Money in a Modern

Economy

By- SANSKRITI KESARWANI

B.COM HONOURS SEM- 2B
Roll No. – 22/COM)120
Introduction

Money is essential to the workings of a modern economy, but

its nature has varied substantially over time. Money today is
a type of IOU, but one that is special because everyone in
the economy trusts that it will be accepted by other people
in exchange for goods and services. There are three main
types of money: currency, bank deposits and central bank
reserves. Each represents an IOU from one sector of the
economy to another. Most money in the modern economy is
in the form of bank deposits, which are created by
commercial banks themselves
 Monetary Aggregate
Monetary aggregates are the measures of money supply in an economy. They capture
the total stock of all types of money such as currency and demand deposits held with
the public as well as with the banks.
The Reserve Bank of India (RBI) categorizes money into four broad categories (also
known as the monetary aggregates) through which it computes and measures the total
supply of money in the market. They are M0, M1, M2, and M4.
Monetary Aggregates
Reserve Money: It is also known as the monetary base or high powered money. It
includes all physical money like coins and currency along with demand deposits and
other liquid assets held by the central bank. It is the total liability of the RBI.
 M0 = Currency in Circulation + Bankers’ Deposits with RBI + Other Deposits with RBI
 Narrow Money (M1): It is known as narrow money as it contains only liquid financial
assets, which are easily accessible on demand. It 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
and other deposits of the banks kept with the RBI.
 M1= Demand deposits with the banking system + Other deposits with the RBI
Note: The Narrow money has another component known as M2 money which
includes M1 component and savings deposits of post office savings account.
Though the size of the post office saving accounts is negligible. The term M2 is
used as all the deposits in M2 are not liquid.
M2 = M1 + Savings Deposits of Post Office Savings account
Broad Money (M3): When we add time deposits into the narrow money, we get
broad money which can be denoted by M3. Broad money does not include the
interbank deposits. However, time deposits of the public with the banks
including the cooperative banks are included in Broad money.
M3= Narrow Money (M1) + Time deposits of public with the banks
Note: When we add total savings deposits with post offices with the Broad money
(M3) we get M4 Money. It excludes national saving certificates.
 M4 = Broad Money(M3) + Total Saving deposits with Post offices (excluding
National Savings Certificates)
 Demand for money
The demand for money explains the desire of people for a definite amount of
money. Money is needed to manage transactions, and the value of transactions
decides the money people want to keep.
The larger the quantum of transactions, the bigger is the amount of money
demanded. Since the quantum of transactions relies upon earning, it should be
lucid that a rise in income leads to a rise in the demand for money.
When people stockpile their savings in the form of money rather than keeping it
in a bank that fetches them interest, the money people stockpile also relies upon
the rate of interest.
 Particularly, when interest rates rise, people become less focused on
stockpiling money since holding money leads to holding less of interest-
earning deposits. Thus, they receive less interest. Hence, the money
demanded decreases at high interest rates.
Quantity theory of money

The quantity theory of money is a theory that variations in price relate to variations in the money supply. It is most
commonly expressed and taught using the equation of exchange and is a key foundation of the economic theory of
monetarism.
The most common version, sometimes called the “neo-quantity theory” or Fisherian theory, suggests there is a mechanical
and fixed proportional relationship between changes in the money supply and the general price level. This popular, albeit
controversial, formulation of the quantity theory of money is based upon an equation by American economist Irving Fisher.
The Fisher equation is calculated as:
M×V=P×T
where:
M=money supply
V=velocity of money
P=average price level
T=volume of transactions in the economy
 Generally speaking, the quantity theory of money explains how increases in the quantity of money tends to create
inflation, and vice versa. In the original theory, V was assumed to be constant and T is assumed to be stable with
respect to M, so that a change in M directly impacts P. In other words, if the money supply increases then the average
price level will tend to rise in proportion (and vice versa), with little effect on real economic activity.
Liquidity Preference and Rate of
Interest
 Liquidity Preference Theory is a model that suggests that an investor should
demand a higher interest rate or premium on securities with long-term
maturities that carry greater risk because, all other factors being equal,
investors prefer cash or other highly liquid holdings.
 Money Supply and Credit Creation
Demand deposits are an important constituent of money supply and the expansion of demand
deposits means the expansion of money supply. The entire structure of banking is based on credit.
Credit basically means getting the purchasing power now and promising to pay at some time in the
future. Bank credit means bank loans and advances.
 A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its
depositors and lends out the remaining to earn income. The loan is credited to the account of the
borrower. Every bank loan creates an equivalent deposit in the bank. Therefore, credit creation
means expansion of bank deposits.
 The two most important aspects of credit creation are:


