and Commodity Markets

By
Dr Gampala Prabhakar
MBA, M.Com, UGC JRF&NET(Management), UGC NET (Commerce), PhD

Assistant Professor
H&S Department
VNR VJIET, Hyderabad
https://sites.google.com/view/dr-gampala-prabhakar/home 1
 UNIT - V
Government Sector — Taxes and Subsidies;
External Sector — Exports and Imports;
Money — Definitions;
Demand for Money —Transitionary and
Speculative Demand;
 Supply of Money — Bank’s Credit Creation
Multiplier;
 Integrating Money and Commodity Markets
— IS, LM Model
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Government Sector — Taxes and Subsidies
Tax is one of the most common financial terms. Taxes are
one of the primary sources of income for the government
through which it fulfils various projects and initiatives. They
are levied by the central and state governments.
Purpose of Tax:
To Country’s economic progress, sustenance and development
To Government welfare schemes
To reduce economic inequality in society
To build infrastructure
To stream line health, finance and judicial kind of systems etc,.

The Indian constitution under Article 246 enlists different

taxations in the country between the centre and the state.
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Classification of taxes:
1. Direct taxes: These taxes are paid directly by the citizen to the
government and can not be remitted to others. In India, the Central
Board of Direct Taxes or CBDT is the governing authority on direct
taxes. Ex: income tax, corporate income tax tax, personal
property taxes, gift tax, capital gains tax etc,. These taxes are
based on the ability to pay principle. It’s a kind of disincentive as it
leads to people work hard-earn more and pay more
2. Indirect taxes: These taxes collected by the producer retailer from
the supply chain and are paid to government. These taxes are
generally levied on goods and services. The Central Board of
Indirect Taxes and Customer (CBIC) is the governing authority on
indirect taxes. Ex:  sales tax, a specific tax, value-added
tax (VAT), or goods and services tax (GST).

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External Sector — Exports and Imports
The external sector of a country’s economy refers to all
international economic transactions between residents of the
country (private and public sector) and the rest of the world.
Imports are the goods and services that are purchased from
the rest of the world by a country’s residents, rather than
buying domestically produced items. Imports lead to an
outflow of funds from the country since import transactions
involve payments to sellers residing in another country.
Exports are goods and services that are produced
domestically, but then sold to customers residing in other
countries. Exports lead to an inflow of funds to the seller’s
country since export transactions involve selling domestic
goods and services to foreign buyers.
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Most modern economies are open. Interaction with other
economies of the world widens choice in three broad
ways
(i) Consumers and firms have the opportunity to choose
between domestic and foreign goods. This is the
product market linkage which occurs through
international trade.
(ii) (ii) Investors have the opportunity to choose between
domestic and foreign assets. This constitutes the
financial market linkage.
(iii)(iii) Firms can choose where to locate production and
workers to choose where to work. This is the factor
market linkage. Labour market linkages have been
relatively less due to various restrictions on the
movement of people through immigration laws.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus here
on the first two linkages.
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An open economy is one that trades with other nations in
goods and services and, most often, also in financial assets.
Indians, for instance, enjoy using products produced around
the world and some of our production is exported to foreign
countries. Foreign trade, therefore, influences Indian
aggregate demand in two ways.
First, when Indians buy foreign goods, this spending escapes as
a leakage from the circular flow of income decreasing aggregate
demand.
Second, our exports to foreigners enter as an injection into the
circular flow, increasing aggregate demand for domestically
produced goods.
Total foreign trade (exports + imports) as a proportion of GDP is a
common measure of the degree of openness of an economy.

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The balance of payments (BoP) record the transactions in
goods, services and assets between residents of a country
with the rest of the world for a specified time period
typically a year. Table 6.1 gives the balance of payments
summary for the Indian Economy for the year 2012-13.
There are two main accounts in the BoP – the current
account and the capital account.
BoP Surplus and Deficit: When exports exceed imports,
there is a trade surplus and when imports exceed exports
there is a trade deficit
A trade surplus or trade deficit reflects a country’s 
balance of trade (which is, essentially, whether a country is a
net exporter or importer, and to what extent).

