<h5 id="31-functions-of-money">3.1 Functions of Money</h5> <ul> <li>Money acts as a medium of exchange, simplifying transactions by replacing barter exchanges which are difficult in large economies due to high costs incurred in seeking suitable persons to exchange surpluses.</li> <li>Money is a convenient unit of account, allowing the value of all goods and services to be expressed in monetary units, enabling calculation of relative prices and value of money in terms of other commodities.</li> <li>Money acts as a store of value, allowing wealth to be stored in the form of money for future use. Its non-perishable nature, lower storage costs, and universal acceptability make it more advantageous than other assets like gold, landed property, houses, or bonds.</li> <li>A rising price level can deteriorate the purchasing power of money, as a unit of money can purchase less of any commodity when prices increase, indicating a decrease in the value of money.</li> <li>Some countries are moving towards cashless societies, with financial transactions conducted through digital information transfers instead of physical bank notes or coins, with India investing in reforms for greater financial inclusion through initiatives like Jan Dhan accounts, Aadhar enabled payment systems, e-Wallets, and National financial Switch.</li> </ul> <p>======</p> <h5 id="32-demand-for-money-and-supply-of-money">3.2 Demand for Money and Supply of Money</h5> <ul> <li>The quantity of money demanded (L) is determined by the public’s income and transaction needs, represented as L = k*Y, where ‘k’ is the proportion of income people want to hold as money and ‘Y’ is the national income.</li> <li>The quantity of money supplied (M) is controlled by the central bank through monetary policy, often represented as M = M0*m, where ‘M0’ is the total amount of money the central bank can create and ’m’ is the money multiplier.</li> <li>The equilibrium in the money market occurs when money demanded equals money supplied (L = M), which helps determine the interest rate and the level of economic activity.</li> <li>The money market is interconnected with other financial markets, such as the bond market, where changes in interest rates can influence investment decisions and economic growth.</li> <li>The supply and demand for money can be affected by factors such as inflation, economic growth, and central bank policies, leading to adjustments in money supply and equilibrium interest rates.</li> </ul> <p>======</p> <h5 id="321-demand-for-money">3.2.1. Demand for Money</h5> <ul> <li>The demand for money is determined by the value of transactions, which in turn depends on income.</li> <li>An increase in income leads to a rise in demand for money.</li> <li>The quantity of money demanded also depends on the rate of interest.</li> <li>When interest rates increase, people are less interested in holding money as it means less interest earned.</li> <li>Therefore, higher interest rates result in a lower demand for money.</li> </ul> <p>======</p> <h5 id="322-supply-of-money">3.2.2. Supply of Money</h5> <ul> <li>In a modern economy, money comprises cash and bank deposits, and is measured in different ways based on the types of bank deposits included.</li> <li>The system creating money involves two types of institutions: the central bank and the commercial banking system.</li> <li>The central bank, a vital institution in a modern economy, issues the country’s currency, controls the money supply, acts as a banker to the government, and is the custodian of the economy’s foreign exchange reserves.</li> <li>Commercial banks accept deposits and lend out part of these funds to borrowers, earning a profit from the difference between the interest paid to depositors and the rate charged to borrowers.</li> <li>The bank deposit and loan creation process involves banks loaning out funds, with the potential to create money through the issuance of paper receipts or demand deposits, while ensuring sufficient funds are available to repay depositors on demand.</li> </ul> <p>======</p> <h5 id="33-money-creation-by-banking-system">3.3 Money Creation by Banking System</h5> <ul> <li>Banks can create money by lending, as they don’t expect all depositors to withdraw their deposits simultaneously.</li> <li>The money supply increases with old deposits plus new deposits (plus currency) when a bank lends to someone.</li> <li>A bank’s assets include loans given to the public, reserves (deposits with the Central bank, cash, and financial instruments), and buildings/furniture.</li> <li>A bank’s liabilities are mainly deposits kept by people. The accounting rule states that Assets = Reserves + Loans and Liabilities = Deposits.</li> <li>Net Worth is calculated as Assets - Liabilities, which should balance per accounting rules.</li> </ul> <p>======</p> <h5 id="331-balance-sheet-of-a-fictional-bank">3.3.1 Balance Sheet of a Fictional Bank</h5> <ul> <li>The text is about the money supply in an economy.</li> <li>Two components of money supply are considered: reserves and deposits.</li> <li>In this case, reserves are 0 (Rs 100) and deposits are 100 (Rs 100), leading to a net worth of 0 (Rs 100).</li> <li>The total money supply (M1) is calculated as the sum of currency and deposits, which is 100 (Rs 100).</li> <li>The total money supply equals the deposits component in this scenario, as there is no currency in circulation.</li> </ul> <p>======</p> <h5 id="332-limits-to-credit-creation-and-money-multiplier">3.3.2 Limits to Credit Creation and Money Multiplier</h5> <ul> <li>The bank is expected to keep 20% of its deposits as reserves, which in this case is Rs 100 (20% of Rs 500).</li> <li>This reserve can support deposits of Rs 500, allowing the bank to give a loan of Rs 400.</li> <li>The money supply increases from Rs 100 to Rs 500 due to the deposit.</li> <li>The requirement of reserves acts as a limit to money creation, in this case, the bank cannot give a loan beyond Rs 400.</li> <li>The money multiplier is calculated as 1/Cash Reserve Ratio, in this example, it is $\frac{1}{0.2}$=5. This means reserves of Rs 100 can create deposits of Rs 500.</li> </ul> <p>======</p> <h5 id="34-policy-tools-to-control-money-supply">3.4 Policy Tools to Control Money Supply</h5> <ul> <li>The Central Bank controls the money supply in an economy through quantitative and qualitative tools.</li> <li>Quantitative tools include changing the Cash Reserve Ratio (CRR), bank rate, or open market operations.</li> <li>Qualitative tools involve persuading commercial banks to alter their lending practices through moral suasion or margin requirements.</li> <li>Open Market Operations refer to the buying and selling of government bonds by the Central Bank, impacting the money supply through reserve increases or decreases.</li> <li>The Central Bank can influence money supply by adjusting the bank rate, which affects the cost of loans to commercial banks and thus their money supply.</li> <li>The velocity of circulation of money refers to the number of times a unit of money changes hands during a unit period of time, and is inversely related to the reserve ratio.</li> <li>The total transaction demand for money in an economy is directly proportional to the total value of transactions and the average price level, and inversely proportional to the transaction deposit rate.</li> <li>The speculative demand for money is inversely related to the rate of interest, as people convert money into bonds when interest rates are low and expect them to rise, and sell bonds when interest rates are high and expect them to fall.</li> <li>The total demand for money in an economy is the sum of the transaction demand and speculative demand, and is directly proportional to real GDP and price level, and inversely related to the market rate of interest.</li> <li>Money supply measures include M1 (currency plus demand deposits), M2 (M1 plus savings deposits with Post Office savings banks), M3 (M1 plus net time deposits of commercial banks), and M4 (M3 plus total deposits with Post Office savings organizations excluding National Savings Certificates).</li> </ul> <p>======</p>