CHAPTER 1: MONEY MONEY AND BANKING – B.COM PART 1
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CHAPTER 1: MONEYMONEY AND BANKING – B.COM PART 1
DEFINITION
Money has been defined differently by different economists.
1. Descriptive Definitions2. Legal Definitions3. 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 money2. Metallic money3. Paper money4. Credit money5. 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 trade2. Influence on income & consumption3. Money is an instrument of making loans4. Money as tool of monetary management5. 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. Simplicity2. Elasticity3. Economical4. Price Stability5. Legality6. Liquidity7. Full employment
INFLATION
Inflation is a continuous upward movement in the general (average) level of prices.
Two causes:1. Demand Pull Inflation2. 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 rates2. Profit push inflation3. Material push inflation4. Higher taxes5. 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 taxation2. Changes in government expenditure3. Public borrowing4. Balanced budget changes5. Control of deficit financing
REMEDIES OF INFLATION
3. Other measuresi. Price support program ii. Provision of subsidiesiii. Arrangements of easy availability of goods on hire purchase to stimulate demandiv. Imposing direct controlv. 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 money2. Cash balance theory of money3. 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 moneya) 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 employment2. Achieve a steady economic growth3. Stable price level as a goal4. Stability in interest rate5. Promoting a more stable financial market6. 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 MONEY1. 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 MONEYAdvantages Disadvantages
Economical Danger of inflationElasticity of money supply Internal price instabilityPromotes economic growth Exchange instabilityInternal price stability Dangerous of mismanagementHelpful in emergency Fear of demonetization Regulation of exchange rates Use within the countryUniform quality
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