Nta UGC-NET dec-2018 Online batch ,Lecture-21

Macro eco Topic- 6 Concept of money,qtm & Keynesian theory of money UGC-NET PAPER-2 (ECO) CONCEPT OF MONEY Intro-

The supply of money means the total stock of money (paper notes, coins and demand deposits of bank) in circulation which is held by the public at any particular point of time.

Briefly is the stock of money in circulation on a specific day.

Thus two components of money supply are

(i) currency (Paper notes and coins) (ii) Demand deposits of commercial banks.

In other words, money held by its users (and not supplier) in spendable form at a point of time is termed as money supply. The stock of money held by government and the banking system are not included because they are suppliers or producers of money and cash balances held by them are not in actual circulation.

In short, money supply includes currency held by public and net demand deposits in banks. Sources of Money Supply:

(i) Government (which Issues one-rupee notes and all other coins)

(ii) RBI (which issues paper currency)

(iii) commercial banks (which create credit on the basis of demand deposits). Money Multiplier. money multiplieris the amount of money that banks generate with each currency of reserves.

Reserves is the amount of deposits that the banks requires to hold and not lend.

Formula 1 Money Multiplier(m) = Required Reserve Ratio

Mathematical relationship between the monetary base and money supply of an economy.

It explains the increase in the amount of cash in circulation generated by the banks' ability to lend money out of their depositors' funds. banks are required to keep at hand only a portion (between 10 to 15 percent, typically 12 percent) of the depositors' funds.

This money-creating power is based on the fractional reserve system under which The rest may be converted into loans, 1. High Powered Money:

High powered money or powerful money refers to that currency that has been issued by the Government and Reserve Bank of India.

Some portion of this currency is kept along with the public while rest is kept as funds in Reserve Bank.

H = C + R

Where H = High Powered Money C = Currency with the public (Paper money + coins) R = Government and bank deposits with RBI

Thus the sum total of money deposited with the public and the funds of banks is termed as powerful money.

It is mainly created by the central bank. Reserve Fund is of two types:

(i) Statutory Reserve Funds of banks which is with the central bank (RR), and

(ii) Extra/excess Reserve Fund(ER).

H = C + RR + ER

High powered money is also known as secured money. high powered money is termed as Base money. Components of High Powered Money:

1. Currency with the public

2. Other Deposits with RBI

3. Cash with Banks

4. Banker’s Deposits with RBI.

High powered Money (H) includes currency with Public (C), important reserves of Commercial banks and other reserve (ER). Thus we get the equation:

H = C + RR + ER

Supply of money (M) includes bank deposits (D) and currency with public (C).

Thus, M = C + D

Dividing both the equations, we get: Now, dividing the numerator and the denominator by D we get:

m=

By substituting Cr for C/D, RRr for RR/D, and ERr for ER/D, new equation become.

1+Cr It is also called money multiplier 1.Money multiplier- 1+Cr m=

2.Suply of money-

1+Cr M= mH= *H

3.High power money- M H= m measures of Money Supply

In India Reserve Bank of India uses four alternative measures of money supply called M0. M1, M2, M3 and M4.

Reserve Money (M0)

The other name of the Reserve Money is “High Powered Money” and also “Monetary Base”.

Reserve Money is all the Cash in the economy and denoted by

M0.

This has the following components: Currency with the Public Other Deposits with the RBI Cash Reserves of the banks held with themselves measures of Money Supply

In India Reserve Bank of India uses four alternative measures of money supply called M1, M2, M3 and M4.

(i) M1 = C + DD + OD. Here C denotes currency (paper notes and coins) held by public,

DD stands for demand deposits in banks

OD stands for other deposits in RBI.

(ii) M2 = M1 (detailed above) + saving deposits with Post Office Saving Banks (ii) M3= M1 + Net Time deposits of Banks

(iii) M4 = M3 + Total deposits with Post Office Saving Organisation (excluding NSC)

Savings deposits of post offices are not a part of money supply because they do not serve as due to lack of cheque facility.

Similarly, fixed deposits in commercial banks are not counted as money.

Therefore, M1 treated as measures of narrow money . Whereas M3 as measures of broad money.

