Lecture 9 - Money | Macroeconomics- Learning and Analysis PDF Download

 Page 1


Money 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
Lesson : Money 
Lesson Developer: Abhishek Singh 
College/Department: Shaheed Bhagat Singh College, 
University of Delhi 
  
Page 2


Money 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
Lesson : Money 
Lesson Developer: Abhishek Singh 
College/Department: Shaheed Bhagat Singh College, 
University of Delhi 
  
Money 
Institute of Lifelong Learning, University of Delhi 
Chapter: Money 
• 1 :Learning Outcome 
• 2 :Introduction 
• 3 :Money 
o 3.1 Monetary aggregates in the economy 
• 4 :Money Supply in an Economy 
o 4.1 Credit creation by commercial banks 
• 5 :Money Demand 
o 5.1 Transaction demand for money  
o 5.2 Speculative Demand for money 
o 5.3 Total demand for money 
• 6 :Equilibrium Interest Rate 
o 6.1 Effect of increase of output on interest rate 
• 7 :Monetary Policy 
• Quantitative controls 
• Qualitative controls 
• Summary 
• References 
• Glossary 
1.Learning Outcome 
? What constitute money would be clear and different functions of money 
? Different measures of money would be clear 
? What determines money supply in an economy will be clear to the reader 
? Why is money demanded and how does it depends upon Income and rate of interest 
? How is equilibrium interest rate determined in an economy 
? What is monetary policy and how does it functions. 
 
 
2Introduction 
The purpose of the chapter is to introduce the reader with the concept of money i.e. what 
constitutes money in an economy, its measure and why one demands money. Money holds 
important place in an economy, as it is the flow of money which determines the level of 
economic activity in an economy. Why money is demanded in the first hand and what 
determines the amount one wants to hold at a point of time, all this would be explored in 
the chapter. The chapter will impart an understanding as to what determines the interest 
rate in an economy and what is the role of the central bank in determining the interest rate 
in an economy. The concept of monetary policy would be explained and what are the 
different tools of monetary policy. After reading the chapter the reader will be in position to 
Page 3


Money 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
Lesson : Money 
Lesson Developer: Abhishek Singh 
College/Department: Shaheed Bhagat Singh College, 
University of Delhi 
  
Money 
Institute of Lifelong Learning, University of Delhi 
Chapter: Money 
• 1 :Learning Outcome 
• 2 :Introduction 
• 3 :Money 
o 3.1 Monetary aggregates in the economy 
• 4 :Money Supply in an Economy 
o 4.1 Credit creation by commercial banks 
• 5 :Money Demand 
o 5.1 Transaction demand for money  
o 5.2 Speculative Demand for money 
o 5.3 Total demand for money 
• 6 :Equilibrium Interest Rate 
o 6.1 Effect of increase of output on interest rate 
• 7 :Monetary Policy 
• Quantitative controls 
• Qualitative controls 
• Summary 
• References 
• Glossary 
1.Learning Outcome 
? What constitute money would be clear and different functions of money 
? Different measures of money would be clear 
? What determines money supply in an economy will be clear to the reader 
? Why is money demanded and how does it depends upon Income and rate of interest 
? How is equilibrium interest rate determined in an economy 
? What is monetary policy and how does it functions. 
 
 
2Introduction 
The purpose of the chapter is to introduce the reader with the concept of money i.e. what 
constitutes money in an economy, its measure and why one demands money. Money holds 
important place in an economy, as it is the flow of money which determines the level of 
economic activity in an economy. Why money is demanded in the first hand and what 
determines the amount one wants to hold at a point of time, all this would be explored in 
the chapter. The chapter will impart an understanding as to what determines the interest 
rate in an economy and what is the role of the central bank in determining the interest rate 
in an economy. The concept of monetary policy would be explained and what are the 
different tools of monetary policy. After reading the chapter the reader will be in position to 
Money 
Institute of Lifelong Learning, University of Delhi 
appreciate and understand various monetary policiespursued by the government in order to 
control inflation and unemployment in an economy. 
3. Money 
What is money? Money is anything which can be used as a medium of exchange in day to 
day transaction. Anything that can be used to settle transaction can be termed as money. In 
earlier period when monetary system was absent the transactions tool place on the basis of 
barter system.     
The basis of barter system was double coincidence of wants. Double coincidence of wants 
refers to a situation where transaction can take place if and only if both the party is willing 
to accept each other goods at the same time. For example if a goat seller wants to buy rice 
then he has to look for a rice seller who is willing to exchange rice for goat. Thus it requires 
double coincidence of wants. Many a times goods exchanged cannot be reduced into smaller 
units to facilitate exchange. For example the hair cutter cannot half cut the hair in exchange 
for other goods. All the above problems are resolved with the coming of money as a 
medium of exchange. 
A store of value: Money should also serve as a store of value to transform purchasing 
power from present period to future period. Generally expenditures and incomes are not 
synchronized and there is mismatch of timing between the occurrence of income and their 
expenditure. Thus money should also provide for store of value. 
A unit of account: Money should also serve the purpose of unit of account. Thus the value 
of all goods and services can be in terms of money. In barter system every goods price is in 
terms of all other goods. Thus the number of prices that are there increases if the number 
of goods is large. The total number of prices that exist in a barter system is
      
