CHAPTER 1: MONEYMONEY AND BANKING – B.COM PART 1

DEFINITION

Money has been defined differently by different economists.

1. Descriptive Definitions

2. Legal Definitions

3. General Acceptability Definitions

DEFINITIONS

(1) Descriptive definitions

“Anything that is generally acceptable as a means of exchange and that at the same time acts as a measure and store of value.” – Crowther in his book: An outline of money

“Money may be defined as a means of valuation and of payment” – Coulborn

“Money is anything that is widely used as a mean of payment and is generally acceptable in settlement of debts.” – Cole

These are considered narrow and partial definitions, because they focus on the functions of money and not on what money is

DEFINITIONS

(2) Legal Definitions:

“Anything which is defined by the state as money is money” – Professor Knap

Professor Hartley believes that money should be legal tender.

These are narrow definitions based on “state theory of money.”

The government can not force the people to accept money. e.g. German currency Mark

DEFINITIONS

(3) General Acceptability Definitions:

“Money is anything which is commonly used and generally accepted as a medium of exchange or as a standard of value.” – Kents

Money is described as “anything which is widely accepted in payment of goods or in discharge of other kinds of business obligations,” by D.H. Robertson.

“Money is anything that is generally accepted in payment of goods and services or in the repayment of debts.” – E. Mishkin

Money here, is defined as anything which has general acceptability.

“MONEY IS ANYTHING THAT IS REGULARLY USED IN ECONOMIC TRANSACTIONS AND SERVES AS A MEDIUM OF EXCHANGE, A UNIT OF ACCOUNT AND A STORE OF VALUE.”DEFINITION OF MONEY

ORIGIN OF MONEY

Money has evolved through five different stages during history:

1. Commodity money

2. Metallic money

3. Paper money

4. Credit money

5. Electronic money

ORIGINS OF MONEY

1. Commodity money:

Commodity money has a value apart from its use of money.

A large number of items such as cows, goats, sheep, rice, grains, etc were used

However they lacked storage capability, durability transportability, divisibility, and homogeneity.

ORIGINS OF MONEY

2. Metallic money:

Coinage: gold and silver were used as coins, stamped by a competent authority.

As time passed, transportation and storage of coins became inconvenient and dangerous

ORIGINS OF MONEY

3. Paper Currency:

Paper currency is made of paper and functions as a medium of exchange

Initially paper currency carried a promise that it was convertible into a fixed quantity of precious metallic gold and silver

This promise was eliminated in 1914 in England and in 1933 in America.

Fiat money: this newspaper money which is considered legal tender because the government says it is money. It has no backing of gold, silver or government securities

ORIGINS OF MONEY

4. Credit money or bank money:

Bank money is the use of cheques as the medium of exchange.

Cheques have made it possible an easier to make transactions for large amounts. They are easier to transport.

They are safe and provide receipts

Checks are not legal tender. They cannot be enforced in payments of debts

ORIGINS OF MONEY

5. Electronic banking stage:

This is a modern system of transferring funds using Electronic Communications.

Payments are now made through magnetic strip cards such as bank debit cards, credit cards, telephone cards etc.

This form of banking has reduced processing costs, lead times for payments and increasing flexibility.

These are also not considered legal tender

FUNCTIONS OF MONEY

Primary Functions of Money

• Money as a medium of Exchange• Money as a unit of account• Money as a standard of deferred payments• Money as a store of value

Secondary Functions of Money

• Aid to specialization, production and trade• Influence on income & consumption• Money is an instrument of making loans• Money as tool of monetary management• Instrument of economic policy

Contingent Functions of Money

• Distribution of national income• Basis of credit system• Measure of marginal productivity• Liquidity of property

PRIMARY FUNCTIONS OF MONEY1. Money as a medium of Exchange

Used to pay for goods and services

Overcame double coincidence of barter system

Introduced time efficiency of exchanging goods and services

Encouraged division of labour. People are now specializing due to easier payment of services rendered..

2. Money as a unit of account Common measure of money.

Used to compare goods in terms money

3. Money as a standard of deferred payments Money is useful in the purchasing goods on credit as it is easy to borrow-and lend

4. Money as a store of value Does not deteriorate and stores value

SECONDARY FUNCTIONS OF MONEY

Money has the potential to influence an economy, by influencing interest rates, price levels, resources, etc.