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How to Decrease Imports/Increase Exports
1. Taxes and quotas
2. Subsidies
3. Trade agreements
4. Currency devaluation

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 Money
Definition of Money: To give a precise definition of money
is a difficult task. Various authors have given different
definition of money. According to Crowther, “Money can be
defined as anything that is generally acceptable as a means of
exchange and that at the same time acts as a measure and a
store of value”. Professor D H Robertson defines money as
“anything which is widely accepted in payment for goods or
in discharge of other kinds of business obligations.
From the above two definitions of money two important
things about money can be noted.
Firstly, money has been defined in terms of the functions it
performs. That is why some economists defined money as
“money is what money does”. It implies that money is
anything which performs the functions of money.
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 Secondly, an essential requirement of any kind of money is that it must be
generally acceptable to every member of the society. Money has a value for ‘A’
only when he thinks that ‘B’ will accept it in exchange for the goods. And
money is useful for ‘B’ only when he is confident that ‘C’ will accept it in
settlement of debts. But the general acceptability is not the physical quality
possessed by the good.
 Functions of Money:
 The primary functions
 Medium of exchange
 Measure of value

 secondary functions
 Standard of deferred payments

 Store of value

 contingent functions.
 Basis of credit

 Distribution of national income

 Medium of compensations

 Liquidity
 Guarantor of solvency
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Forms of money
 Money of account: Money of account is the monetary unit in terms of
which the accounts of a country are kept and transactions settled, ie., in
which general purchasing power, debts and prices are expressed. The
rupee is, for instance, our money of account. Money of account need not,
however, be actually circulating in the country.
 Limited and unlimited legal tender : Money which has legal sanction is
called legal tender money. So its acceptance is compulsory. It is an
offence to refuse to accept payment in legal tender money. Thus a legal
tender currency is one in terms of which debts can be legally paid. A
currency is unlimited legal tender when debts upon any amount can be
paid through it. It is limited legal tender when payments only up to a
given limit can be made by means of it. For example, rupee coins and
rupee notes are unlimited legal tender in India. Any amount of transaction
can be made by using them. But coins of lower amounts like 50 paisa is
only limited legal tender (up to Rs.25/-). One can refuse to receive beyond
this amount. When a coin is worn out and become light beyond a certain
limit, then it ceases to be a legal tender. When one rupee and half-rupee
coins are more than 20% below the standard weight they are no longer
legal tender. 19
Standard money : Standard money is one in which the value of
goods as well as all other forms of money are measured. In India
prices of all goods are measured in terms of rupees. Moreover, the
other forms of money such as ten rupee notes, twenty rupee notes,
fifty rupee notes, hundred rupee notes etc. are expressed in terms
of rupees. Thus rupee is the standard money of India.
Standard money is always made the unlimited legal tender money.
In old days the standard money was a full-bodied money. That is its
face value is equal to its intrinsic value (metal value). But now-
adays in almost all countries of the world, even the standard money
is only a token money. That is, the real worth of the material
contained in it is very much less than the face value written in it.
Token money: Token money is a form of money in which the
metallic value of which is much less than its real value (or face
value). Rupees and all other coins in India are all token money.

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Bank money: Demand deposits of banks are usually called bank
money. Bank deposits are created when somebody deposits money
with them. Banks also creates deposits when they advance loans to
the businessmen and traders. These demand deposits are the
important constituent of the money supply in the country.
It is important to note that bank deposits are generally divided into
two categories: demand deposits and time deposits. Demand
deposits are those deposits which are payable on demand through
cheques and without any serving prior notice to the banks. On the
other hand, time deposits are those deposits which have a fixed
term of maturity and are not withdrawable on demand and also
cheques cannot be drawn on them. Clearly, it is only demand
deposits which serve as a medium of exchange, for they can be
transferred from one person to another through drawing a cheque
on them as and when desired by them.

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 Demand for Money —Transitionary and Speculative Demand

The demand for money tells us what makes people desire a

certain amount of money. Since money is required to conduct
transactions, the value of transactions will determine the money
people will want to keep: the larger the quantum of transactions
to be made, the larger the quantity of money demanded. Since
the quantum of transactions to be made depends on income, it
should be clear that a rise in income will lead to a rise in demand
for money. Also, when people keep their savings in the form of
money rather than putting it in a bank that gives them interest,
how much money people keep also depends on the rate of
interest. Specifically, when interest rates go up, people become
less interested in holding money since holding money amounts to
holding less interest-earning deposits, and thus less interest
received. Therefore, at higher interest rates, money demand
comes down. 22
The quantity of money people hold depends on: 1) The price
level 2) The interest rate 3) Real GDP 4) Financial innovation
1) The price level: Nominal money is the quantity of money
measured in rupees. The quantity of nominal money
demanded is proportional to the price level. If price increases
by 10%, people will hold 10% more of money to buy the same
bundle of goods. For example, if you spent ₹5 to buy a cup of
tea before year 2020, now you need to hold ₹10 more to buy
the same bundle.
The Interest Rate: The opportunity cost of holding money is
the interest rate a person could earn on assets they could
hold instead of money. Higher interest rate (higher
opportunity cost) causes lower money demand.