Narrow money (M1)is the most liquid part of the money supply

M4 is the Least liquid part of the money supply

Sequence in terms of liquidity- M1>M2>M3>M4

It may be noted that liquidity means ability to convert an asset into money quickly and without loss of value.

M3 as the official measure of money supply M1 = C + DD + OD M2 = M1 + POSD M3 = M1 + TD M4 = M3 + POSD

RBI mostly relies on M3 measure for determine money supply

QTM- QTM- Fisher’s Cambridge approach. approach.

Cash transaction approach Cash balance approach Intro- the theory was first stated in 1566 by Jean Bodin, it received its full-fledged popularity at the hands of in 1911.

Later, an alternative approach was given by a group of Cambridge economists.

However, the basic conclusion of these two theories is same varies directly with and proportionally to money supply. 1. Quantity Theory of Money— Fisher’s Version:

In its simplest form, it states that the general price level (P) in an economy is directly dependent on the money supply (M); P = f(M)

If M doubles, P will double. If M is reduced to half, P will decline by the same amount. This is the essence of the quantity theory of money. Like the price of a commodity, value of money is determinded by the supply of money and demand for money.

In his theory of demand for money, Fisher attached emphasis on the use of money as a medium of exchange.

In other words, money is demanded for transaction purposes. Demand for money is function of income.

Rate of interest have not effect on demand for money.

Fisher emphasized supply of money demand for money is constant. Fisher has explained his theory in terms of his :

PT=MV+ M’ V’

Where P = price level, or 1/P = the value of money;

M = the total quantity of legal tender money;

V = the velocity of circulation of M;

M’ – the total quantity of credit money;

V’ = the velocity of circulation of credit money.

T = the total amount of goods and services exchanged for money or transactions performed by money. This equation equates the demand for money (PT) to supply of money (MV=M’V’).

The total volume of transactions multiplied by the price level (PT) represents the demand for money.

The truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V’ and T remain constant,

P is also doubled, but the value of money (1/P) is reduced to half. Panel A shows the effect of changes in the quantity of money on the price level.

To begin with, when the quantity of money is M, the price level is P.

When the quantity of money is doubled

to M2, the price level is also doubled to P2.

Further, when the quantity of money is

increased four-fold to M4, the price level also increases by four times to P4.

This relationship is expressed by the curve P = f (M) from the origin at 45°. In panel В, the inverse relation between the quantity of money and the value of money is depicted

When the quantity of money is M1 the value of money is 1/P.

But with the doubling of the quantity of

money to M2,

the value of money becomes one-half of

what it was before, 1/P2.

And with the quantity of money

increasing by four-fold to M4, the value of money is reduced by 1/P4.

This inverse relationship between the quantity of money and the value of money is shown by downward sloping curve 1/P = f (M). Assumptions of the Theory: 1. P is passive factor in the equation of exchange which is affected by the other factors.

2. V and V’ are assumed to be constant and are independent of changes in M and M’.

3. T also remains constant and is independent of other factors such as M, M, V and V. 4. It is assumed that the demand for money is proportional to the value of transactions. 5. The supply of money is assumed as an exogenously determined constant. 6. The theory is applicable in the long run.

7. M and M’ are independent as well as constant. The Cambridge Version of the Quantity Theory

Cash balance approach

The Cambridge economists—like Alfred Marshall and A. C. Pigou,Robertson, and Keynes—presented an alternative to Fisher’s version of Quantity Theory.

They have attempted to establish that the Quantity Theory of Money is a theory of demand for money (or ).

Prof. Fisher has considered money only as a medium of exchange while analysing the ‘Quantity Theory of Money.

But the Cambridge economists do not agree with this view point. everybody wants to keep a part of his present income in the form of cash or liquid so that if there is a sudden need it can be fulfilled. Marshall’s Equations:

Prof. Marshall has given his equation in the following way:

Marshall used income as a variable factor.

P= M/KY OR M = KPY

Where,

M = Supply of Money P = Price Level

Y = Total Real Income

K = the part of real income which people want to keep with them in the form of cash. Robertson’s Equation:

Robertson use transaction as a variable factor for his study Robertson has given his equation in the following way:

P = M/KT Or M = PKT

M- suply of money P and T have been taken same as those in Fisher’s equation and K has been taken from Marshall’s equations.