1. Aid to specialization, production and trade

2. Influence on income & consumption

3. Money is an instrument of making loans

4. Money as tool of monetary management

5. Instrument of economic policy

CONTINGENT FUNCTIONS OF MONEY

Contingent functions are derived from primary & secondary functions

Distribution of national income

Basis of credit system in banks

Measure of marginal productivity

Liquidity of property

QUALITIES OF A GOOD MONEY SYSTEM

The term monetary system refers to the type of standard money used for making payments. It refers to the value of money, organization, arrangement, control and management system of money.

1. Simplicity

2. Elasticity

3. Economical

4. Price Stability

5. Legality

6. Liquidity

7. Full employment

INFLATION

Inflation is a continuous upward movement in the general (average) level of prices.

Two causes:

1. Demand Pull Inflation

2. Cost Push Inflation

DEMAND PULL INFLATION

When aggregate demand increases faster than aggregate supply of goods and services, prices will increase and inflation occurs.

Also called aggregate demand inflation.

Occurs when there is excess demand for output.

Sources of rise in demand pull inflation Monetarist view: (Million Friedman)

If central bank issues and prints more money into the economy than its demand.

Non monetary view: (J.M. Keynes)

Increase in purchases of goods and services due to increase in wealth.

Higher business investments

Increase in government expenditures

Foreign demand for country’s goods.

COST PUSH INFLATION

Cost push inflation occurs when prices are forced upward by increases in the cost of factors of production and not by excess demand.

Sources of increased costs are:

1. Increase in money wage rates

2. Profit push inflation

3. Material push inflation

4. Higher taxes

5. Rise in import prices

REMEDIES OF INFLATION

1. Monetary Policy It is a policy which influences the economy through changes in the money supply and available

credit.

2. Fiscal Policy

1. Change in taxation

2. Changes in government expenditure

3. Public borrowing

4. Balanced budget changes

5. Control of deficit financing

REMEDIES OF INFLATION

3. Other measures

i. Price support program

ii. Provision of subsidies

iii. Arrangements of easy availability of goods on hire purchase to stimulate demand

iv. Imposing direct control

v. Rationing of essential consumer goods in case of acute emergency through holding of Friday and Sunday markets

INFLATION & DEFLATION

Inflation

Deflation

DEFLATION

Deflation refers to the situation where price level fall is causing major increase in unemployment, reduction in output and decrease in the income off the people.

“Deflation is that state of the economy where the value of money is rising or prices are falling.” -- Crowther

CAUSES OF DEFLATION

When the level of money income falls relatively to the current supply of goods and services.

Deflationary process may occur due to: Fall in private investment

Persistent unfavorable balance of payments

Continued government-budgetary surplus

Sudden increase in the total output

By action of central bank to raise the discount rate or by selling securities

All are due to the combined effect of all of these factors

REFLATION

A real Reflation is a sustained rise in the general level of prices.

It is a situation all rising prices after the full employment is reached. This phenomenon is due to increased in aggregation demand without any increase in production of goods and employment.

The solution is the result of efforts made by the government to lift the economy out of depression.

REFLATION

Similarities between inflation and reflation:

The money supply increases

Upward movement of general price level

Differences between inflation and recreation:

Inflation causes a serious problem of rising prices without any increase in output and employment, whereas reflation leads to more production and employment.

Reflation is adopted by the government.

It takes place below the level for employment

Prices rise very slowly under reflation, but very rapidly under inflation.

DEVALUATION

Devaluation is the a reducing of value or exchange rate of national currency with respect to other foreign currencies.

Under the fixed exchange rate system, the exchange rate is determined by the demand for and supply of foreign exchange.

DEVALUATION

Depreciation is the lowering of currency value in a free-floating exchange rate system.

Devaluation is the lowering of currency value in a fixed exchange rate system.

VALUE OF MONEY

Value of money refers to its purchasing power: that is its capacity to command goods in exchange for itself.

Value of money is high if it buys more commodities. And vice versa.

The value of money varies inversely with the general level of prices.

VALUE OF MONEY

1. Quantity theory of money

2. Cash balance theory of money

3. Modern quantity theory of money

QUANTITY THEORY OF MONEY

In the 16th century, gold and silver inflows from the Americas into Europe were being minted into coins, because of which there was a resulting rise in inflation.