 Liquidity – The bank must pay cash to its depositors when they exercise their right to demand cash
against their deposits.
 Profitability – Banks are profit-driven enterprises. Therefore, a bank must grant loans in a manner
which earns higher interest than what it pays on its deposits.
 The bank’s credit creation process is based on the assumption that during any time interval, only
a fraction of its customers genuinely need cash. Also, the bank assumes that all its customers
would not turn up demanding cash against their deposits at one point in time.
Banks must hold in cash reserves for meeting the depositors’ demand for cash.
Excess Reserves – The reserves over and above the cash reserves are the excess
reserves. These reserves are used for loans and credit creation.
 Credit Multiplier – Given a certain amount of cash, a bank can create multiple
times credit. In the process of multiple credit creation, the total amount of
derivative deposits that a bank creates is a multiple of the initial cash
reserves.
 Credit creation by a single bank
 There are two ways of analyzing the credit creation process:
 Credit creation by a single bank
 Credit creation by the banking system as a whole
Monetary Policy

Monetary policy is the control of the quantity of money available in an economy

and the channels by which new money is supplied. Economic statistics such as
gross domestic product (GDP), the rate of inflation, and industry and sector-
specific growth rates influence monetary policy strategy.
A central bank may revise the interest rates it charges to loan money to the
nation’s banks. As rates rise or fall, financial institutions adjust rates for their
customers such as businesses or home buyers.
 Additionally, it may buy or sell government bonds, target foreign exchange
rates, and revise the amount of cash that the banks are required to maintain
as reserves.
Types of Monetary Policy
Monetary policies are seen as either expansionary or contractionary depending on the level of growth or
stagnation within the economy.
Contractionary
A contractionary policy increases interest rates and limits the outstanding money supply to slow growth
and decrease inflation, where the prices of goods and services in an economy rise and reduce the
purchasing power of money.
Expansionary
During times of slowdown or a recession, an expansionary policy grows economic activity. By lowering
interest rates, saving becomes less attractive, and consumer spending and borrowing increase.
Tools of Monetary Policy
Open Market Operations
 In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells
additional bonds to investors to change the number of outstanding government securities and money
available to the economy as a whole.
The objective of OMOs is to adjust the level of reserve balances to manipulate
the short-term interest rates and that affect other interest rates.
Interest Rates
The central bank may change the interest rates or the required collateral that it
demands. In the U.S., this rate is known as the discount rate. Banks will loan
more or less freely depending on this interest rate
Reserve Requirements
 Authorities can manipulate the reserve requirements, the funds that banks
must retain as a proportion of the deposits made by their customers to ensure
that they can meet their liabilities.
Conclusion

In conclusion, money is a fundamental aspect of modern economies, serving as a

medium of exchange, a store of value, and a unit of account. The evolution of
money has been shaped by technological advancements, changing economic
structures, and shifting societal needs. Today, digital currencies and innovations
such as blockchain technology are transforming the way we think about money
and its role in our lives. As we navigate this rapidly changing landscape, it is
important to continue studying and understanding the complexities of money and
its impact on the economy and society as a whole.