 
, where n is 
the number of goods available in the economy. With money as unit of account the number 
of price in the economy lands down to n prices. Thus money reduces the number of prices 
that exists in an economy many a times. 
Thus anything that can serve as a medium of exchange can be used as a measure of 
money. The fallowing section deals with all those things that can be used as medium of 
exchange and therefore forms part of money supply in an economy. 
3.1 Monetary aggregates in the economy 
In India RBI has given the fallowing measures of money supply. There are four different 
measures of money in India. 
MI = Currency with the public + Demand deposits of Commercial Banks+ Other deposits of 
RBI 
M2 =M1 + saving deposits of post offices 
M3 = M2 + Time deposits of commercial banks 
M4 =M3 + all kinds of deposits of post offices. 
Page 4


Money 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
Lesson : Money 
Lesson Developer: Abhishek Singh 
College/Department: Shaheed Bhagat Singh College, 
University of Delhi 
  
Money 
Institute of Lifelong Learning, University of Delhi 
Chapter: Money 
• 1 :Learning Outcome 
• 2 :Introduction 
• 3 :Money 
o 3.1 Monetary aggregates in the economy 
• 4 :Money Supply in an Economy 
o 4.1 Credit creation by commercial banks 
• 5 :Money Demand 
o 5.1 Transaction demand for money  
o 5.2 Speculative Demand for money 
o 5.3 Total demand for money 
• 6 :Equilibrium Interest Rate 
o 6.1 Effect of increase of output on interest rate 
• 7 :Monetary Policy 
• Quantitative controls 
• Qualitative controls 
• Summary 
• References 
• Glossary 
1.Learning Outcome 
? What constitute money would be clear and different functions of money 
? Different measures of money would be clear 
? What determines money supply in an economy will be clear to the reader 
? Why is money demanded and how does it depends upon Income and rate of interest 
? How is equilibrium interest rate determined in an economy 
? What is monetary policy and how does it functions. 
 
 
2Introduction 
The purpose of the chapter is to introduce the reader with the concept of money i.e. what 
constitutes money in an economy, its measure and why one demands money. Money holds 
important place in an economy, as it is the flow of money which determines the level of 
economic activity in an economy. Why money is demanded in the first hand and what 
determines the amount one wants to hold at a point of time, all this would be explored in 
the chapter. The chapter will impart an understanding as to what determines the interest 
rate in an economy and what is the role of the central bank in determining the interest rate 
in an economy. The concept of monetary policy would be explained and what are the 
different tools of monetary policy. After reading the chapter the reader will be in position to 
Money 
Institute of Lifelong Learning, University of Delhi 
appreciate and understand various monetary policiespursued by the government in order to 
control inflation and unemployment in an economy. 
3. Money 
What is money? Money is anything which can be used as a medium of exchange in day to 
day transaction. Anything that can be used to settle transaction can be termed as money. In 
earlier period when monetary system was absent the transactions tool place on the basis of 
barter system.     
The basis of barter system was double coincidence of wants. Double coincidence of wants 
refers to a situation where transaction can take place if and only if both the party is willing 
to accept each other goods at the same time. For example if a goat seller wants to buy rice 
then he has to look for a rice seller who is willing to exchange rice for goat. Thus it requires 
double coincidence of wants. Many a times goods exchanged cannot be reduced into smaller 
units to facilitate exchange. For example the hair cutter cannot half cut the hair in exchange 
for other goods. All the above problems are resolved with the coming of money as a 
medium of exchange. 
A store of value: Money should also serve as a store of value to transform purchasing 
power from present period to future period. Generally expenditures and incomes are not 
synchronized and there is mismatch of timing between the occurrence of income and their 
expenditure. Thus money should also provide for store of value. 
A unit of account: Money should also serve the purpose of unit of account. Thus the value 
of all goods and services can be in terms of money. In barter system every goods price is in 
terms of all other goods. Thus the number of prices that are there increases if the number 
of goods is large. The total number of prices that exist in a barter system is
      