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Real GDP: Money holdings depend upon planned spending.
The quantity of money demanded in the economy as a whole
depends on Real GDP. Higher-income leads to higher
expenditure. People hold more money to finance the higher
volume of expenditure.
Financial Innovation: Changing technologies affect the
quantity of money held. These include: 1. Daily interest
checking deposits y Automatic transfers between checking
and savings deposits , 2. Automatic teller machines, 3.Credit
cards In general, the above innovation reduces the demand
for money.

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The Demand for Money Curve:
The demand for money is the relationship between the
quantity of real money demanded and the interest rate.

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The Determinants of Demand for Money
The Keynesian proposition that the money is held for
transactions and precautionary purposes does not conflict with
the classical theory : a transactions balance is nothing but
money spending/saving as the medium of exchange. Same can
be said for the precautionary balances also. However, the third
motive introduced by Keynes, viz., the speculative motive for
holding money, represents a distinct break from the classical
theory. The speculative demand for money also sometimes
called the 'asset demand for money'.
1) The transactions Motive
2) The Precautionary Motive
3) The Speculative Motive

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 The transactions motive:
 The time of receiving income and the time of incurring
expenditure by an individuals/firm generally do not coincide. In
order to meet the needs of transactions during this time gap some
money is kept aside, known as the transactions demand for
money.
 The smaller the time gap between a person's receipts and
payments, lesser will be the transactions, demand for money is
also low.
 Let us understand this with the help of an illustration. Two
individnals, A and B who had the same salary per month say
₹.4000. Individual A is paid ₹. 4,000 on first day of every
month, while B is paid ₹. 1,000 on first day of every week
(making an aggregate of ₹. 4,000, assuming exactly four weeks
in a month). Assuming that the each individual spends his
income each day in such equal amounts that at the end of the
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The pattern of transactions balance of the two individuals is
shown in following figure. The above assumption implies that
the average transactions balance during the income-period
would be equal to half of the income of that period. Individual
A would therefore, have a transactions balance of ₹. 4,000 X
1/2 = ₹. 2000, while transactions balance of individual B would
be ₹. 1,000 X 1/2 = ₹. 500.

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The Precautionary Motive:
The precautionary demand for money arises mainly due to
the uncertainty of future receipts and expenses. The cash
held by an individua/firm helps in meeting unexpected fall
in receipts or rise in expenditure or both in future.
A firm’s precautionary, demand for money is influenced not
only by the level of income of the firm but also by factors like
political situation and business conditions prevailing in the
economy.

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The Speculative Motive:
According to the speculative motive, money is demanded as an
asset to make speculation in bonds which are long-dated
government securities. The speculative demand for money comes
from the people who desire to make capital gains by buying
bonds/securities when their prices are low and selling them when
their prices rise. people holding speculative balances keep
anticipating about the behavior of bond prices in future. If they
expect bond/other securities prices to fall in future, they hold
speculative balances so as to be able to buy the bonds/other
securities when their prices actually fall and sell them when their
prices' actually go up.

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Supply of Money — Bank’s Credit Creation Multiplier
Supply of money in an economy at any point of time refers to the
volume of money held by the households and firms for
transactions and settlement of debts. In the generally accepted
measures of money supply we do not include the money held by
the government and money lying with the commercial banking
sector. This is done mainly to separate the producers of money
(i.e. government and banking system) from the demands of it
(i.e., the households, firms and institutions).
The supply of money at any point of time consists of: 1)
Currency, 2) Net demand deposits, 3) 'Other deposits' with
Reserve Bank of India
The conventional measure of money supply (known as M)
includes coins and currency notes in circulation with the public
and the net demand deposits. This measure is often referred to as
a narrow measure of money supply. 31
Agencies Influencing Money Supply:
The Central Bank and Money ,Supply
Commercial banks and money supply
Government and money supply