Where,

M = Supply of Money P = Price Level

T = total volume of goods and services purchased(transaction)

K = fraction of T. Pigou’s Equation:

Prof. Pigou’s used resources as a variable factor.

Prof. Pigou’s equation is as follows:

P = KR/M

Where, P = Common Price level M = Total amount of money R = Total real resources in terms of wheat. K = proportion of real recourses. Keynes’ Equation:

Keynes used currency circulation for for determining prices.

P = n/K

OR

N= PK

K- Number of consumption unit forms of cash. n- total currency circulation. P- price level. Similarities between Fisher and Cambridge Equation:

(1) Prof. Fisher’s equation is related to a period of time while Cambridge equation associates with point of time.

(2) The conclusion of Fisher and Cambridge ideologies is the same. Both show a direct and proportional relationship between the price level and the amount of money.

(3) The amount of money has been considered an important element of price determination in both the ideologies.

(4) P represents the price level in both the equations. Difference between Fisher and Cambridge Equations: Friedman’s Theory of the Demand for Money

The foremost exponent of the Chicago version of the quantity theory of money who led to the so called “Monetarist Revolution” is Professor Friedman.

He, in his essay “The Quantity Theory of Money—A Restatement” published in 1956′, set down a particular model of quantity theory of money.

In his reformulation of the quantity theory, Friedman asserts that “the quantity theory is in the first instance a theory of the demand for money.

It is not a theory of output, or of money income, or of the price level.” He regards the amount of real cash balances (M/P) as a commodity which is demanded because it yields services to the person who holds it.

Thus money is an asset or capital good.

Hence the demand for money forms part of capital or wealth theory.

In Friedman’s restatement of the quantity theory of money, the supply of money is independent of the demand for money.

The supply of money is unstable due to the actions of monetary authorities.

On the other hand, the demand for money is stable.

It means that money which people want to hold in cash or bank deposits is related in a fixed way to their permanent income Friedman presents the quantity theory as the theory of the demand for money and the demand for money is assumed to depend on asset prices or relative returns and wealth or income.

He shows how a theory of the stable demand for money becomes a theory of prices and output. MD is the demand for money curve which varies with income.

MS is the money supply curve which is perfectly inelastic to changes in income.

The two curves intersect at E and determine the equilibrium income OY.

If the money supply rises, the MS curve

shifts to the right to M1S1.

As a result, the money supply is greater than the demand for money which raises total expenditure until new equilibrium is established at E1between MD and M1S1, curves.

The income rises to OY1. the long run demand for money function is stable and is relatively interest inelastic,

where MD is the demand for money curve.

If there is change in the interest rate, the long-run demand for money is negligible. MCQ’S Q1. Money supply M1 include.

A. C+DD. B. C+DD+TD C. C+DD+OD D. C+DD+TD+OD

Q2.High power money is sum of bank reserves and

A. Demand deposit. B. Term deposit. C. Currency with public. D. None.

Q3. money multiplier is the ratio bw

A. Change in money supply and change in high powered money. B. Change in money supply and change in money demand. C. Currency with public and money supply. D. None. Q4. demand for money is a/an

A. Direct demand . B. Derived demand . C. Indirect demand. D. All of the above.

Q5. quantity of money and value of money has

A. Direct relation. B. Indirect relation. C. Not related. D. None.

6. Income approach of QTM given by

A. Irving Fisher. B. Robertson. C. Pigou. D. Marshall. Q7. P= M/KT is the equation given by

A. Irving Fisher. B. Robertson. C. Pigou. D. Marshall.

Q8. P= KR/M equation given by

A. Irving Fisher. B. Robertson. C. Pigou. D. Marshall. ANS KEYS

1 C 2 C 3 A 4 B 5 B 6 D 7 B 8 C Nta UGC-NET dec-2018 Online batch ,Lecture-22 Macro eco Topic- 7 Keynesian theory of money & Liquidity prefence. Boumal and tobin theory. UGC-NET PAPER-2 (ECO)