 
, where n is 
the number of goods available in the economy. With money as unit of account the number 
of price in the economy lands down to n prices. Thus money reduces the number of prices 
that exists in an economy many a times. 
Thus anything that can serve as a medium of exchange can be used as a measure of 
money. The fallowing section deals with all those things that can be used as medium of 
exchange and therefore forms part of money supply in an economy. 
3.1 Monetary aggregates in the economy 
In India RBI has given the fallowing measures of money supply. There are four different 
measures of money in India. 
MI = Currency with the public + Demand deposits of Commercial Banks+ Other deposits of 
RBI 
M2 =M1 + saving deposits of post offices 
M3 = M2 + Time deposits of commercial banks 
M4 =M3 + all kinds of deposits of post offices. 
Money 
Institute of Lifelong Learning, University of Delhi 
Demand deposits of commercial banks are those deposits which can be withdrawn on 
demand. Demand deposits consist of saving deposits and current deposits of commercial 
banks. Against demand deposits commercial banks issue check which can be used for 
exchange. Thus along with currency, demand deposits of commercial banks are also used 
for exchange.  
Realizing the importance of savings for an economy and given the large proportion of 
population dependent on agriculture, it was realized that savings of the rural population 
would be important to mobilize. To mobilize domestic rural savings it was realized that 
banks can play an important role. However the cost of setting up commercial banks in 
sparsely distributed population in rural areas made it very costly to set up commercial 
banks branch in rural areas. The task of mobilizing small savings of rural population was 
assigned to post offices. Post offices playan important role in mobilizing small savings of 
rural households. In rural areas where branches of commercial banks are missing, post 
offices also play the role of banks where the rural population can save their small savings. 
This is the reason why post offices deposits are also included in a money supply of the 
economy. However after independence several branches of commercial banks opened in 
ruralareas. As a result the importance of post offices in mobilizing savings has declined in 
recent past. Therefore now M2 and M4 have become obsolete for measuring money supply. 
M1 and M3 are now used for measuring money supply in an economy where M1 is a narrow 
measure of money whereas M3 is a broad measure of money.  
The above paragraph develops the concept of money and how to measure it in an economy. 
The fallowing section deals with the determinants of money supply. 
4. Money Supply in an Economy 
It is generally believed that total money supply in an economy is the total currency issued 
by the central bank. However this is not true. The total money supply in an economy is 
much larger than the total currency issued by the central bank. This statement would be 
true if currency is the only medium of exchange. However commercial banks demand 
deposits also acts as a medium of exchange and therefore constitutes money.Thus while 
measuring money supply in an economy one needs to takes into account the demand 
deposits of commercial banks along with currency in circulation in the economy. Thus the 
supply of money is greater than the currency issued by the central bank as commercial 
banks create money by creating demand deposits through the process of credit creation. 
The process through which the commercial banks create money is known as credit creation 
process. Before going into the explanation of credit creation, let’sunderstand how it works. 
 In older times when there were no modern banks. The medium of transaction was gold. 
People find it risky as well as inconvenient to carry huge amount of gold to make 
transactions. In order to overcome this problem, people began storing their gold with 
goldsmiths for safe keeping. On receiving the gold the goldsmith use to issue receipts 
against gold deposits to the depositors. The goldsmith use to charge a small fee for safe 
keeping the gold. After a time the receipts issued by the goldsmith, against gold, 
themselves started to be traded for goods in exchange. The receipts became a form of 
paper money. It saved the population from carrying gold in physical form. This practice of 
Page 5


Money 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
Lesson : Money 
Lesson Developer: Abhishek Singh 
College/Department: Shaheed Bhagat Singh College, 
University of Delhi 
  
Money 
Institute of Lifelong Learning, University of Delhi 
Chapter: Money 
• 1 :Learning Outcome 
• 2 :Introduction 
• 3 :Money 
o 3.1 Monetary aggregates in the economy 
• 4 :Money Supply in an Economy 
o 4.1 Credit creation by commercial banks 
• 5 :Money Demand 
o 5.1 Transaction demand for money  
o 5.2 Speculative Demand for money 
o 5.3 Total demand for money 
• 6 :Equilibrium Interest Rate 
o 6.1 Effect of increase of output on interest rate 
• 7 :Monetary Policy 
• Quantitative controls 
• Qualitative controls 
• Summary 
• References 
• Glossary 
1.Learning Outcome 
? What constitute money would be clear and different functions of money 
? Different measures of money would be clear 
? What determines money supply in an economy will be clear to the reader 
? Why is money demanded and how does it depends upon Income and rate of interest 
? How is equilibrium interest rate determined in an economy 
? What is monetary policy and how does it functions. 
 