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Integrating Money and Commodity Markets
— IS, LM Model
 According to Prof. J. M. Keynes, national income is determined at the level
where aggregate demand (i.e., aggregate expenditure) for consumption and
investment goods (C + I) equals aggregate supply.
 Keynes in his simple analysis of equilibrium in the goods market/
Commodity market, he considers that investment is determined by the rate
of interest and marginal efficiency of capital and it is independent of the
level of national income.
 According to Prof. Keynes, rate of interest is determined in the money
market equilibrium by the demand for money and the supply of money.
 There is one flaw in this Keynesian model of money market equilibrium. In
this model whereas the changes in the rate of interest in the money market
affect investment and therefore the level of income and output in the goods
market, there is apparently no inverse influence of changes in goods market
(investment and income) on the money market equilibrium.
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 Hicks, Hansen, Lerner and Johnson have put forward a complete and
integrated model based on the Keynesian framework where
investment, national income, rate of interest, demand for and supply
of money are interrelated and mutually interdependent and can be
represented by the two curves called IS and LM curves.
 The IS- LM model (“investment-savings” and “liquidity
preference-money supply”) shows how the level of national income
and rate of interest are jointly determined by the simultaneous
equilibrium in the two interdependent goods and money markets.
 By Commodities Market, we mean all the buying and selling of goods
and services.
  By Money Market, we mean the interaction between demand
for money and the supply of money 

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Goods Market Equilibrium: The Derivation of the IS Curve

 The goods market is in equilibrium when aggregate demand is equal to income.

 The aggregate demand is determined by consumption demand and investment demand.
 In the Keynesian goods market equilibrium we also introduce the rate of interest as an
important determinant of investment.
 When the rate of interest falls the level of investment increases and vice versa.
 When the rate of interest falls, it lowers the cost of investment projects and thereby raises the
profitability of investment. The businessmen will therefore undertake greater investment at a
lower rate of interest.
 The increase in investment demand will bring about increase in aggregate demand which in
turn will raise the equilibrium level of income.

 The IS curve seeks to find out the equilibrium level of national income as determined by the
equilibrium in goods market by a level of investment determined by a given rate of interest.
 The IS curve shows different equilibrium levels of national income with various rates of
interest.
 The lower the rate of interest, higher will be the equilibrium level of income.
 The IS curve is the locus of those combinations of rate of interest and the level of national
income at which goods market is in equilibrium.
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Why does IS Curve Slope Downward?

 The decrease in the rate of interest bring about to increase in the planned investment which
increases the aggregate demand (upward shift of aggregate demand) therefore leads to the
increase in the equilibrium level of national income. This makes the IS curve to slope
downward.

The steepness of the IS curve depends on:

1. the elasticity of investment demand curve; and

2. the size of the multiplier.

Shift in the IS Curve:

 It is the autonomous expenditure which determines the position of the IS curve and changes
in the autonomous expenditure causes a shift in it.
 By autonomous expenditure we mean the expenditure (investment expenditure, government
expenditure, consumption expenditure) which does not depend on the level of income and the
rate of interest.

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Money Market Equilibrium: Derivation of LM Curve
 The LM curve can be derived from the Keynesian theory from its
analysis of money market equilibrium.
 According to Keynes, demand for money to hold depends on
transactions motive and speculative motive.
 Demand for money can be written as: Md = f(Y, r)
 The intersection of various money demand curves corresponding to
different income levels with the supply curve of money fixed by the
monetary authority would give us the LM curve.
 The LM curve relates the level of income with the rate of interest
which is determined by money- market equilibrium corresponding to
different levels of demand for money.
 The LM curve tells what the various rates of interest will be (given
the quantity of money and the family of demand curves for money) at
different levels of Dr
income.
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 LM curve slopes upward to the right. This is because with higher levels of income, demand
curve for money (Md) is higher and consequently the money market equilibrium (that is, the
equality of the given money supply with money demand curve occurs at a higher rate of
interest).
 This means that rate of interest varies directly with income.
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The Criticisms of the IS- LM Model:
1. It is based on the assumption that the rate of interest is quite flexible.
2. The model is based on the assumption that investment is interest-
elastic that is, investment varies with the rate of interest. If investment
is interest – inelastic, then the IS- LM model breaks down.
3. Don Patinkin and Milton Friedman have criticised by saying that the
division of the economy into two sectors- monetary and real is
artificial and unrealistic. These sectors are quite interwoven and act
and react on each other.
4. Further, Patinkin has pointed out that the IS- LM model has ignored
the possibility of changes in the price level of commodities.
According to him, the various economic variables such as supply of
money, propensity to consume or save, investment and the demand for
money not only influence the rate of interest and the level of national
income but also the prices of commodities and services. 42
Review Questions from Unit-V
1. Illustrate the concept of liquidity trap and when does speculative demand for money
curve become flat?
2. Examine and explain the impact of fluctuations in demand of steel on aviation industry.
3. Define Money. Explain the types and importance of Money.

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End of UNIT – V

Thank You

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