Changes in money supply will directly impact both prices and inflation rates.

The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. 

According to QTM, if the amount of money in an economy doubles, price levels also double and value of money is halved.

TOTAL MONEY SUPPLY SHIFT IN MONEY SUPPLY

QUANTITY THEORY OF MONEY

Irving Fisher studied and derived an equation to demonstrate this effect, based on:

a) Supply of money

• Total volume of money in circulation during a time period = MV

• M: quantity of money in circulation

• V: Velocity of money in circulation

b) Demand of money

a) People demand money for the means of exchange.

QUANTITY THEORY OF MONEY

Equation of Exchange:

or

P is the price LevelM is the quantity of moneyV is the velocity of circulation is the volume of credit money is the velocity of circulation of T is the total volume of goods and Trade

QUANTITY THEORY OF MONEY

Assumptions:

Full employment: The theory is based on the assumption of full employment in the economy.

T and V are constant: The theory assumes that volume of trade (T) in the short run remains constant.  So is the case with velocity of money (V) which remains unaffected.

Constant relation between M and M1. Fisher assumes constant relation between currency money M and credit money (M1).

Price level (P) is a passive factor. The price level (P) is inactive or passive in the equation. P is affected by other factors in equation i.e., T, M, M1, V and V1 but it does not affect them.

CASH BALANCE APPROACH

Fisher’s Transaction Theory Cash Balance Approach

Based on medium of exchange function of money

Based on store function of money.

Demand for money Demand for cash balances

Focuses on demand/supply over period of time

Focuses on demand/supply at particular point of time.

Demand for money increases; Price level increases

Demand for money increases; Price level decreases because of decrease in expenditures

CASH BALANCE THEORY OF MONEY

Cambridge Equations:

Alfred Marshall’s Equation:

M = K P y

Keyne’s Equation:

n = P k

M : quantity of moneyP : price levely: aggregate real incomeK : fraction of real income which people wish to hold in money form

P : price level of consumption goodsn : total supply of money in circulationK : total quantity of consumption units which people wish to hold in cash

MODERN THEORY OF VALUE OF MONEY

Wealth Theory of Demand:

Money is a durable consumer good held for the services it renders

The demand of money depends on volume of total demand, and relative returns on the different forms of assets.

Assets can be held in form of: money, bonds, equities, physical goods & human capital.

Money Demand Equation:

Demand for money is a function of permanent income ( resources available to individuals, and expected returns on other assets)

VALUE OF MONEY

• Irving Fischer

Quantity Theory of Money

• Cambridge Economists: Keynes, Marshall

• M = K P y• n = P kCash Balance Approach to Money

• Milton Friedman

Modern Theory of value of money

MONETARY POLICY

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability

The official goals usually include relatively stable prices and low unemployment.

MONETARY POLICY

Objectives:

1. Promoting high employment

2. Achieve a steady economic growth

3. Stable price level as a goal

4. Stability in interest rate

5. Promoting a more stable financial market

6. Stability in the foreign exchange markets

MONETARY POLICY

Expansion

• increases the total supply of money rapidly

• combat unemployment in a recession by lowering interest rates

Contraction

• expands the money supply more slowly than usual or even shrinks it

• slows inflation to avoid the resulting distortions and deterioration of asset values.

MONETARY POLICY

Quantitative controls Qualitative controls

Open market operations Varying margin requirements

Variation in the bank rates Consumer’s credit regulation

Credit rationing Use of moral persuasion

Varying reserve requirements Direct action

KINDS OF PAPER MONEY

1. Representative paper money This type of money is fully backed by metallic money

It possesses all the fundamentals qualities of a good money system

2. Convertible paper money It is money which Carries a promise by the issuer that the paper can be converted into the standard

money metal at some future date.

In actual practice, the state bank never keeps a 100% metallic result. It is always less than 100%.

State bank of Pakistan does not issue this kind of money

3. Inconvertible paper money This money cannot be converted into standard money metal

It is regulated by the law of state, and is also called Fiat money

PAPER MONEY

Advantages Disadvantages

Economical Danger of inflation

Elasticity of money supply Internal price instability

Promotes economic growth Exchange instability

Internal price stability Dangerous of mismanagement

Helpful in emergency Fear of demonetization

Regulation of exchange rates Use within the country

Uniform quality