 
2Introduction 
The purpose of the chapter is to introduce the reader with the concept of money i.e. what 
constitutes money in an economy, its measure and why one demands money. Money holds 
important place in an economy, as it is the flow of money which determines the level of 
economic activity in an economy. Why money is demanded in the first hand and what 
determines the amount one wants to hold at a point of time, all this would be explored in 
the chapter. The chapter will impart an understanding as to what determines the interest 
rate in an economy and what is the role of the central bank in determining the interest rate 
in an economy. The concept of monetary policy would be explained and what are the 
different tools of monetary policy. After reading the chapter the reader will be in position to 
Money 
Institute of Lifelong Learning, University of Delhi 
appreciate and understand various monetary policiespursued by the government in order to 
control inflation and unemployment in an economy. 
3. Money 
What is money? Money is anything which can be used as a medium of exchange in day to 
day transaction. Anything that can be used to settle transaction can be termed as money. In 
earlier period when monetary system was absent the transactions tool place on the basis of 
barter system.     
The basis of barter system was double coincidence of wants. Double coincidence of wants 
refers to a situation where transaction can take place if and only if both the party is willing 
to accept each other goods at the same time. For example if a goat seller wants to buy rice 
then he has to look for a rice seller who is willing to exchange rice for goat. Thus it requires 
double coincidence of wants. Many a times goods exchanged cannot be reduced into smaller 
units to facilitate exchange. For example the hair cutter cannot half cut the hair in exchange 
for other goods. All the above problems are resolved with the coming of money as a 
medium of exchange. 
A store of value: Money should also serve as a store of value to transform purchasing 
power from present period to future period. Generally expenditures and incomes are not 
synchronized and there is mismatch of timing between the occurrence of income and their 
expenditure. Thus money should also provide for store of value. 
A unit of account: Money should also serve the purpose of unit of account. Thus the value 
of all goods and services can be in terms of money. In barter system every goods price is in 
terms of all other goods. Thus the number of prices that are there increases if the number 
of goods is large. The total number of prices that exist in a barter system is
      
 
, where n is 
the number of goods available in the economy. With money as unit of account the number 
of price in the economy lands down to n prices. Thus money reduces the number of prices 
that exists in an economy many a times. 
Thus anything that can serve as a medium of exchange can be used as a measure of 
money. The fallowing section deals with all those things that can be used as medium of 
exchange and therefore forms part of money supply in an economy. 
3.1 Monetary aggregates in the economy 
In India RBI has given the fallowing measures of money supply. There are four different 
measures of money in India. 
MI = Currency with the public + Demand deposits of Commercial Banks+ Other deposits of 
RBI 
M2 =M1 + saving deposits of post offices 
M3 = M2 + Time deposits of commercial banks 
M4 =M3 + all kinds of deposits of post offices. 
Money 
Institute of Lifelong Learning, University of Delhi 
Demand deposits of commercial banks are those deposits which can be withdrawn on 
demand. Demand deposits consist of saving deposits and current deposits of commercial 
banks. Against demand deposits commercial banks issue check which can be used for 
exchange. Thus along with currency, demand deposits of commercial banks are also used 
for exchange.  
Realizing the importance of savings for an economy and given the large proportion of 
population dependent on agriculture, it was realized that savings of the rural population 
would be important to mobilize. To mobilize domestic rural savings it was realized that 
banks can play an important role. However the cost of setting up commercial banks in 
sparsely distributed population in rural areas made it very costly to set up commercial 
banks branch in rural areas. The task of mobilizing small savings of rural population was 
assigned to post offices. Post offices playan important role in mobilizing small savings of 
rural households. In rural areas where branches of commercial banks are missing, post 
offices also play the role of banks where the rural population can save their small savings. 
This is the reason why post offices deposits are also included in a money supply of the 
economy. However after independence several branches of commercial banks opened in 
ruralareas. As a result the importance of post offices in mobilizing savings has declined in 
recent past. Therefore now M2 and M4 have become obsolete for measuring money supply. 
M1 and M3 are now used for measuring money supply in an economy where M1 is a narrow 
measure of money whereas M3 is a broad measure of money.  
The above paragraph develops the concept of money and how to measure it in an economy. 
The fallowing section deals with the determinants of money supply. 
4. Money Supply in an Economy 
It is generally believed that total money supply in an economy is the total currency issued 
by the central bank. However this is not true. The total money supply in an economy is 
much larger than the total currency issued by the central bank. This statement would be 
true if currency is the only medium of exchange. However commercial banks demand 
deposits also acts as a medium of exchange and therefore constitutes money.Thus while 
measuring money supply in an economy one needs to takes into account the demand 
deposits of commercial banks along with currency in circulation in the economy. Thus the 
supply of money is greater than the currency issued by the central bank as commercial 
banks create money by creating demand deposits through the process of credit creation. 
The process through which the commercial banks create money is known as credit creation 
process. Before going into the explanation of credit creation, let’sunderstand how it works. 
 In older times when there were no modern banks. The medium of transaction was gold. 
People find it risky as well as inconvenient to carry huge amount of gold to make 
transactions. In order to overcome this problem, people began storing their gold with 
goldsmiths for safe keeping. On receiving the gold the goldsmith use to issue receipts 
against gold deposits to the depositors. The goldsmith use to charge a small fee for safe 
keeping the gold. After a time the receipts issued by the goldsmith, against gold, 
themselves started to be traded for goods in exchange. The receipts became a form of 
paper money. It saved the population from carrying gold in physical form. This practice of 
Money 
Institute of Lifelong Learning, University of Delhi 
transaction taking place on the basis of gold receipts instead of gold itself was an efficient 
way of carrying transaction. It saved the population from carrying huge quantities of gold. 
 Initially the receipts issued by the goldsmith were backed by 100 percent gold. In other 
words if the goldsmith use to have deposits of 100grams of gold, it issued receipts worth 
100grams of gold only. In other words the entire receipts were backed by gold. In due 
course of time the goldsmith realized that people did not often come to withdraw gold. This 
was because the receipts were as good as the gold itself. As a result the goldsmith had a 
large stock of gold continuously on hand. 
The goldsmith realized that since people are not withdrawing their gold deposits, it always 
had excess of gold reserves in his vault. The goldsmith realized that it can easily lend some 
of this gold without any fear of running out of gold. The goldsmith started issuing receipts in 
excess of gold deposits it has in its vault. The receipts which were issued without any gold 
deposits were charged with some rate of interest by the goldsmith. Thus the goldsmith 
started lending money in terms of gold receipts in excess of gold deposits. This is how the 
goldsmith created money. The gold receipts issued by the goldsmiths were as good as gold 
itself and they were readily accepted in day to day transaction. The gold receipts issued by 
goldsmith were in excess of gold deposits which implies that total money in circulation in 
the economy was greater than total gold available in the economy. This is how credit 
creation takes place. 
4.1 Credit creation by commercial banks 
The narrow definition of money (M1)is the sum of total currency held by the public and 
demand deposits of the commercial banks. Other deposits of the Central Bank are so small 
as compared to other components that it can be neglected or assumed to be close to zero. 
The total currency issued by the central bank is either held by the public in terms of cash or 
held by banks in terms of Reserves. 
  H = C +R           
H = High powered money or the total currency in the economy issued by the Central Bank. 
           C = Currency 
held by the population or households in the economy   R = cash with the 
commercial banks in the form of cash reserve ratio. 
 The banks operations includes accepting deposits and then lending the same deposits at a 
rate higher then deposit rate to provide them with working expense as well as profit. Given 
this situation the most profitable situation for a bank is when they lend the maximum 
amount possible. To maximize their profit the banks can over-lend, a situation where they 
find it difficult to meet the withdrawal demands of the depositors. To avoid such a situation 
and to provide a safety net to the depositors the central bank of a country demands every 
bank to keep some cash to meet the withdrawal requirements of the depositors. This 
minimum cash requirement is known as cash reserve ratio of the banks. Cash reserve ratio 
is defined as the percentage of demand deposits which the commercial banks have to 
maintain in terms of cash with the central bank. After meeting the cash reserve ratio, the 
cash remaining with the banking sector is known excess reserves. The commercial banks